Live Chat! Transcript 3.15.18

March 15, 2018

[Editor's note: Live! 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 back to Live, where I try not to make an utter fool of myself answering questions.
We had a good run of questions last week; feel free to keep them coming. 
You can enter your questions below, and no need to use a full name if you don't want to.
With that, let's get rolling.


Todd Rosenbluth, CFRA Research: Dave, You wrote in the past about the impact of potential liquidity disclosure rules for funds. What do you think of the latest SEC decision requiring less disclosure? Do you think investors understand the related risks of what's inside high yield bond funds?
Dave Nadig: Hi Todd! Great question. So, the liquidity rule as proposed, gosh, I guess over a year ago, would have required that funds (including ETFs) make quarterly reports on the liquidity of their holdings.
I won't wade into all the details, but the news today was basically that the SEC said "about that ... how about you just send US a report."
While I'm generally in favor of radical transparency, in this case, I think the way the liquidity rule was structured had a LOT of hairy problems.
Some of it was that they didn't really carve out ETFs as well as I think they could have, but it also just had some fuzzy logic about how to think about the real liquidity of things like bonds.
So, in short: I think a period where issuers send the SEC a whole pile of data for a while is actually quite smart. Hopefully it will let the SEC issue a smarter rule, eventually.
The core issue of funds (mutual funds in particular) having the ability to meet redemptions is legit. So I'm not saying "good riddance." I'd just like a better version of what they were after.


Joel Miller: They were talking about new fund RVRS on Bloomberg yesterday. Would you buy that one or just RSP?
Dave Nadig: Hi Joel.  So RVRS -- that's the Reverse S&P 500 Fund.  It basically weights the S&P backwards.
Theoretically, if you take SPY and RVRS and you own them equally, you're "sort of" making RSP. RVRS is just a much more extreme version of overweighting the midcaps.
I think it's an "interesting" product. It's a bit of a scalpel for reweighting your large cap -- or really megacap -- exposure if you're an S&P 500 investor.
So I think it's a pretty narrow, fine-tuning use case.  Honestly, you can say that for a lot of funds launched in the last few years: narrow, fine-tuning use cases.


Warren: What is the best low-cost, diversified, liquid ETF for commodities as a broad asset class?
Dave Nadig: So, the commodities space, despite not being a huge asset gatherer in the last few years, has seen a lot of interesting innovations.
The biggest has been the launch of so-called "no K-1" funds. That is, funds that use a clever dodge to avoid having to send investors a K-1 partnership tax form at the end of the year. Those forms are a pain, and a lot of investors, say, 5 years ago, had some unpleasant experiences.
To actually ANSWER your question, there are now a bunch of no-K-1 broadly diversified ETFs out there (you can see the list of all commodities ETFs here:)
If you sort that list just by expense ratio, you'll see it gets up above the 0.45% level pretty quickly.
The good news is that down at the low end, you've got some very solid options, particularly from two firms: ETFS and GraniteShares.
In fact, several of them even track (or target) the same set of indexes from Bloomberg.
Investors seem most enamored with COMB and BCI, both of which are solid choices I'd say. And pretty inexpensive!


Roger: Did you ever have hair?
Dave Nadig: HAH!
I love it. So YES, I did. I like to say I didn't give up on hair, hair gave up on me. Moving on...


Mike: SPY has way more liquidity than IVV, but IVV has ample liquidity and a lower expense ratio and it has outperformed SPY over the long-term. Seems like IVV is a better choice. Under what scenarios is SPY the better choice?
Dave Nadig: GREAT question. So, in MANY cases, there are what I would consider two choices of identical exposures. Certainly SPY and IVV (and VOO, Vanguard's S&P fund) are a case where you can have a bit of a head scratch about why these funds all exist, given how similar they are.
If I recall, the expense ratio gap is about 5 basis points in IVV's favor here (9 vs. 4)... Which isn't NOTHING, but isn't a TON of money either, so its definitely the case that people see them as pretty much identical -- however, there are two big differences.
The first is that SPY is actually a different underlying structure -- it's a UIT, not an open-ended fund ...
Most of the time, nobody should care, but the manager of a UIT can't really make any decisions. Like, they can't decide to take the dividends they got yesterday and invest them in futures to "equitize the cash."
So SPY is generally sitting on a little pile of cash in between dividend distributions, when it pays that out to investors.
IVV doesn't have to do that. So, over time, if the market is going up, SPY will have a SMALL amount of cash drag, hurting performance. If the market's going down, it will have a tiny bit of outperformance.
Over long periods of time, it's a difference of another handful of basis points.
So that's super nerdy answer 1. Answer number 2 is just liquidity.
SPY is the single-most-liquid security in the world, last time I checked.
That means if you're some giant hedge fund looking to make a BIG trade in a VERY BIG hurry, SPY's your friend.
You see similar "trader vs. investor" dynamics in a few other places - gold funds, for instance.


Phil Bak: On the current trajectory, when does the amount of assets in cap weighted funds hinder price discovery for stocks? What are the ramifications to the overall market if that happens?
Dave Nadig: Oh good, a simple question with a one-sentence answer (I kid, but I'll try to make this a bit shorter!)
There is an extreme example where every dollar in the world is in cap weighted indexes, and thus, there's literally nobody left to decide that, for instance, Apple should be worth less today, and Microsoft worth more.
But nearly up until that point, there are myriad price discovery opportunities, even if everyone's in index-based ETFs.
When you decide to invest in the S&P instead of, say emerging markets, you're personally participating in price discovery -- that between, say, Gazprom and Exxon.
If you decide to invest in small caps, you're helping small stocks reprice vs. large stocks. Same with sector funds. Same with stocks vs. bonds. Same with buying a niche blockchain-focused fund instead of a giant tech fund. All those LITTLE decisions all feed into price discovery. And on top of ALL of that, if in fact index funds create this huge distortion, you would expect the intra-S&P-500 performance to be very similar -- the gap between the top and bottom performers. In fact, that gap in 2017 was something north of 150% -- near all-time highs. So the math just doesn't actually support the idea it's all going to 1.0 correlations. Too many options. Too many investors.


Yin: This question is a bit technical. For ETFs that track foreign equity indices, how do traders price them during US hours when the underlying are not traded? I assume it's a mixture of statistical guesswork and currency arbitrage?
Dave Nadig: GREAT question. The very short answer is: they guess.
But, since it's all math nerds, the guesses are VERY GOOD guesses. Japan's the best example. There's zero overlap between the US and Japanese trading days.
Yet, we have tons of Japanese equity ETFs that trade like water in the U.S.
If you're the authorized participant, you build a model on how far from last night's Tokyo close you think a given ETF *should* be based on various market dynamics hapening in the U.S.
So for example, your model might suggest "OK, if the S&P is down 5%, Japan will probably open up down 4%" or something.
And you use a LOT more than just the U.S. market as a proxy. You look at ADRs. You look at futures markets. You look at anything you can, to come up with a proxy for what it SHOULD be worth.
And then, you make markets based on how confident you are in your model, which is usually inversely proportional to volatility on any given day. Crazy day in the U.S. markets? You'll probably let the price of Japan ETFs move a bunch more than on a slow day.


NA: Hi Dave, do we have any “crash-proof” ETFs that offer ways to protect against (or even profit during) a bear market?
Dave Nadig: Well, there's always MINT (grin). But seriously, the only way to minimize your risk of participating in a crash is to (surprise) have a strategy that's not in the crashing asset, or hedges against it.
There are quite a few funds that have triggers that try to manage either a hedge, or a cash position.
Off the top of my head, the TrendPilot series, from Pacer, for example, purports to do exactly this.
But of course, they're all based on models, and models need inputs, so there's no way to guarantee anything. That's just insurance.
As for profiting -- obviously there are all sorts of inverse ETFs, volatility ETFs and so on. But they all have significant risks, so -- big time do your homework!


Pete: Not asking for a buy recommendation, but what is your single favorite ETF?
Dave Nadig: I am TOTALLY going to cheat on this and pick two funds that are no longer trading.
The first is the Healthshares Dermatology and Woundcare ETF (HRW) -- because it just seemed ... ridiculous.
Whenever a reporter asks me if we've reached peak ETF, I point out that HRW launched over 10 years ago.
The second would be the Nashville ETF.
NASH, if I recall. For largely the same reason.


DMV: What's the difference between factor investing and smart beta? Aren't they the same thing? I see them used interchangeably and sometimes distinct... it's confusing.
Dave Nadig: Yep, it's confusing. I don't really know anyone who loves the term "smart beta."
But we're a bit stuck with it, like calling facial tissues "kleenex."
Most smart-beta funds are in fact playing somewhere in the factor sandbox.
But there's really not much point in getting into definitional arguments. Factor investing I can least explain -- it's bucketing a pile of securities by a set of non-industry characteristics, believing that those characteristics are a source of risk premium, and thus unique returns.
So: value, momentum, quality, volatility, etc.
There's a TON of academic research behind that, notably the Fama-French model, which looked at value and size in particular.
So when you buy a value fund, you're a factor investor. And since I'm a big-tent kind of guy, i consider all of those "smart beta" funds.
It gets much more complex when you start combining factors, and bringing models into play that react to signals. Another area you REALLY have to dig deep into each fund on.


Cryp-To & The Snow Dog: Why is $100 million in assets and $1 million in average daily trading volume the threshold everybody uses to decide whether an ETF is big enough to invest in? Is it still a fair benchmark, or should investors be thinking smaller/bigger?
Dave Nadig: Love the name -- I imagine TinTin buying Ethereum. So rules of thumb ...
We all have various rules of thumb for things, and the bigger the pool we have to decide from, the more likely we use some initial screen. Like, my wife simply won't see horror movies, period. It doesn't matter if I tell her "Get Out" doesn't have any jump scares.
So people use that rule of thumb, or one like it, just to limit their decision pool.
I would argue, however, that they're pretty dumb when it comes to ETFs. At least the asset level one. There are quite a few ETFs that now cross the $100M mark that really don't trade very much, because they're bespoke for a given institutional client.
On the other hand, most less-liquid ETFs can easily be bought and sold by a reasonably careful investor.
Ultimately, what the exposure is matters SO much more than the asset levels or the trading volume. Those are just shorthand for "can I get in and out?"
And with limit orders and a little care, the answer is almost always "yes."


Curious and Confused: How can biblically responsible ETFs be considered part of socially responsible investing, considering these ETFs actively screen out things like the "LGBT lifestyle?" Deciding something is "Socially Responsible" seems a bit arbitrary at times -- who/what decides if a fund is a socially responsible ETF?
Dave Nadig: So, first, allow me to promote a webinar I'm doing on Tuesday on PRECISELY this topic.
Second, ESG suffers from pretty much the exact same problem as the smart-beta question I answered a few minutes ago. My version of it may be totally different than yours.
In fact, it might be literally opposite -- just like with factor funds. You may want to screen OUT gun stocks and booze companies. That might be my actual target for investing.
It gets most complicated around the "S" - and again, there's no magic solution. We use the ESG flag as a convenient bucket for funds that have, as their stated goal, something related to ESG -- whether that's a fund that excludes certain kinds of companies, or one that deliberately targets so-called "sin stocks."
(I admit, it's far from an exact science -- we don't call fossil fuel ETFs "environmental funds" even though they're the equivalent of a "sin stock" fund on the "social" vector.)


Marty: So you think we have reached product development peak?
Dave Nadig: See my comment about Woundcare! But the short answer is: no.
While we keep seeing a lot of new, niche products, we also see a pretty healthy rash of closures. I see that as mostly a good thing.
Ultimately, there's a natural limit on some parts of the market. I don't think we're going to end up with 50 robotics ETFs, for instance.
But there's certainly room for a few. Not only do exposure differences matter, there's a difference between, say, Schwab launching a new fund, and me launching "Dave's Excellent Fund." Schwab has distribution.
So even in a seemingly crowded market, where it seems like all the obvious ideas are taken, I still think we'll see new products launch -- and thrive.
I think there's a lot of room in thematic ETFs. I think we'll see a bunch of new active ETFs, and I think ESG will continue to be a slow, but steady trickle.


Cryp-To & The Snow Dog: It's tax season, so: What the heck is a K-1 form and why does it matter that some ETFs don't issue it?
Dave Nadig: We have an article going up on this shortly, but in a nutshell:
If a fund is organized as a partnership (like, say, a commodities pool is) then it has to issue a form showing your partnership interest. Form K-1.
In the commodities space, this both means more complex taxes, AND, critically, that you will have a reported gain (or loss) whether or not you have actually sold anything.
So you can theoretically be sitting on a nice gain in your, say, agricultural fund, get your K-1 form, and then have to write a check to pay the taxes on that unrealized gain.
And I don't know anyone who likes paying their taxes or filing them.
So ditching all of that is generally a pretty good deal.


Eli Krohner: What do you think of Grantham from GMO saying to invest most of your money in EM and the rest International?
Dave Nadig: Hi Eli (and sorry, I don't think I'll get to the rest of your questions)...
So, first -- I'm not a "market call" guy. I used to be an active mutual fund manager, and I was bad at it. My portfolio is incredibly boring.
That being said, ...
I read those comments though, and his argument seems to simply be "Boy, this all looks really expensive"
My experience has been that getting those kinds of calls right is essentially impossible. Of course SOME people will get it right. Every time we have a major correction, stars are born. Like clockwork.
But part of why I'm a boring investor is to not have to worry about that. There's no question in my mind that the markets will have several huge corrections before I'm dead. But I also know there's no way I'll time them right.
So I'm a big believer in just being boring, allocating in over time, and rebalancing on a regular basis. Rebalancing cures so many problems.
OK, a few minutes left, and I'm sorry if I didn't get to your question, I'm trying to just sort of mix them up.


Paul: After the letter from SEC on 18th Jan, do you still see the possibility of a Bitcoin ETF? Will the industry be able to tackle issues mentioned by SEC (valuation, liquidity, custody, arbitrage, manipulation)?
Dave Nadig: Well, I won't comment on what regulators will or won't do, but I will say that I appreciated the crystal clarity of the SEC memo. It was frankly really unnusual to have that clear a delineation of things from them.
In general, I see this as primarily an ecosystem problem.
Ecosystem problems tend to be solved by time, more than by regulation.
So if we look at the challenges faced in crypto, in cannabis companies, even in corners of the market like green bonds -- it's mostly just long-term market forces that will solve these problems.
Sorry if that sounds like a cop-out, but I genuinely believe that's the core issue -- it's not that any of these markets are broken, it's that they're just young.
I also think we're just at the beginning of seeing how this SEC is going to interact with the ETF issuer community.


Cryp-To & The Snow Dog: Do you think we'll see a regulatory crackdown on "closet indexing" in U.S.-listed active funds the same way we're seeing it overseas?
Dave Nadig: OK, last question.
In short - I really don't think so. The U.S. regulatory regime has largely been about structure, transparency and disclosure as the mechanisms of investor protection.
What your talking about is really looking under the hood at what's going on inside a fund -- and in the U.S. environment, that's supposed to be the domain of the fund's directors. They're the ones looking after shareholder interests.
Technically, if an active fund manager is charging 1% and just hugging the benchmark, the board should probably fire them. In practice, I don't see a lot of that happening (to say the least).
All that said, I have talked to a bunch of fund boards in the past year or two, and the rise of passives/ETFs has made them MUCH more focused on the core question of "what are my investors getting for what they're paying?"
That process (technically, the 15c process) is getting a lot more attention than I was seeing, say, 20 years ago.
So ... baby steps.

OK, that wraps up the hour. Thanks everyone for the great questions. Sorry for the ones I missed, and hope to see you all next week. We'll post the time for it on Twitter, and put up an article the day-of like we did today.
Have a great day folks.

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