Live Chat: Market Timing & Vanguard's New Angle

November 14, 2018

[Editor's note: Live! with Managing Director Dave Nadig happens Thursdays at 3:00 p.m. ET.]


Dave Nadig: Good afternoon folks! Welcome to Live!
As usual, you can type your questions in the box below, and I'll try and cram in as much in as I can in 30 minutes.
There will be a transcript up later as well, in case you miss anything.
With that, let's get started!


Harold: Hi, I have typically been a long-term mutual fund investor but am becoming a bit frustrated with the recent market volatility. I am looking at possibly doing some short-term trading of ETFs, hoping to buy when the market has taken a recent downturn, but futures appear to be up. Then if the market goes up, sell the ETF and capture any profit to reinvest next time the market takes a downturn. Is this a very dangerous strategy? It seems to make sense, but almost too easy.
Dave Nadig: Hi Harold,
So, what you're describing is essentially flat-out market timing.
You're just betting that you will be correct in your entry and exit points: buying low, and selling high.
In doing so, you're competing against literally every other participant in the market, and you're assuming that the price you're buying at today is somehow the "wrong" price.
We know from history that investors are almost universally awful at this. And anyone who's actually consistently good at it ends up running (and then closing for new money) a hedge fund somewhere, honestly.
I mean, take today as an example.
Market has been down a bunch, it's down a bunch more today. So, what makes TODAY the day you say, "Well, it won't go down any more from here!"
So my honest answer is: It's a terrible idea, unless you've somehow missed your calling.


Todd Rosenbluth - CFRA Research: We recently published a piece on the ETF leader board and noted the iShares and Vanguard were taking more share than normal. The feedback I got was "what are the smaller firms. How can they innovate?" Do you think there's still room for new product innovation from smaller firms as I do?
Dave Nadig: Hi Todd!
So, I do think there's still a LOT of greenfield space. I don't think you somehow start an ETF company in a garage and kick Vanguard off the top of the flows leader board though.
The move to low-cost vanilla isn't going to end anytime soon, and the big players have huge entrenched advantages.
But we've seen a lot of funds come to market with innovative, niche strategies and do very very well for themselves.
So, whether it's more themes, more subindustries, ESG takes, smart beta, I think there's still a lot of room out there for new ideas.
Here's a great nerdy question:


J. Gross: I have a question with regard to the logistics of the creation/redemption process. Let's say that an ETF is trading at a premium. An authorized participant would sell the ETF short and purchase the underlying securities. The AP would then trade in the underlying securities for the ETF shares and use those ETF shares to close out the short position. When the AP trades in the underlying securities for the ETF shares, when is this done? Is this done during the trading day or is this done after the 4:00 pm close?
Dave Nadig: So, two things. First, the AP doesn't HAVE to necessarily do the create at all. In fact, if they believe they could unwind that pair of positions (short the ETF, long the securities) through normal trading tomorrow, they might sit on it to avoid paying the creation fee (a small but nonzero amount).
As market makers, they actually have five days to deliver those ETF shares they sold short.
But, assuming they want to flatten their book, they generally have to get the order in to the issuer before the close (3, 3:30; it can depend on the issuer). Sometimes it's literally a phone call, sometimes its a fancy automated portal system.
The actual order itself is processed through the NSCC over night as part of the continuous net settlement process.
Note: The timing here doesn't actually matter. The AP books the buy and sell whenever they like, and from that point on, they have no economic exposure, because they are long two things of identical value and exposure.


Renee: I'm looking to invest about $15,000 toward retirement. Is today a good time to purchase a 500 index ETF to hold for at least five, maybe 10 years? I am considering IVV or VOO.
Dave Nadig: So, big caveat here is that neither I nor are financial advisors, and we don't make market calls. So I can't actually answer the "is today a good time" question for you. That depends on so many things: your risk tolerance, what else you own, and so on.
But, if you're looking for S&P 500 exposure in particular, you aren't going wrong with either IVV or VOO. If you can trade one of them without a commission (check with your broker) I'd have that be the deciding factor.
I'd also say: There are more funds out there that provide similar exposure to the U.S. equity markets that are super cheap. Schwab has the lead on cost there for the most part, and if you're a Schwab customer already, free to trade.


Tina Margulies: A long time ago, Matt Hougan wrote a column about the world's cheapest ETF model portfolio being 0.16%. What's it down to now?
Dave Nadig: So cheap it's almost free: 0.05%
Here's the last time he hit the article I think: 
Generally he emerges from his bitcoin coma every six months or so to give it a look again.
But I don't think it's changed much.


MerMan3000: I thought Vanguard had a long-standing reputation as a passive manager. Why did they get into the active arena? Just, too much competition NOT to be in it anymore, and/or ...?
Dave Nadig: Vanguard's been in the active mutual fund space for decades, most people just don't actually know it. In fact, I think last year Vanguard had the largest inflows of any ACTIVE fund manager in the mutual fund side of things.
They have solid expertise there, and many many billions in assets.
So it makes sense for them to start bridging into ETFs as they get comfortable being fully transparent.
Which brings us to this question:


Quant22: How is there even a market for nontransparent active ETFs?
Dave Nadig: Well, we don't actually know there is a market for them.
But we know there are asset managers who really want in on the ETF action, but really don't want to show their hands.
Whether investors will care, I'm skeptical about. Never say never, but unless one of the firms actually closes the mutual fund version, I don't see folks converting in droves from, say, a Growth Fund of America to a Growth ETF of America.


Conrad H.: Which are potentially more "dangerous": leveraged ETFs, or, ETNs?
Dave Nadig: Hi Conrad.
So, the "danger" in an exchange-traded note—I'd rather say the "risk"—is from a few sources.
The biggest is just your exposure. If it's an ETN tracking the S&P 500 for instance, well, that's your biggest risk: the market.
ETNs have really one unique risk though, and that's the risk of default.
Since they're just bonds at the core, like any bond, if the issuer goes out of business, you get in line with all the other bondholders.
I find it pretty unlikely folks like UBS or Citi or Credit Suisse are just going to spontaneously collapse, but hey, remember Lehman? They had some ETNs ...
So, ETFs don't have that risk (leveraged or not).
The risk of a levered ETF is again, just the risk of the exposure. 3X S&P 500 is amazing on some days, and terrible on others.


Darryn Thompson: "Authorized participant" seems like a strange or generic term. What do they actually do?
Dave Nadig: So the term comes from the legal language. In a traditional mutual fund, you, the individual investor, can open an account with, say, Janus, send them a check, and they will create new shares of a fund for you.
That's how new shares get made.
In an ETF, individual investors can't do that.
Only a special class of investor, who signs a separate contract, gets to make new shares. They agree to participate in a whole process that involves having direct relationships with the NSCC, and custodians, etc. 
So they are "authorized" by that contract, to "participate" in the process.
Not a particularly clever title, but it is actually descriptive.


Dan Matthias: What metrics (in order of importance?) should an investor consider when evaluating an ETF besides expense ratio?
Dave Nadig: Forced ranked!
OK, if I had to pick an order of operations for ETF due dilligence it would probably go:
1) Exposure: Gotta know what you own and why you're owning it. Most important.
2) Tracking Difference: This is the measurement of how the fund does vs. its own index (if it's passively managed). Tracking differences INCLUDES the effect of expense ratio, but also includes how well the fund is run, the impact of securities lending revenue, internal trading friction, and so on.
3) Tradability: Measured by a combination of advertised on-screen spreads and volume.
That would be my quick: 1-2-3


Lyndon: Hi Dave, 2 questions. Are there some specific ETPs for playing the rising interest rates right now ... Also, ditto for if a recession hits?
Dave Nadig: So, Lara Crigger wrote a whole piece on this a few months ago:
(one sec) 
OK, it was more than a few months ago, but the list there still holds, and the arguments behind them.
Off the top of my head though, I like the Fidelity Rising Rate ETF (FDRR). It's a very interesting take on the question, because it actually looks for stocks correlated with rising rates as its core methodology.
It actually did quite well in the last few months compared to the S&P.
As for a recession, well, that's really a fundamental asset allocation call.
I mean, if you think we're headed for a deep, meaningful economic recession, you'd look for classic safety plays, whether that's value stocks, or just out of equities, etc.
(Sorry, maybe not that helpful an answer.)


Tracy McIntyre: Could an ETF ever "default," like ETNs can? Or are their structures just too different?
Dave Nadig: Nope. But bad things can still happen.
In a traditional ETF, the underlying structure is just a mutual fund.
Literally the same: It's a '40 Act registered mutual fund.
As such, it's a separate trust actually owned by the shareholders.
There are custodians to hold the assets, and a board that you technically vote on to oversee things, and a contract with an asset manager to run the thing.
If that asset manager just went poof, the fund still owns its own assets, and can just appoint a new investment manager (which happens rarely, but does happen).
Of course, the fund could close (a bad thing) but that's not the end of the world. You don't lose all your money, you just effectively get "bought out" whether you wanted to be or not.
A fund can also de-list, which happens VERY rarely, but again, CAN happen, and that's just like when a penny stock delists: You have to sell out on the pink sheets. I can't think of any '40 Act-based ETFs that have delisted, off the top of my head. Some ETNs have though. It's a pain to ever unload them.
But you'd have to really not be paying attention for that to happen.


JJ: If you aren't a U.S. citizen, but buy a U.S.-listed ETF, is there a difference on how your dividends from them are taxed?
Dave Nadig: So U.S.-listed ETFs don't do any internal witholding of dividends, as a rule.
So they just take whatever, say, IBM, pays to them, and they in turn pay it to you.
If that happens in your taxable account (as a U.S. investor), well, you report it in your taxes and pay something ... if you hold it in your IRA, you don't.
if you're a resident of, say, France, well, you'll have to pay whatever France says you're supposed to pay on dividend income, etc.
So it will be just whatever your local tax authority says.
This is a fun one:


Micah Knudson: What's the shortest amount of time an ETF existed before it was closed (for whatever reason)?
Dave Nadig: This is a crazy one. I believe the answer is "3 days."
There are a series of stealth ETNs run on behalf of Fisher Investments.
Some of them are quite large (FIGY, I think).
They are bespoke products made really exclusively for his clients. Good luck finding out much about them outside the fund pages here.
They don't market them at all, you won't find glossy fact sheets and whatnot.
And in March this year, they launched two new ones, I think internationally focused.
They opened on the 19th, and they closed on the 22nd.
And nobody I've ever talked to has been able to tell me why (if you're reading this and DO know why, please send me an email!)
Easily one of the craziest stories in the ETF universe.


Peter Brady: How do you think the proposed ETF rule and the idea that it will become easier to launch an ETF will affect the ETF market-making space?
Dave Nadig: I don't see the ETF Rule affecting the market-making community much at all, honestly.
And I don't think the ETF Rule will open some floodgate to 1,000 new funds. There just aren't that many big investment management brands that aren't already in, or at least filed.
So short answer: not.


Darla Martin: Seems like ESG ETFs really sprang out of the gate hard, but haven't seemed to have taken off. Thoughts?
Dave Nadig: I agree. Although we've had some stealth winners, like Goldman's JUST.
I think it crossed $200 million in assets in about four months.
That's pretty solid.
But I think it will continue to be a slow trickle. A big sustained market downturn may actually help, as I suspect some money has moved/will move to the sidelines. When it comes back, it may have broader perspective.


Jason F.: Hey Dave, Is there a tool on this site where a user could simulate some "forward-testing" to see how they might do if they tiptoed into using ETFs? Like a practice run for a newbie to ETFs?
Dave Nadig: You know, that's a great idea, but I don't actually think I know any site for "forward testing" ETF portfolios.
The financial web is woefully short on fully featured portfolio modeling websites or apps. Likely because you need a lot of data to drive them, and it's actually a fairly sophisticated set of problems under the hood, which I suspect is why most of the good tools are expensive/professional grade.
Still, it would seem like brokerage platforms would do more here.
I'll do some poking, and if I find anything awesome, I'll write about it for the site!
OK, running a bit long, so last question here:


Danielle: Are "preferred ETFs" good for rising interest rate environments?
Dave Nadig: So the whole "preferreds in rising rates" discussion is always an interesting one.
On the surface, because they are "bondlike," the conventional wisdom is that the price of a preferred will be interest rate sensitive: it goes down as rates go up.
That said, there are a lot of preferred ETFs, and they mostly hold ones with floating returns that can theoretically adjust, so they should be less sensitive than a straight piece of debt.
And of course, there's yield to offset a potential decline in price.
So personally, I think it's an area to be cautious of: You'll need to really understand the portfolio. It's probably worth doing some deeper dives on issuer websites, and see if they explicitly address this issue.
It's VERY much the right question to be asking. And hey, don't be afraid to make a phone call to the issuer as well, or use their contact info, if you don't find anything.

That's going to do it for today; sorry if I didn't get to your questions.
We'll have a transcript up shortly.
Thanks everyone, and have a great afternoon.

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