Live Chat: How Buffer ETFs Work & Ticker Talk

October 30, 2019

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

Dave Nadig: Good afternoon, and welcome back to Live!
As always, you can enter your questions below, and I'll get to as many as I can in the next half hour.
So fire them questions in, and I'll get started here.
First off, soundtrack: no link today, but I've been jamming on Father John Misty.

John: Why are these buffer ETFs tied to months of the year, do they expire? I don't understand why I can't buy a buffer fund without a certain month associated with it.
Dave Nadig: So, we're talking here about the Innovator Defined Outcome ETFs, like BOCT.
The reason they’re tied to a year is that on a specific day (the launch day), the exposure is essentially fixed at the "headline" level, and the fund uses flex options tied to a one-year holding period to achieve its buffers.
So for example, in the case of BOCT, it has insulation from the first 9% of downturn, but in return, a cap of 15% (if I’m remembering right) on your upside.
That’s true on the day in October it resets.
As soon as the next day happens, while the "end date" remains the same, some amount of the upside cap or downside buffer gets "used" because the market moves.
So for instance, right now if you buy BOCT, which just reset on October 1, you have a buffer of 9.34%, and a cap of 12.47%.
You can always check by going to the innovator website:
Hope that helps.

Todd Rosenbluth - CFRA Research: Hi Dave. Another month nearly complete and fixed income ETF demand remains strong. Do you think the popularity continues in 2020, or is this specific to Fed actions in 2019?
Dave Nadig: Well, certainly being in a declining rate environment is good for people who are already in a bond fund of almost any kind, because the principal value will go up to offset the new, lower rate offered by competing bonds.
But I also think fixed income ETFs have come out of the shadows a little bit. Certainly commission-free trading helps there, for rebalances or "parking" in shorter-duration funds.
So I don't really expect much to be different in 2020. I mean, it’s just crystal ball time. I can paint a story of "actually the data isn’t so bad, no recession, pile into stocks!"
And I can also see exactly the opposite. Sooooo many unknowns right now.
But I think the more time passes, the more comfortable people get with ETFs, period. Fixed income came on slowly in ETFs, and I think it's sort of finally at "appropriate" flow levels.

Axel R.: Any downsides regarding target date funds?
Dave Nadig: Well, aside from the fact there now aren't any target date ETFs!
But all kidding aside, I think target date funds are FANTASTIC for certain uses. It's my default recommendation to younger folks just getting into a 401(k), for instance.
And while many of them are a bit too expensive, they're all better than not being invested at all, or being stuck on one end of the barbell (leaving it in cash, sticking it all in the S&P 500, which may folks end up doing).
Until the advent of commission-free trading, dollar cost averaging schemes, like 401(k)s, were really a terrible fit for ETFs. But I think that's changing.
Which leads to this question:

Freeloader: So, everything trades free, and now with fractional shares. Does this have any real impact on the ETF market?
Dave Nadig: For 25 years, the big advantage traditional mutual funds have had over ETFs has been twofold: fractional shares and the friction of trading.
The recent moves by brokers (Schwab in particular) are eroding that very, very quickly.
So if free and fractional becomes the industry default (which I suspect it will), then there's really not much advantage in being in a traditional fund.
They won't just disappear, but I think it just further accelerates ETF adoption.
(Add in the introduction of nontransparent, well-known active managers later this year, and I think we're in for a growth spike!)

Tom: What are the mechanics behind the steady massive short interest in the retail ETF XRT? How can there always be more shares shorted than outstanding?
Dave Nadig: SUPER nerdy question. Here's my understanding (and please, if you read this, and know better, email me!)
But what I've been told is that when reg SHO passed (which prohibited naked shorting by anyone other than market makers actually making markets), there was a grandfathering of some existing short positions. Those positions have effectively bounced around from firm to firm, as they seek locates on the shares. So the short positions do in fact exist, and are likely just hedged out on various people’s books.
Perhaps because it's cheaper to hold a short, and a hedge, then it is to unwind the position.
But XRT has been the weird anomaly for at least 10 years.
But it's a bit of a white whale among us deep ETF nerds—really teasing out the who and when of it all.

Marisol: What criteria should investors look for in a robo advisor (as perhaps compared to a “human” financial advisor?)
Dave Nadig: With everyone and their uncle offering a robo-type platform, I think it's reasonable to be skeptical, particularly if the robo is "free."
Since nothing is truly free, ask yourself where the company you’re looking at is making money.
The poster child here to me is Schwab. They offer a free robo, but they put you in their ETFs (so they make some bps there), and they put you in too much cash, offsetting that cash with (presumably) riskier fund positions.
So you may end up with the same portfolio risk; you’re just getting there in an odd way.
Why do they do that? To make money on the difference between the cash position and what they can get in the short-term market investing it themselves (they keep the spread).
So, to me, that's No. 1: Ask how they're getting paid.
And from there, I'd take a smell-test of the recommended portfolio, and ask if you think it makes sense to you, and then whether the services they're going to provide (rebalancing, etc.) are worth the outright costs.

Guest: Is it more beneficial to invest in REITS, or REIT ETFs?
Dave Nadig: My answer is pretty much the same for every asset class: Do you really want to be invested in single securities?
Diversification is generally a good thing, and particularly with REITs, there can be some single-REIT risks.
So I guess I'd turn it around: Why not invest in a REIT ETF? Do you think you really have the ax on getting the undervalued REIT that the rest of the market is mispricing?
If not, are you going to play one REIT against another somehow, say, making a call on retail vs. health care or something?
It's the same with buying bonds or buying stocks: If you don’t have an edge, diversification is your friend.
(And there are some quite cheap REIT etfs out there now.)

ETF Bro: Any issues owning an ETF that has a large majority shareholder? Specifically, with BYOA, should this be a concern for average investor?
Dave Nadig: Generally, I wouldn't worry about this, because 99% of ETFs are structured like mutual funds, with an independent board.
And for the most part, the board of an ETF doesn't have many tricky decisions to make where you'd be worried about undue influence or anything.
If anything, I would think a firm that has successfully launched a BYOA-type product to their own platform is showing they're eating their own cooking. That's often a pretty good stamp of approval and a sign the firm will stick by the products.
All else equal, there's some comfort in being in a fund with a larger asset base than a smaller one (not that’s in any way prescriptive; I'm just saying if you literally had a choice of being in the exact same fund, at $100 million or $500 million, why not be in the larger one?)
So for me, no real concerns at all.

J. Gross: Hello Dave. Vanguard just posted their updated annual reports for their S&P 400 and S&P 600 ETFs. The expense ratios for both funds are about to be lowered to 0.05%. iShares still has these two funds (as part of their core suite of ETFs) with expense ratios of 0.07%. Do you think that this might finally nudge BlackRock to take another look at their core suite and decide to reduce some expense ratios? In my opinion, they have been laggards with respect to reducing expenses.
Dave Nadig: Mostly this feels like it's not worth bothering.
Do you really think that 2 bps is going to make a big difference in anyone’s buying decisions?
I mean, it's an annual cup of coffee on a large position.
So I kind of think once you’re down around/under 10 bps, this is really just noise for most people.
Sure, if you’re the $1 trillion Norwegian sovereign fund, a basis point makes a real difference in your operating budget.
But for even a large investor with a few-million portfolio, it’s such a small amount of difference. Generally it will be completely overwhelmed by tracking difference noise—small variations in how rebalances are handled, taxes are recaptured, and so on.

Troy Campbell: Any idea if the IRS is currently “addressing” taxpayers’ crypto use, and if not, if they plan to in any way? What do you see as the issue, that taxpayers may be receiving income in that way, and they need to be taxed on it, or …?
Dave Nadig: Hi Troy. So the IRS has actually been really clear about this I think. One sec:
Yeah, this was all the way back five years ago:
Bitcoin is specifically called out here as being just an asset. So you have to treat it like any other piece of property.
If it’s your actual business (mining) you have to treat it as income when received, etc.,
same with capital gains.
I very seriously doubt they're going to give much more guidance than that.
Now, less honest folks might say, "Well, how will they know?" but that's between you and your accountant. And possibly your audit defense attorney ...
But for sure, trading bitcoin isn't any different than trading stocks, bonds, art, real estate or beanie babies. It's all taxable property transactions.

Ty: ETFs with cute tickers and clever marketing get plenty of media attention, but how do they really fare?
Dave Nadig: Heh.
There's no question clever tickers matter in the short term. They really matter for early adopters (MJ, HACK, etc.).
But outside of niche stories, I don't think they make or break a fund.
Put another way: Of course a ticker shouldn’t matter. At all. Ever. But they do because we're human beings with short attention spans. And you're more likely to remember, say "PBJ" as the ticker for a food and beverage ETF, or MOO for an agg ETF, than some random collection of letters.
But I will tell you: Issuers agonize over tickers. So it's real.

Tony: Do international equity ETFs use ADRs and foreign-listed shares interchangeably, or are there any distinctions that matter meaningfully?
Dave Nadig: Meh. At the end of the day, you're getting exposure to the movement of the underlying. If you're not planning on doing anything with currency hedging, it's largely the same. The ADR bakes the currency in (instead of forcing the portfolio manager to convert to, say, euro, and then invest in the local currency).
The biggest issue is that if you’re limited to ADRs, you are by definition not getting exposure to the totality of whatever theme you’re chasing. Not every international company has a liquid ADR. Not by a long shot.
So the presence of an ADR? Fine. The use of only ADRs to get international exposure? Limiting.

OK, that's a wrap for today. Sorry if I didn’t get to your questions (some good ones in the hopper still). But I should be back next Thursday afternoon, so hopefully we can hit them then.

I should have a transcript up shortly, in case you missed anything here.

Thanks for coming, and have a great rest of the week.

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