Live Chat: ETFs' Role In Credit Sell-Offs

July 25, 2019

[Editor's note: Join us for a weekly Live Chat! with Managing Director Dave Nadig.] 



Dave Nadig: Hey folks, welcome back to Live!
As always, you can type your questions in the box below, and I'll get to as many as I can in the next half hour or so.
We'll post a transcript shortly after as well, in case you miss anything.
So with that, let's get rolling.


MusicMan: And Dave's weird music of the day is ...
Dave Nadig: So, I've been on a Sleater-Kinney kick, which led me to this local band from the area that I'm enjoying:
"Dump Him" is the band.
But on to the ETF stuff!


Aya Jamison: Good morning Dave, is robo advisory sustainable? Only the very few largest have yet made a profit.
Dave Nadig: So, providing a financial intermediation service for around 25 bps seems very sustainable.
The question is, "for who"? I think it's a very tough business to start from square one.
Ultimately, the tech behind a robo isn't rocket science, so it's much more about marketing, packaging and distribution (as a business) than it is about managing assets.
So while I think some of the early players like Betterment or Wealthfront have a shot at long-term sustainability (or acquisition), I don't think I'd be backing a startup today, especially now that the market has figured out this model, and folks like Schwab are offering pretty good services effectively for free (or, if you're a cynic, for the cost of leaving a small cash balance with Schwab at below-market interest rates).
I think the space evolves a lot, however, and migrates more toward unique offerings like ESG-centric direct indexing.


Naomi: Why do some think ETFs could exacerbate a credit sell-off?
Dave Nadig: So, the credit markets (particularly things like bank loans, floaters and junk) are inherently illiquid.
When you wrap them in an ETF, you get a secondary liquidity layer. But ultimately, just because that wrapper CAN be more liquid and much easier to trade than the underlying securities (because ETFs are exchange traded, not OTC) doesn't mean price discovery is magically different.
So if everyone wants to SELL, say, junk bonds, a lot of that selling will happen quickly, in the most liquid vehicle: ETFs.
The underlying bonds, however, might not even trade in that moment, so the ETF will "seem" to trade lower than the last (stale, wrong) price of the bonds.
So it looks like the ETF is "driving down" the prices. What it's actually doing is just REFLECTING the market much more quickly and accurately than the underlying holdings.
The alternative is actually much worse. If junk bonds could, for example, only be held by private investors and not in any funds, and they all wanted out, well, then it's a complete fire sale market, where only some incredibly deep pocketed bank could be the buyer of last resort.
The ETF, at least, lets the sellers find buyers.


Gary Latham: Do you think quantitative easing will start again?
Dave Nadig: Hi Gary, I assume you mean in the U.S.
In Europe, it's essentially already starting. There's discussion just today about the ECB buying bonds.
In general, I would expect U.S. QE to be a bit of a last resort. Certainly it would come AFTER interest rate cuts. So I don't see any reason for it to be imminent without some kind of monster crisis.


Robert: I read on one of the cannabis ETFs is using swaps rather than purchasing shares of the cannabis companies themselves. What's the difference between a swap and stocks?
Dave Nadig: So, the best way to think about a swap is that it's a bar bet. You and I set the terms: If this basket of (in this case, pot stocks) goes up, you owe me the difference between yesterday and today. If it goes down, I owe you. And we settle up every night, moving some cash between two accounts.
Now, one of us (the one providing the long exposure (so in this case, you) will hedge the risk of the stocks going up by just buying the stocks!
So it's a way for me to get what I want (long exposure to a basket of pot stocks) without having to TECHNICALLY own those stocks.
Swaps get used anytime the underlyings are problematic or complicated (think managing a daily basket of rolling VIX futures, for example).
In this case, I suspect it's also an issue of custodyship.
So the swap counterparties don't HAVE to own anything, but generally the one offering the "long leg" of the swap goes and hedges by buying the long underlying (or some sort of proxy).
But technically, you can write a swap contract to cover anything you can measure: temperature, polling numbers, etc.


Willie N.: Do you foresee the market becoming saturated with pot ETFs?
Dave Nadig: Well I think we're up to three now? MJ, YOLO, THCX and now TOKE.
That seems pretty saturated when you consider there are only a few dozen stocks of note worth chasing in the space.
So I think it's pretty unlikely we get a LOT more here.


J. Gross: Hello Dave, Vanguard just introduced a new commodity mutual fund that tracks the Bloomberg Commodity Total Return Index. It is priced at 20 bps - do you think this might spur some price competition in the ETF space? There are a number of ETFs that track this same Bloomberg commodity index (Graniteshares, iShares). Do you think any other indexes may show up in some new funds?
Dave Nadig: Commodities, while having a special place in my heart, are still a pretty niche asset class.
So I think it's unlikely we get a huge rush of new competitors unless we have a huge run in commodities as a broad basket.
Graniteshares is clearly in the fee competition business, so if Vanguard started offering up the new fund in an ETF (I'm not clear on whether they are right now), then I would expect them to respond.
As for new indexes, the BB is pretty much the second standard after the GSCI, and everything else is some form of smart beta really: managing tenors or using signals to pick the individual commodities.
Some of these, like USCI, have had their moments in the sun, but it gets pretty nichy pretty fast.
(On cannabis, several of you pointed out I missed CNBS! Which is what I get for going on vacation for a week!)
So five cannabis ETFs!


Todd Rosenbluth - CFRA Research: Hi Dave. How do you think ETF investors should track earnings season? MSFT or AMZN can be pretty big weights in many ETFs, particularly sector or style ones, but some investors are buying and holding for the longer term.
Dave Nadig: Well, the honest truth (which I am going to guess you agree with Todd!) is that if you're a long-term investor, you should mostly ignore earnings season.
Any information from earnings gets priced in essentially instantly, certainly before an individual investor can "trade" on it somehow.
Which means if TSLA gets slammed, it will go down in your portfolio, whether you're in SPY or RVRS, at least on that day.
But the bigger issue, of course, is just minding your concentration. Yes, firms like AMZN and AAPL are a HUGE part of some major indexes.
The good news is it's pretty easy to monitor at least one fund at a time. If you go to, you can see what it holds.
And if you're curious, you can go the other direction too ...
... and see who owns how much of something.
In general, the more narrow the fund, the bigger issue this can be: Google shares are now something like 25% of the communications ETFs, for example.


Marshall T.: Why are silver ETFs suddenly so attractive?
Dave Nadig: So I see silver as sort of a "bridge metal." It still gets lumped in as a precious metals play and all that entails (inflation hedge, guns-and-butter panic store of value, all that), but at the same time, silver actually gets used a lot more in industrial applications and is less tied to the vagaries of things like the Indian wedding season.
More recently, silver lost some of its connection to gold, so this can be seen as a bit of a rubberbanding back to how gold's been doing, Mario Kart style.
I think that's really it.
OK, last question, and it's a doozy:


Nemo: Is there any connection between the price of traditional leverage and the price for implicit leverage through options? If so what is the mechanism of transference?
Dave Nadig: OK, strap in, because this isn't the simplest answer.
So first off, buying options inherently involves some leverage. If the call option on a $100 stock is (making things up) $5, well, you need to know a few more things.
The first is the delta of the option.
The delta is the ratio of a price move in the underlying to a price move in the option price itself.
So, if the delta of our option is, say, .5, then we can say that the implied leverage is .5, times the price of the stock (so, in this case, $50), and then divide that by the price of the option itself, to get your implied real leverage.
So the math would come to 10, or 10X implied leverage here.
So that's where you start.
The second part here is how that ties to interest rates.
All else equal, call options get more valuable because of this leverage.
So in this case, since we know our option has a 10X implied leverage, for a $10,000 notional exposure, we can stick $9,000 in something ELSE, and let our $1000 option position do the work.
If we're in a high interest rate environment, you make more parking that $9K.
(And in lower interest rate environments, that becomes less attractive.)
Puts essentially have the opposite for the same reasons.
Then, last (and yeah, this is a firehose), there is a Greek measurement for how interest rate sensitive a given option position is, which is (and boy I hope I'm remembering this right) Rho.
It tells you in dollar terms (if I'm remembering right) the price movement in the option for a 1% move in interest rates.
Rho/delta (and all the other greeks) are something you should really learn if you're going to trade options regularly, and it goes FAR beyond what I'm covering here.
The OIC is a great place to start there (or the website of our parent company,

OK, with that mind-bender, I'm going to wrap it up for the day. Thanks for the great questions, and we'll see you same time next week!

Have a great afternoon.

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