The 10th Man

Was It All Worth It?

October 20, 2016

People still think of me as an “ETF guy,” even though it’s been years since I’ve made markets in ETFs.

I was in the ETF business during the Jurassic period, when ETFs were mainly trading vehicles, not something you really invested in. But I’ve seen the entire arc of the industry, from inception (those crazy days of the QQQ on the AMEX) all the way to the present, disrupting the mutual fund industry and gathering trillions in assets.

I have some thoughts about the journey.

  1. In a sense, I agree with Vanguard CEO Jack Bogle—as the story goes, he resisted Vanguard’s push into ETFs, thinking that people would be encouraged to trade and speculate instead of buy and hold. There is also something attractive about the open-end fund structure, that you can only buy or sell at the close—it discourages rapid trading. I think, with the benefit of a little hindsight, that most investors are happy to let shares of an ETF sit unmolested in a brokerage account, but there is a small minority of investors who like to trade actively, and the ETF issuers have come up with products that are best suited to trading.
  1. Along those lines, I continue to be shocked at the sort of products the SEC approves—a leveraged volatility ETF like TVIX is just as mathematically complex as options on variance swaps—maybe even more so. I think a number of products out there (including all leveraged ETFs) are best suited for hedge funds, but have retail appeal. Confusion happens when retail investors mistake these trading products for investing products, like holding 3x leveraged ETFs for a year or more. This sort of thing has, on occasion, given ETFs a bad name. It is too bad.
  1. The mechanics and legal structure of an ETF are obviously a terrific innovation, but ETFs have benefited from the passive/indexing revolution more than anything. Just recently, I saw a big piece in the Wall Street Journal on how passive investing is destroying the actively managed mutual fund business, with assets fleeing active funds and piling into passive funds. I’ve written about this in the past, and while there is a place for passive investing, when it starts taking up a large percentage of the market, really big distortions can happen. As a thought experiment, what if the entire stock market were held by index funds? My guess is this is closer to a fad than a structural shift than people think.
  1. People have taken their shots at the ETF industry over the years, most notably the Kauffman report in 2010, which called ETFs “derivatives” and called attention to ETFs that were heavily sold short. These theories were all debunked. People are still waiting for that ETF “blowup.” Six years after the Kauffman report, it hasn’t happened. It will never happen, absent counterparty risk with swaps in leveraged ETFs or ETNs, or human error in managing the funds. The legal and operational structure is sound.
  1. As an ETF trader, I used to get bent out of shape at what I would call “throwing-spaghetti-at-the-wall” ETF listings. It is cheap to list an ETF (relatively speaking) versus the probability that it might gather a lot of assets, so issuers are incentivized to list as many as possible (within reason) in the hopes that one or more of them catch on. It’s a similar business model to venture capital. (For an example of this, see WSKY.) I’ve concluded that, aside from the ticker clutter, there really isn’t any harm in issuing a bunch of funds, even if you know that most of them will eventually close—investors aren’t harmed; they get their cash back at the NAV. It’s simply a business decision for the ETF issuer.
  1. 10 years ago, there was a lot of excitement that the ETF fund structure could be used for actively managed products. A lot of that enthusiasm has waned over the years, for good reason: the ETF structure doesn’t lend itself well to active management, because the ETF market-maker is never really sure what is in the basket. So the promise of tracking error reduces liquidity in the fund, which increases trading costs. Open-end funds are much better for active management. I think people have finally started to figure this out.
  1. I think what is lost in the whole discussion about ETFs versus open-end funds is the closed-end fund structure. Closed-end funds are actually pretty handy, especially when you are dealing with illiquid asset classes like leveraged loans or emerging market debt. I am always surprised that closed-end funds haven’t gathered more assets over the years—they are still basically an afterthought in the asset management industry. For sure, they have some weaknesses (including one big one, the fund discount/premium, and the fact that it is hard for a fund to grow), but in a world where both mutual funds and ETFs have liquidity constraints (most recently imposed by the SEC), maybe this isn’t such a bad thing.

I have been accused of being a “pro-ETF” guy, which I guess is sort of true, but there can definitely be too much of a good thing. We are starting to see those distortions from too much indexing.

But there can also be too little of a good thing. Face it: the exchange-traded fund has to be one of the top five financial innovations in the last 100 years. Hands down. People who have bet against it have been made to look very foolish.

Something else before I sign off: I recently mentioned that we were putting an ETF Trading Master Class together. But you know me, I’m not satisfied with creating a good product. Either it’ll be the best thing ever, or I don’t even bother to start.

So in the next few weeks, I’m going to ask you to act as my “beta team” to make this the best ETF course ever. Watch for more details in upcoming 10th Man issues.

Jared Dillian
Jared Dillian

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