Speaker 1: Hello, and welcome to another edition of the Odd Lots podcast.
Speaker 1: I'm Joseph Wisenthal, Managing Editor Bloomberg Markets, and I'm Tracy Alloway,
Speaker 1: Executive editor of Bloomberg Markets. So, Tracy, today we're going
Speaker 1: to be it's like a special episode. We're talking to
Speaker 1: one of our colleagues here, special edition of Odd Lot
Speaker 1: We're gonna be talking about one of the most important
Speaker 1: financial innovations of the modern era. Wouldn't you say? I
Speaker 1: would definitely say so. Isn't it something like a three
Speaker 1: trillion dollar industry? Is that right? And that industry is
Speaker 1: the e T F And I think almost everybody at
Speaker 1: this point who is aware of markets knows what e
Speaker 1: t s are. Their exchange treated funds. You can use
Speaker 1: them to make a bet on the STP as a whole.
Speaker 1: You can use them to make a bet on gold,
Speaker 1: and you can use them to do crazy stuff like
Speaker 1: make a three x levered bet on junior gold. Miners
Speaker 1: do that all the time. But it's like a basket
Speaker 1: of things, right, and it trades like a single stock
Speaker 1: on an exchange exactly right. And these e t f
Speaker 1: s have been hoovering up assets, as you said, trillions
Speaker 1: of dollars away from traditional funds, from traditional money managers,
Speaker 1: and it doesn't look like they're slowing down anytime soon.
Speaker 1: And not only that, they continue to innovate. So there
Speaker 1: are more and more new kinds of e t F
Speaker 1: s all the time. From what humble beginnings did the
Speaker 1: e t F market come to us? This is the
Speaker 1: fascinating thing. We're going to discuss with our colleague Eric Balcunas.
Speaker 1: He has a new article out in Bloomberg Markets magazine
Speaker 1: called the e t F Files, and that's based on
Speaker 1: a new book that he's publishing. And so it turns out, Eric,
Speaker 1: thanks for joining us, thank you for having me. So
Speaker 1: the e t F, this monster innovation that's changing how
Speaker 1: people invest, came out in a weird way. It came
Speaker 1: out thanks to basically a memo, right yeah, memo, will
Speaker 1: be putting it mildly at eight hundred and forty page
Speaker 1: governed report is really where the seed for the e
Speaker 1: t F was found. So what happened was in the
Speaker 1: seven crash called Black Monday, right the worst, the worst
Speaker 1: stock market crash in history. There was SEC spent four
Speaker 1: months writing a report about what happened. They were trying
Speaker 1: to figure out what really not the macro events that
Speaker 1: caused selling, but what exacerbated the sell off that it
Speaker 1: was so brutal, and Key tell us what did happen?
Speaker 1: Because we can't pass up an opportunity to talk portfolio insurance.
Speaker 1: I'm sorry. Sure. So what they found was, when the
Speaker 1: dark clouds were going over the market, institutions had all
Speaker 1: started using something called portfolio insurance, which essentially was a
Speaker 1: strategy that involved shorting futures right based on indices as
Speaker 1: soon as the stocks they held started hitting a certain level.
Speaker 1: So essentially what happened was on that day there were
Speaker 1: just weren't that many buyers for the people trying to
Speaker 1: sell insurance. Then on top of that, you had program
Speaker 1: traders who were arbitrage in the futures to the individual stocks,
Speaker 1: which involved buying the futures and then selling all five
Speaker 1: hundred or how many of our hundred stocks at the
Speaker 1: same time, right, So what happened was those program traders
Speaker 1: stepped in and they were putting all the cell orders
Speaker 1: on the individual stocks. That caused more panic and all
Speaker 1: all of a sudden, Really what you had was all
Speaker 1: these forces looking to sell individual stocks all at the
Speaker 1: same time and that's when you had the crash. And
Speaker 1: how much was the crash that day the crash it
Speaker 1: was a five D eight point drop in one day.
Speaker 1: I mean, we've had like some flash crashes in recent years,
Speaker 1: but that really puts it into perspective. It also reminds it.
Speaker 1: You know, we've blamed high frequency trading and all kinds
Speaker 1: of stuff on modern flash crashes, but you can get
Speaker 1: some extraordinary moves. It seems about just about any area,
Speaker 1: that's right. Yeah, Okay, So the SEC put out after
Speaker 1: several months of studying that crash in they wrote an
Speaker 1: eight hundred and forty page memo. And what was in
Speaker 1: that memo that led to the e t F Sure
Speaker 1: on chapter three, right deep into the into the actual
Speaker 1: white paper memo, there was something where they talked about
Speaker 1: if an alternative approach were to be examined, so they
Speaker 1: used that language, and what they're basically saying was the
Speaker 1: SEC was thinking that the futures market volatility and sell
Speaker 1: off had transmitted to individual stocks. So they thought, you know,
Speaker 1: if there was only a way to do basket trading,
Speaker 1: so you didn't hit sell on five stocks at once,
Speaker 1: but you hit sell on a basket and you had
Speaker 1: market makers and specialists who were able to trade those baskets.
Speaker 1: It might have provided a buffer in between the futures
Speaker 1: market in Chicago, which the SEC doesn't have any regulation over,
Speaker 1: and the individual stocks in New York, which they do.
Speaker 1: So they just put it in there is maybe a
Speaker 1: possible alternative approach. However, they did use the word product.
Speaker 1: And then the two guys at the m X, who
Speaker 1: were hungry for some more volume because that exchange was
Speaker 1: really in third place at the time, read this and
Speaker 1: really looked at it as a product propos Well from
Speaker 1: the SEC. I mean, it's kind of a creative approach,
Speaker 1: right to read an CEC paper on this huge negative
Speaker 1: event in markets and think I have a product idea
Speaker 1: out of that. Yeah, I mean the SEC does use
Speaker 1: the word product and they say alternative approach. Remember they
Speaker 1: worked at am X, right, So exchanges were really into
Speaker 1: this report. Because I asked Stephen Bloom, who was one
Speaker 1: of the two guys who read it, they said they
Speaker 1: were riveted by every page. I thought, who would read
Speaker 1: an eight d forty page government report, But they did,
Speaker 1: and they you know, they got rewarded for reading every
Speaker 1: word like that, So they were really excited. One of
Speaker 1: the quotes that we found from him was that he
Speaker 1: said he walked into his boss's office and said, here's
Speaker 1: an opening. We can drive a truck through this exchange.
Speaker 1: In particular, MX was hurting, so they were really looking
Speaker 1: for something. So they had their eyes wide open when
Speaker 1: the report hit. I just want to pause and say,
Speaker 1: I love that point that he who hears you, who
Speaker 1: reads an eight hundred and forty page government white paper
Speaker 1: and really notices all the details, there's a reward to
Speaker 1: that they deserve to make money. Yeah, exactly, I think.
Speaker 1: So Eric tell us about the product that they eventually
Speaker 1: came up with. What were the actual beginnings, right, So
Speaker 1: they thought, okay, well let's get a basket trading product. Right.
Speaker 1: Their first idea was to go to Jack Bogel at
Speaker 1: Vanguard and see if they could trade an SMP index
Speaker 1: fund for from Vanguard. Jack Bogel met with Nate Most,
Speaker 1: who Nate Most and Steve Bloom with the two guys
Speaker 1: and basically said thank you, but no thank you. And
Speaker 1: when I interviewed Jack Bogel, he said, Nate Most walked
Speaker 1: into my office. I looked at his proposal. I said,
Speaker 1: I'm not interested anyway, but I will give you three
Speaker 1: criticisms flaws that I think your product has that if
Speaker 1: you fix them, might be better. So that's what Bogel claims.
Speaker 1: So basically he said no, thank you, because Jack Bogel
Speaker 1: wants nothing to do with trading anywhere near his funds.
Speaker 1: You know, he's anti trading, and this would be a
Speaker 1: product that would trade. So that was really where the
Speaker 1: difference lies. So Nate Most said that that meeting got
Speaker 1: him thinking about a way where you could trade a
Speaker 1: fund but not drive up cast us and the fund
Speaker 1: from people coming in and out of it. That was
Speaker 1: the big problem. And this is where the I think
Speaker 1: the value from Nate Most than the AMEX came in
Speaker 1: to make the e t F more than what the
Speaker 1: SEC called for. And that is that Nate Most was
Speaker 1: seventy four years old and he used to be a
Speaker 1: commodities trader, and he used to be president of the
Speaker 1: Pacific Commodities Exchange, and he basically looked at the paradigm
Speaker 1: of the commodities warehouse receipt, which is where you know,
Speaker 1: palm oil or coco. You don't want to move the
Speaker 1: merchandise back and forth. So what you do is you
Speaker 1: store it in a warehouse, you get a receipt, then
Speaker 1: you trade the receipt. That way you don't have to
Speaker 1: move anything, and then he saves costs, and that saves costs.
Speaker 1: Then you could gather up the receipts at any time,
Speaker 1: go to the warehouse and get your commodities back. So
Speaker 1: that that paradigm was then applied to the sort of
Speaker 1: the SEC's general idea, and that really was the sort
Speaker 1: of foundation of the et start. So let's just break
Speaker 1: down what we've learned, because I think this is really fascinating.
Speaker 1: And for those who don't know, Jack Vogel famous for
Speaker 1: his belief in indexing not trading, the key to winning
Speaker 1: and investments is low costs, and so theoretic at least
Speaker 1: something like an SMP index fund could have appealed to him.
Speaker 1: When he saw this product, he said, hey, this is
Speaker 1: a trading vehicle. He's not into vehicles that make it
Speaker 1: easy to get in and out of the market and
Speaker 1: be there's too much costs involved in the internal running
Speaker 1: of the fund. But when they solved that problem, it
Speaker 1: still didn't really solve the fact that it's a trading vehicle.
Speaker 1: But it did become a low cost product that people
Speaker 1: can use to make a directional bet on the market
Speaker 1: in a way that we didn't have before. Yeah. And
Speaker 1: I think what it did was the meeting with Bogel,
Speaker 1: even though it was never going to happen with him
Speaker 1: because he was anti trading, the meeting pushed them to
Speaker 1: think of something different. And that's where bringing this commodities
Speaker 1: paradigm is why et f s can trade upwards of
Speaker 1: eighteen trillion dollars a year. They trade all day long,
Speaker 1: right uh. And if you look at like sp Y
Speaker 1: for example, trades about billion dollars a day. That's the
Speaker 1: big sp five, that's the big SMP. That's the one
Speaker 1: that they first designed, these two guys. But yet someone
Speaker 1: like my aunt Joyce could go into the SMP Spy
Speaker 1: for ten years and that trading every day does not
Speaker 1: bother or drive up costs for her long term investment.
Speaker 1: And that is where the model really was something special.
Speaker 1: And when you talk to the guy who was one
Speaker 1: of the lawyers who wrote the market break report, the
Speaker 1: SEC document, he said when he saw the proposal come
Speaker 1: in from am X with this design, he was blown away.
Speaker 1: It was way more than he thought when they were
Speaker 1: writing it. So he thought this product would had much
Speaker 1: more utility than even they thought when they said we
Speaker 1: need something for a basket trading product. So hold on
Speaker 1: one second. They borrowed the commodities warehouse idea with the
Speaker 1: sort of trading receipts, but you still need a virtual
Speaker 1: warehouse for the shares, right, how did that come about? Right?
Speaker 1: So there, right, there's no warehouse, right, So instead of
Speaker 1: a warehouse is called a custodian. So State Street was
Speaker 1: one of the first obvious places they went, and so
Speaker 1: that's became the custodian for the stock. So the custodian
Speaker 1: is the virtual warehouse that and today every et F
Speaker 1: needs a custodian to store those stocks or bonds or
Speaker 1: whatever holding. And that is what makes the e t
Speaker 1: F slightly different than a derivative. Some people say E
Speaker 1: t s are a type of derivative. The fact is
Speaker 1: that these stocks that are in the spy or any
Speaker 1: E t F our literal picture, and they're literally stored
Speaker 1: in a warehouse just happens to be a custodian's electronic
Speaker 1: But the fact is those are receipts for those physical
Speaker 1: they're physically backed and that that's what makes some difference
Speaker 1: in like a futures contract and tell us how those
Speaker 1: stocks actually get in the virtual warehouse, if you will,
Speaker 1: because that's a process that's really important for e t S,
Speaker 1: right sure, It's called the creation redemption process. And this
Speaker 1: is where I sometimes teach courses on e t S
Speaker 1: where the students get really like confused and bored. I'll
Speaker 1: be honest. That's why are our listeners are not going
Speaker 1: to give our Our listeners are very sophisticated, wonky people,
Speaker 1: and this is the part they're going to be most
Speaker 1: excited about. So well, and that's why I went into
Speaker 1: the story of how the first t t F came about,
Speaker 1: because when I tell the story, people get it more. Right,
Speaker 1: when I explain the commodities visual, they understand it. So
Speaker 1: the way creation redemption works is an authorized participant, which
Speaker 1: is a gigantic bank connected to the system with you know,
Speaker 1: a lot of money. Basically they are Every et F
Speaker 1: has several aps that are assigned to it. When a
Speaker 1: new creation is done, the AP will hand in the basket,
Speaker 1: which is say five s in the SMP into the
Speaker 1: state into the issure state Street and in return they
Speaker 1: get fifty shares of spy and that would be like
Speaker 1: the receipts. Then they sell those on the exchange, and
Speaker 1: that's where those receipts will trade. And then if there's
Speaker 1: a redemption, the same thing will happen. They'll take spy shares,
Speaker 1: hand them into State Street and get their five stocks back.
Speaker 1: And then that is sort of the creation redempture process,
Speaker 1: which I sort of equate to the flux capacitor from
Speaker 1: Back to the Future. You know it's in that movie.
Speaker 1: It's how time travel works. What I just described is
Speaker 1: how the e t F has been so resilient in
Speaker 1: several market stress events. And I think, you know, people
Speaker 1: are waiting for them to blow up, but that what
Speaker 1: I just described does make them, I think a little
Speaker 1: more resilient than people think who are sort of just
Speaker 1: learning about them. So what actually motivates the a p
Speaker 1: s to bring their shares and things to this warehouse
Speaker 1: and get the sort of the E t F share
Speaker 1: in return? Right, the AP gets a small cut from
Speaker 1: a spread when they deal with the market makers, and
Speaker 1: they also are able to do arbitrage, and arbitrage sounds
Speaker 1: like a bad dirty word, but it's actually really effective
Speaker 1: for e t s because if the basket, if the stocks,
Speaker 1: if the e t F price starts to go a
Speaker 1: little higher than the value of the stocks, the AP
Speaker 1: can arbitrage by handing in the e t F shares
Speaker 1: and buying the underlyings or vice versa. So they can
Speaker 1: always arbitrage the e t F versus the basket by
Speaker 1: using the creative redemption process. That in effect is a
Speaker 1: natural economic motive for them to keep the price close
Speaker 1: to the n A V. And that's a huge difference
Speaker 1: on e t F compared to close end funds, which
Speaker 1: don't have that ability to create and redeem new shares
Speaker 1: any time, because clothes and funds are limited shares outstanding,
Speaker 1: so that there's always massive premiums or discounts. That is
Speaker 1: one sort of way the E t F evolved. These
Speaker 1: then fun to you know, improve that model, because if
Speaker 1: I'm an authorized participant and I see a huge difference
Speaker 1: between the underlying shares and the share of the E
Speaker 1: t F, I'm gonna want to come in and take
Speaker 1: advantage of that and try to arbitrage it. Out right,
Speaker 1: it's free money, it's a risk free profit for that
Speaker 1: APay right, and that you know, again everybody wins. Again,
Speaker 1: that economic incentive is crucial, and that is the secret
Speaker 1: sauce that keeps everything going and makes the regular retail
Speaker 1: investors get a price that's really close to the fair
Speaker 1: value of those of the basket of stocks. All right,
Speaker 1: let's go back to the stories. So now we understand
Speaker 1: we have this the SPY which still trading, the gigantic
Speaker 1: SPI index fund. They launch it, how does how did
Speaker 1: it go? How did they do it attracting people do
Speaker 1: trade it? And how did that work out? Right? So well,
Speaker 1: first I had to wait four years to get SEC approval.
Speaker 1: SEC did not know what to do with this. They
Speaker 1: were even though they suggested the reason it took four years.
Speaker 1: It had to go through which is the strictest of regulations.
Speaker 1: So finally got approval under the that's what regulates mutual funds.
Speaker 1: So when it came out in ninety three, it had
Speaker 1: a good first day. They had a lot of hype.
Speaker 1: They had a large spider hanging from the ceiling and
Speaker 1: the trade a million shares, but a spider because because
Speaker 1: they're called the Standard and Poors Depository receipts with acronym spider.
Speaker 1: And back to the commodity warehouse receipts. Depository receipts is
Speaker 1: even in the name of Spider, which kind of connects
Speaker 1: to the commodities warehouse receipts. But they traded a million shares,
Speaker 1: but then it dwindled down. But even more, ETFs don't
Speaker 1: offer brokers any commission to sell them. It's why people
Speaker 1: like them, it's why they're so low cost. But it
Speaker 1: also inhibited some of the early sales growth. So what
Speaker 1: happened it was some true believers who really thought, wow,
Speaker 1: this is a great product. They were doing guerilla marketing.
Speaker 1: When it really came back after like two years, they
Speaker 1: were almost thinking of closing it. It It traded eighteen thousand
Speaker 1: shares one day about five months after launching, which is
Speaker 1: that's that's like less than the Global X Solar Energy
Speaker 1: e t F trades today, So it was not trading all.
Speaker 1: So you had people who were just out there figuring
Speaker 1: out ways to sell it, and some institutions caught on.
Speaker 1: But really what happened was the nineties kicked in was
Speaker 1: like an epic year for the market, so just buying
Speaker 1: the SMP became a big deal, and then that really
Speaker 1: was the supreme catalyst and it never looked back at
Speaker 1: doubled assets every year after. How important was the rise
Speaker 1: of sort of discount retail brokerages online brokerages in the
Speaker 1: mid nineties, you know, in terms of you mentioned that
Speaker 1: there was no brokerage commission on these things. But once
Speaker 1: people got into this idea during the nineties market boom
Speaker 1: of investing for themselves and trading, did that help their rise? Yeah?
Speaker 1: It did, believe it or not. Though institutions were some
Speaker 1: of the first early buyers, like pensions, And there's even
Speaker 1: a story about a rich Seattle investors in the mid
Speaker 1: nineties and the guy was like, he's very, very wealthy
Speaker 1: from Seattle. You guys could probably guess who it is
Speaker 1: like to use spy because they could buy options on
Speaker 1: it to protect their position. So the first adopted as
Speaker 1: were big institutions. Because some of the institutions like using
Speaker 1: in play who is the investor? I think it's Bill Gates,
Speaker 1: but he wouldn't tell me. I'm just thinking what they
Speaker 1: think that he got he was into them for his
Speaker 1: personal investments. Yes, interesting, yeah, but we don't know that.
Speaker 1: We don't know. That's the second. Very wealthy is why
Speaker 1: I thought and from Seattle. Maybe Paul Allen, I don't
Speaker 1: know one of those guys, probably Steve Jobs isn't that
Speaker 1: rich yet, but I don't think that's right. He was
Speaker 1: from California. Well, okay, wait, so we've told the story.
Speaker 1: We're now at this point where you know, the s
Speaker 1: p Y e t F is trading like twenty five
Speaker 1: billion worth of shares a day. But beyond just the
Speaker 1: story of that particular e t F, we've also had
Speaker 1: the entire industry kind of grow around it. We have
Speaker 1: all these new kinds of e t F. Tell us
Speaker 1: about what's changed since the early days when you look
Speaker 1: at it. You know, in the SEC commissioner who was
Speaker 1: around in the late eighties who I interviewed, he said, well,
Speaker 1: we didn't envision anything non stock baskets. We thought just
Speaker 1: some stock baskets would really help with the stock market volatility.
Speaker 1: But now you've got fixed income ETFs. You've got gold
Speaker 1: g l D was a game changer. That was the
Speaker 1: first commodities et F. Now you've got a hundred and
Speaker 1: fifty commodities ETFs. Fixed income. As you know, we've discussed
Speaker 1: this several times. It's a hot topic because bonds don't
Speaker 1: trade like stocks. So now you're taking something antiquated and
Speaker 1: over the counter and putting it in a stock like vehicle,
Speaker 1: and that's created some concerns. And then you've gotten things
Speaker 1: like leverage ets which whold total return swaps, or oil
Speaker 1: futures that hold you know, literally hold futures contracts, and
Speaker 1: now you're basically buying an et F that is like
Speaker 1: your personal oil futures trader. So they've expanded into every
Speaker 1: asset class and what I call standardization, just like a
Speaker 1: ubs port or a gas bump is standardized, you know
Speaker 1: that need for consumers. The e t F has basically
Speaker 1: made everything trade like a stock, which means you can
Speaker 1: see the pricing, you can buy it easily, and it's
Speaker 1: taxed like everything else. So that kind of standardization, I
Speaker 1: think is one of the big reasons people like using
Speaker 1: them and for a long time, or you know, when
Speaker 1: I think of e t F, so I think of
Speaker 1: something really simple like SMP gold, but something sort of
Speaker 1: underlying is passive. But increasingly the composition changes and they're
Speaker 1: active e t f s and their e t F
Speaker 1: based on formulas where the where the stocks are changing. Right, Yeah,
Speaker 1: that's a whole thing called smart beta also slightly controversial,
Speaker 1: but basically the early products were just you know, their
Speaker 1: market cap weighted beta one they call you know whatever.
Speaker 1: That very simple understand So some people came along and said, hey, look,
Speaker 1: academics have studied what factors active managers rely on to
Speaker 1: get alpha, such as tilting to small caps, tilting to value,
Speaker 1: tilting to volatility momentum, and they've taken these tilts and
Speaker 1: they've put them into rule based passive products. And so
Speaker 1: smart beta is sort of fills the void that existed
Speaker 1: between pure active and pure passive, and that's a four
Speaker 1: hundred billion dollars section of the e t F world,
Speaker 1: and that is where you're getting a lot of the
Speaker 1: new players like Goldman, Sachs and JP Morgan. They think
Speaker 1: smart BATA is the future because there's ten trillion dollars
Speaker 1: in active mutual funds right now and a lot of
Speaker 1: that money is going to go away because the mutual
Speaker 1: fund structure. So they think that a smart beta will
Speaker 1: be a place where a lot of the new assets
Speaker 1: will go from the money that's coming over from pure
Speaker 1: active because they want to try to beat the market,
Speaker 1: but they don't want to pay the fees and they
Speaker 1: want something that's easy to trade, and they don't want
Speaker 1: to capital gains taxes either. So smart beta e t
Speaker 1: f s are in some people's eyes, a real interesting
Speaker 1: arm of the e t F expansion. Well, can we
Speaker 1: talk more about how the sort of active fund management
Speaker 1: or mutual fund industry feels about e t F s.
Speaker 1: Uh I gather not so positive necessarily probably not. I mean,
Speaker 1: if you're an active mutual fund, you've got to make
Speaker 1: a decision do I ride the gravy train? Because if
Speaker 1: you look at the fees, like you know, I look
Speaker 1: at my mom's statements sometimes and I'm just I'm stunned
Speaker 1: at how much she pays and the load she already
Speaker 1: paid for mutual fund in a Class A share. So
Speaker 1: they're making so much more money than e t f
Speaker 1: s even though ETFs are growing, so it's a gravy train.
Speaker 1: Still they have to ask themselves, do I cannibalize myself
Speaker 1: to survive in the future. Do I just ride this
Speaker 1: until it's over? And you can see some are struggling
Speaker 1: with that question. PIMCO is a good example of one
Speaker 1: that said, look, we've got to get involved. So they
Speaker 1: came in with active etf they've been somewhat successful, and
Speaker 1: then other companies have come in with smart beta versions
Speaker 1: of their active products. So a lot of these firms
Speaker 1: are trying to figure that out. For sure, it's a
Speaker 1: big it's a big deal intellectually, I wonder so you
Speaker 1: you mentioned these different factors that people have discovered leads
Speaker 1: to outperformance, like momentum factors, so stocks that exhibit strong
Speaker 1: momentum tend to outperform, or sometimes people say value stocks
Speaker 1: or stocks with strong balance shoes, whatever it is. But well,
Speaker 1: these factors, like once it becomes so cheap to play
Speaker 1: these strategies, do they cease to be useful? Like are
Speaker 1: people who for a long time have been investing these
Speaker 1: in these strategies worried that now that everyone can just
Speaker 1: press a button and instantly get momentum and that of
Speaker 1: having to say find it themselves will ruin the strategy itself. Sure,
Speaker 1: I think that is largely based on the herd mentality
Speaker 1: as well. You know, momentum. Everybody can make money by
Speaker 1: all piling into momentum stuff that's rights work. I see
Speaker 1: it happened with low voltility all the time. Low ball
Speaker 1: has a big ear and then it has a bad
Speaker 1: year and then it has a big year in a
Speaker 1: bad year, and it kind of swings like a pendulum.
Speaker 1: And you actually know how ETFs trying to solve that problem,
Speaker 1: which is called multi factory t f s where they
Speaker 1: switch from the different factors based on market signals. So
Speaker 1: they got all, this is another strand on the smart
Speaker 1: beta evolution line. And so yeah, people are concerned with
Speaker 1: which factor by using when, and but then generally like
Speaker 1: a dividend, DTF dividend is a factor that is something
Speaker 1: that just general retail investors like, they're not trying to
Speaker 1: time anything, they just want dividend. Little less vultility wouldn't
Speaker 1: scrifice a little upside. So some of these factors can
Speaker 1: actually be used in the long term, not just trying
Speaker 1: to play it and beat the market. Let's go back
Speaker 1: to the very beginning of our story, because we had
Speaker 1: the sc SEE put out this report that somehow years
Speaker 1: down the line managed to spawn a huge, huge industry.
Speaker 1: And nowadays we see the SEC talking about e t
Speaker 1: f s in a slightly different light. Right, you've touched
Speaker 1: on it before. We've seen worries and concerns about e
Speaker 1: t f s. Uh, the liquid wrapper that might not
Speaker 1: be suitable for all sorts of assets. Yeah. The the
Speaker 1: SEC has two main areas of focus where they literally
Speaker 1: have written rule proposals. I think that's the most important thing.
Speaker 1: One is on liquidity, right, so they've written some strict
Speaker 1: rules that e t s will have to be able
Speaker 1: to sell off a certain amount of assets that within
Speaker 1: fifteen days. That would affect how you'll bond. ETFs might
Speaker 1: have affected some emerging market funds. Uh, there's gonna be
Speaker 1: some negotiations. Black Rock is lobbying them relentlessly, I'm sure,
Speaker 1: and so the final rule might not be as hardcore
Speaker 1: as the proposal. But that's one and then the other
Speaker 1: one is derivatives. They have a rule that would essentially
Speaker 1: limit the amount of leverage to one fifty, which would
Speaker 1: really at some leverage gts have a way to work
Speaker 1: around it, but largely that would inhibit a lot of
Speaker 1: three times, especially and maybe some of the two times.
Speaker 1: And then beyond that are e t F where they
Speaker 1: move three x the underlying automatically, so you could buy
Speaker 1: a three x financial stocks one and if the banks
Speaker 1: rise one percent in a day, theoretically the e t
Speaker 1: F rises three percent that day. That's right. Every day
Speaker 1: that the three times doesn't work over the long term,
Speaker 1: but per day that that's what they promised. But the
Speaker 1: other two areas that they have looked at was one
Speaker 1: is August last year, which ironically was called Black Monday.
Speaker 1: To right, it was referring to that as Black Monday,
Speaker 1: and uh e t f s were all involved in that,
Speaker 1: and that's why this whole Black Monday to Black Monday.
Speaker 1: It's kind of ironic, h that the e t F
Speaker 1: was designed to kind of counter one Black Monday, and
Speaker 1: there they are in the next one, right, because people
Speaker 1: are concerned about the ability of e t f s
Speaker 1: to actually function and track their underlying stocks and assets
Speaker 1: in an environment of intense volatility. August, though, can be
Speaker 1: explained pretty easily. I've looked into it. It's really about
Speaker 1: the halting that the exchange has so on Black Monday, basically,
Speaker 1: market makers came in, stocks were halted, and if a
Speaker 1: market maker can't figure out the real time value and
Speaker 1: it needs all the stocks prices to figure that value out,
Speaker 1: it has to widen it spread on the e t
Speaker 1: F because it doesn't know where you are. The aps
Speaker 1: in as well, just just in order to protect themselves
Speaker 1: from risks. So a market maker needs to know the
Speaker 1: actual real time, inter day net asset value of the stocks.
Speaker 1: And if all the stocks aren't having pricing because are halted,
Speaker 1: that's a chain reaction that makes it harder for e
Speaker 1: t F to trade. So if you look at Nastact
Speaker 1: that day, e t F traded fine because they didn't
Speaker 1: have the same halting rules that Nicey did, and Bondy
Speaker 1: TF traded fine that day because they weren't halted. So,
Speaker 1: in essence, August was a little bit of a complicated issue,
Speaker 1: but certainly a concern. And then the other fourth area
Speaker 1: that SEC is concerned with is just complex products. We've
Speaker 1: described a little bit today, multi factor e t f s.
Speaker 1: They even brought up the millennial e t F which
Speaker 1: we uh, which you and I know about, that's designed
Speaker 1: to track stocks that theoretically millennials, as they get older
Speaker 1: and spend more money, will do well. Eric, I guess
Speaker 1: the big question and I have, and maybe Joe has
Speaker 1: after listening to all of this, is do you think
Speaker 1: e t f s have been a net positive for
Speaker 1: investors or a net negative? Well, I'm a net positive.
Speaker 1: I've studied hedge funds, mutual funds and clothed and funds.
Speaker 1: I've been in fund data for fifteen years, and when
Speaker 1: I was assigned ETFs in two thousand and six, I
Speaker 1: quickly started to, you know, sniff around them, like, wow,
Speaker 1: these things are really useful. They're they're fully funded and
Speaker 1: approved by the SEC N of the nine gives them
Speaker 1: some security. So I do think their net positive. I
Speaker 1: think I don't think any of the things that I
Speaker 1: just mentioned or the SEC is looking at, is really
Speaker 1: the thing I would be concerned with. I think a
Speaker 1: lot of that is um them reacting to media. Uh,
Speaker 1: there's some concerns there, But the big concern for me
Speaker 1: is I would feel the same way as Bogel does.
Speaker 1: They trade eighteen trillion dollars a year, but they only
Speaker 1: have two trillion assets. That's n turnover. Put that in perspective.
Speaker 1: Stocks only turn over two d and fifty percent a year,
Speaker 1: so E t f s trade three times more. So
Speaker 1: when you trade, all you do is work over money
Speaker 1: to Wall Street. So I think that for investors, if
Speaker 1: they get hooked on trading too much, I think that's
Speaker 1: probably a losing scenario. So that would be my That
Speaker 1: would be maybe the net negative. Structurally, you'd say their
Speaker 1: sound and they are low cost vehicles. But if the
Speaker 1: net result is it people get hooked on trading them,
Speaker 1: that undermines their benefit, is what you're saying, and that
Speaker 1: that's their choice. I just think if a retail investor
Speaker 1: starts trading, like we just talked about millennials loving the
Speaker 1: three x crude oil e T n H, then yeah,
Speaker 1: I think people could get hurt and that would leave
Speaker 1: a bad experience for that customer. We are like so
Speaker 1: into that. Thank you very much. Eric bolcons fascinating discussion.
Speaker 1: Thank you so, Joe. We just learned a whole lot
Speaker 1: about the origins of e t f s. Would you
Speaker 1: think I thought it's fascinating. I mean it, guess when
Speaker 1: it comes to financial products, you just sort of take
Speaker 1: them for granted that they exist sometimes and you forget
Speaker 1: that someone had to invent them, someone had to design
Speaker 1: the mutual funds, someone had to design various structures of
Speaker 1: bonds that exist, and of course et f s are
Speaker 1: no exception. And I love that it was discus ord
Speaker 1: in this gigantic SEC memo that was by mind numbing
Speaker 1: to the vast majority of the population. I really like
Speaker 1: the idea of the whole thing kind of coming full circle.
Speaker 1: We had them spring from this SEC memo, and now
Speaker 1: we see the SEC kind of worried that maybe the
Speaker 1: structure has been applied to things that aren't appropriate for it, right,
Speaker 1: like the idea in the beginning, Okay, we're gonna make
Speaker 1: this incredibly simple product. It's going to be good for
Speaker 1: market stability, very low fees. And now you have these
Speaker 1: incredibly increasingly complex mutual funds, actively manage mutual funds, triple
Speaker 1: lever mutual funds, mutual funds where the underlying assets aren't
Speaker 1: particularly liquid, and now you have all these people like,
Speaker 1: oh what, what, where's this going? E t s for
Speaker 1: every single need you could possibly imagine, And it seems
Speaker 1: like the evolution of E t f s is not
Speaker 1: slowing down anytime soon. So well, I have to check
Speaker 1: back in on this story in ten years and see
Speaker 1: where it is. Yeah, we will, And in the meantime,
Speaker 1: our listeners can go and read the full article over
Speaker 1: in Bloomberg Markets Magazine or on Bloomberg dot com. And
Speaker 1: Eric has a whole book coming out on E t
Speaker 1: F So if you really want to dive more into it,
Speaker 1: you should check out his book for sure. All Right,
Speaker 1: I'm Joe, Why isn't Thal? Thanks for listening to The
Speaker 1: Odd Lots Podcast. You can follow me on Twitter at
Speaker 1: the Stalwart and I'm Tracy Alloway. You can follow me
Speaker 1: on Twitter at Tracy Alloway and you can also follow
Speaker 1: Eric at Eric Balcunas. Thanks for listening.