Live Chat: Tricky Telecom & Direct Indexing

August 16, 2018

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


Dave Nadig: Howdy folks; welcome to the (mostly) weekly edition of Live!
As always, you can ask questions in the box below, and I'll get to as many as I can in the next half hour.
So, let's get started -- we'll post a transcript at the end of the session if you miss anything.

but it's amazing the largest ETF stake for Cisco Systems is iShares US Telecommunications (IYZ) according to the Stock finder tool This used to be an ETF holding only AT&T, Verizon and other slow stodgy companies. Do you think the investors in the ETF understand they are in growth stocks like Palo Alto Networks and F5 Networks too?

Dave Nadig: Hey Todd, thanks for using the stockfinder tool (you can see how to use it just with the URL Todd posted here).
The potential danger of a lot of these subsectors or thematic funds is twofold, both of which you're pointing out.
The first is accidental or unexpected exposure.
I think most folks think "telecom," and they just assume they're getting AT&T and so on.
But that would nearly be uninvestable; there just aren't enough of them out there.
So the definitions are necessarily often a bit broad, and you get potentially less-pure, or at least less-expected holdings in your fund.
It gets even worse when you get to something that's potentially open to interpretation, like, say internet funds.
The second issue is concentration; in many cases, these funds make some very big bets.
The most egregious example of this was the old Business to Business Holders (BBH I believe), which ended up having just one major holding.
It got away with it because its structure (now defunct) let it own more than 25% of a stock.
We won't end up there, but it's a real issue, and no, Todd, I imagine a lot of investors don't quite expect this from the headline.


Hank Seymour: So, Dave, what exchange-traded products do you hold?
Dave Nadig: Hi Hank, I get this one surprisingly often, and I've answered it in different forums.
The reality is I decided some years ago to NOT own ETFs, because my entire job was talking about them, and it would be too easy for it to look like favoritism.
So what DO I hold? Well I have two main accounts (Schwab/Fido), and I own generally just their super-low-cost index mutual funds, in weights that look surprisingly boring and like the world's cheapest portfolio.
Most of those funds have the same expense as ETFs.
To be fair, I've had several folks tell me "I don't own ETFs" is a copout, but it does save me the headache of ever having to add disclosure language to things I write!


Trace Jenkin: Good morning Dave, So, for some time, many have said commodities markets have been subject to manipulation. Has this been the case for other investment instruments?
Dave Nadig: Well, I generally get nervous about "many say" arguments, but sure, folks have complained that commodities are manipulatable by the <<tents fingers>>evil speculators.
The reality, of course, is pretty complicated.
We have had some notable examples of manipulation in commodities over the years.
Most notably around copper and silver.
And of course, serious gold-followers often sit in chat rooms discussing who's manipulating global prices.
Ultimately, however, I think this tends to be short-term-trader-driven noise.
Commodities are the single most supply-and-demand-driven part of global investing.
So fighting against that long term seems quite difficult, and requires enormous capital -- like say, that of central banks buying and selling gold reserves.
As for "where else" -- well, there are of course folks who worry about whether information in one market affects another disproportionately.
For instance, all the discussions about the 2010 flash crash, where finger pointing between derivatives and equity markets was the main end result of the investigations.
But for long-term investors, I think that modern markets are now SO efficient that these kinds of things tend to happen -- and play out -- very quickly.


Heidi T.: How would treating ETFs as a separate asset class from, say, equities, derivatives or fixed income improve execution quality?
Dave Nadig: Interesting question -- it's a bit hard for me to imagine exactly what that structure might look like.
There have been various proposals to further embed the "hybrid" nature of ETFs into the market -- coming up with ways of doing NAV trading and so on.
But actually, taking non-equity asset classes and putting them in an exchange-tradable wrapper has improved execution quality SO dramatically I can't imagine going the other way.
Fixed income, currencies, commodities, you name it -- there are ETFs that trade MUCH better than those underlying markets, giving you the same exposures.
I mean just think about the spreads in individual junk bond names, or aggs for instance.
ETFs are a bargain-and-a-half there.


Amy Threadgill: Does a bull market or a bear market spark more inflows into ETFs, or is that moot due to things like inverse/leveraged funds, shorting options, volatility, etc.?
Dave Nadig: Great question, and one I've been getting a lot. Barry Ritholtz actually did a great piece on this yesterday I believe.
Over at Bloomberg.
But short answer: history would suggest that bear markets are actually, in the long run, very good for passive, and not so great for active/trading vehicles.
If you look at the response after 08/09, it was ETFs in a landslide.
But we saw similar (albeit smaller) samples after the dot-com crash (although there were only 100-200 ETFs back then).
Mostly what happens is 70% of active managers get it wrong, 30% get it right and make new 10-year careers of having been right, and all those folks invested with the 70% start asking why they paid so much to be wrong.
And those folks end up - a lot of them - over in index and ETF land.
I suspect that will almost always be the case.
Now, if we had a market structure issue that somehow featured ETFs in the headlines? Sure, that's different. But sustained bear markets? Regular old revaluation? ETFs win.


Jon Martins: Hi Dave. Won't a bitcoin ETF be kind of the opposite of what bitcoin itself is supposed to be?
Dave Nadig: Hi Jon. So I have heard this argument -- and actually the same one about gold.
If the "point" of owning bitcoin is to have a reserve asset that's immune from modern financial systems -- having your bitcoin ETF shares custodied over at Schwab may not actually help you much.
Same with, say, your GLD. You can't go get the ETF out of the safe and use it to pay for food, and so on.
That said, I think there's enormous interest in crypto, and it's just plain hard, and a bit scary, to start trading it on its own.
So there's HUGE appetite for people to get access through normal means -- witness the Swiss ETN that's now listed as a BB stock. Buyer beware!!!


Loc: If I’m a student beginning to invest and every week I have $25, would buying ETFs through M1 Finance be a way to go? No commission on trade and auto rebalance and reinvestment, etc. P.S. will you be playing Battle for Azeroth? Go horde!
Dave Nadig: Hey Loc - so sure, that's the whole pitch of something like M1. They basket-up trades so dollar cost averaging works out a bit more cleanly.
I will say, though, that you could do this in a regular brokerage account using traditional index mutual funds, or using ETFs that don't trade with a commission.
You might have to wait a few weeks before making trades, but you could certainly do it.
(And yes, I've been playing the new WoW expansion, but haven't had more than an hour or so in the evening!) 


mojo: Triple play... what is direct indexing? How is it different than an index fund and why is Wealthfront pushing it over ETFs?
To me this is the next logical step. If someone like Wealthfront or M1 is essentially just a big broker, holding, say, 1000 accounts, those 1000 accounts represent one big "portfolio," if you will.
If you don't care about intraday trading, there's no reason they can't keep track of what piece of that "portfolio" is yours, and when you make changes, just roll those up to the big portfolio level.
So you "subscribe" to an index -- like the S&P 500, and you give them $1,000.
They just add that notionally tiny position to the amount of each stock the big P portfolio needs to own today.
And keep track that you own .03 shares of Amazon, or whatnot.
To manage it, they just trade once a day, and "eat" the fact that there will always be a fractional share of missing exposure -- they own that extra in the house account, as it were.
Why bother? It cuts a whole layer out of the investment process -- the ETF issuer.
You pay directly for the IP of the index you want, etc.
Nobody is REALLY doing this in a big way yet -- Wealthfront, M1 are nibbling at the edges.
But I think if you look out long term, it's highly logical.


Ben F. : Hi Dave. We keep seeing issuers like J.P. Morgan moving money out of iShares or Vanguard ETFs and into their proprietary funds, many brand new. Is there any downside here, or risk to advisors and investors whose assets are being shifted from established product to new product?
Dave Nadig: Hi Ben,
So funds like BBJP and today BBCA are getting big internalized flows from JPM clients and internal holders (other funds, for instance).
I don't think there's any risk that's new here other than whatever concern you might have about JPM (which, to be clear, I don't have).
But if this were "Bob's Donuts & ETFs" and you didn't believe they could manage an index fund? Well sure, that would be concerning, seeing a HUGE pile of money show up to some no name.
But NoName JP Morgan is not.
The only caveat is that Assets != Trading. So you can end up with a billion-dollar ETF that's still a bit tricky to trade.
So as always -- good trading hygiene, no matter how big the fund looks from an AUM perspective.


Hector: Hi Dave, glad you're back from vacation! I've seen a few articles going around discussing how private equity/venture capital is becoming a more popular or lucrative alternative for funding new companies. This got me thinking, would it theoretically be possible for an ETF to invest in private equity, since the usual creation/redemption mechanisms don't really apply?
Dave Nadig: GREAT question here.
The short answer is "not really."
Most ETFs are organized as pretty boring, traditional 1940 Act mutual funds underneath the hood.
And there are significant restrictions about the kinds of things those funds can invest in. This was actually part of what was behind the rise of some of the public/private equity firms back in the dot-com boom, like Softbank.
So, unfortunately, the process works -- the whole point of being publicly traded is to provide certain constraints to make investments appropriate for average investors.
If you don't/can't do that, you're very limited in whose money you can take as a company -- whole different process.
And ETFs can't REALLY play.
That said, there ARE ETFs that have "Private Equity" in the headline:
But these generally go through listed private equity firms.
Like, as I said, Softbank and its ilk.
OK, last question before we wrap:


J: What effects, if any, will clients see from the upcoming GICS changes?
Dave Nadig: So, these changes hit I believe end of September.
The biggest shift happens in and around tech.
Lara Crigger wrote a GREAT summary piece on this and which funds are most affected, here:
Facebook and Google are the big ones that get shoved around.
So if you have a big tech or comms fund, you should for sure check and see if the exposures are going to be quite what you expected.


That's gonna wrap it for me. Be sure and check out the weekly podcast here:
This week we look at how Fidelity's mutual fund gambit (taking two to zero) is the new Free Toaster of investing.
We'll have a transcript up here shortly in case you missed something, and we should be back next week, same time, same place.
Have a great day everyone!

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