Why Global Bond ETFs Make Sense & That K-1 Thing

May 24, 2018

[Editor's note: ETF.com Live Chat! with Managing Director Dave Nadig happens Thursdays at 3:00 p.m. ET, with the question window available two hours before and during.]

Dave Nadig: Howdy folks, welcome to our weekly ETF.com Live Chat! session. 
You can enter questions in the box at the bottom of the page, and I'll do the best I can to answer them. 
A transcript of this chat will go live by the end of the day in case you have to hop sometime in the next half hour before I get to your question. 
And with that, let's get rolling!


PKD: What's the point of a total global/US bond ETF or, for that matter, global/U.S. stock ETF... seems like a dilution of sort. 
Dave Nadig: I'm guessing this comes a bit on the heels of Vanguard announcing they're launching a global bond fund. One sec for the link ...


Most investors have ridiculous home bias.  They invest far too much in their own country. 
Even worse, many investors are overloaded not just in the U.S., but in the industry or even the company in which they work. 
The reasons here go back to Peter Lynch - we were all raised to invest in what we know, and hey, what do I know about, say, Brazil? 
The problem is, what we want is big diversified portfolios that push us out on the efficient frontier. 
To do that, we need to have access to different patterns of returns. 
And if we limit ourselves to the U.S. - well, we're leaving opportunity on the table. 
So, just like you shouldn't invest only in tech, or only in U.S. stocks, you really shouldn't invest only in U.S. bonds as part of your fixed income exposure. 
Partly it's dollar diversification, but it's also just taking advantage of opportunities. 
Can you go too far? I don't actually think so, if you're investing for the long term.  Of course if you're trying to trade tactically, you want sharp tools, and a 5,000-bond portfolio isn't going to be super volatile, which you'd WANT as a trader. 
But long term, diversification is pretty much always your friend. 


B. Keller: I believe I read that ETFs have overtaken mutual funds in "inflows." Do you think eventually, likewise, ETFs will eclipse investments in stocks themselves? 
Dave Nadig: Ah, interesting theoretical framework here. 
So, structurally, really, ETFs can't own "everything," which is what this implies. 
ETFs are currently about 6% of market cap, which is a long, long way from owning "everything." 
Global market cap - just in equities - is something like $110 trillion. 
ETFs are, last i checked, globally, about $5 trillion. 
And a lot of that $5 trillion is not in equities, it's in bonds, or even gold or commodities. 
So there's a long, long way to go. 
On a "flows" basis though, it's tough to measure.  All money comes from somewhere. 
The flows into ETFs have come from mutual funds, sure, but they've also come from new-cash (earnings that's invested) or even other less liquid assets (someone sells a house, and invests the proceeds). 
Some, for sure, has come from people selling stock, but if you sell $1,000 of AAPL and buy $1,000 of SPY, you haven't pulled any money out of the stock market. 
So, in short, I'm quite sure I will be long, long in the grave before we reach some theoretical tipping point of ETFs owning "too much" of global markets.


Anonymous: Can you please explain the creation-redemption and arbitrage process for ETNs? 
Dave Nadig: So, background: ETNs are exchange traded notes -- they're not pools of assets; they're really bonds issued by a bank that promise a pattern of returns tied to an index. 
But the cool thing is, they have pretty much the same creation/redemption mechanism as an ETF; they just do everything in cash. 
So if an authorized participant wants to make new shares of an ETN, they just have to hand cash to the issuer, and they get shares back. 
Same in reverse: they present shares, and get cash. It's actually even easier than it is to be an AP for a traditional fund, because they don't have to create a basket of securities (or get handed one, at the end of the day). 
The only hiccup can be if the bank for some reason doesn't want to accept creation orders for some reason -- this HAS happened a few times. 
Most notably, Credit Suisse stopped making new shares of TVIX, an vol-tracking ETN, some years ago, and it traded to a large premium until it finally came back down to fair value. 
But that can happen with an ETF as well (and has, in rare cases, like EGPT during the Arab Spring).


Roberto: There are target date mutual funds for managing your retirement assets. Why don't we have similar products in an ETF? 
Dave Nadig: Hi Roberto -- the short answer is - you just missed it! 
I think it was 2014 when the last target date fund closed 
But we used to have a whole slew of them.  The problem is, nobody really used them, so they languished, so they eventually closed. 
So the question is, why did nobody use them?  The answer is that most target-date funds aren't used once, they're used as part of a continuous investment strategy, typically, a defined contribution plan, or an IRA where you're making regular contributions. 
ETFs aren't always a great choice for that, because you have to pay commissions, or at least you have to incur a spread on the trade. 
So, while target-date funds are awesome for 401(k)s, they're not a perfect fit for ETFs.  Or put another way, ETFs aren't a perfect fit for 401(k)s.


Anonymous: Do you report tracking error anywhere on your fund pages? 
Dave Nadig: No, and we have a good reason for it. 
"Tracking error" is actually not that useful a statistic for most investors -- it's the standard deviation of daily return differences. 
It's pretty non-intuitive, because it doesn't tell you much about your actual performance experience as an investor. 
It also bakes in lots of noise -- any discrepancy between how the fund calculated NAV and how the index is calculated blows it up.  And there are lots of reasons for small discrepancies -- pricing service differences, currency timing decisions, etc. 
So what we present is what we call "Tracking Difference," which is a comparison of 1-year returns between the fund and the index it tracks.  The specific stat we show is a median 1-year holding period in a 2-year window (so a year's worth of observations). 
We also show you the best and worst 12-month period in that window. 
In general, you'd expect the number to just be the expense ratio. 
So for instance, SPY has a Tracking Difference of -.13%.
Its expense ratio is .09%. 
So you'd expect it to have a Tracking Difference of -.09%. 
So it does slightly worse than you'd expect.  In the worst 12-month window, it trailed by .17% and in the best by .11%. 
So that gives you a real, tangible window on what your experience as an investor would be, compared to the theoretical index. 
We think it's a lot more useful. 
(Incidentally, the reason SPY trails is because there is a tiny bit of cash drag from uninvested dividends between distributions, because it structurally can't invest that cash, as a UIT under the hood). 
Great question though.


Jillian T.: Re your comment about target date funds, why is it that ETFs "aren't a perfect fit for 401(k)s"? Could that change? 
Dave Nadig: Good follow-up -- this has come up a lot, but it's worth repeating.  ETFs' big advantages include intraday trading and tax efficiency.  Both of those are irrelevant to 401(k) investors. 
On the flip side, they add transaction costs (no matter how small) and can only be bought in whole shares (advantage: mutual funds). 
I don't see this changing quickly, although there are folks like Invest'n'Retire and Schwab who've "cracked the nut" on getting all the accounting to work and minimizing the impacts.
But cheap index mutual funds are a natural fit for 401(k) investors generally. 
(There's another issue, which is that many 401(k)s use more expensive funds, that bake in a 12b-1 fee, which is used to offset recordkeeping expenses.  That's another thing ETFs don't do -- charge big 12b-1 fees!)


Todd Rosenbluth - CFRA Research: Hi Dave. What do you think about the SEC's proposal today to allow brokers to publish and distribute research reports on ETFs?  If they do so, would it be the largest and most liquid ETFs, focused on fees, volume and tracking error? Something else? 
Dave Nadig: Hi Todd!  So, I don't think this will have nearly the impact the headline suggests.  There have been all sorts of nibbling at the edges on this for years, 
but I don't think that sell-side research shops are just DYING to get their hands on writing coverage. 
I also think the buy side isn't clamoring for it either.  They've gotten pretty used to relying on, say, the excellent coverage you guys (CFRA) provides, or the fine folks at FactSet or Morningstar, and so on. 
With ETFs, research is mostly about data, and that's a bit of a solved problem.  So I just don't think it really matters all that much. 
Many brokerages publish economic research and model portfolios that include ETFs already, so again, just edge cases here.


Heather Smithson: What are K1 fees and why are they a bad thing? 
Dave Nadig: Hi Heather - so a bit of confusion here.  When we talk about "K1s," what we're talking about is a form you get from a limited partnership that reports your partnership income, which you have to send to the IRS as part of your taxes. 
It's not a fee, it's a form. 
The reason people hate it is it complicates your taxes significantly, and has a few quirks -- they can often be late, they mark things to market at year end, and so on. 
It's a bit of a "gosh I hope you have a CPA" red flag for folks.
The "no-K1" funds get around this by investing in a Cayman Islands subsidiary, which in turn, makes investments. 
So the fund just looks like a normal fund, with one big investment. 
(All of the above is about commodity funds). 
It's not 100% that one is better than the other.  In fact, the K1 funds may give you slightly better tax treatment of a commodity strategy, due to the nuances of how gains are taxed for commodity pools (that have to send the K1).


John Doe: If I look at fund flows day-to-day, can I use that to catch waves of investor sentiment? 
Dave Nadig: So, we publish flows for days, weeks, months, and quarters on our site. 
But I'd really be cautious about reading too much into them, especially over short periods of time. 
All that "flows" means is "there was a buy/sell imbalance big enough for an authorized participant to arbitrage out a price difference between the ETF and its underlying holdings." 
But those flows can also be part of rebalance activity, or a big ETF strategist making an allocation out of one fund into another with similar exposure for subtle reasons, and so on. 
Over long periods of time, sure -- if you see a ton of money flow into, say, tech, it's axiomatic to say "golly, investors are loving tech." 
But I think using it as a signal for a strategy is a bit of a mug's game.  By definition, you're chasing the past activity. 
It's also the case that the data itself can be a bit noisy.  There's no regulatory requirement to post changes in share counts daily, so errors DO creep in.  Our data provider (FactSet) catches that better than anyone else (in my opinion), but corrections aren't unheard of.


Miss Piggy: What possible use could there be for a pet industry ETF or a space ETF? Are issuers running out of good ideas? 
Dave Nadig: OK, the name made me chuckle. 
So, it's reasonable to look at the filing (ProShares, I think) and wonder if we've gone too far. 
Frankly, you could say that about any narrow, thematic approach like this. 
(Link: http://www.etf.com/sections/daily-etf-watch/planned-etf-target-pet-ind...
But it's a BIG industry, and a legitimate part of retail, so if there's room for an online-shopping ETF, or a social media ETF, well, who's to say pets are a bad idea? 
Some of these ideas will catch, and some won't. 
It's not particularly new; we've seen this in the mutual fund industry for years. 
The literal worst-case scenario is nobody buys it but you, and then the issuer closes it and gives you your money back. 
ETFs closing isn't some sort of catastrophic event. 
And remember, we used to have a "wound care" ETF, so this is actually pretty normal!


Nimish: Hi, Looking for the best Tech ETF with momentum and new technology mix bag. 
Dave Nadig: We'll be surfacing some factor data later this year that will make questions like this super easy to get out of our screener, but I happen to have the data here, so I can just tell you ... 
There's actually a specific ETF for this - PTF - the PowerShares DWA Technology Momentum Portfolio, which is very, very heavily loaded on the momentum factor (1.2 standard deviations away from a naive portfolio, if you're a nerd like me). 
Next in line would be the ARK Web x.0 ETF (ARKW) or the AdvisorShares New Tech and Media ETF (FNG), which both also score super high for momentum loading. 
Hopefully soon you'll just be able to see that when you screen for tech ETFs on our website. 
OK, one more question for the day ...


Garth Luccas: So ETFs are transparent and low cost. Are there any negatives? 
Dave Nadig: Sure - like any investment, there are always caveats. 
ETFs are generally low cost -- but not all of them are.  You definitely can find expensive ones.  And you also need to be very sure what you own.  ETFs have made access to anything really simple, but just because you CAN buy something doesn't make it a good investment.  So if you're wading into a new asset class for you - junk bonds, or commodities, or whatever -- make sure you understand what, and more importantly, why. 
Structurally, the "T" in ETF is a real thing.  You need to learn at least basic trading hygiene: not using market orders, not leaving stop orders open, and so on. 
ETFs are great tools, but they're just tools.  So's a chainsaw or a scalpel. 
With that, I'll wrap it for this week.  Thanks everyone.  As I said, a transcript will go up shortly. 
Also, don't forget to check out our segment of the ETFPrime podcast over at etfprime.com.  It's been a lot of fun working with those folks the last few weeks. 
And we'll be back here next week, same time, same URL. 
Have a great rest of your week.

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