Odd Lots - ETFs Are Eating the Financial World and They're Not Done Yet

Episode Date: October 23, 2017

By now, almost everyone in financial markets is familiar with ETFs (exchange-traded funds), and how they allow investors to move quickly in and out of a basket of stocks with a few clicks. But perhaps people don't realize quite how revolutionary they are, and how much of an impact they've had on the financial system. On this week's episode we talk to Eric Balchunas, an ETFs analyst at Bloomberg Intelligence and Joel Weber, the editor-in-chief of Bloomberg Markets magazine about how extraordinary ETFs are, how far they've come, and how they're about to evolve and get even more gigantic.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. And welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthal. And unfortunately, it is terrible news. My co-host and colleague Tracy Allaway is traveling this week and couldn't join me for today's episode. So I'm already starting the episode. in a bad mood. Nonetheless, I persist because I'm very excited about today's topic. Probably one of the biggest stories, themes, whatever you want to call it in finance right now. And that is the rise, the seemingly inexorable rise of the ETF. Exchange traded funds, completely changing the way how people invest, being able to invest in an index or a strategy or all kinds of other stuff just as simply as buying a stock completely revolutionizing the industry, striking terror in the hearts of many managers. People say ETFs are this godsend that have made

investing much cheaper and simpler for the average person, enabling more complex strategies. Other people say it's going to be the end of capitalism and that it's the road to Marxism. Nothing quite causes controversy like ETF. Some people think they're going to be the source of the next systemic risk. So there is literally an endless amount of stuff we could talk about with ETFs. And to do that, we have two great guests who are also my colleagues. Joel Weber, he's the editor-in-chief of Bloomberg Markets Magazine. And Eric Belchunis, he is an ETFs analyst for Bloomberg Intelligence. He's literally written the book about ETFs, knows all about how they work. And so today we're going to talk to both of them, or I'm going to talk to both of them, about

how ETFs have eaten the finance world and where they're going next, how they're going to evolve, how they're changing the industry every single day. So without further ado, let me welcome Joel and Eric. Thanks for having us. Thank you. Thanks to both of you. So, Eric, I want to start with you, but, you know, both of you just jump in. Let's have a conversation. I always like to make sure that I introduce things correctly because I think, you know, I want to make sure that I set it up. But when you look at the ETF world, and this is what you do at Bloomberg, from the minute you get on to the moment you log off. And even after that. And even after that, you're thinking about ETFs all the time.

This is your life's work, understanding this behemoth. Is that a reasonable characterization of what's going on? Yeah. I mean, you know, I remember I was in Bloomberg data back in the early 2000s. And the only reason I got ETFs, I was covering mutual funds. I had been a fund reporter back in the day, and I got ETFs assigned to me because the woman covering them went on return leave and never came back. I remember it was 2006. It was just right after GLD had launched.

And it took me, you know, I can't remember exactly the timeline, but it just took me very quickly to realize that these things were going to be a big deal. And I just saw an opportunity, so I was already familiar with funds. And I think that when you're familiar with mutual funds and hedge funds and close-end funds and you start to sniff around the ETF, you realize this thing isn't just like, like one little notch better than the rest. It's like six notches better. It's a game changer. So I definitely, I guess life's work seems strong, but I guess it is. I have been doing it for a decade.

So you mentioned something there that's very interesting, which is the GLD ETF, which is the Spider Gold shares ETF. It tracks the price of gold. It launched in late 2004, more or less, buying it gives you exposure very, very, directly to the price of gold. And that seems very simple. You buy this. It holds gold. But it is revolutionary, isn't it? Because prior to the existence of this ETF, if you wanted to have exposure to gold, it was not easy. You had to go out and buy, maybe buy physical gold. And that was difficult, and there was this huge markup. And then you get a safe. You get a safe. You're going to

figure out how to store it. Remember the password for the safe. Remember the password? And suddenly, this very complicated, costly, time-consuming strategy is as simple as buying a share of Microsoft. Yes. I think what you're describing is two things that come to mind to me is convenience. I mean, everything in this world that's a business, usually convenience is a big part of why people like it. And the second thing is the democratization of investing. So the idea that being able to buy anything under the sun like it were shares of Microsoft, and everybody likes the way stocks trade.

essentially making everything trade like stock. So, you know, the Bloomberg terminal has the yellow keys. All those things now trade like equities. And the structure itself allows for some arbitrage, which helps the nav stay close to the price. So you get a fair deal on what you're looking to get. And now it's level the playing field. And the other thing about it that's democratized that is everyone pays the same price. In mutual funds, you have these share classes that are like a regressive tax system. and with the ETF, it basically everybody gets the institutional level fee. It's like the Sam's Wholesale Club. The thing that I wanted to kind of point out, Eric, was I was looking at Flows here.

And, you know, Spy, which tracks the S&P 500 and actually was the very first ETF, which you've actually written about for me in Bloomberg Markets. But there are obviously other ETFs since then, which that came out in 1993. So even though Spy is the biggest ETF of all, there are other. are S&P 500 competitors, right? And one of the things that's happened this year, when we look at flows, is that even though the spy is up 16% for the year to date, flows are way down, right? And other S&P 500 products are up. What's going on there? Yeah, so the ETF industry, you know, I refer to it as a jungle, as you know, Joel, because it's brutal. People are undercutting fees and there's similar products, and there's

hardly any money. I mean, ETF industry only produces about $6 billion a year in revenue. To put that in perspective, hedge funds make about $65 billion a year in revenue. So, and they have less assets. So there's not much assets, and people are clawing.

And so spies outflows are a function of BlackRock, who has IVV, which is the other S&P 500, ETF, Vanguard has one too. It came in at 0.04%. So they lowered their fee from 0.07 to 0.04. Spy charges 0.09. and just a couple of basis points was enough to completely change the flows.

And spy is not in any trouble, though don't feel bad for it. It's still, spy will always appeal to like really hardcore traders and big institutions. It trades more each year than Japan's GDP, basically. And there's, you know, options market is massive. And so ultimately, IVV has been stealing not institutional money, but retail and advisor money. They care more about the fee because we, When you go in long term, the expense ratio does matter way more than any little, like, extra basis point on the spread. Which is, I think, an interesting thing to keep in mind here is that buying and holding ETFs is kind of a recent phenomenon, right?

Because here to date, it's been more of a trading strategy, which is always also the knock on on ETFs because they're so easy to trade with. People just trade with them constantly. But buying and holding because they're so cheap is sort of really catching on now, right? I call this the investor enlightenment age, where investors are finally understanding the importance of cost. They're getting better at asset allocation. But the next phase of this is behavior. And I think there is some credence to John Bogle's criticism of the keyfs that the temptation to trade goes up a lot, unlike a mutual fund where it's like just kind of a, it's just like too annoying to have to sell it.

And you get out the end of the day. But if you could trade intraday, the temptation goes up. And I think if you do too much trading, you basically, completely kill all of the cost savings. So I think the next baton is like how do you basically not trade yourself out of the cost savings from using the ETF in the first place. But there is some buying and holding. So there's two things here that I think are really important. And one is, you know, again, it's similar to the gold ETF. You think, oh, it's really simple. You buy this ETF. It just tracks the gold. That's not a complex strategy. But when you think about how

difficult it is to actually own gold and store it. It turns out that something very difficult has become very simple. It's the same for this, right? I mean, like, there would not be, prior to the existence of this ETF, we think of an S&P 500 index tracker as about as plain vanilla as it gets when it comes to investing. But imagine the impossibility for the average person of replicating that on their own buying 500 stocks. If they wanted to trade that in and out, it'd be essentially impossible being able to always trade in and out of this perfectly balanced index of 500 stocks. That would actually qualify as an extremely complicated thing to do, you know, before we even get into more complicated ETFs. That alone would be an investment vehicle that the person, you know,

would be almost impossible. Now, we talk about this incredible fee compression. that we're seeing and the idea of people going crazy finding the ETF that offers the same thing for a slightly lower fee. And this is a big part why these vehicles strike terror in the heart of the financial industry just because the extraordinary, you know, this is where people make their money, the extraordinary fee deflation we're seeing. Well, I think the other thing to mention there, too, is that this is first and foremost sort of an improvement on the mutual fund, right, which was an index thing already.

You could always buy the S&P 500, and it was a mutual farm. And you couldn't trade it intraday. But then the vehicle itself went from just whatever index you want to track to, boy, we can make anything an index. And not only can we make anything an index, but we can look at oil, which you as a retail investor could never touch before. And all of a sudden, now you can dabble in things that are really crazy, I think, from a retail's perspective. and as a consumer, I think that's the scary part is that you can look at this and you can buy anything you want, even though you might not understand it. Well, let's talk about that, Eric, because one of the most, you know, biggest phenomenons of the last year, maybe a couple of years, but it's really sort of taken on life of its own is people trading volatility products. So exchange, trade, and notes similar to ETFs that track not a specific basket of equities or even a commodity.

But volatility itself. Explain to us what those are and why they've become this subject of fascination. You know, the VIX in general, it's like betting on fear. And I think that's just, here's the thing. The VX in general, I call it media proof. And the ETN that tracks is VX. That's the main one that goes long VIX futures on the short end of the curve. That thing, because you have to roll the futures, it basically will lose about 40% a year just on that rolling. some call it decay. But people still trade the you know what out of it every day. And it's never had one bit of good ink written about it. It's media proof because why? When the market goes down, like say the S&P goes down 2%. The VIX would be up like, say, I don't know, 18%. The XX would get up about half that, 9%. So 9% is more than even a negative triple leverage inverse S&P 500. So I call it it. It's the jackpot. When VIX works, it's like the payout from heaven. So that's one reason people go along the VIX, and the short one, XIV, which you and I've discussed a lot, I think you call it the

magic money machine, if I'm correct, which I think is a perfect name for it because it just spits out money. I sometimes call it the greatest of all time because it's had the best performance of any product ever in the existence of ETF. Seriously, if you're listening to this, if you're at home and you've never checked out the ticker XIV, bring it up somewhere, take a look at this chart, it just goes up. I mean, so the thing is, is that I've got to be really careful. It's one day it's not going to go up. So I don't want to be representing that you're going to make money on this.

However, here to four, since its existence in 2010, it goes up. Occasionally it has these really sharp drawdowns because when volatility does spike, it gets crushed. But it almost completely erases them very quick after. in, you know, since the beginning of 2016, it started 2016 around 20. It's up fivefold. So betting against volatility has been like just this incredibly good trade. And this vehicle has just made people an extraordinary amount of money. Yeah, I mean, this XIV ultimately takes advantage of what that 40% a year loss in VXX that I talked about.

That's a 40% gain for XIV. So somebody just, and that's sort of the innovation of ETFs. People complain about this one thing. and then all of a sudden there's a new ETF to take advantage of that complaint or correct it. And XIV, you know, it's controversial, but as long as VAL stays low, it doesn't make money on VIX going down. It makes money on basically the role. So it benefits from that.

But it certainly is something that I think, like we're developing this rating system at B.I. Where we're going to give every ETF a green, yellow, or red light. And this would be a red light. It doesn't mean you can't use it. It just means that if you're retail, You really need to read the fine print and understand what you're buying because XIV on a bad day could go down 40% in a day. Right. And it wouldn't even take anything that extraordinary for that to happen. Right. Like around, I think Brexit, it went down. I can't know the exact, maybe 20%.

August 24th it was down like 30 or 40% over two days. And if it goes down more than 80%, it will just shut down. It'll close and redeem the money. Wow. I didn't realize that. And just to be clear, this, This is a strategy that the average person will never prior to this existence have any real way of playing. Like being, I mean, there was just the ease with which one can now bet against volatility can't even be compared to the level of technical skill and knowledge that it would have required to make the same trade prior to the existence. I mean, it's completely incomparable. Totally. This is why, again, I think a rating system like movies is what ETFs need. Yeah.

Because I don't think you want to ban an ETF like XIV because for a certain group of investors, it's great. It's a convenient way to do what you'd have to go basically short fixed futures. In this case, it just does it for you. But yeah, for certain investors, this is definitely off the charts potentially complicated. And the other one is like leverage ETFs, which use total return swaps, which ultimately you needed to have like a prime broker or no, you know, have connection with Goldman Sachs to get a swap contract. Now any investor can basically access them through leverage ETFs. So the democratization has gone into some really complicated, potentially dangerous areas. There's no denying that.

All right. So we've talked about these very early ETFs that, you know, seem quite simple but are, in fact, incredibly, you know, complicated. They make life a lot simpler. Now there's this obsession with, you know, various products that we see today that would essentially be impossible for the average person to replicate on their own. but now the ETFs make it incredibly simple, even if the people maybe don't really understand what they're buying a lot of the time, necessitating a need for more clarity on some of the risks. Let's look forward. Where is this industry going next?

I see two evolutionary lines. One is a race to zero. So we talked about IVV and SPY and that whole battle. That also includes Vanguard and Schwab. And they're going to be in this fee war that now has them down to like selling the whole stock market for 0.03%. That's probably going to be zero in a year or two. So on the one evolutionary line, it's great for investors.

You've able to get your whole portfolio will be free, probably within five years. That's a tough line to do business in, by the way. That's like taking on Vanguard and Schwab is just almost like suicide. But hey, for investors, it's great. There's also that idea, though, that you might get paid to own an ETF. Yeah, there's some talk about that. It's possible that they might do like a negative expense ratio where they actually give you four or five basis points just to buy the thing, just because they want your assets, because then they can lend some securities out. Or in Schwab's case, they'll, they invest some in treasuries, make the interest.

Basically, whoever can sit on the biggest pile of assets, they feel like they could give free exposure to everybody and make money in other ways. That's why these companies would go that low. But the other evolutionary line, I think, is the one where, for me, an analyst, it's exciting because that first one is very plain vanilla. But the other one is, like, everything that ever happened on Wall Street ever, and every idea in anyone's head could be packaged into an index. And that's what's happening there. That's like the experimental, innovative side where you see, like, T. Boone Pickens is going to package his oil strategy into an ETF soon. Gunlock made an ETF. Then you're going to have things like this new ETF powered by IBM's

Watson, the robotics ETF, all kind of wild stuff. They can charge a little more because the potential to outperform is higher. And that's where you see a lot of the bigger companies go eventually because they're just not going to fight Vanguard. So they'll come out with some more repackaged active. And we've seen that like, you know, what is it, Goldman Sachs has launched ETFs based on, what is it, the recommendations of their. What are there are some Goldman ETFs that are sort of based on their own internal research, right? Yeah. So close.

They had Goldman Sachs VIP hedge fund research ETF. Now, here's the thing. That is a research report, but it's based on hedge fund holdings. So it's not quite Goldman's picks. Now, you bring up a good point, though, because this week, literally this week, and by the way, you brought up Marxism earlier, the group, the research group behind that Marxism claim that passive was the road to Marxism is now launching ETFs. So irony aside, or hypocrisy aside, they're now going to basically do what you just said. They're going to put their top 60 or their 60 outperform picks into an ETFs. This is Bernstein, by the way, and you'll be able to buy it. Now, if this gets any traction, look out for Goldman and J.P. Morgan to do that, which I think is great. That's, you know, well, sell-side research is one of the last things to be democratized or, you know, turned into an ETF. On the flip side, that's pretty proprietary stuff.

So giving it away like that, I'm, you know, I'm not sure if that would irk current clients. The other thing is, once you put all your calls in an ETF, we now know how good you are. Oh, yeah. You know, Eric, the other thing that that brings to mind when you're talking about research is sort of the implications of MIFID, too, in Europe, which is this, you know, kind of hallmark piece of legislation that's going to take effect January 3rd. And there's a lot of speculation that ETFs are going to be one of the biggest winners of that eventuality. Can you speak to that a little bit? What do you see happening when Mithid goes into effect? So Mifid 2, I know that some people just probably went to sleep, but it basically,

this myth. This is a rule that's just basically, in Europe, you know how here the investors will like sell you out for one basis point for the cheaper ETF? It's the opposite in Europe. People have no idea what they're paying. So people pay two to five percent in a mutual fund fee. And then they get broker commissions on top of that. So they could be paying up to seven or eight percent. And here we're arguing over seven basis points. So this is going to make all that transparent. People are going to see line items of all the stuff they're paying for in their fund. One of those is research. That was the impetus, but the side effect of this is that once the cost are transparent, they think a lot of people will switch over to ETFs because it's sort of

like the DOL rule here. Anytime regulations in any country step in and say, hey, we need to make things more transparent, ETFs and passive are going to win that fight like almost every single time. They thrive in the light, whereas when there's layers of fees, that's sort of more the way the mutual fund industry has thrived without that transparency. So MIFID II is bad for mutual funds, probably good for ETFs. And this is, I think, to put all of this in context, is why these things are going to continue to eat the world, right, Eric? Because we're talking, there's a sizable amount of money. How much money is wrapped up in ETFs right now? So three trillion U.S., four point five globally. And then you think about where this is going, and the most bullish projection is what, Eric?

bullish or sober? Well, let's do both. Okay, so the most bullish is $25 trillion in the next eight years. Which is almost the size of the U.S. stock market right now. Yeah, that's not the sober one. In case that wasn't obvious. Most sober estimates are $10 to $12 trillion in 10 years. All right, real quickly, because we have to go,

but someone is going to be really curious. Can you just real quickly summarize the argument that ETFs could lead to Marxism? Sure. The argument is that if passive is passive, so ETFs and index funds, which also have three trillions, so passive has six trillion collectively in the U.S. As that number grows to 10, 20 trillion, passive will own a lot of America's companies. So right now, Vanguard and BlackRock and their passive funds are the top two owners of about 75% of the S&P stock.

and that's going to grow, only grow. So the question is, if an index fund is my big owner and I'm CEO, do I get a free pass? You know, what about the corporate governance here? And so that's sort of the – and whereas I guess if you had an active manager, they would be, like, keeping the CEO and the company's feet to the fire. So there's some argument that the rise of passive will, like, sort of, like, hurt capitalism in that regard. I usually confront that with, you know, like, first of all, like, Steve Jobs did not. invent the iPhone because of a Tiro price manager. So capitalism is going to happen anyway. The question is

how good is active at making sure prices are where they should be. And I do think there's some more interesting debate on that. But right now, passive, all told, only owns 15% of the stock market. So I think until we get to 30, 40, I just don't think it's that big yet. Well, we will be out watching out for if Marxism happens. And that will be very interesting. This is a great conversation because I feel like we, ETFs are obviously everyone's heard of them by now, probably a lot of people, have exposure to them. But it's like we can't state it enough in a way, how really like they're a revolutionary technology as I see it. And I think the, you know, talking to you guys, it sounds like the revolution isn't complete. So Joel Weber of Bloomberg Markets magazine.

Eric Beltunis, ETF analyst at Bloomberg Intelligence. Thank you so much. That'll be it. You know, Tracy's not here this week, so, you know, I have no one to banter with like I normally would, but I really enjoyed that conversation. Hey, we're here. We're here. Don't forget about us. But that was the whole thing was the banter. No, it was really great talking to both of you. And that has been another episode of the Odd Lots podcast. You can follow me on Twitter at The Stalwart. Joel. I'm at Joel Weber's show. Eric.

I'm at Eric Balchunis. If you can spell that, you know. You can follow me. And you can also follow Tracy on Twitter, which you should do even though she wasn't here at Tracy Elway. And our producer, Sarah Patterson, at Sarah Pat with two T's. Thanks for listening.