Live Chat: Vanguard's Game Changer

July 05, 2018

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


Dave Nadig: Good afternoon folks, and happy East Coast heat wave. 

As always, you can enter questions in the box below, and we'll post a transcript of this session at the end of the day. 
Also. two things of note: Don't forget to check out our weekly podcast at ETFPrime, and we have a new feature on the site today which we'll talk about in a few minutes ... ETF Stock Finder.
With that, let's get rolling.


Khaleesi B.: Do you think indexes that rely on artificial intelligence for their selection better capture their targeted sectors/themes? 
Dave Nadig: So, this is really related to a series of iShares products that recently launched, that use natural language processes to try and put the right stocks in the right buckets. 
This basic issue is actually surprisingly difficult in the modern era. Most companies have more than one source of revenue, so figuring out whether, for instance, Amazon is a "retailer" or a tech company is less obvious than it seems. 
There are a lot of competing methodologies (GICS, IBC, RBICS, Bloomberg, etc.).
And most of them share in common that a group of analysts digs into financials and tries to assess where most of the revenue comes from.
The AI approach basically just reads news articles and Twitter and analyst reports, and then tries to guess. 
It's intriguing, but I'm super skeptical about it.  At the end of the day, the key thing in sectors is getting high correlations within a sector, and low correlations to other sectors. 
Last time I did the math, the Reuters methodology marginally did that best, but I haven't seen the full data on some of the AI approaches, so I would say "jury still out."



Anonymous: When will the new SEC ETF rules currently under comment period come into effect? And what is the custom baskets part of that about? 
Dave Nadig: So, technically we're in a 60-day comment window from whenever the proposed rule hit the Federal Register (which I'd guess would have been last Friday). 
During this window, everyone with an opinion sends notes to the SEC. 
The SEC then takes those comments and can: 
1: Do nothing, letting it die (this strikes me as unlikely this time around). 
2: Ignore the comments, and republish the rule as a "final rulemaking." 
3: Take the comments into account, and either issue a new proposal, or a new final. 
How long they take is up to them - but 2 months is a reasonable guess.  So if they close comments on Sept. 1, we could see a proposed final by Nov. 1. 
It's really at their discretion from there how long it takes to implement, or if there is a second round of commentary.  In general, these kinds of things phase in over time.  So I would be a bit surprised if this went into effect on Jan. 1.  More likely there's a phased approach, where Issuers have to report which funds they think are effected by a certain date, and then at a future date, the old exemptive orders sunset, and so on. 
As for custom baskets, it's fairly simple.  Anyone with relatively recent exemptive relief has to put a full, pro-rata slice in their basket, either to make new shares or to get rid of old ones. 
Older firms can tweak that - putting in a security they want to sell in the redemption basket, for instance, and one they want to buy in the creation basket. 
This gives them a lot of flexibility to manage both internal trading costs, and taxes. 
So this levels the playing field. 
(Sorry, long answer; I'll try and type faster!)



Galadriel Nunchucks: How do you tell when a niche or theme is too narrow to be a fund? Any funds from recent years come to mind? 
Dave Nadig: Well, we used to have a "Wound Care" ETF, and an ETF that only invested in companies based in Nashville. 
So I actually think we've come back from the brink! 
Practically speaking, it can be hard to get too narrow for diversification reasons.  Back when we used to have a structure called "Holders" (HLDRS), they could avoid the IRS diversification rules.  At the very end, I think the B2B holder from the '90s had like 2 companies in it. 
So that's DEFINITELY too narrow. 
Once you get down to lists of 10-15 stocks in your niche, I think it's legitimate to ask, "why bother" putting it into an ETF?



J. Gross: With Vanguard's announcement that they will offer 1,800 ETFs commission free on their trading platform, do you believe this is a signal that the lowering of expense ratios has reached its limit? 
Dave Nadig: I think this is a pretty big deal. 
Essentially Vanguard is subverting the paradigm of brokerage firms charging for shelf space.  Right now, if you're a small ETF issuer and you want to get on the No Transaction Fee (NTF) program at, say, Schwab, you have to pony up.  Call it somewhere around 25 basis points (it's all private, and negotiated). 
Vanguard is basically saying, "we'll decide, and don't worry about paying us." 
So why would they do this?  To gain a ton of assets in a hurry, on the belief that a lot of those assets coming in from other brokerages will find their way into either Vanguard products, or to a Vanguard advisor (where they charge). 
I think it's another price war entirely, and one that is ultimately great for investors. 
It's part of a trend toward asset management being "free" and advice being charged for appropriately. 
But it's a big, big phase shift for the industry.



Punching Above My Weight: Should fund AUM matter when choosing to invest in a fund? There are no cash flow issues like in mutual funds, we assume that newly launched ETFs have funding to be a going concern, and if a fund does close, I can redeem via in-kind. I just dont' get it. 
Dave Nadig: Well, no, not really.  For an index-based ETF, having just the initial $5 million or $10 million in assets is usually enough to run the strategy and deliver the returns you expect. 
The reason people get hung up on AUM or volume is because they're mostly worried about their funds closing. 
But this is also a bit of a silly concern.  Literally the worst-case scenario when a fund closes is that you get it "sold out from under you" and potentially have a taxable gain you didn't plan on. 
It's not like a closed fund means you lose all your money. 
Advisors, however, hate it, because it's an awkward conversation to have with a client: "Hey, that awesome ZYX fund I found last quarter?  Well, it's closing ... so here's what I want to do ..." 
It's not a good call. 
OK, let's see if I can successfully grab a question from Twitter: 


Dave Nadig: So, the continuation is, is this good or bad for the business of calculating INAVs (intraday NAVs) and indexes in general? 
The dirty little secret of INAV/IOPV is that really, almost nobody uses them. 
They are really only useful as a yardstick for small investors who happen to be looking at trading a less-than-super-liquid ETF that happens to be holding nothing but U.S. stocks. 
If there are any international holdings, or even bonds, INAV just doesn't work well because of timing problems. 
And institutions just run their own real-time calculations of fair value, so they ignore it too. 
So in the wake of the new rules, I see it mostly going away, but I don't think indexing disappears. 
There's a certainty to indexing that's been appealing for 40 years or so, and I don't think it's going to go away anytime soon. It's essentially always cheaper to index. Maybe just a LITTLE cheaper, but indexes are simple, easy to explain, and somewhat predictable.



BitcoinETF: When should we expect to see a reject from the SEC for the VanEck/SolidX ETF?  If it does get approved, why is each share going to be priced around $200K?  If this is the case, will anyone be able to afford 1 share? 
Dave Nadig: Interesting question!  I know nothing about the internal timeline for this, but it's important to note that the SEC doesn't have an artificial clock to hit. 
They have certain deadlines for responses, but it can go on forever, essentially. 
I'm not convinced the handle-hack (the $200K) answers enough of the SECs issues to get through, but it's clever. 
The reason for the hack is to essentially guarantee that nobody who isn't an accredited investor can even buy in. 
The current standard is, I believe, $1 million in liquidity, or $200K in reported annual income. 
So while this isn't EXPLICITLY off limits -- I suppose someone could have no income and a 300K portfolio, and sneak in -- it definitely sends a "no little guys allowed" signal. 
And since the SEC is always looking after that little guy, it could make a difference. 
I think their other issues (around pricing, functioning markets, etc.) don't get solved that easily though.



Lois Gregson, FactSet Research: During my 20+ years in working with ETFs, I can think of a handful of specific events when advisors pulled money from other products and directed the assets into ETFs.  One such time was when C share mutual funds were inappropriately being used.  The benefit to ETFs was that the advisor did not have to worry about A, B, C share classes; the advisor could just buy or sell the ETF. If ETFs were to create different share classes, wouldn't that degrade the ETF structure? 
Dave Nadig: Hi Lois! 
So, this is really an adjunct of the Vanguard question. 
One of the follow-on possibilities of Vanguard taking all comers on their NTF platform was suggested by Michael Kitces in a video a few days ago.  He posited that issuers would have to make new share classes of ETFs, with higher fees, that could then be put in, say, Schwab or TD. 
I agree, Lois; this would be AWFUL for investors.  Just the worst. 
But then again, it's EXACTLY what iShares did with their Core funds. 
EEM and EFA are vastly more expensive then IEMG and IEFA, but they are almost (not completely) identical.
And surprising nobody, we've seen assets positively FLOOD out of the expensive funds into the cheap ones this year. 
So I don't think it would even work, honestly, to have someone like State Street start launching, I dunno, a "cheap" version of TOTL, or an "expensive" version of MDY, just to split platforms.
I see why it could happen, but I just think the industry is smart enough to see how awful it would be.  Fingers crossed.



Elphaba: Are there any ETFs that will benefit from the re-emergence of tariffs? 
Dave Nadig: Good questoin.  The very short answer is that (my opinion here) tarrifs are essentially bad for everyone. 
A global trade war slows GLOBAL GDP growth. 
So, are there relative winners and losers? 
The most intriguing answer I've heard on this lately was from Tyler Mordy at Forstrong, who (paraphrasing a dinner conversation) said that China simply has more tools to win with than anyone else, so while it will hurt for a while, 10 years from now, China actually probably benefits more than it suffers. 
But as for specific sectors and so on, I think it's a bit of a mug's game to try and second-guess the market pricing in all this information -- and believe me, it prices it in, quickly and violently. 
We've seen that through all the news flow here.



Blaine Rogers: Hello Dave, "Passive" vs "active" seems like a hot button, with folks strongly aligned on one side or the other. What's the bottom line on the difference: is "passive" basically just leaving your money in some "index" account, and "active" is having a money manager in charge of your portfolio and you pay higher fees for that, or ...? 
Dave Nadig: Welcome to investment semantics 101: hair splitting. 
In all seriousness, it's a surprisingly reasonable question. 
At the core, "passive" is about minimizing internal portfolio turnover and getting complete exposure to an asset class. 
By that definition, we'd all just buy VT and go home.  But most folks don't. The average passive ETF investor probably owns 6-7 ETFs (there have been some surveys on this). 
Those ETFs might be 10 bps and super passive, low-turnover indexes, but if that investor decided that "40% in U.S. equity seems about right" - well, they just made an active decision about their asset allocation. 
The definition really is always about where two alternatives sit on a spectrum. 
Even the S&P 500 has a committee.  It's essentially long-term, slow, active management, but compared to, say, Contrafund, It's very passive. 
And Contrafund compared to, say, a tactical hedge fund, would look pretty passive. 
So the question you should always be asking is "vs. what alternative"? So, this fund looks cheap, compared to what? 
This fund looks like it performed well, compared to what? 
This fund says it's got great dividend yield and low vol, compared to what? 
Great question though. 
OK, last question here.



Sammy C.: So if tarrifs are bad for everyone, is that the kind of thing that would "benefit" from a BlackSwan ETF? 
Dave Nadig: Very broad question, but I like it. 
We've got a variety of "black swan"-style ETFs in registration - today Amplify just announced another one. 
They all have some version of "get some upside, but minimize your crater risk" in them.  Essentially risk management.  Usually using options as a way to get the desired return pattern. 
The problem with those strategies isn't that they don't work -- I'm sure they will do what they say on the ingredients label -- it's that you never know how the future is going to actually pan out. 
"Bad for global GDP" doesn't mean, necessarily, a black swan event.  It could mean low-volatility 3% equity markets for 5 years.  It could mean high-volatility mean reversion, with lots of stomach drops. 
It could mean a long slow bear market.
Nobody actually "knows." 
I mean, I know friends who went to cash when Trump was elected, and I know friends who doubled down and levered up. 
Both very smart. 
So sure -- COULD one of the scenarios of a protracted trade war play right into the hands of a risk-managed strategy?  Absolutely.  Could such a strategy end up sacrificing upside? Of course. That's how they are designed. 
OK folks; that's going to wrap it up for today.  Sorry I missed a few questions. 
One note: Our stock finder is up, and you can get there most easily by typing in your browser, like this:
Hope you enjoy it. 
See you next Thursday!

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