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Bogleheads on Investing with Eric Balchunas – Episode 15

Post on: November 8, 2019 by Rick Ferri

Our guest this week will be Eric Balchunas, Senior ETF Analyst, Bloomberg Intelligence. In this role, he writes research, articles and feature stories about ETFs for the Bloomberg terminal and Bloomberg.com. He also appears in a weekly on-air segment for Bloomberg TV and Radio called “Exchange-Traded Friday” in which he discusses different ETFs and the way investors can utilize them.

He is author of the book “The Institutional ETF Toolbox,” which was published by Wiley. The book is at once a primer on ETFs that both novices and professionals can understand as well as a guide to doing proper due diligence on the fast-growing world of ETFs.

This podcast is hosted by Rick Ferri, and is sponsored by the John C. Bogle Center for Financial Literacy.

You can discuss this podcast in the Bogleheads forum here.

Listen On


Rick Ferri: Welcome to Bogleheads on Investing, podcast number fifteen. My name is Rick Ferri, and today we have a special guest Eric Balchunas, senior ETF analyst at Bloomberg Intelligence, and the author of a book, “The Institutional ETF Toolbox”.


Rick Ferri: Welcome again to Bogleheads on Investing, podcast number 15. This podcast, like all podcasts, is brought to you by the John C. Bogle Center for Financial Literacy, a 501(c)(3) corporation. 

In this episode of Bogleheads on Investing I am happy to have with us Eric Balchunas, the senior ETF analyst at Bloomberg Intelligence. I’ve known Eric for many years, since he started doing this research. He is also now on the air at Bloomberg radio and TV, a weekly television show, yeah, where he discusses different ETFs and the way investors can utilize them. He has a book, “The Institutional ETF Toolbox“, published by Wiley. 

So with no further ado, let me bring in Eric Balchunas. Welcome Eric.

Eric  Balchunas: Great to be here Rick.

Rick Ferri: I’m so glad to have you on the show. I get so many questions about exchange-traded funds versus mutual funds: What should I buy? Should I buy an ETF? Should I buy a mutual fund?  And I’m hopefully going to be able to answer a lot of those questions today, but let’s start out with you. How did you get involved in the ETF business?

Eric Balchunas: Yeah, good question. I was an economics major and a journalism major, so I did a couple things out of college. One was I worked at Institutional Investor, the magazine. I was in the newsletter division. At first, covered derivatives but then I got moved over to covering funds and a newsletter called Fund Action, which is still around today, actually. Ironically, now they’ll call me to get a quote. So come full-circle. So, I wrote for them.

Rick Ferri:  When was that. When did you start?

Eric Balchunas: Mid to late ’90s. I remember the Vanguard PR guy, John Worth. He actually sent me recently an email I wrote him in like ’97 asking him for information on some Vanguard fund which I didn’t recall, but at the time the big companies were T. Rowe Price, Fidelity. Like, Vanguard was a little more down the list. Indexing was still a minor player in the funds business but I certainly remember covering them a little bit. So then I went off, worked at, did some third-party marketing, a couple different jobs. But I found a job at Bloomberg in year 2000 and I instantly loved it. So I was working in the public relations department for about two years. But then right around 9/11, a few months after that, I moved back out of Manhattan to South Jersey and I didn’t want to make that commute to New York, so I transferred to the data office and I took a job there. And the closest thing that would be applicable for me was fund data, so I worked in the data – at the funds data area of Bloomberg for fourteen years and right in the middle of that time, I got assigned ETFs in about 2006.

I immediately saw they were going to be a big deal and you know, after you talked to some people, go to a conference or two, you’re like, yeah, this is actually, this product makes a lot of sense. And you sort of see that if you know mutual funds and closed-end funds you sort of see  the ETF is taking a few evolutionary steps forward at once, not just one little step but a few. And so I just sort of made myself the expert on ETFs around that time. Started going to conferences and at the same time building out the DES page for ETFs to make them more ETF-ish, add fields like index rating methodology and so forth. So I was like the ETF data guy for many years.

And then I started writing a little bit because I had that background and the research group just  took a notice in some of the posts I would do for the–our website, and asked me to join research and head up the ETF research for Bloomberg Intelligence which is the research wing of Bloomberg. And I’ve been doing that for about three years now, and managed a team of four people who now write ETF research. Although we’ll do mutual funds a little bit; we’ll do hedge funds even; and will work in some of the global scene as well, but largely we stick to US ETs.

Rick Ferri: And you also do a television program once a week.

Eric Balchunas: Yeah, so when I was trying to become the ETF guy within Bloomberg in the late 2010- 2012- 2014, like around that time I felt there was vacuums in ETF coverage all over the company, whether it’s sales, television, radio. And so I just sort of  tried to forge through and make myself available and sort of doing a couple hits here and there for televisions. Found myself a weekly segment on Friday at 4:30 p.m. which is like 3:00 in the morning for financial television but still beggars can’t be choosers.

That was a segment that got me some reps. Yeah then a TV show form, it’s called  “ETF IQ”. It’s about two years old. It’s with Scarlet Fu and I’m sort of, I come on and give color commentary, will play a good hand in sort of getting some of the guests, in writing the script each week. And then I have a podcast called “Trillions ” that formed about two years ago.

So I think ETFs kind of went mainstream with inside, inside Bloomberg for sure, and in the general market about three or four years ago. So I think the show and podcasts and some of the, a lot of the great news coverage you see at a Bloomberg is all part of the sort of  mainstreaming of ETFs even at a big company like Bloomberg although they were covered heavily for a long time in the trade publications obviously. Like I just look today Financial Times and Wall Street Journal both had multiple ETF articles out. I guess every month or so they put out like a special report so they’ve definitely gone mainstream, and I think the show and the podcast are just sort of symbolic of how big they’ve done.

Rick Ferri: And there’s a few things that have occurred here in the last year that is going to even cause that to accelerate which we’ll get to in a few minutes. But before then I want to sort of walk down memory lane and go back to the beginning, and I know you did a couple of shows on this where you researched the beginning of ETFs and why they were created and who was involved and talked about why these products even came into existence and what they were originally for and how they’ve changed and evolved over the years.

Eric Balchunas: You know it really goes back to the ’87 crash Black Monday. That was a monster event. There still has not been a percentage decline day in the market that has even come close to that. What happened was the SEC went and wrote a post-mortem on what happened and in that report, you know they sort of, there’s a lot of things going on, but it was portfolio insurance which used futures contracts, and that was the key.

I think they thought that there was a downward spiral created between stocks and futures and the futures were not managed by the SEC. And in that report SEC kind of hinted that if there was something like a futures contract that was like, under our supervision, that the basket trading could be done on the exchange.

This big event might not happen because the futures market had different rules and regulations and they thought some of that kind of contaminated the stock market in New York. And that was part of, I believe, the motive for writing that report and sort of suggesting that if people wanted to do basket trading and hedge, there might be a better way to do it.

So this report was read by Nate Most and Steve Bloom who were at the American Stock Exchange. Now Amex was in third place in trading so they were hungry to try to find a new product that would increase volume, and so when they read this report they sort of took this little sketch of a basket trading product and ran with it and they sort of kicked around a few ideas and this where the story gets interesting for Bogleheads. Nate Most had this idea to have the Vanguard 500 be traded on an exchange and that would be this new ETF idea. He goes to Bogle’s office and he, Bogle, basically says, no way in hell would I ever do anything like this to my precious Vanguard 500. I’m anti trading yada yada. But Bogle, and when I interviewed him about this said, Nate Most was a great guy, you know we remain friends. And Bogle said he gave Nate Most three problems with the product that would help separate the trading and the cost inside the fund, and Bogle said, no thank you, but here’s some suggestions.

So Nate Most went and reworked the product at that point and I think a key part to what made the product work so well was in order to separate the trading that goes on in an ETF every day from the long-term investors because they don’t want to incur the cost of the trading, that’s part of the problem with the mutual fund, is the trading costs.

What they did was Nate Most used his background of working at a commodities warehouse. He ran the Pacific Commodities Exchange for a number of years and in a commodities warehouse instead of trading soybean oil back and forth and moving a lot of product around you store the soybean oil in this warehouse and you get a receipt and then you can just trade the receipt with people. And if you get enough receipts where you actually want your soybeans, you just go to the warehouse and give them all the receipts, they get you the soybean oil back in your possession. And vice versa, for you’re sitting on a lot of soybean oil and you’d rather not, you can go into the warehouse, get the receipts and then sell those. 

And he just took that concept and applied it to the 500 stocks in the S&P, so that’s where the word “Spider” actually comes from, SP depository receipt. So try to tell people ETFs are like a receipt to the 500 stocks sitting in a warehouse except another set of warehouses to custodian. So that concept is where Nate Most really took that SEC sketch and took it to the next level, added in Bogle’s suggestions, and what they did is they submitted to the SEC this idea which is, you know, the ETF. And it sat there for four years. The SEC had a lot of internal back-and-forth and issues, but the wait was worth it because a lot of other types of derivative products that were based on the indexes were coming out, but nothing had the sort of fiduciary long-term ability as “SPYs”.

So when SPY came out what made it, I think, so powerful for many is that a lot of people could see the long-term investor potential for it, not just the trading aspect.  But of course Amex really designed it to increase trading on the exchange and it definitely worked. That thing traded although it took a couple years. It wasn’t like a hit right off the bat. The ’90s market helped get some true believers, and had a couple big investors early on. People used it to hedge options on it, helped people, so it took a long while but towards the late ’90s the assets and the volume started to double.

Rick Ferri: I was in the brokerage industry at the time in the 1990s and I had had my epiphany about index funds and I was really limited to what I could use. I was over at Smith Barney and active management was just not doing well relative to markets and you know Spiders had come along and then, I think it was’ 96, “Midis” which are the mid cap S&P 400 mid cap came along, and I was able to swap out actively managed funds and individual managed accounts of equities for Spyders and Midis and they weren’t ETFs at the time, nope the acronym “ETF” didn’t exist. They were Spiders; that’s what they were called. So I began using these ETFs as a broker, and I had to be one of the first brokers to actually use them in retail accounts, but I thought they were great, and they were very low-cost. 

So since the popularity of SPDR, which was a State Street product, Vanguard also came out with a S&P ETF (VOO)  and iShares has an S&P product (IVV) and they’re both lower cost versus SPY.  SPY has higher fees, and yet it has, it’s so much bigger and has, you know, more volume and so why would money flow into the higher cost S&P product when there are lower cost S&P products available.

Eric Bachunas: Well liquidity. It’s got what I call oceanic liquidity and if you look at the investors in SPY, there are some big giant fish using this thing. Everybody from Bridgewater, right it’s the world’s biggest hedge fund; you’ve got Bank of America, Goldman Sachs, JP Morgan; there’s pensions in there; there’s endowments. So a lot of people like the liquidity, and a lot of people use SPY as a liquidity sleeve, like if they’re active, or doing something else, SPY could be something that they just use to tweak up or down their beta exposure or equity exposure on their portfolio. This might not be their core equity exposure.

I think also that SPY’s assets have been hurt by the fee, because if you look at SPY over the last three years it’s, I think, seen a little bit of outflows or it’s at least flat. All the new money is going to, the net new flows are going to IVV and VOO. But what’s interesting is we study volume market share and asset market share for ETFs and what’s fascinating is while SPY’s asset market share has been going down pretty steadily for a number of years, it’s volume market shares is almost unmoved I think it still is about 95% of all the volume in the S&P 500 ETFs, and this is where we come to our conclusion, which is that in a fee war it’s much easier to steal land than sea.

You can, Vanguard has an amazing army. You know they’re going to steal your land because they’re cheaper. Assets can be moved pretty easily but when it comes to liquidity it’s a lot harder to peel off people who seek liquidity, like institutions and traders. And so SPY, MDY, that wasn’t mentioned earlier, they’re going to be around and big for a long time because it will be quite a while before IVV, you know, hits that tipping point where it becomes actually more liquid. Could be ten years from now.

We used to think it would happen quicker and it, you know, those older more liquid ones that cost more would just go away.  But it could take a long long time for that to happen. It probably will at some point but I mean SPY at this point is sort of like a sun and there’s a whole solar system connected to it. The options on SPY have a volume that is about half of all equities, it’s enormous. That takes a long time to eat into.

Rick Ferri: So Eric, where could I find more information about the history of ETFs.

Eric Bachunas: If you go to Google and you type in “the etf story” you will find a site called The ETF Story, and me and my podcast colleague Joel Weber did a Ken Burns-style audio documentary, a six-part series on the history of ETFs. Starts on Black Monday and goes right through to the invention of smart beta basically. And it really is fascinating. We include, we interview people who were there and we- Bogle is also in the interview, that part about, you know, him being involved. He talks about the ETF and it’s just fascinating. So if anybody finds this somewhat interesting, you will love this documentary. I highly recommend it.

Rick Ferri:  Let’s get into the whole concept of how these things work and really why they could be a better mousetrap. They certainly are from a tax perspective for taxable clients. How do I know when I put my order in that I’m going to get a decent price? These funds also have a iNAV that shows what the value was up to 15 seconds ago, you know but still I mean the market moves faster than that. So let’s get into the whole mechanics of how ETFs are created, how they’re redeemed, how they’re traded. Start out with the creation. I mean how do you get an ETF into the marketplace? 

Eric Bachunas: So if you think about a creation, go back to that commodities warehouse receipt right, where in order to create new shares of an ETF an authorized participant, which is, you know, really just a gigantic bank, that is hooked up to the whole system. In fact, when Spider was being designed, when the original ETF is being designed here’s, a quote from Kathleen Moriarty, who’s a lawyer working on it at the time:

“In order to create all 500 stocks you’d have a portfolio basket that was worth about one million. The average person was never going to come in and ask for a million so we need to deal with companies who were dealing with the DTC and the NSCC.”

So people who were broker dealers, it had to be somebody hooked up to the system so that’s why it took a Goldman or a Credit Suisse, these are the AP’s, and each ETF is assigned a couple AP’s who do this creation/redemption. And so they’ll take the 500 stocks in the S&P, go to that proverbial warehouse, hand it in in a certain size and get shares of the ETF, or receipts. Those receipts then trade on the open market. 

So if there’s a lot of demand for a product, let’s say the solar energy ETF. It has a  good month and everybody starts to want it. The demand on the exchange will start to get so high that market makers and the AP will say, hey why don’t we arbitrage this. We’ll put new shares on the market and sell the stocks and pocket the difference, and that arbitrage is really what creates creations and redemptions in a normal market. 

So the fact that you can take the underlying basket, hand it in, is really wonderful because it does utilize arbitrage and arbitrage is a, you know, nasty sounding word but it’s actually very useful in this case because arbitrage is what keeps the price of the ETF very, very close to the net asset value, which is what the portfolio is worth. You know in my book I call that the flux capacitor, you know in “Back to the Future” that’s how time travel works. This, the creation/ redemption process, is ETF’s flux capacitor. That’s the brilliant part of it that really makes it work and survive and work well in nasty days, up days, down, sideways days. It makes it very robust.

Rick Ferri: The way it works for an individual investor when they put their order in to buy a hundred shares of VTI, the Vanguard Total Stock Market Index Fund, they’re going to the exchange, they’re getting their hundred shares from somebody else. They’re not getting it from the fund company.

Eric Balchunas: Yeah so if somebody puts, sorry go ahead.

Rick Ferri: No and then they, so it’s an exchange between two people as opposed to open-end mutual funds where you would go to Vanguard directly and buy the total stock market mutual fund directly from Vanguard with cash. Here you’re going to the exchange with the same cash and you’re buying somebody else’s shares that are trading them on the exchange.

Eric Balchunas: Correct, and I think that’s an important difference. Most people who are buying the ETF are probably just going to buy it from somebody else who’s selling that day, just like a stock. There’s about 90 percent of ETF volume is that. Ten percent, give or take, the asset class will be creation and redemption activity where there’s just a bigger order that there’s not enough shares on the exchange so somebody has to go and do a creation to satisfy that big order, or there’s just a frenzy of excitement for an area and they need more supply. So that market maker will then go ahead and make creations in order to feed that demand. But again, that’s only a small portion of the time. Most of the time the market just is buyers and sellers going back and forth like stocks.

Rick Ferri: Now there’s a lot of benefits to an individual investor for using ETFs. There’s some drawbacks but there’s some benefits as well. I’ll hit a couple of drawbacks first. So when you go to the exchange and you’re going to buy or sell something you really don’t know what the price is. I mean you can look on your computer screen, but I mean the information we get as an investor trading down here in Texas using my app on my custodian is, you know, light years behind what is actually going on in the marketplace. So I put my order in to buy. I really don’t know what I’m going to get, so I, but I try to put in a limit order of some sort so I don’t overpay, but again I don’t know what the price should be and I put the order in and I get an execution, but I don’t know whether or not that’s good or bad, so this is kind of a disadvantage, you know I’m in the dark trading, whereas if I was going to go directly to say Vanguard, and you know there are other companies out there, there’s Schwab and so forth, but I’m just using Vanguard as an example. If I was going to go to Vanguard directly and buy their open-end fund I know I’m going to get NAV at the end of the day, no question. So how close really is my trade as a retail small investor doing ETF trading? How close am I to actually getting NAV on a big fund like VTI?

Eric Balchunas: It’s going to be very close. VTI, I mean I have a chart here I’m pulling up over the percent premiums. It’s, I mean, if you look at it on any given day it’s one basis point, one basis point, two basis points. So we’re talking two basis points. And let’s just say the bid-ask spread is another bip [bps], and by the way, sometimes you could actually pay a little less than the NAV if you’re lucky, so it doesn’t always work against you. But let’s just assume you’re going to pay two bips of a premium. In worst case scenario you could put a market order in, maybe three. Right you add a bip to that there’s four. So yeah that’s a real extra cost, and as you get to.

Rick Ferri: how much is a bip, if I’m investing ten thousand dollars, what’s a bip?

Eric Balchunas: Ten thousand dollars, that’d be a dollar.

Rick Ferri: Oh okay, well it’s not like, oh hundred dollars or anything like that. 

Eric Balchunas: No, no, I mean so VTI. Let’s see here’s our, in fact, it’s a great excuse to do a total cost of VTI. The ER charges you three bips so that’d be three dollars on an annual fee. Let’s say the premium let’s say there’s two there, and your spread is one, so there’s three. That’s six.

The good news is Vanguard will do a little securities lending in this thing and if I look over the past year it’s put in two basis points worth of securities lending revenue so that takes two away so you’re looking at maybe four; four bips but again you have to remember that the trading cost that we just mentioned are just a one-time fee. It’s the expense ratio that comes, you know, day after day, rain or shine so that’s really, if you’re long term, the more important thing and the trading cost becomes less.

If you’re trading all day and you’re like a maniacal day trader, that is why SPY is so popular, because it is just going to be that, the more liquid it is, the more it’s going to just completely digest all these orders right at NAV and the arbitrage will be almost, you know, it, the arbitrage is so good that you’re paying the NAV virtually almost all the time.

So that’s why as you get further out, you know, in terms of your investment horizon, it’s probably better to go to the cheaper funds even if that does mean an extra bip in a spread or something. You know it’s worth it because it goes away as time goes on. But I’d go even further to say if your long term and you’re a Boglehead type there may not be a reason to buy the ETF at all. You know, unless you trade or have a portfolio where you just want to use ETFs, because you want to like, you know, move it around a little bit. And index mutual funds, especially Vanguard you can get the same fee virtually, or if not cheaper and they do the same exact thing and they benefit from that securities lending revenue I talked about. So I don’t really see any reason to use the ETF if you’re a buy and hold, you know, Boglehead. There’s really no, you know, you don’t have to mess with all this. 

So I’m not thinking ETF should do really much to replace the index fund if you’re long-term.

Rick Ferri: It does make a difference if you’re holding your account at Schwab, or TD Ameritrade, or Fidelity where if I wanted to buy the Vanguard Total Stock Market Index Fund and I did it through Fidelity, or if I can even buy it through Fidelity, don’t even know if I can just with the mutual fund, they would charge you know a commission of 25. I mean I think if you’re at Schwab, if you bought a Vanguard mutual fund they’re going to charge a lot of commission dollars. But they don’t charge anything to do an ETF trade. So if I’m holding my assets at Schwab and I wanted to buy a Vanguard fund, if I can do it with an ETF seems like a better deal?

Eric Balchunas: Absolutely, and this is part of why Vanguard launched the ETFs, to be able to distribute better, because of that reason. So if that’s the case then obviously with that scenario, with VTI becomes a better deal.

Rick Ferri: It’s one other thing too, that I want to talk about is Vanguard has a unique structure where their ETF share is a share class of the open-end fund. They’re the only ones who have this. They have a patent on it.  And so when it talks about tax efficiency their mutual funds have the same tax efficiency as their ETFs within the same fund, it’s spread across all classes of shares equally. Now the fee might not be exactly the same I mean actually Vanguard now is actually lowering the fees on their ETFs because administrative costs are actually less expensive to them, for holding shares away at Schwab or Fidelity, the cost to hold shares there is less so they’re actually now passing that savings on to the ETF shareholder. So if you look at VTI or some of the other funds, the ETF share class is actually starting to trickle down even below the admiral share class.

But the question is taxation. I was talking with a client a few weeks ago who said they made the mistake last year of buying a Schwab S&P 500 mutual fund in their taxable account last year and they got a tax distribution at the end of the year, pretty big one apparently, enough to make them upset about it. Rather than buying an ETF like IVV in their account where they would not have gotten a tax distribution. So from an investor standpoint, an individual investor’s standpoint, can you tell me why an ETF would not make capital gain distributions while a mutual fund that’s following the same index might? Not including Vanguard because as we just talked about they’re the same. 

Eric Balchunas: Right, Vanguard is a special case and if you’re using Vanguard index funds don’t worry about this. 

I am looking at the Schwab, you’re right, this mutual fund put out capital gains opening almost religiously every year. Yeah I hear ya that’s annoying and that, look this tax efficiency of the ETFs that you hear about is fascinating because it’s for some people it’s the number one benefit. ETFs probably have ten features like a smartphone, but some people use two or three or hardly anybody uses all ten. But tax efficiency might be the most important thing for certain people because of those taxable caps [cap gains].

Now the reason this happens is that creation/redemption process, the portfolio manager is able to sort of wash out gains if there are some in that process of the creation/redemption. All that’s happening in the primary market. It doesn’t affect the investors.

The mutual fund you just don’t have that. So the mutual fund’s a lot easier to understand. You’re, somebody’s running the fund. They have to, let’s say somebody wants to get out of the fund, they’re going to have to sell some equities or they have a lot of cash, which in case you have cash drag. But let’s just say they don’t, they have equity. You’ve got to sell something to meet those redemptions and so that’s going to trigger a gain and the people who sat there get it. Which is annoying because all you did was sit there.

And that is what ETFs don’t have, so you rarely get a capital gains distribution. There are a couple cases when you will see them, but they’re usually in special situations and more exotic products. But the big general ones don’t really, really do that and I think that that track record of not having capital gains is very valuable.

They didn’t design the ETF to sidestep the tax rules. It was a happy accident when they made the creation/ redemption, which was really largely to keep the costs of trading separate from the investors, and by doing that they kind of made the taxes separate too. And that is a big win for ETFs and frankly I think that’s more fair. I think mutual funds, when you look at them side to side, have the unfair way. I’d almost, you know, obviously ETFs have a lot of advantages. This is one where I almost feel bad for mutual funds because it is an unfortunate way. It’s almost like you just get taxed when you make the action as the investor. If you sell that’s on you and that you do get the capital gains distribution if you sell your ETF, but you don’t get one just sitting there. And I think that’s a more fair way to get taxed.

Rick Ferri: Gene Fama won the Nobel Prize in Economics a few years ago. He and his research partner Ken French, wrote an op-ed Wall Street Journal article, and I want to say 13-15 years ago, where they talked about this problem with mutual funds. Not with ETFs, they said that ETFs were doing it the right way, and it’s the way that mutual funds are not tax efficient, and there needs, the Congress needs to change the way mutual funds work so that they could become on a level playing field with exchange-traded funds. So it was clear, you know, a long time ago that this was a better mousetrap from a tax perspective.

Eric Balchunas: Yeah and I think some people say why doesn’t the ICI, you know, lobby Congress, I first of all not sure they want to, you know, mess with what’s obviously good tax revenue; number two I’m not sure they fully understand it; and number three, the ICI nowadays is filled with people who have ETFs and mutual funds. Like these companies all have both mostly. Back in the day it might have been smarter if the ICI was more full of just active mutual funds, but now it’s ETFs are kind of part of all these big companies lineups and so be hurting, you know, a lot of their own members. So you know, that’s why I don’t think you’ll see any pushing to undo it. But I could be wrong. It’s possible they, somebody decides to change.

Rick Ferri: What happened, by the way, ICI is the Investment Company Institute, which kind of is a trade group of fund providers.

Eric Balchunas: Yes, ICI is like the big trade group. And as we know how Washington works, usually you need some group like that to sort of get the ball rolling on what would be otherwise pretty complicated tax issue and I just don’t see them taking that initiative. 

Rick Ferri: We said Vanguard doesn’t make any difference because it’s everything’s treated the same and it’s all tax efficient. In fact Vanguard is really super tax efficient and we can get into why this sort of double structure of having it as a share class of a mutual fund is actually even more tax efficient because when there are cash redemptions in the mutual fund side you can get rid of stocks that are at a high cost and are at a loss and therefore gather losses in the fund and then when there’s a redemption the ETF side you can get rid of low cost basis stock. So it really is a super efficient model that I always wondered why other fund companies didn’t just go to Vanguard and pay them a fee to use that invention that they have a patent on because it is so tax efficient. I mean it would make your open-end mutual fund so much more tax efficient if you had an ETF share class of it and you could get rid of the low-cost basis stock so you don’t have these distributions at the end of the year. But I’ve not heard of any company that has successfully gone to Vanguard and gotten them to let them use the patent. I’ve heard that companies have tried but that Vanguard wasn’t listening.

Eric Balchunas: This comes up sometimes when we talk about this new structure coming on next year called non-transparent active where they have a way to have a certain active ETF not have to show its holdings to the public every day. It almost seems like licensing Vanguard’s patent would make more sense. I agree with you. I’m not totally sure why more people haven’t thought of that and the patent runs out, I believe it’s 2022.

Rick Ferri: I think that’s what I’ve heard.

Eric Balchunas: Yeah so you can either wait it out, they might not be, I mean the flows are getting pretty, pretty, pretty rough out there and I think a lot of active firms don’t want to wait that long. So maybe they just don’t want to have to pay Vanguard, which they see is like the Amazon of the industry.

Rick Ferri: I have heard that as well.

Eric Balchunas: Yeah I mean there could be some pride involved here you know don’t wanna, I just can’t do it, I can’t bring myself to pay Vanguard. They’re doing enough damage to me. So but yeah I don’t know. I think maybe they want more control, who knows? But I would think that might work better than what they’re going to do, which is if they come out with these sister ETFs or something  close so their, you know, where do they price them to not alienate that existing mutual fund investors, yet appeal to the low-cost obsessed ETF type investors? So this is a real puzzle they’ve got to deal with, I’m curious to see what they do. 

Rick Ferri: Well speaking of, you know, the future. First off how many ETFs are there now in the US alone? How many, how many do we have?

Eric Balchunas: Okay well I can give you an exact figure. It’s going to be around 2200. I, well, I’m here with my steady terminal: 2369 in the US. Worldwide?

Rick Ferri: Well sure worldwide sounds good. Go ahead.

Eric Balchunas: I’m going to get 8,000 let’s see what the survey says here. Probably going to be, it’s interesting the US only has about a quarter of all the global ETFs but we have about seventy percent of the assets. It’s a huge market in terms of assets and we have about eighty five percent of the volume so a lot of the action is here. But there’s products galore in other countries.

Rick Ferri: So I’ve heard that the number of…

Eric Balchunas: The answer is 8259. So 8529 worldwide.

Rick Ferri: So screening these things could be a real issue. I’ve heard that with index mutual funds and ETFs that are tracking indexes, now equity indexes, that there are more equity index mutual funds and more equity index ETFs than there are stocks on the US stock exchange. Is that true?

Eric Balchunas: Oh, yeah. This chart, I put this in a bit once, I took the number from Sanford Bernstein that there was, I don’t know, something like 7000 indexes and it was a huge spike up. You can imagine almost like a hockey stick, growth in the number of indexes. So what we did is we took that chart, reference them, and we put the number of stocks on top of it and you can see the number of indexes just fly right past the number of stocks.

Everybody went wild, even [Jeffrey] Gundlach commented on this on Twitter. It was just a chart that just, it just struck a nerve or a chord with people. I think of nerves better, in terms of indexes taking over. A couple things. According to that number of 7,000, there’s more mutual funds than stocks too and nobody cares; and to quote Meb Faber there’s also more words than letters. And also for some reason nobody’s got any problems with that, in other words there’s so many stocks, there’s so many combinations you can make, so it doesn’t matter. And there’s an index association group, I forget the exact name, but they claim there’s 2.7 million indexes so that number from Stanford Bernstein was actually way underdoing it. A lot of indexes have many versions, but largely you could have a billion indexes, most of the money is going to be connected to a small tiny portion of those anyway. Most of them are just meaningless, so you could go ahead and design, if a statistician or a mathematician were to take the number of stocks and figure out how many different combinations you could have, I bet the number is infinity.

You know it doesn’t really matter. It’s just more, look it’s a sign of the times. It strikes to the fears people have of passive sort of like taking over and that’s what that chart did but it was much more optics than reality.

Rick Ferri:  Now you said that a lot of these funds don’t have a lot of money in them and I think somebody wants to refer to them as zombie funds, where they’re the Walking Dead. So what happens when one of these funds doesn’t make it and closes. I mean how do people get their money out? Is it a taxable event? How does that work?

Eric Balchunas: Yeah that’s the problem is, if you will if it went up, you’ll get hit with a tax bill on that. You don’t lose your money, I mean, and yeah, you’re right there’s a lot of ETFs that close. In fact if you look at all the ETFs in the US ever launched about a quarter of them have closed. That’s a pretty high number, you know. This year we’re looking at closures that may rival a record. It could be close, but a lot of issuers will just close them if they don’t work.

The good news is hardly anybody’s in them if they close them. So you’re probably not owning the ones that close. But let’s say you do. The problem isn’t that you lose your money, the problem is you would get hit with a tax bill. Either you sell it and it’s at a gain, so there you go. Or if you just forget, they’ll cash everybody out at the NAV that day. So the tax consequence is the reason that there’s a quote “closure risk” in ETFs, but it’s not credit risk per se and it’s important to distinguish the two. But this is part of the reason why there are people who are nervous, advisors in particular, about going into ETFs that don’t have a lot of assets and so welcome to the plight of the small issuer, especially the indy issuer that doesn’t have a big distribution. That’s why you see some of them go into zero fee and trying to, you know, lure you in other ways because they know how hesitant people are to buy ETFs that don’t have, say like over 50 million in assets or a 100 million. It’s hard out there. And there’s currently, I don’t know, about half of all ETFs are probably under a hundred million.

Rick Ferri: Is that the break-even point do you think for a new ETF, a hundred million?

Eric Balchunas:  I’ve heard fifty. Thirty to fifty is like a break-even. We could say at fifty probably like you won’t close. If you look at the average closure size it’s about thirty million, so we think, okay, if you’re 50 you’re probably not going anywhere because you’re  probably like break-even at least. If you’re a hundred you’re officially in the middle class. We consider the middle class to be a hundred to a billion, and then once you’re over a billion you’re you know you’re rich, you’re elite, you’re the top 10%. And so about half of the ETFs are below that middle class line, and about half of those are in the danger zone which is 30 million or less. Which are the most at risk of closing. Yeah there’s a ton of them, like 500 are  probably in that danger zone.

Rick Ferri: As an  investor, if I am looking at an ETF, do you think that that should be one of my criteria, that it has at least 50 million or if it doesn’t I know that I’m taking more risks somewhere.

Eric Balchunas: I don’t want to ever say you should never look at small ETFs because some people think that if  there’s not a lot of volume or assets then you can’t actually even trade it. But the fact is you could put a limit order in and probably get a decent price because there’s never a liquidity risk to being in a small ETF. Again, a market maker or somebody could always do a creation. Like, there is the closure risk. If getting that tax bill is that annoying to you, and it’s you just say, how much is this strategy interesting to me? Because keep in mind a lot of the innovation in the financial world is in the ETF market I call it the Silicon Valley of investments because a lot of PhDs, a lot of smart people are putting products out. They may not have 50 million for a couple years but you may love the product. I would say okay, well how much do I love it. Is it worth the potential of this tax bill? You know there’s a percentage chance that it could close. And you have to weigh that.

But I wouldn’t necessarily not go into a small product because you feel like, in like an equity you could get stuck. I don’t really see that as the spread could be a little wider but again as long as you use a limit order in trading these smaller ETFs you’re probably fine. So I also have a soft spot for the indy ,smaller issuers. I think a lot of them are so overwhelmed by Blackrock and Vanguard. It’s tough but there’s a lot of good ideas, a lot of the innovation happens with smaller issuers that are closer to their market.  And so some of the best products are coming out from the small guys and it takes them a couple years to get to 50 million, so I don’t want to say make that a hard rule, but just understand that closure risk tax bill possibility.

Rick Ferri: Just want to remind listeners that Eric’s book is called “The Institutional ETF Toolbox” and it has a lot of these screening due diligence explanations of cost and spreads and when to trade and a lot of good information in the book, so let’s talk about the future.

A lot of things have happened. Used to be a lot harder to issue an ETF. Let’s say if I decided Rick Ferri wanted to issue some balanced ETFs. And I bring that up because there are so few balanced ETFs out on the marketplace that are just, you know a basket of balanced bonds.

Eric Balchunas: Let’s go into this a minute. This is a fascinating question. Okay because my podcast host, Joe Weber, always says why isn’t there an ETF with the ticker EASY, that just holds everything? And I’m like, they exist, they’re called “asset allocation”. Blackrock has a couple but they have almost no assets. I mean Blackocks have a couple billion, but for them that’s small. But it’s a small category. 

The reason and I’m pretty sure–this is my theory but I’m  pretty sure I’m right– is advisors are the biggest consumers of ETFs, and advisers want to be the pickers and once you, if the advisor shows up with just one product on their sheet that might not go over well. So I think that’s largely the reason why. Plus when you go balanced, you know, it’s a one size fits all and not everybody has the same needs as the way that balanced fund does it. You think that’s a good theory? I’m curious to get your thoughts. 

Rick Ferri: No. I think the first part of that is absolutely correct. I mean you know advisors don’t want to give up control of doing something in an account and if they can take four funds, five funds, twelve funds, fifteen funds and put it in a portfolio and make it complex it gives them a reason for being. Because then they can rebalance it and, you know, people get a statement that has a whole bunch of things on it and it looks like it’s, you know, the advisor’s doing something and therefore the advisor should get paid a fee.

You know in reality though, if the client on their own went out and bought a balanced ETF that has four or five basic index funds in it, the client would do just fine. So where you’re talking about the ETF marketplace as focusing on advisors, this product, this balanced product that I’m talking about would focus on a new and huge potential market. And that is the individual investor who is embracing ETFs faster than I think the market and the ETF companies really  understand.

From my business, and I deal with almost all do-it-yourself investors, they’re buying ETFs and they would really like to have balanced ETFs for the small accounts. But to me, there’s a market there but it’s not the traditional market of institutions, it’s not the traditional market of advisors. It’s a new and huge market of direct and the do-it-yourself investor.

Eric Balchunas: Yeah I think you’re, you know, you’re definitely onto something with the do-it-yourself individual investor. 

That is an area that is growing, all the research shows that. We heard some anecdotal data from Blackrock about that. I think the number I heard is the percentage, this is ballpark, but some people ask me like who owns the ETFs and you know it’s roughly can break down like 10 percent institutions, depends on how you define institution, but then maybe 15 percent do-it-yourself retail, the rest is advisors. So a lot of times when I do my analysis I default to  advisors because they are the majority of the users. But you’re right that direct, especially with commission free trading, I only imagine that category is absolutely going to grow.

Rick Ferri: It’s huge, yeah it’s huge. I sometimes talk to ETF providers and say, hey why don’t you launch this or that type of fund because it seems there would be a market for it. I remember back in the 1990s, early 2000s, I said, “Hey why don’t you do factor ETFs?” So, you know, why don’t you have like value and growth and quality and this and that. And they said that’ll never fly. That was back in like early 2003.

Anyway you know seven eight years later there’s factor funds everywhere now. I’m saying, “Well why don’t you do balanced  ETFs because this market out there, this huge individual investor market, do-it-yourself market, would use them and they would appreciate them, especially if there was some tax advantages to doing it. But you know I throw that out there. I’m not going to do it myself. But you know in addition to that the SEC has just made it easier for companies to issue ETFs, they no longer need this thing called exemptive relief. And could you go through some of the regulation changes that have taken place?

Eric Balchunas: It speeds up the length and shrinks the cost for launching, so it expedites the launching of ETFs. And it was long overdue. There was no reason to have this exemptive relief, especially as ETFs got to multiple trillions of assets. At one point I think there was 1200 ETFs filed. But this comes, this would have sped up launches ten years ago, I don’t think it does much today.

I think that over the last 10 years, you know this is why I call the ETF industry the terrordome, it is absolutely brutal. The investors are so cost obsessed and they will sell you out for like one basis point. And we have a chart we call the cost obsession thermometer and we just look at the percentage of flows going to ETFs that charge 20 basis points or less. That number this year is at an all-time high, 98%. Last year was 96%. You throw in index funds you go to 99%. 

So it is really unbelievable and sometimes a fund will come and cut a fee by one basis point, and actually can move the needle on inflows. So I think over this year especially, a lot of people in the pipeline might think twice before launching because of just how utterly difficult it is to find success.

And I think that’s why this will not do much, or I would say this rule might bring up the people who might have, you know, make it easier and might attract some new issuers. But at the same time that the increasing brutality of the market I think will scare an equal or more amount away so you might have even net less launches going forward even with the rule. Although ten years ago I think this would have really expanded launches. I don’t think it does much now.

Rick Ferri:  What about the new rule on non-transparent ETFs for Citi and Funds LLC active share ETF structure. This is all very new. Where in the past you had to disclose every day what you had in your ETF, now onto this new structure you don’t have to anymore. Is this going to change things for the active managers?

Eric Balchunas: They hope so. When you look at the active mutual funds space, active fixed income mutual funds there’s seen over a hundred billion dollars in inflows this year. So as long as rates remain steady or low I think active fixed income mutual funds are dandy, that they will probably just continue to launch the occasional transparent active fund. On the equity side, a lot of the managers are hesitant to put their secret sauce out there in an ETF that shows your holdings every day.

I think they’re overestimating how much people care in terms of both front running and just like copying their holdings. I don’t know if there’s that much interest in doing that but anyway they’re it’s their livelihood right, they don’t want to share their stocks and their weighting so they’ve come up with, there’s a couple different  models of ETF structures that will have a fund trader on exchange but without showing the holdings every day. That way they can have some degree of secrecy while at the same time benefiting from a lower cost overall expense ratio and tax efficiency, which is huge as we mentioned earlier. 

So there’s a couple different models. Some will have a special representative who works with the AP, like a blind trust, and some will have a proxy portfolio where the stocks are very close to what the manager holds or correlated but not what they hold.

And so there’s a couple different ideas on how to do that and the SEC just approved the first one which is the Presidium model. I expect it’ll be approved at some point. And so you have companies like JP Morgan, Blackrock, T. Rowe Price, the list goes on. American Century I think is the first one who’s going to come out next year. Monster active managers hoping this is a way for them to participate in this sort of new world of ETFs without having to show their holdings every day.

I’m pretty bearish on it but this is what they think might help stop some of the bleeding on the active equity mutual  fund side and help them regain some of the customers that they might be losing.

Rick Ferri: Okay one last question, and that has to do with the new thing out there which is  ESG, environmental social and governance, ETFs which are the new new thing.The old new thing being smart beta, and I guess  the old old thing being just beta, which is still collecting the most money. So we went from beta, which is still doing well, to smart beta, which seems to have slowed down and now everybody is ESGing. How does the landscape look for ESG investors?

Eric Bachunas: Okay, so there’s two ways to look at ESG ETFs. If you look at them isolated you could go, okay well ESG ETFs went from 6 billion to 15 billion this year. They more than doubled their assets. They’re growing faster than everything else. Okay fine, but 15 billion is what is that, that’s 0.50% of all ETF assets. So it’s microscopic and it’s microscopic compared to the hype especially. There’s all these articles on ESGs.

Rick Ferri: What, what, what? Bite your tongue! [laughs]

Eric Bachunas: The hype around ESG, the press is good. You know, look, a lot of the media is based in Manhattan. I think this is an issue that’s important to them. I don’t know how much the rest of the country cares about ESG investing.There’s some disconnect I see. It has, there’s a disconnect that happens a lot with what you know the media world might consider important and what actually investors care about. But I think ESG may fall in that gap because given the media coverage and the years, they’ve been out for ten years now, 15 billion isn’t that much. Although again you got to give them credit for growing. So I’m not sure how much actual raw demand is there.

The problem with ESG is that it’s subjective. I don’t think any two people would have the same exact criteria of what should be in or out of their ESG ETF. So you’re, you know it might not fit what you want and some ESG funds have X and some don’t, right a lot don’t. Vanguard might do it one way, they might include alcohol but you may be fine with alcohol. Like this is where the subjectivity also, I think, is a headwind with ESG.

The good news for ESG and what I thought caused the bump up is Vanguard coming out and Vanguarding the category. They came in cheap and now the rest of the launches since then for the most part have come in cheap. So there’s not a lot of ESG ETFs that are well below 20 basis points, which is that magic number where all the flows go. So I think that helped a lot and as long as they’re dirt cheap they have a fighting chance, I think to get flows but I’ve yet to see real money.

When you said smart beta let me just give you a comparison. Smart beta ETFs have 920 billion. 

 So what’s fifteen into 920?

Rick Ferri: I don’t know. I have a CFA but I’d have to get out my calculator and take a look. [laughs]

Eric Bachunas: [laughs] It’s 30 or 40 times the amount of assets of ESG, so you know that’s my quick take on that.

But you know Millennials apparently are the generation that’s most interested in them according to surveys. But again I also think the surveys might be overhyped because who is going to answer on a survey they’re not into ESG, you know, and risk being judged? So I think that the numbers on the surveys might be higher than reality because people fear, of like being the person who doesn’t care about ESG. I always saw people if you’re really into ESG why would you not want to own the companies that you think could be better?  What you should do is just buy a passive index fund, like from Vanguard or Blackrock or State Street, because those corporate governance groups, once you own the whole index, you are now basically giving your money to Vanguard or Blackrock’s corporate governance group to go and vote, and they’re very ESG oriented. 

So I always say that, like, active managers are out there, they are concerned about the products and the profits. And then the rest of the ownership is, they’re passive they’re concerned about ESG so I find that’s actually like those two things can live in harmony, but if you buy the whole index you own everybody and you own Blackrock’s voting on all those companies including the bad actors. So I would argue that the ESG route might just be to own the whole market via the index and give them your votes.

Rick Ferri: The large holders of total market index funds like Vanguard and Blackrock have a ESG responsibility. I didn’t know that.  Could you, could you explain that?

Eric Balchunas: Yeah, so Blackrock seems to be a little more aggressive with things like issues like gun control and climate change but they’re all really interested in corporate governance. For example Vanguard has six principles for good corporate governance including things like independent oversight, right, board accountability, shareholder voting rights, consistent with economic interest, annual director elections, and minimal anti-takeover devices, sensible compensation type of performance, shareholder engagement. So I think you know when it comes to Vanguard, and none of that is, hey make me more money, but I think they’re saying look, if we set up the right parameters it gives the company the best chance to be successful. So I think their focus is more on the G of ESG and just trust them to vote in the yes, you know, to push for the SG policies within those companies. But that’s up to, you know, how investors want to want to play it.

Rick Ferri: Thank you Eric.You’ve been extremely helpful and very knowledgeable about the  ETF marketplace and looking forward to a lot of great things. I remember when we first met at a conference and first heard you speak and I knew you were going to go places and you certainly have. So looking forward to a lot more from you in the future. Thanks for being on the show.

Eric Balchunas: Yeah thanks for having me and looking forward to having you back on ETF IQ again.

Rick Ferri: Oh thanks, appreciate it.

This concludes the fifteenth episode of Bogleheads on Investing. I’m your host, Rick Ferri. Join us each month to hear a new special guest.  In the meantime visit bogleheads.org and the Bogleheads wiki, participate in the forum, and help others find the forum. Thanks for listening.


About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant



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