‘The Institutional ETF Toolbox’

March 15, 2016

ETF.com: I'm a retail investor. I want to learn about ETFs. Do I read this book?

Balchunas: Yes, this book is written very informally. However, the one thing I do in the book is I will say net asset value, the value of the fund, and then I'm off. I don't take two paragraphs to go into exactly how the NAV is calculated. Having a tiny degree of foundation in investment vehicles will probably help the reading go faster. I couldn't stop and spend two paragraphs defining every single thing.

But the sweet spot for this book would be advisors, especially larger advisors; all kinds of institutions, especially smaller and midsize institutions; consultants; and then the ETF industry itself. Because again, throughout the book, I have quotes and case studies of how institutions are using these products to highlight how some of their clients are using ETFs.

I also have a whole section on tracking difference, which to me is one of the best metrics ever invented. If you consider tracking difference, you could find that institutions—even the largest ones—can get exposure that's as good as their separately managed accounts.

But the point is, if you add in a few of the other features of an ETF, and you can match the cost, and you can train institutions to not just look at expense ratio but tracking difference, you then get closer to that free exposure they’re used to because they are these gigantic spoiled institutions that are used to getting dirt-cheap SMAs.

ETF.com: Let's go away from the book. What's wrong with ETFs right now?

Balchunas: I'm not really sold on junk bonds being the problem, or even leveraged ETFs. They have such a small amount of assets that they really aren't going to cause any systemic risk. And frankly, something like the iShares iBoxx $ High Yield Corporate Bond (HYG | B-68) has lived through 10 years of all kinds of financial events. ETFs are battle-proven. They've lived through a lot of stuff. And they gain assets afterwards.

What I will say is that having spent an hour-and-a-half with [Vanguard Founder] John Bogle on this book, he seeps into your thought process. The one thing he points out—which I think is probably not so much for the institutional manager to worry about, even though it probably applies to them—is overtrading. If you look at ETFs, they have $2 trillion in assets, but they trade $20 trillion a year. That's a turnover of 1,000% a year, basically. Stocks only turn over about 250% a year, total. ETFs trade four times more than stocks.

If investors start out as buy-and-hold, and then they turn it into trading maniacs, that is a huge danger. The more you trade, the more you end up just working your money over to Wall Street. The temptation to trade is strong, undermining from that long-term investment discipline that a lot of people should have. That's probably No. 1 for me.

ETF.com: Who is the biggest offender in terms of overtrading ETFs? Retail investors?

Balchunas: Certainly most of the volume comes from legitimate traders who trade. And that's great; good for them. When you look at the turnover in the iPath S&P 500 VIX Short-Term Futures ETN (VXX | B-47), it's 100% a day. That's fine, because if you're trading VXX, you should be trading the heck out of it, because if you hold it long term, you're going to get screwed over.

Another thing is something MarketWatch wrote about; millennials using the triple-leveraged oil ETF. Do people know what roll costs are? Do people know what daily resetting and leverage is, and how it grows returns? I'm going to guess millennials don't understand any of that.

One thing I came up with in the book is what I titled the "Nasty Surprise Rating System." Some ETFs hold illiquid holdings, like senior loans. Some have tax surprises, such as the SPDR Gold (GLD | B-100), which is taxed as a collectible. Other funds have just some weird taxes for MLPs and futures. Then there are hidden fees that are in some of these ETFs, like a shorting cost.

I came up with a five-tiered system for giving advanced information to any investor on how much fine print you need to read, and the level of nasty surprise in the ETF. I use movie ratings in order to get the point across.

For instance, Vanguard funds are rated “G.” Anybody, including my grandmother, could use them. There's nothing weird going on. But then “PG” would be for something like GLD, because you get taxed differently. Or smart beta, equal-weighted funds would be PG, because there's a little more volatility and you might not understand that.

“PG-13” would be stuff like junk bond ETFs, and maybe China A-shares, stuff that's extra volatile. Then something like a leveraged fund or futures-based ETF like the United States Oil (USO | B-100) would be rated “R” because you can seriously lose a lot of money without knowing anything. It's complicated math.

This would give people advanced information so that if a millennial says, “OK, I really want to play oil, but wait, this thing is rated R. Why?” they’d at least try to figure out why. If they still go in, well, they were warned. What you don't want is a nasty surprise.

Overtrading and nasty surprises are the two things I personally think could be issues with ETFs.

Contact Drew Voros at [email protected].

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