ETF Edge - The Russia Rollback

Episode Date: March 7, 2022

CNBC's Bob Pisani spoke with Dave Mazza, Head of product at Direxion, Jim Davalos, Research analyst and portfolio manager at Horizon Kinetics and Ben Johnson, Director of global ETF research for Morningstar. Last week was a wild one not only for the U.S. but also Russian stocks...between individual names and ETFs getting halted by exchanges and major providers like MSCI, FTSE Russell and S&P removing listings from their indexes - that's sparking a lot of debate about what qualifies as "uninvestable" right now. In the 'markets 102' portion of the podcast, Bob continues the conversation with Ben Johnson from Morningstar on lasting damage to ETF investing. Hosted by Simplecast, an AdsWizz company. See https://pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge Podcast is sponsored by InvescoQQQ, supporting the innovators changing the world. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you're in the right place. Every week we're bringing you interviews, market analysis, and breaking down what it means for investors. I'm your host, Bob Pisani. Now, last week was a wild one for the United States, but also for Russian stocks. Between individual names and ETFs getting halted by experts.

We had major providers like MSCI, Futsi Russell, and the S&P removing listings from their indexes. That sparked a lot of debate about what qualifies as investable or uninvestable right now. We'll talk about it and what it means for your portfolio. Plus more on how to grapple with rising inflation. Here's my conversation with Dave Mata. He's the head of product at Direxion. Jim Davilos is the research analyst and portfolio manager at Horizon Kinetics. And my old friend Ben Johnson is director of global exchange traded.

research for Morning Star. Dave, you managed the direction Russia Bull, two times shares ETF, that's a mouthful, but it provides two times the exposure to a market cap weighted index of Russian companies. But I talked to you last week, you were going to halt trading on

March 11th, but the NYAC did it for you. They hold the trading of your fund and two others on Fridays. Tell us a little bit about how you and the ETF industry are reacting to what is essentially the forced closure of that fund. Yeah, exactly. If we take a step back, we have two concurring forces that are happening at the same time.

On one hand, we know that local equity markets in Russia are unable to be transacted. They've been closed now for some time. So the actual ability to price the security that's not trading is very difficult. So even though the weights in many larger emerging market ETFs and indices for Russia are small, Russian-specific ETFs, of course, are going to be larger. So in those cases, the NYSC as an exchange, made the decision to out. actually halt the trading of those particular securities because their prices were so disconnected from the potential price of Russian security. Who can say what a particular company should be valued

at if you can't trade and an investor can't transact? Yeah, you know, Ben, it seems like, and I was talking to Dave about this, and you too, it seems that we're seeing the retreat of globalization played out in the investment space. I know Russia is a very special situation. We have a war. situation. But we've talked about this for a long time, you and I. There are broader concerns about global investing. What about other regimes that are not at war, but we do not approve of, like China. You and I have talked about this in the past. Are parts of the world starting to become uninvestable? Well, Bob, what comes next is anybody's guess? And in the meantime, what you

see is that the index manufacturers are really playing by the rules. What you see outlined in certain chapters of the rule books is exactly what's being executed right. now. When the underlying markets are closed, all bets are off on these securities, not just in Moscow, but in London and New York, they can't get a good price. And index providers depend on having good prices. The asset managers that are trying to track those indexes certainly don't want to track an index that doesn't have prices for its underlying constituents. So the indexes are playing by the rules. The asset managers are trying to play by the rules. Some of these rules specifically that are unique to the asset managers to whether or not they can transact,

they can't, and they can't dispose of any securities that they can't actually make an economic transaction in. So we're going to be making some things up as we go, and we're really in uncharted waters here right now. Yeah, I certainly agree that the index providers are playing by the rules, but I'm interested in the broader philosophical implications of what we've been discussing, not just with Russia, but even with China and other areas of the world. So, Dave, some have argued that China's autocratic actions should be sufficient to convince some investors that China itself isn't investable any longer. U.S. Senator Marco Rubio, we have had him on many times.

He's led calls to convince pension funds, particularly government pension funds, to sell their China stocks. While index providers have declined to delete China from the global indexes, it's not the same. same thing as Russia. They've made it clear that if there was demand for an index of global stocks that excluded China, it could be easily provided at this point. So you get my point here. We're debating very broad issues about inclusion and investability at this point that we were never debating two or three years ago. Yeah, no, that's absolutely right. And I think individuals right now, of course, need to make a decision either by themselves or with an advisor to say if a particular country or security is right for their portfolio. But if you even take a step back from that,

we have been in an environment where for years we were being told to diversify away from the U.S., away particularly from the U.S. fang stocks and the mega cap growth that have dominated indices, and the area people have been going to is emerging markets because they've been so out of favor and so inexpensively valued relative to their history. And that's all really changed. So I think what you're seeing here is that the door is potentially open for index providers, to take greater action than many people had assumed. To Ben's point, much of this is laid out in rule books, in guidelines, things of that nature,

but most people don't expect, of course, to wake up and find a war situation. But the question I would have, and I would advocate investors large and small to think about, is what actually is the potential playbook and path forward? This is not to say that we're going to see a particular action that China may take or not. It's just simply, if that occurs,

I think we know that index providers aren't going to wait around anymore to necessarily be told what to do. And they might be moving faster than asset managers. Yeah. So, Ben, what about that playbook? Is it different? You know, he's right. For years, we were told we should diversify. We talked about how to lay it out. Now we're told sort of maybe not diversify. What will the new global investment order look like? The old order we you and I grew up with simply investing globally by market capitalization, it may not have resonance for a lot of investors anymore, even if they just remain in index funds. Well, in light of certain current circumstances, Bob, I think it might not resonate in the case of broadly diversified market cap-weighted exposures to emerging markets,

where you see China really looming large and larger than ever, in fact. And the direction of travel in recent years is to include more exposure to China by way of, for the first time, onboarding exposure to onshore listings of Chinese equities. I think this is a moment that's going to give many investors pause. We've already seen index providers respond by offering emerging markets ex-China benchmarks. There's countless different benchmarks out there. There's funds now that track them. And there are some clever ways beyond just broad-based market cap weighted that you see index providers and ETF providers bring exposures to bear to investors that invest in emerging markets, but keep a close eye on some of the issues that we're living through in this very moment. I can mention tickers like FRDM, a freedom-weighted index that has not had exposure to either China or Russia.

You look at another fund like Wisdom Tree's XSOE. Now, that's got exposure to some of these markets, but specifically looks to remove state-owned enterprises from the mix. So, you know, there's no sort of limit to the creativity, the dynamism, the options that index manufacturers and fund sponsors have to try to navigate some of these issues. Yeah, Perth Toll at the FRDM is a friend of ours, a friend of ETF Edge. Ben, try to explain something to people who don't quite understand how these ETF work. what these funds are going to do with these Russian stocks. You know, the Telegraph in London has reported that investors have a billion pounds trapped in the Russian stock market. It's amazing that the index providers like MSCI have simply decided the value of these Russian assets are now zero.

They made zero. So with the fund like, I don't know, I shares emerging market ETF, the EEM, that's indexed to MSCI's emerging market index. It has roughly a 3% waiting to Russia. They now have a bunch of stocks. iShares emerging market ETF that have a zero value all of a sudden. Can these ETFs sell their holdings if and when the

Russian market reopens? How does this work? Well, there are a variety of things that have to happen first, Bob. For the time being, all they can really do is sit on their hands and keep up to speed on developments as things continue

to change on the ground. So, until the Russian exchange or the listings of any of the ADRs or GDRs begin trading hands again. They simply can't do anything. They've marked down in many cases the value of these positions to zero. They continue to sit in the portfolio. The owners of these funds will have a claim on those underlying securities in the event that they become liquid, that they become tradable again. There could be a bit of a pop. Certainly, you would expect a pop beyond a value of zero. And that point,

point in time, those securities are going to be liquidated from these index portfolios because they're no longer in the index. So you'll see a little bit of a blip in terms of positive tracking error. Investors will get out of those securities. And in all likelihood, Russian stocks will be in the penalty box for the foreseeable future off on their own until the index providers can get comfortable mainlining them again if that ever happens. Yeah. I want to move on and talk about the current hot investment idea, playing the inflation card. I want to bring in Jim Davalos. He's the portfolio manager and research analyst over at Horizon Kinetics. He runs the Horizon Kinetics inflation beneficiaries. The symbol is INFL. You know, Jim, you started this fund 13 months ago.

We've already got a billion dollars in assets in this. This is companies expected to benefit from inflation. You have mining, transportation stocks, real estate companies in here, exchanges. But you've emphasize whenever I've talked to you about that we don't just buy them willy-nilly, you want asset-like kind of assets. Can you explain what that is and what's the philosophy of INFL? Sure. So I think that it's pretty easy with kind of first derivative logic to say, hey, who can raise prices with inflation? I'm no expert, but I would say Apple can probably raise the price of their iPhones. But a lot of companies are going to have expenses that are as much or greater than they can grow revenue. So that's why it's really important to have a hard asset,

so a physical, tangible asset that can benefit from inflation driving your revenue, but absent that those fixed costs are the high capital intensity that drive a lot of your costs of goods sold, and that's G&A. So in other words, while your revenue grows with a lot of these companies, your margins are also going to expand. So the companies benefit twofold, whereas a lot of other companies are going to have a lot of trouble with the cost side. Yeah. Now, you own, There's certain companies that make a lot of sense. You own land companies, for example. So owning land would be a logical asset.

Texas-specific. You own a bunch of energy companies that are in this fund. But you also own stock exchanges. You own a significant investment, for example, in Deutsche Borz. Now, what's the, why is that an inflation-linked asset in your mind? So if you think about it, at the end of the day, inflation is a great uncertainty on the market. And financial exchanges are basically, they are,

marketplace for selling and buying risk. And so one of the biggest drivers of volume on exchanges, whether it's equities, fixed income, rates, commodities, is volatility, uncertainty. So right now, all of these exchanges, whether you're talking about the U.S. exchanges, the ICE, the CME, the Deutsche Burs, the ASX, they're all printing record revenues. And what does it really cost for them to have all of that extra revenue? I mean, we're sitting here on the NYSC floor, but for them to do another trillion dollars a derivative volume at the ice, they plug in another computer mainframe. So it's really a

toll booth on financial activity, and we've all kind of been spoiled by 10 years of low volatility that has suppressed volume. So I think that the margins and the revenues are going to really go up across the global exchange complex with inflation. Yeah, and that makes some sense. So market makers, for example, also would do very well. People who would benefit from volatility, high levels of trading, for example, would make a lot of sense. You know, Well, Ben, this is the ETF theme of the moment. You and I have watched all of this go through for many years. We remember pot ETFs.

They had their day. Then we had Bitcoin equity-related ETFs that they had their day. Then we have thematic tech ETFs in 2020 and 2021. Now it's inflation ETFs. And, you know, this is the beauty of ETFs. But it also means investors chase themes that get a rush of money, then, you know, fizzle out. Either because people get bored with them or they don't pan out. Is it good to allow investors to chase these kinds of, essentially fads is what they are right now?

Yeah, so, Bob, taking stock right now on the ETF menu, we currently have a deflation ETF, we've got a number of inflation ETFs, there's a stagflation ETF that isn't filing. So we've got all our various flation scenarios covered. And the problem more often than not is what you see is that oftentimes the contents of that portfutable, don't necessarily align with that objective or that theme. Now, that's not to say that there aren't thoughtful sponsors that get things trued up. And I think we've got a case here where there's a good degree of thought that's been put into it. What's more challenging still is just to get the timing right.

So by the time most of these funds come to market, we've long since sort of bought the rumor. Many people have sold the news. And all that's left to do is really short sell the thematic. because many investors for some period of time now have set themselves up to be a victim of their own behaviors. We've seen time and time again buying exactly at the wrong time when all of this enthusiasm, all of these expectations have already been priced in to the securities that are represented in these portfolios. So investors need to think twice, I think, when they begin to approach these things. You know, to borrow from John F. Kennedy when it comes to inflation

or what have you, the best time to fix your roof is when the sun is shining. And right now, as it pertains to inflation, the sun is certainly not shining. The time to batten down the hatches was a long time ago. There is a behavioral, what Ben is saying is there's a behavioral economics aspect of this whole thing, that people rush in towards the shiny new object, as we like to call it, and suddenly get interested. With that said, you've done very well. When did this happen? January last year, right?

As I recall, I had you on, right? is that came on last year, and now you've got almost a billion dollars in assets under Ben.1. 1.1. And so it does work. It does. We might say, Ben and I might sit here like, you know, ETF philosophers, as I call Ben, the ETF philosopher, because he is, and I agree with them, that shiny new objects,

you should be careful about them, but they do work. They do get assets. And I don't disagree with what Ben said at all. I think that there's a big nuance between beta where you're making a binary bet on CPI, on a commodity, on interest rates. That is for traders, and that's not something that I do. What I've designed is a full cycle portfolio where these businesses, I think they're going to generate very strong economic returns under the pre-inflation status quo. So returns on equity 20, 30, 40, 50 plus percent. And so there's not a binary bet on inflation.

you'll do just fine if it continues, but to the extent that there is lasting inflation, you're going to do very well in these stocks. And so what I call this is a full cycle or multi-cycle way to play a structural shift in the economy that has to do with a lot of these hard assets versus kind of the service dominance of the past decades. Yeah.

Hey, Dave, you have a lot of familiarity at Direc, Sean, with leverage and inverse ETFs. Speaking of things that might be, a hot topic in the future. You've had a filing for single-stock ETFs. I know it's a filing, and it's not trading yet, but can you give us a little insight into what you're thinking here and what kind of single-stock ETFs you're filing for? Yes, we filed for a series of leverage and inverse ETFs on single securities. Now, I can't speak much further than what has been put out in that particular filing for regulatory reasons, but you're absolutely right.

In my opinion, there's innovation that can still occur in the ETF industry that we've seen over the years into different areas. ETFs were launched in a humble way just for a diversified portfolio of equities, and now it's in fixed income, commodities. We're talking about thematics and inflation solutions. So we're always looking for ideas to provide traders, especially for our particular business. And these are tools, most of our ETS are tools for traders, people who can manage their portfolios on a daily basis to make decisions, either to amplify exposure or to hedge other risks in their portfolios. So can you tell us what stocks you filed for right now? So this would be Amazon's one of them, right?

There's a filing for Amazon, right? Correct. So there's filings for Amazon, Meta, Tesla, among others. So really core, large, liquid securities that have been filed for at this time. And these would offer what? Leverage and inverse? be a little more explicit. This ETF for Amazon, for example,

it would be two times levered? What's the filing for? Yeah, exactly. So each particular filing has a pair. So two times on the upside, which is called a full fund, two times on the bear side, a bear fund. And then also just a one-x bear fund. So that's just the inverse exposure.

It's important to remember. that like all leverage ETFs, these would be done on a daily basis. So really intended to be tools for traders, both to amplify or, again, to hedge that exposure. Now, correct me if I'm wrong, but this is the first, yours would be the first one in the United States. It would be single-stock ETFs. They do exist in Europe, right? But there isn't any here in the United States that are single-stop, right? That's correct.

There's none in the market today, but there is, if you were to look overseas to the European U-SSat's market, there's actually more than a handful of ETFs that have similar objectives, I should say, that trade in that market. But as we know, there are other, whether we're talking about cryptocurrencies or others, there are actually markets that are actually ahead of the U.S. ETF market, whether it's, again, Canada or Europe, that we really hadn't seen in the past few years. So they're really making innovations, and in some cases we're now following. So, Ben, here we go.

this is sort of the ultimate thematic tech ETF, a space bet on a single large tech stock, whether it's Amazon or Tesla, several of the ones that Dave has filed on. What do you think of this idea? Yeah, I mean, I would characterize a lot of what we've been seeing lately, Bob, at the margin in the ETF space, as it pertains to product development like this, as it pertains to the trading volumes that we saw last week and some of the Russia-focused ETFs. This is really the late Jack Bogle's worst nightmare regarding ETFs manifest, that they become a strictly speculative tool.

We've come a very long way from the origins of the space, and that's not to say that they don't have a use case for certain investors, for speculation. But for your average investor, I wouldn't touch these things the 10-foot pole. Yeah, I'm not trying to drag you into this, Jim, but Jack Vogel didn't even like an S&P 500 ETF because he thought it would encourage speculation

and intraday trading, as Ben aptly points out. Imagine what he would think of this at this point. I mean, it's really rather remarkable development. But that's logically, if people want to do it, fine, I guess, is the right answer, correct? Despite what Jack would think, and those of us who are Jack Vogel disciples might not our heads in agreement, but... People use these for a lot of different reasons. They size them appropriately.

People might have underlying exposures that they want to hedge or enhance. So I think it's all about using it intelligently versus using it speculatively, and like everything in this world, size it appropriately. Yeah, and now, of course, Ben, we're going to have to explain what it means to have to adjust on a daily basis for these funds. Like, remember what we did three, four years ago? and how we had to do it. We're going to have to go back to that playbook explaining how you don't actually get, you know, if it's up 25% this month, you don't actually get it because of the daily adjustment. And Dave, you're going to have to be explaining that a lot, too, I suppose, in the near future.

Do we have any sense, Dave, of when these might be able to begin trading, or is that too far in the future to figure out? Yeah, I think that's a bit too far in the future to be able to provide any certainty around that. But, again, you raise a great point. To me, whether we're talking about single beta ETFs or ETFs that are intended for tactical traders, which these products would be, it's all about education, understanding how the products work, what your exposure is. And in particular, if we're talking about tools that are for trading, to have the ability to make a buy and sell decision on a daily basis. And if that's the case, you know, I recommend investors doing their due diligence, getting their education, because these can be tools for traders that can be very powerful for them. if used appropriately.

And we really, again, advocate for folks to do that due diligence, do the education on our website or other sources to understand that. And if they're not right for you, don't use them. Again, if they're not right, if that's not your potential, stay away and look for other options to build diversified portfolios. Yeah. Well, Dave, let us know when it's coming, and we'll have you on and we'll explain what it means to reset on a daily basis.

I love doing the math on those kinds of things. Now it's time to round out the conversation. with some analysis and perspective to help you better understand ETFs. This is the Markets 102 portion of the podcast today. I'll be continuing the conversation with Ben Johnson from Morningstar. Ben, thanks very much for staying around with us. I'm wondering what, if any, more lasting damage we might be seeing the ETFs and mutual fund investing.

I see this morning we have a fairly small fund, the two cream wheat fund, which essentially invests in wheat futures, was halted early. early on and it was declared that there would essentially no longer be any creations of new shares although they would be you could still redeem them can you briefly explain what that means is that mean there's a problem now with determining whether the fund is really trading at the net asset value what does this mean for the investors when you halt creations of a of a fund yeah it's a good question Bob and in what it means in in this instance is that there's

There's not enough shares of this particular ETF out there on the market to meet current demand. It's seen a ton of money flood in as weed prices have shot higher. The problem is that the fund can only own wheat futures in a certain amount, at least as it stands today. So it's bumped up against that limit. It's had to close the doors to any new money coming in until it can have that limit raised. And what you see, just based on the supply demand dynamics for the shares as they're trading hands back and forth on an exchange, is that they're going to come untethered to an extent from the underlying value of the portfolio.

Typically, what you see in this scenario is that the price of the ETF shares will trade above its net asset value. It'll trade at a premium until such a time as this situation can resolve. They can take greater positions in wheat futures, and they can issue new shares to address this supply-demand imbalance for shares of the ETF. So the key point here is there's a limit to how many futures. They can't go out and just corner the wheat futures market with an ETF, right? There's actually in the perspective it states how much what the limit is they can own. Yeah, that's exactly right. So this is unique to the fund.

There are also going to be limits at the level of the exchange. And we've seen similar instances of... of this in the past with oil futures funds. Actually, I shares gold ETF, IAU at one point in time, very briefly hit its limit on its ability to issue new shares. So there's a lot of devils in those details that are outlined in these funds prospectuses

that really don't come to light until we run into situations like this. And this is not done to mess around with people's heads. It's done for a very important reason. You don't want any fund, cornering the market anything essentially. I mean, it's really done for investor protections. You don't want this to become so, these things to become so big that they're systematically dangerous for the markets. Is that right?

Absolutely. And I think especially in an instance where at the end of the day, what we're talking about, what the underlying is, is food, right? So we don't want to see a scenario where speculative interest in wheat is in any way disproportionately affecting the prices for wheat around the world. I think the key point here is there's a very important reason why people actually want to put limits on the amount that these funds can hold. And so there's a public interest reason why they hit the limit. We'll keep an eye on that. Let me ask you about fund flows. this has been such a wacky start to the year.

Does anything in terms of where the money is going strike you, ridiculous amounts of money and do or out of bond funds, particular stock funds? What strikes you is interesting after two months of the year? Yeah, so looking at the flows data through February, what really jumps off the page is the fact that Vanguard has just been absolutely relentless. So through the first two months of the year, Vanguard has taken $26 billion more into its ETFs than its next nine largest competitors combined.

And a lot of that money is flowing into the very basic plain vanilla. Every bit as exciting is watching paint dry and grass grow at the same time funds. Vanguard total stock market index, their S&P 500 ETF, their value ETF, which is part of a broader rotation. seeing into value and away from growth. But why Vanguard? I mean, why not BlackRock? Why not Schwab? I mean, what is it about Vanguard that keeps getting so much plain vanilla money?

Well, you've got to look at the makeup of its client base, right? Vanguard grew from the grassroots on up, right? From individual investors and more recently making inroads into the advisor market into the institutional market. And what you see is that Vanguard investors, tend to live, tend to exemplify the vanguard mantra of staying the course. You know, to quote the late Jack Bogle, invest we must. And in light of current market volatility, they're sticking tight to that script.

Sure. Let me ask you, this is a separate question, but I'm always interested in your active, passive report. every year, actually twice a year, you put out a report about how active fund managers are doing against their benchmarks. You just put out the year-end 2021 report, I believe last week. And what's remarkable to me is how little the numbers actually changed. It's a testimony to how difficult it is to outperform the markets. And what's amazing to me is fund managers, after 10 years, the vast majority, and I think, correct me if I'm wrong, it's that 85% don't outperform their

benchmarks after 10 years when things like survivorship are taken into account. Can you summarize the findings of the report? And what is this told us? You have been doing this for many, many years at Morningstar. Yeah, so we've been doing it now for it'll be just about seven years, our Morningstar active, passive barometer report. And what you see in the short term, Bob, is a lot of notes. So active managers success rates can go up and down quite a bit over any given 12-month period, even over certain three-year periods.

But as you go further back in time, the signal rings through. And the signal is it's tough to be an active manager. It's tough to survive as a portfolio manager. What we see is over a long period of time. Most funds don't necessarily fail. They just fail to survive, which ultimately, if you look at their performance, it's also because they haven't performed very well. And even the ones that survive, most of them in most categories fail to do any better than an investor might get in terms of their returns from just a dirt cheap index portfolio.

So that comes through time and time again. The other signal we see is that survivorship is much lower among more expensive funds and success rates are much lower among more expensive funds. So investors really, if they're going to partner with an active manager, need to keep a close eye on costs. Cheaper funds tend to do better. And they need to pick their spots because there are some categories where active managers have had an easier go of it than others. So if you look at U.S. large caps, that's awfully difficult. Most investors are best served in most cases to index in the U.S. large cap space. But if you get into corners of the market, like emerging markets, high-eeled bonds, bank loans, you name it.

Those are areas where you might be better off partnering with an active manager. Yeah, and as Jack Bogle always used to say, if you choose active management, make sure it's low-cost active management. That's the key. And you've demonstrated that year after year with that active, passive report. Ben, thanks very much for joining us. I really do appreciate you sticking around. This is Ben Johnson, everybody,

director of global ETF research at Morningstar. and thank you for joining us on the ETF Edge podcast. InvescoQQQ believes new innovations create new opportunities. Become an agent of innovation. InvescoQQQ, Invesco Distributors, Inc.