In the world of ETFs, while there are many people who claim a deep understanding of ETFs, there are few who actually possess it.
Eric Balchunas is an exception.
Eric has a deep bench of experience in the ETF industry. For starters, he is the senior ETF Analyst with Bloomberg Intelligence, and he has written a great ETF book, “The Institutional ETF Toolbox,” which is the best ETF book on the market as far as I’m concerned (For anyone interested to learn more, we recently reviewed Eric’s book). In addition to his book, Eric writes an ETF-related Bloomberg column that covers everything from the origins of ETFs, to the newer thematic ETFs. It’s a must-read for anyone trying to stay on top of the rapidly evolving ETF industry.
We were able to sneak in a few minutes with Eric so we could pick his brain and get his thoughts on some current issues facing the ETF industry.
ETF distribution and the future of the fund industry
AA: You talked in your book about how with ETFs, “No one is getting paid to sell them…it is purely a grassroots movement, where constituents are telling their advisors and institutions they want them.” Can you elaborate a bit more on this and how fund managers–traditionally forced to play with the bank distribution model–are tackling the problem?
ERIC: It is forcing them to get creative. Mutual funds are used to to fish jumping in the boat thanks to distribution fees and defined contribution plans. ETFs don’t have those luxuries. That’s why I say that that ETFs got their assets the hard way- from after tax, picky investors. For a mutual fund company entering the ETF space it’s akin to going from a country club to the jungle. And in the ‘ETF jungle’ you are forced to get creative and hustle. Since none of them are courageous, or perhaps crazy, enough to try and take on Vanguard or Schwab in a fee war, they are all launching smart-beta products based on their active manager secret sauce. Or, they are launching thematic products with the hopes that one resonates with the public. All this explains why Janus is out there launching an “Obesity ETF.”
AA: In your book, you describe how institutions use “smart beta” products (especially in equities) mostly as a complement to core passive holdings, or as a short-term replacement. Do you think institutions will increasingly use smart beta as a standalone investment?
ERIC: To a degree, yes. Generally speaking, smart-beta is used as a replacement to the active part of a portfolio. Not many passive management purists are going to be swayed by the promise of smart-beta, but for those who feel like they were paying too much for an external manager or hedge fund, smart-beta will be seen as a cheaper, less emotional and more tax-efficient alternative. We saw CalPERS start using smart-beta in place of hedge funds. Also, smart-beta ETFs have the best shot at making inroads with consultants, who typically are apprehensive to recommend ETFs since they specialize in active manager due diligence. Smart-beta is active-like and requires more due dil so they can still feel like they are providing value to clients.
AA: Do you think mutual funds are going the way of the dodo bird (i.e., extinct)?
ERIC: Yes and no. The media loves to write stories about how mutual funds are facing extinction. But the fact is Vanguard’s mutual funds this year have taken in more money than all ETFs combined! So how is that going extinct? But yeah, basically money will migrate away from actively managed mutual funds and into index funds and ETFs. But, I think the bigger trend taking place is the migration from high cost to low cost. This covers the active to passive trend, human to robo trend and mutual fund to ETF trend. Generally speaking, cost is quickly becoming the first checklist item in an investor’s decision. This is why I think in 10 years the asset-weighted average active mutual fund fee will be less than .50%, which will attract investors and result in more outperformance. That’s point where the pendulum may swing back the other way towards active.
Undersanding ETF liquidity
AA: On August 24, 2015, the stock market swooned, and liquidity for some large ETFs briefly dried up, when trading was halted on some of the underlying securities. The press jumped on this as a reason to question ETF liquidity. What’s your view on what happened with ETF liquidity last August?
ERIC: This was all about NYSE’s rules for halting stocks. If you look, NASDAQ didn’t have these problems. In addition, fixed income and international ETFs didn’t have these problems. It was isolated to U.S. stock ETFs trading on NYSE. Basically the market opened way down and stocks were halted. So market makers were unable to fairly value the ETF and so they widened out their bid ask spreads. This is like laying dry brush in a forest. Then, it just takes one market order (cigarette butt) to hit a low bid and then stop loss orders are triggered and you have a forest fire. In the end, ETFs should be in tune with stocks when it comes to halts. With that said, you could argue the market makers’ spreads were way too wide. You could also place some blame on the investors for putting in a market order at the open, or on the issuers for not educating them on how to better trade ETFs. However, with all this said, the total percentage of bad trades was below 1 percent on the day. ETFs by and large handled the stressful with flying colors and over 99 percent of the $200 billion traded went off without a hitch.
AA: You recently wrote a piece in which you referred to how the Bank of Japan owns 59% of that nation’s ETFs. What happens when the BoJ needs to unwind?
ERIC: The BOJ can just do an in-kind redemption when they want to exit, meaning they will hand in their ETF shares in exchange for the underlying stocks, which they will then sell in the open market. So, yeah, it will result in stocks falling, and the ETF will follow, but will do nothing unusual to the ETF or its existing investors. The ETF has shown it can lose 90% of its size or quadruple in size without missing a beat thanks to the creation/redemption process.
AA: We love the “ETF Implied Liquidity” field on Bloomberg terminals. Can you explain how it works and how you came up with field?
ERIC: The field is based on a calculation that David Abner of WisdomTree came up with when he was a market maker. I read about it in his book and then asked him for permission to use it. It basically tells you how many shares of the ETF you could create instantly without being more than 25% of any of the underlying stocks’ average 30 day volume. Put another way, it is a back of the envelope calculation to tell you how liquid the holdings are. Since market makers use the holdings to hedge, they are important piece to an ETFs’ liquidity profile.
But it isn’t just a nifty calculation, it is really the key to unlocking the full ETF toolbox. The smartest ETF investors, namely ETF strategists, know how to use implied liquidity and as such are able to use products that have better designs or are cheaper or fit their needs better. This is in contrast to the vast majority of investors who are hung up on volume and thus, stuck using 15 ETFs that came out in the 1990s (eg SPY, QQQ). They look at ETFs as stocks, but with an ETF, liquidity can be manufactured if the holdings are liquid. And since 90 percent of ETFs have either high volume or high implied liquidity, it opens up the toolbox in a big way.
AA: Thanks a lot, Eric. I’m sure this will give readers a lot to consider.
ERIC: My pleasure.
Wow, a lot to digest and think about for those currently in the ETF industry and for those who work with the industry. Thanks again to Eric for his insights and thoughts. Comments welcome.