‘The Institutional ETF Toolbox’

March 15, 2016

Eric Balchunas is a senior ETF analyst at Bloomberg, where he has more than a decade of experience working with ETF data, designing new functions and writing ETF research for the Bloomberg terminal. He also writes articles, feature stories and blog posts on ETFs for Bloomberg.com and appears each week on Bloomberg TV and Radio to discuss ETFs. ETF.com caught up with him to discuss his just-released new book, ‘The Institutional ETF Toolbox.’

ETF.com: There are other ETF books out there. What were you trying to do with this book?

Eric Balchunas: Most of the [ETF] books out there address retail and advisors. I wanted to find out how institutions were using them. They might be increasing their usage, but really only about 1% of institutional assets are in ETFs. It's not really that much in terms of their total assets.

What I found was they also don't use them just to go long, like to buy and hold. For a lot of advisors in retail, the ETF is a better, more tax-efficient, cheaper version of the mutual fund, game over. ETFs can beat a mutual fund five different ways. But on the institutional side, they have more choices. They can get cheap separately managed accounts. They love active managers. They love alternatives. The Yale model is a whole big thing with institutions.

Institutions use ETFs as adjustment mechanisms to do manager transitions and cash equitization, and to be liquid. Most of the institutions have investments in active managers, separately managed accounts and private investments.

Those things are not liquid. So they love ETFs for the liquidity. They can't get that kind of instant liquidity anywhere else. And for them, the liquidity is really about freedom. They don't have to call anybody. They can just get in and out. Part of what the book is saying is, here's how the big guys use them.

What I also found was they're not that good at using them. They tend to just use ETFs that have the most volume. The reason the top 15 ETFs make up 50% of the volume is because the size of the investors are so big, so the dollar volume becomes massive in those funds. But what they aren't doing is using the toolbox.

My case to the institutions is, “You don't have to use just the one that has the most assets. You can go into the toolbox if you learn how to use implied liquidity. That is the key to opening up the toolbox.”

The basket liquidity is really what the smartest ETF strategists look for. They don't even look at volume; they're looking at the basket liquidity. I make the point that institutions spend all this time and money on consultants and due diligence on active managers, but they don't spend any time on the due diligence of ETFs.

ETF.com: When you say “basket liquidity,” you're talking about what?

Balchunas: About how liquid the stocks or bonds are that are in the holdings. And that's crucial, because an institution, frankly, could just do a creation. They can skip the whole exchange to just have their market maker gather up all of the stocks, hand it in to the ETF issuer and get the shares.

Therefore, the liquidity of the stocks is more important. Most people generally think of ETFs as stocks. They think the volume equals liquidity. The fact is, that is true for stocks. But with ETFs, liquidity can be manufactured.

ETF.com: There seems to be a real sense of resistance to using ETFs on the institutional front. Are the vested interests of the consultants outweighing the responsibility they have for their client? Is that too cynical?
I wrestled with this during the book. You can go down that road and start getting negative about it. Or you can say, well, these are people who have jobs. They want to provide value. They're maybe a little nervous about the ETF being a sort of disintermediating technology. And that's scaring a lot of people. Look at robo advisors; same thing’s happening with the advisors. ETFs are really having a huge effect.

No matter where you turn, ETFs are a technology that everybody's having to deal with. And usually if the technology's that good, it will find a way. The intermediation will start to collapse because it's just that good.

Retail investors—and I think advisors to a degree—have thrown their hands up and said, “You know what? We can't pick a best manager. The costs are too much. It's hard to beat the market.” The retail crowd is a little ahead of the institutions.

Long-term allocation was the 11th-top usage in the chapter on institutional usage. It wasn't anywhere near the top. Institutions see ETFs more as a replacement for a futures contract or potentially cash. Or they might do long-and-lend. Or they use ETFs just to have a little liquidity rebuffer for a portfolio rebalance.

So the question is, will long-term allocation slowly move up the list for institutions like it is for advisors and retail? It's yet to be seen.

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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