Live Chat: Keys To 'ETF Rule' & Bitcoin Setback

October 10, 2019

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

Tactical Allocator: Any thoughts on two new allocation ETFs, LGH & QQH, that Heather Bell reported on today? How hard is it for a new ETF issuer that is tactical and expensive to gain traction with investors?
Dave Nadig: So, these are two new funds from Howard that I classify as "flippers" in that they use signals to get in or out of the market.
While I'm always rooting for new players, I have to say, this strikes me as a set of pretty tough launches.
They charge 1.36%. There's no way to look at that and not pause a bit.
That's an extraordinarily high expense ratio for an ETF. And a very high hurdle for their strategy to beat. I suspect (and for their sake, hope) that they believe they already have distribution lined up.
Most funds coming to market like this (relatively unknown, relatively expensive) have been able to gain some traction by leaning on existing relationships. Perhaps there are institutional clients or advisors who are already in a similar strategy through SMAs or mutual funds that will migrate.
So, while I respect anyone's ability to charge what they think their intellectual property is worth, I have to say, this seems like a BIG hurdle to overcome.


ETF Bro: Not sure if you've read through the ETF Rule yet, but was wondering if there were any less obvious effects on industry/issuers, etc.
Dave Nadig: Great question. I have indeed read through it several times, and perhaps the biggest news here is that there really weren't any big surprises. I see the biggest impacts (for investors) coming from a few angles.

  1. Custom baskets. This is just leveling the playing field, letting new entrants do what the older firms have always done: use the creation/redemption process to maximize tax efficiency and minimize tracking error. It's an unfettered good.
  2. It's now marginally cheaper for a newcomer to come to market. Whether this is good or bad depends on if you think there are already too many ETFs.
  3. Some additional disclosure around trading costs. This is good, and will help standardize things.

That's really pretty much it for investors. For issuers, it's mostly cleanup.
But it gets a lot of the legal "cruft" out of the way, and that's just generally positive.


Bill Donahue: I hope things are well, Dave. There have been a number of papers written lately related to mutual funds converting to ETFs. The SEC has not approved any such conversions to date. What are your thoughts on the potential opportunity of mutual funds converting to ETFs?
Dave Nadig: Hi Bill! I think the BIGGEST opportunity here would be around semi/nontransparent active funds (with the ActiveShares model from Precidian being currently the only approved structure).
Obviously there are some small operational hurdles (how you deal with fractional shares, or with fund holders who have a direct relationship with the fund company). But none of those seems insurmountable.
I wouldn't be surprised at all to see a few conversions in 2020 using the Precidian model. It would provide immediate scale (and potentially liquidity) for a firm coming in with a traditional active equity approach. Frankly, I really hope we see it.
A few questions on bitcoin here:


Cardiff: What do you think it’s going to take for an exchange to make the SEC comfortable that it can prevent market manipulation or illicit activities so that a bitcoin ETF will finally be approved?
Aisla: Hi Dave, Just like the world once scoffed at digital currency firmly taking hold, is it also just an inevitability that the SEC will eventually approve a bitcoin ETF?
Todd Rosenbluth - CFRA Research: With the latest rejection of a bitcoin ETF, do you think this increases the likelihood of Matt Hougan returning to his ETF analytical/commentary roots? Or will he remain a part time player like Deion Sanders did in baseball>
Dave Nadig: (OK, the last one made me laugh.)
So, in case you missed it, the SEC rejected Bitwise's proposed ETF last night on the grounds that it was uncomfortable with the underlying.
That's an important nuance, as I read it. I don't think they were objecting to the idea of a crypto ETF; they were simply saying, "We're worried the underlying cryptomarkets are too susceptible to manipulation."
So that puts the ball back in the crypto court.
To your question, Todd: I think Matt (and the other good folks at the several firms pursuing this) takes this as a challenge, and an interesting intellectual one at that. How do you prove that your market isn't manipulatable?
So I suspect we see a lot of interesting underlying research on the plumbing side of things, including transaction and event analysis, that's going to be a blast to read.
I suspect this maybe pushes things out six months to a year, but not indefinitely. Perhaps past the election, but not a lot further out than that.


Phoebe W.: Do ESG funds cost more than traditional ETFs?
Dave Nadig: In general, yes. I think you can think of ETF fees as being on a spectrum, where broadly speaking, the more "boring" the exposure, the cheaper you should expect.
"Boring" ETFs are generally under 10 bps by and large.
I'd put straightforward ESG exposure in the "slightly more interesting camp," and thus you see most of them pricing around 25-50 bps. That seems completely fair to me. Your dollars are going to license a lot more than just a list of stocks by cap weight. There's real work and expense under the hood.
At the higher end, you get more "smart beta" like ESG approaches, and they tend to be closer to 75 bps. And again, they're more expensive because they're doing more work. Whether that's valuable to you at that price, you'll need to decide.
But it's reasonable to expect to pay more for, say, SUSA, than SPY.


ETF Guy: Does the SEC rule have any impact on the typical 75-day window from filing date to launch date for an ETF?
Dave Nadig: For sure. I would expect 6C11 (that's the ETF rule, technically) compliant funds to be able to come to market in a matter of weeks going forward, frankly. A compliant fund should basically get pretty light scrutiny. We won't know for sure until we're in full implementation, but that's my suspicion. [NOTE: When I answered this live, I wasn't thinking of the normal 75-day window for any ETF/MF filing, where funds automatically go live 75 days from reg.  I believe that's what the question was *actually* about, and my legal-friends tell me this likely won't be affected.]


Anonymous: Are Brexit jitters affecting only European ETFs, or U.S.-listed ones as well?
Dave Nadig: I think Brexit feeds into a global market of uncertainty. Between what's happening in Syria, the trade war, Brexit, uncertain Fed policy, the earnings recession, there are just a ton of nervous unknowns out there. Markets generally don't like uncertainty.
That's why we see "relief rallies," however short, anytime it looks like any of these things is calming down.
Obviously, U.K.- and EU-specific funds will have more volatility around Brexit news and resolution than, say, EAFE funds. But it's all part of the overall picture.
Markets are simply too interconnected in the modern world for it to be any other way.


Inez Schuyler: Seems like REITs were a real hot ticket for some time. Are they no longer a star investment?
Dave Nadig: The attraction for REITs right now is that, historically, they outperform the broad equity markets in late-cycle. Whether we're in late cycle is a good question, but that's been the history.
The challenge with any call like this is of course timing. Getting in "too early" or "too late" in REITs could blow up what might otherwise look smart.
For that reason, I think a prudent approach isn't to try and time an entry but to just consider whether you want REITs as a slice of your overall asset allocation, and then rebalance as the markets shift.
So for example, I know a lot of advisors see REITs as an alts allocation, and keep a consistent 5% or so exposure to them, much like they would gold. That seems like a prudent approach to me.


Guest: How soon til the robo advisor becomes mainstream?
Dave Nadig: I'd argue it already has. And the latest fee war (all the big brokers going commission free) is going to drive this even harder.
Consider Schwab for instance. Since it now no longer makes money from commissions, we can assume they're also going to forgo the money coming in from ETF issuers paying to be commission free.
So where do they make money? Cash is a big part of it. If they can pay almost nothing on cash balances, and manage their own cash book well, they can eke out a chunk of revenue, and that's always historically been true. So that's not new revenue.
They can provide ancillary services (I, for instance, now have my primary banking relationship with Schwab).
But mostly, they can drive investors into Schwab-branded funds where they earn basis points. That's what their robo is all about.
So I imagine you're going to see a very strong push from all the brokerages to get folks into their robos, whether to collect direct fees for those services or just to funnel money into house-branded funds.


Sloane: What would other ETF issuers (e.g., Fidelity, Direxion, Global X) have to do to ever try to near the AUM of the big two (iShares, Vanguard)?
Dave Nadig: Complex question. Some of this is an act of will.
Nobody is crying over Fidelity's total AUM; they're enormous, of course. But they come from a different world: charging for active management.
The iShares brand was built off the opposite end of the investment world: low-cost beta, all the way back to the 1980s.
So there's really just a philosophical difference.
Fidelity could become a top 5 ETF issuer quite quickly: They'd just need to convert, or close-and-redirect, their flagship mutual funds.
But that's a level of cannibalization and fee compression I can't imagine them stomaching.
As for the other folks you mention, a lot of this comes down to institutional adoption. It's very hard to compete with decades of institutional focus. State Street and BlackRock in particular are absolute institutional darlings. They get multibillion-dollar mandates.
And while most of those mandates end up in SMAs, the ETFs act as a liquidity sleeve on those. That's a huge entrenched advantage.
So I don't see a huge usurpation coming soon; it's just too hard. This doesn't mean folks can't compete; it just means I don't see trillion-dollar shifts happening in the next decade.


Tony: My indexed options for U.S. exposure in a tax-deferred account is limited to an S&P 500 index mutual fund. How important would it be to complete that out with VXF in my Roth IRA? If I use VXF, how do I determine the right ratio or amount of VXF to buy to create a total market index?
Dave Nadig: This is a great question, and one I imagine a lot of investors face.
So many of us are in this position: We have limited options in one set of accounts, and unlimited options in another. You're absolutely thinking about this in the right way.
Truly, you need to think about your "portfolio" well outside your "account"; for instance, if you have $500,000 in a 401(k), and $100,000 in a rollover IRA, and $100,000 in your bank account as your cash position, and say, a house. You have to roll all that together to understand your exposure.
I know a lot of investors who say, "Oh no, I don't have any cash in my investment portfolio," but are sitting on cash somewhere else. That's still cash!
So if your 401(k) has really limited options, it's absolutely the right call to think about how you balance that out. Whether it's an extended market position (like you mention, VXF) or individual funds, or using your taxable account to get your gold exposure, or whatever, holistic is the way to go.
This can be surprisingly hard to keep track of, of course. Many folks have accounts on different platforms and so on. That's where a lot of advisors earn their keep: consolidating and reporting on those disparate exposures.


OK, that's going to do it for today. Sorry if I didn't get to your questions. Next week we'll be doing this same time, same day, so come on back and we can continue things.

Have a great rest of the week, and see you all next time!

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