What’s Next for ETFs
By Crystal Kim
“The innovation around ETFs means you can now trade all sorts of things most individual investors never wanted to trade.” —DAVE NADIG Photo: Matt Furman for Barron's
No invention has been more disruptive to the asset-management industry in the last quarter-century than the exchange-traded fund. Its tradability, tax efficiency, and cost ignited the low-fee revolution, sapping assets from actively managed mutual funds and fundamentally changing how advisories, brokerages, and asset managers conduct business. Just as the smartphone led to more innovation—interactive maps, ride-hailing apps, and social media—the ETF has created liquidity in hard-to-trade asset classes, enabled price discovery during trading halts, and delivered strategies previously reserved for institutions to the investing masses.
As the ETF industry matures—it now has $3 trillion in more than 2,000 products—Barron’s convened a panel of experts to discuss what sort of innovation investors can expect next: Ben Fulton, CEO of Elkhorn Capital Group, who just sold his $217 million ETF strategist firm to Turner Investments; Corey Hoffstein, co-founder of Newfound Research, the quantitative asset-management firm; Dave Nadig, CEO of research and data provider ETF.com; and Barry Ritholtz, co-founder and chief investment officer of Ritholtz Wealth Management, which oversees $607 million, 44% of it in ETFs. They are innovators—Fulton, the architect, created nontraditional benchmark indexes; Hoffstein, the quant, built algorithms designed to time major market moves; Nadig, the philosopher, offers opinions that are widely quoted; and Ritholtz, the investing sage, has guided the public through market peaks and valleys.
Barron’s: People in the ETF industry love saying two things: That ETFs are innovative, and that ETFs are a technology. How is the first true, and what does the second even mean?
Dave Nadig: ETFs are fundamentally a technology. They are mechanisms to achieve a certain goal, like phones. Traditional mutual funds were rotary phones. ETFs are smartphones: They do the same thing but are in a better package. The ETF structure, the technology itself, is straining to do all the things that we want it to do. People want ETFs to be like mutual funds.
Trying to shoehorn nontransparent active management into an ETF is the easiest case in point.
Barry Ritholtz: Innovation is all about asking, “What is less than ideal, and how can we find ways to solve it?” ETFs have solved many problems in the world of investing.
Corey Hoffstein: ETFs are innovative in that they trade more efficiently, but most financial advisors say the real benefit is the tax deferral for long-term investors. [Mutual funds often distribute capital gains that fund investors, even if they don’t sell their fund shares, must pay a tax every year; ETFs generally do not distribute gains.] ETFs cost much less, because ETF providers don’t have to pay platform fees. Most brokerages charge a variety of platform fees for mutual funds, including distribution fees and service fees. All of that ended up being an incredible solution and improved everyone’s circumstances.
Ben Fulton: Technological innovations go through cycles, and ETFs are no different. The ETF was a structural innovation. Then came index innovation, with cap-weighted, equal-weighted, float-adjusted-weighted ETFs—the list of new ways to build an index goes on. That drove product expansion. Now we’re seeing distribution innovation, also known as the Charles Schwab [ticker: SCHW] story. They created their own family of fundamentally weighted ETFs in 2013, and the firm in no time gathered $90 billion in ETF assets. That’s the evolution.
Of course, innovation can come with its own problems.
Ritholtz: Jack Bogle has hated the idea of ETFs because he thought it was going to encourage people who should be long-term investors to become active traders. I don’t know how accurate that fear has proved to be.
Nadig: It’s true that the innovation around ETFs means you can now trade all sorts of things most individual investors never wanted to trade. My mom can now buy long-dated oil futures, because ETFs democratized access. It puts a bigger onus on caveat emptor: Buyer beware. But it has also enabled entire businesses like Newfound to use ETFs as vehicles for a larger investment objective. In the hands of uneducated individuals, they can be a problem. ETFs are extremely sharp tools in the drawer.
Fulton: Mutual funds sell the concept of “once you buy this fund, you can own it the rest of your life and we’ll take care of the rest through all market cycles.” None of us built ETFs that way. Exposure to emerging markets and high-yield bonds—there’s a time you want them, and there’s a time you don’t. Do you think you are going to own the iPhone 7 for the rest of your life? It is going to be replaced. There will be new options.
Ritholtz: We’re in the middle of this Cambrian explosion of new ideas, some of which will work out splendidly, and some of which will crash and burn spectacularly.
That doesn’t sound like great news for investors.
Ritholtz: There are products the investing public should want but doesn’t know it yet, and there are things it wants but Wall Street doesn’t know it yet. I love what Jeff Bezos said—if we are not failing, we are not trying enough new and innovative things. Most companies don’t know how to fail, so it is left to the marketplace to decide. We should be throwing a lot out there. It should be responsible—I don’t think we need a 10X-leveraged Bitcoin ETF. But we certainly should be trying new and different ideas. That Darwinian process of natural selection is ultimately going to lead everybody to a place where the menu is full of attractive options.
“Most of the industry agrees that we are entering a period of much lower returns for stocks and fixed income. That’s a problem for younger generations.” —COREY HOFFSTEIN Photo: Matt Furman for Barron's
As someone who uses behavioral finance in his practice, you know people get overwhelmed by an extensive menu. How do they choose?
Ritholtz: Ask the waiter. Really, there is something to be said for the wisdom of the crowd. It’s not a coincidence that the SPDR S&P 500 [SPY] is the largest ETF.
Nadig: There are more than 2,000 ETFs and 9,000 mutual funds, and just 3,500 stocks, in the U.S. There is nothing magical about the ETF structure that makes an investment decision any easier, except that it gives investors access to more types of assets and lowers costs. But you have to understand what you’re investing in. A triple-leverage inverse S&P 500 ETF can be a very efficient hedge for an insurance company. But if my mom is investing her retirement in it, that’s an inappropriate use of that product.
Where would you like to see more innovation?
Fulton: We need more high-conviction, concentrated stock ETFs.
Ritholtz: My big beef on the product side has been environmental, social, and governance, or ESG, investing. In major ESG indexes, the top holdings— Microsoft [MSFT], Procter & Gamble [PG], Merck [MRK], Coca-Cola [KO]—are all well-regarded giants under the green umbrella, often in the consumer, tech, and pharmaceutical sectors. So you get a variation of the Standard & Poor’s 500 or some other broad index. My office created a set of ESG portfolios that are variations of our core portfolios because clients demanded it. This is one area where the mutual fund industry is still far, far ahead of the ETF industry and there is unfulfilled demand.
I want a concentrated ETF full of investments that can actually move the needle. Monsanto [MON] is being acquired, so it’s not a great example, but it and other companies developed drought-, salt water-, and stress-tolerant corn, soybeans, and wheat. That’s huge for farmers. They don’t call it impact investing for nothing.
Nadig: The reason for that is active management. That’s changing slowly; companies like MSCI now have a huge ESG data set people can build indexes off of. Sustainalytics is another. We have some of those products now, but the mutual fund industry has had more runway to make that happen. There is a specious argument about whether indexing flummoxes activists from extracting value from companies. Just because an investor is passive doesn’t mean he or she doesn’t have opinions.
Ritholtz: There is demand, especially among millennials, from people who want their money to reflect their values. Rational homo-economist-type people think of investing as utilitarian: I invest my money so when I retire, my standard of living doesn’t drop. In the real world, real people don’t think or behave that way.
Hoffstein: ESG investing isn’t going to help people retire better. Most of the industry agrees that we are entering a period of much lower returns for stocks and fixed income. That’s a problem for younger generations. The innovation needs to be around efficient use of capital.
Instead of an ETF that holds intermediate-term Treasuries, I would like to see a U.S. Treasury ETF that uses Treasuries as collateral to buy S&P 500 futures, so you end up getting both stock and bond exposure.
That sounds like the equivalent to the 130/30 mutual funds that were so popular in the mid-2000s. Those funds shorted as much as 30% of the portfolio.
Hoffstein: By introducing a modest amount of leverage, you can take $1 and trade it as if the investor has $1.50. After 2008, people became skittish around derivatives, shorting, and leverage. But these aren’t bad things when used appropriately.
“The challenge for every advisor today is to explain what their value-add is, because the portfolios are, if not free, cheap.“ —BARRY RITHOLTZ Photo: Matt Furman for Barron's
Nadig: There is a ProShares Large Cap Core Plus ETF [CSM], which tracks the Credit Suisse 130/30 Large Cap Index. There is always a cost and always additional risk for that excess return. My concern is that we are starting to get down to very narrow exposures.
Do you mean overly specific ETFs?
Nadig: We’ve had a lot of ETF launches recently—38 in the past month alone—and part of the reason is because people are still trying to motivate investors to slice their portfolios up into chunks. The world’s most boring portfolio is VT, or the Vanguard Total World Stock ETF.
Most mom-and-pop investors would be well served by a one-, five-, or six-ETF portfolio. They don’t need 2,000 to get diversified.
Professionals are putting ETF portfolios together in innovative ways—combining active and passive to meet a specific objective.
Hoffstein: Most major ETF providers offer their own allocation model for free, but those models are filled with their own products. Newfound takes a multimanager approach. We have a portfolio that aims to provide diversified asset allocation with lower risk and includes JPMorgan Diversified Return U.S. Equity [JPUS], which tilts toward value and momentum; iShares Core U.S. Aggregate Bond [AGG], one of the lowest-cost core-bond ETFs you can get; as well as our own Newfound Multi-Asset Income mutual fund [NFMAX]. We want low-cost access to U.S. stocks, and we want to key in on factors that can produce better returns over time. We also include the AQR Managed Futures Strategy fund [AQMIX] for crisis-type situations. It helps us manage risk because it can short asset classes around the globe. The Newfound fund is designed to provide a variety of different alternative income sources such as high-yield bonds, bank loans, and emerging market debt, but in an actively risk-managed manner that allows us to move the portfolio to short-term Treasuries if there is significant risk of loss.
So none of you see a problem with providers bringing more and more products to market just to see what works?
Fulton: There needs to be innovation with regulation. Regulators have held up approval on new structures, causing sponsors to abandon some ideas. If I want to create portable alpha, like the fund Corey described, it’s a six- to nine-month process. Even a simpler product, like a market-weighted, concentrated basket of 20 biotech stocks, will still take three to four months to get approved. Something that simple should be able to come to market faster. The market is changing all the time, and we can’t adjust quickly enough with this process. So you have to be great at predicting change. I’m fine with regulation, but there has to be an expediting process.
Nadig: You can launch a new fund onto an existing pile of funds quickly. When BlackRock builds a new country ETF for its suite of single-country ETFs, it is effectively an amendment.
But there is no reason to expect the process to get much faster, because there’s still a giant pile of paperwork. That isn’t holding back the ETF industry—300 products launched this year already. About the same amount have shut down. I don’t feel we need to have that pace go up to 1,000 a year. Regulatory reforms are needed to even the playing field among providers and make it clear how the structure is supposed to work. Right now, a product from iShares lives under a different set of rules than one from Elkhorn
What needs to happen on the regulatory front?
Nadig: The ETF is a structure living via loophole—every ETF that comes to market is, in effect, breaking the rules. That’s why providers need to file for exemptive relief with the Securities and Exchange Commission; they’re essentially asking permission to break the rules. That is a fundamentally bad way to run an industry.
The fact ETFs have succeeded despite that is phenomenal. There is no desire in Congress to reform the ’40 Act [the 1940 legislation that governs mutual funds] or to pass an ETF rule. The last time that was floated was in 2008, and it died on arrival. I see zero movement for any broad regulatory reform of core investment products.
On fees: “If you can’t compete, you’re wrecked.” —BEN FULTON Photo: Matt Furman for Barron's
There’s a lot of concern around ETFs that own illiquid securities, like high-yield bonds, bank loans, and foreign stocks. Is that a problem?
Hoffstein: Are ETFs that own illiquid securities structurally dangerous for the market? No, I don’t think so. The concern is that because ETFs offer secondary liquidity—the ability of ETFs to trade without touching the underlying holdings—the ETF’s value can meaningfully stray from the net asset value of the underlying holdings. If the underlying portfolio is illiquid, its prices can get stale. Maybe the question should be: Are investors educated enough to know that the value of the ETF can trade above or below its NAV on any given day? But that secondary liquidity is an innovation born from ETFs.
So it’s a feature, not a bug, that an ETF’s liquidity can be greater than its holdings?
Nadig: ETFs have effectively saved some illiquid asset classes. The high-yield bond market dried up, because bond dealing became an illegal activity for most banks. [In 2014, the Volcker rule effectively dismantled the proprietary trading desks at big banks, which had served as the primary market makers for high-yield bonds.] ETFs took the ability to basket a bunch of high-yield bonds and find another place to trade them—in this case, the stock exchanges. That became a saving grace for an asset class that otherwise would have become a person-to-person market owned by issuers, insurance companies, and Pimco. By moving that liquidity on screen into HYG [iShares iBoxx $ High Yield Corporate Bond] or JNK [SPDR Bloomberg Barclays High Yield Bond], we’ve created a price discovery vehicle for junk bonds.
What do you mean by price discovery?
Fulton: Take the PowerShares QQQ [QQQ]. Let’s pretend that Apple [AAPL] stopped trading for whatever reason. The ETF would continue trading. If you knew Apple represented a portion of that portfolio and stopped trading at X price and the ETF is trading at Y—if we can see that the other 99 stocks are priced exactly the same, we can calculate what Apple stock will open at. We can isolate a single stock, because the market’s view of that stock is reflected in the ETF’s value. In a mutual fund, no one knows until the end of the day.
Nadig: Junk bonds are illiquid; there is nothing you can do about that. If the bottom falls out of junk bonds and all of a sudden everyone wants to be out, it will fall. Laws of supply and demand don’t get repealed in an ETF. But the holdings in these very liquid junk-bond ETFs—some of which will go days without trading—are about as illiquid as you can get in a security. How do you price that underlying bond that doesn’t trade? You go to a bond-pricing service and they tell you: We think it is worth X today, because of what this other bond that is like it traded at yesterday or 10 minutes ago. The ETF will expose that problem because the ETF will trade down first.
Hoffstein: When you say bond-pricing service, you mean State Street or BlackRock’s trading desk?
Nadig: I mean Bloomberg’s junk-bond pricing service, or something like it. The input into evaluating the theoretical price of this untraded bond is where the ETF is trading. Usually, you figure out how much the ETF is worth by looking at the price of all the things it holds, but here holdings are retroactively priced based on where the ETF trades.
Ritholtz: How accurate is that compared to actually seeing the bonds trade?
Nadig: It’s not, but there is no better way to do it, because until somebody trades that individual bond, there is no price. The prices are determined by the market; if there is no market for this piece of junk paper and nobody is willing to actually take it off your hands, your only option is a fire-sale price from some big asset manager’s bond desk. The ETF structure doesn’t make junk bonds more liquid, it simply creates a price-discovery mechanism.
Hoffstein: My favorite example of this is the five-week Greek stock market shutdown. The Global X MSCI Greek ETF [GREK] continued to trade during that period. Trading of stocks on the Greek stock exchange was halted, but the Global X ETF continued to trade on a U.S. exchange and was the only vehicle of price discovery. When the market reopened, Greek stocks fell about 20%—the index came down to where the ETF was.
OK. On to the term everyone loves to hate—smart beta.
In 2014 and 2015, these alternative indexes, many of which weight their indexes according to certain stock qualities known as factors, took in $127.5 billion, according to research firm ETFGI. In 2016 and 2017, inflows dropped to $46 billion and $53 billion, respectively. Is this the end of smart beta?
Nadig: I don’t think smart beta is dead. What we are calling smart beta now we called “tilt and timing” in 1992 and quant before that. Flows have been overwhelmingly going to low-cost beta. We haven’t seen huge flows into smart beta despite the continuing flood of product launches.
Ritholtz: There’s a huge swath of academic literature that says, over time, value will beat growth, small will beat large, quality will beat lower quality, momentum beats lack of momentum, etc. We started with the Fama/French three-factor model [developed by economists Eugene Fama and Ken French], and now there are arguably six, seven, or eight factors. But while these factors will outperform over the long run, many won’t for periods of time. We’re in the middle of a period where growth is trouncing value. We had the same situation in the 1990s, when value was doing terribly and Warren Buffett had supposedly lost his touch.
Nadig: The real issue for investors is their timeline. Most of the research says you need to hold factors for seven years for your portfolio to outperform, which means you have to be willing to lose for three years to gain for four. Most investors don’t stick it out for three years of underperformance.
There’s a near-constant but low-level buzz around actively managed ETFs. Pimco and DoubleLine have had great success with their actively managed bond funds. Davis Advisors launched three actively managed stock ETFs earlier this year, but they are still small. Will actively managed ETFs ever rise? Do they solve a problem?
Hoffstein: This debate is all about where you draw the line in the sand between active and passive. I consider most indexed smart-beta funds to be active. They purposely deviate from market-cap weighting. So based on that definition, I would say active ETFs have already been incredibly successful. Just because they do it in a transparent, systemic, and rules-based manner doesn’t mean it isn’t active.
Smart-beta ETFs solve a problem in that they allow managers to replicate their market views in a more consistent manner and price them competitively. What about non-transparent active ETFs, which Dave mentioned earlier?
Nadig:There are many proposals that would allow active management in an ETF without the transparency ETFs are known for. The most popular one is the model put forth by Precidian [a New Jersey–based ETF shop in which Legg Mason has a minority stake]. It puts a third party between the market and the fund; that third party knows what is in the fund, but the outside market doesn’t.
How does that work?
Nadig: So there’s the fund, the third party we’ll call Bob, and Alice, the investor. Alice wants 50,000 shares of an ETF. The fund tells Bob what it needs, then Bob, after collecting the check from Alice, goes and buys all those things the fund asked for and gives the shares to Alice. Bob is contractually obligated to never tell anyone what the fund is buying.
Sounds complicated, and not great for Alice. Do nontransparent active ETFs solve a problem?
Nadig: It solves a problem for the portfolio manager but not necessarily for Alice, unless she really believes she’s getting a fund with some unbelievable special sauce. That’s the story managers use when they won’t disclose what they’re buying. I personally don’t buy that story.
A portfolio manager taking big, high-conviction positions in microcap stocks may not want to show their hand, so maybe an ETF isn’t the right structure for that guy’s fund. That said, I do think eventually one of these nontransparent active structures will get approved, and you will see a bunch of active managers come to market.
Hoffstein: As an active manager, I don’t see the need to hide my trades. Even if you put all of the funds operating in illiquid securities together, they make up a small piece of the whole.
Let’s talk disruption in the advisory business.
Fulton: It goes back to distribution innovation. What is a robo-advisor but an account-opening scheme?
Hoffstein: Portfolio management has been commoditized; robo-advisors are proof of that. ETFs have brought costs down dramatically, and technology has made making asset-allocation models easier and cheaper. Advice and financial planning are the advisors’ best value-add.
Nadig: The headlines go to Wealthfront and Betterment, but the assets are going to Vanguard. To open a robo account at Vanguard, you have to talk to a human being. That bionic model, where a human is involved in the discussion, is stolen from Canada, where it is a legal requirement. That model is going to dominate precisely because of that behavioral coaching component to a financial relationship, which is where most alpha will come from. You could be in a mediocre portfolio, but get the behavioral call right—i.e., not selling on the day the market crashes and not waiting until it runs up 30% before you get back in—and a mediocre portfolio will beat the pants off the guy who has the perfect asset allocation, but pulls the trigger at exactly the wrong time.
Ritholtz: Vanguard’s robo-advisor is coming up on $100 billion in assets incredibly quickly, though no one will officially say it. They’re several times bigger than any of the top robo-advisors and growing like a house on fire. The challenge for every advisor today is to explain what their value-add is, because the portfolios are, if not free, cheap.
There’s a lot of consolidation in the ETF business: Invesco’s PowerShares picked up Guggenheim’s ETFs; WisdomTree bought a piece of ETF Securities’ suite in Europe. Turner Investments just acquired Elkhorn. Why wouldn’t an active shop just build its own ETF business?
Fulton: Some do build their own, but you want the right person leading the group. Turner, which has been traditionally active, realized ETFs were the future, so they needed passive sooner rather than later. The gentleman who runs it has a big vision for incorporating research and other global partners. He didn’t want to just put a big toe in; he wanted to jump in. We sold our firm because we realized that being small does not make it easy to stay relevant. You have to fight to get to that $10 billion level.
This gets back to your point about distribution.
Fulton:You are right there. We needed to be bigger to be relevant and be a part of distribution strategies. On our own, that’s hard to do. There is a ton of pricing pressure, and now with insurance companies in the mix, it’s only going to get worse, as large companies try to attract assets quickly. If you can’t compete, you’re wrecked.
Thank you, gentlemen.
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