Here’s How ETF’s Can Bring You Joy

Steve Pomeranz: Investing in exchange-traded funds or ETFs had become really, really big business and an important part of the investment landscape. So I’ve asked Eric Balchunas, who’s a Senior ETF analyst for Bloomberg Intelligence, and he focuses on these exchange-traded funds. In his introduction, he wrote that he is a tired dad, a Rutger’s alum, and you can also find him on ETF IQ on Bloomberg TV and Trillions on iTunes where he hosts a podcast. Hey, Eric, welcome to the show.

Eric Balchunas: Hey, great to be here.

Steve Pomeranz: So let’s talk ETFs. So Exchange Traded Funds, give me one paragraph explanation of what an ETF is.

Eric Balchunas: The best way that I’ve heard is it’s a mutual fund with benefits.

Steve Pomeranz: [LAUGH] Okay.

Eric Balchunas: It’s regulated just like a mutual fund. Some people try to use derivative on ETF, but it’s not. It’s a fund under the same regulations as a mutual fund. The big difference is it trades under an exchange, so that’s the one area people maybe want to get in and out when they want. That’s why some people trade ETFs, but it’s essentially a mutual fund. I think the other big, I guess, advantage of them is they’re very, very low cost. Typical mutual fund might charge anywhere from 60 to 100 basis points or 0.6 to 1% and that’s being pretty nice. An ETF will, on average, the asset-rated average fee is now about .2%. So I think those are the two big advantages—low cost and liquidity.

Steve Pomeranz: Right, so easy to trade, but they are just pooled funds, like a mutual fund, only they have a different mechanism on how they trade and it creates certain tax benefits and the ability to charge low fees and other things. So let’s move on, that’s just for those who may not know but ETFs if you don’t know about ETFs and you’re listening to this program, you need to google that and start to learn about it, it’s an important part of having investment portfolio now.

So, money has been moving out of traditional mutual funds for years. And I noticed on one of your presentations on the ETF IQ Program that money really started moving out this last—for the fourth—quarter of 2018 which was a pretty terrible quarter for the stock market tell us about that real quick.

Eric Balchunas: Yeah, so if you look at last year, this is some ballpark stats. But you saw about 400 to $450 billion leave actively managed mutual funds. ETFs took in about 320 billion. And then indexed mutual funds took in about another 150 billion. So about 500 billion into what we call passive. The mutual fund ETF debate gets a little cloudy because index mutual funds, which track an index, are also very cheap.

Those are what people use in their 401k for Vanguard and such. We kind of lump them with ETFs sometimes, in terms of passive, so it wasn’t that mutual funds did that horribly. It was that active mutual funds definitely saw their worst outflows on record. And this is I guess against what may be a lot of people were hoping, especially who are active managers, in that volatility in a down market, they would show their worth, and people would want a human hand guiding them. It turns out, that it’s the exact opposite. People used it as an excuse to switch over to the ETF or the index mutual fund.

Steve Pomeranz: If I had a dollar for every time someone said that active managers will outperform in a volatile or down market, I would have, millions of dollars. And the point is thatI would like it to be true. It sounds like it should be true. But just the statistics and the facts just do not bear it as being true.

So you just kind of have to go with what you know. Now the bottom line is if someone is telling you, stay with this active manager because, in bad markets, they’ll be there for you, really the statistics don’t really prove that. Now, Eric, these ETFs come in many shapes and sizes, the most ubiquitous are the ones that match or model the S&P 500. That’s where it all started. So, we all know about the S&P 500, and that years ago Vanguard created an index fund based on the S&P 500 and that has now morphed into ETFs as well. But, ETFs have also evolved a great deal. They’ve gotten very kind of industry-specific. Let’s go out to the outliers now. What are some of the more interesting and the kind of the sexier ETFs out there now?

Eric Balchunas: Yeah, I think, just one of the real interesting areas, obviously, is bonds. The fact that you can trade, say, corporate debt or high yield bonds in an ETF wrapper has been a big hit. Then you look to gold. I think when the gold ETF-

Steve Pomeranz: Yeah.

Eric Balchunas: When that came out, that was a game changer. I think people really thought, wait, we can actually put a bunch of things into ETFs. Now that you can get oil futures on ETFs, big futures, there’s a lot of exotic areas. We call them the rated R section.

Steve Pomeranz: [LAUGH]

Eric Balchunas: They’re probably not for resell investors but certainly for traders who’d rather just trade it like an equity. Even traders like the ETFs structure, that’s how robust and powerful it is and how it conserves so many investors. But then some other areas, I think the area that I think is probably the most interesting is for investors who may not want to just have the sort of Vanguard 500 returns and want to try to do a little better, smart beta is where active has a home in ETFs.

Active will take their sort of secret sauce. Right, whether it is a value tilt using 6 different metrics in a certain weighting scheme. And we’ll package it and design an index using that secret sauce. And that index can then have an ETF track it and that ETF can be low cost and doesn’t have emotion like a human manager because it rebounds by design, on a recorder or such. And it also doesn’t have the capital gain distribution that you get with the mutual funds. So smart beta to me is sort of like an advanced artificial intelligence version of an active manager. So I think smart beta is an area that is high growth area. And that’s where you see a lot of the innovation, and finally, themes. Now they’re putting all kinds of themes, like name a news cycle, there’s probably an ETF for it. Robotics.

Steve Pomeranz: Right, cannabis.

Eric Balchunas: Cybersecurity, cannabis.

Steve Pomeranz: Yeah.

Eric Balchunas: Yeah. Cannabis is the big one right now.

Steve Pomeranz: But let me stop you for a moment and go back to this smart beta. We’re throwing out these terms that people may or may not understand. So remember we have these two kinds of investing. Active investing which is this idea that there’s a person or a team of people behind it who are well trained and who are managing this money on kind of a day-to-day basis. And then you have the kind of the passive which is just an index or is just a list of stocks or bonds like the Dow Jones 30. If you had all those 30 stocks, you put together in a list and in the exact proportion that they are in the index, and you created an ETF, you could invest in that.

So along comes a lot of these active managers who have been managing mutual funds for years and, as you’ve just described, are losing all of these assets. They’re not sitting idly by. They’re saying, well, how can we get into the ETF space and charge more in fees so we can kind of continue our business model, but also gain the benefit from the popularity? So, what they are allowed to do though, is since they can’t really go in and manage it with a human being, they’ve created these formulas or these algorithms that target a certain kind of investing. And then they run the ETF via those formulas. Now, Eric, I want to ask you a question. How viable do you think most of these formulas are? I mean, do you think that they are also going to be able to outperform truly passive?

Eric Balchunas: I think they’ll have their years, they’ll have their months. I think if you have a value smart beta ETF. Value’s been very out of favor.

Steve Pomeranz: Yes.

Eric Balchunas: Doesn’t matter how good the design is.

Steve Pomeranz: That’s right.

Eric Balchunas: It’s going to underperform. But the growth ones have done much better. Momentum has done pretty well. So these different flavors are going to have their sort of day in the sun. I think it’s really up to the investor to sort of have that opinion of what they want to do. Now there are actual actives, ETFs, where they have a human picking the stocks. And some of those do better than others but, just like in mutual funds, about a third beat the market, two-thirds don’t, and the problem is the third that beats the market usually cannot persist.

So it’s tough, but there are some success stories on the active side and on the smart beta side, I think you can’t expect anything to outperform all the time. I think you sort of have to go, look, I think growth has been in favor for ten years; I think value is coming back, let me now look at the value ETFs. As long as you have that goal and opinion, then you sort through and say which one do I like the best. Which design is for me, some are more watered down, some are more deep value where they hold small stocks.

Steve Pomeranz: Yeah, well, I know there’s one ETF that takes the trading algorithms from so-called great investors, this is what Buffett does. This is what other great managers who’ve been successful do. This is how they’ve said they’ve invested, and he’s put many of those into the ETF. So you’re kind of getting an average of these algorithms. So there’s so many ways to slice this bread, it’s really quite interesting and exciting to see such an innovative area of the marketplace, for sure.

Eric Balchunas: Yeah, absolutely, I mean ETFs, again, I’ve told people this, for a long time. The metaphor for the ETF is like the MP3; the whole music industry had to make use of that and the compact disc sort of went by the wayside. So the ETF is the technology that everything in the industry, whether it’s active or a trade, an actual trade, like currency -hedging or it’s just a hedge-fund strategy. It’s all sort of being packaged in this new technology that sort of people are interested in buying their investments through.

Steve Pomeranz: On behalf of mutual funds, I will say that the set up for the standard mutual funds is unfair. The way it’s structured tax wise is unfair I think to the shareholder and also to the manager as well. I think the open-ended aspect, the fact that money comes in and comes out all the time, makes it very difficult for a money manager to beat an index which doesn’t have this problem of money coming in and money coming out, especially in an ETF. If they have to leave cash in there because people are redeeming their fund, they’re going to underperform a similar investment that is fully invested. And-

Eric Balchunas: Yeah, and-

Steve Pomeranz: Go ahead.

Eric Balchunas: Can I jump on that for a minute?

Steve Pomeranz: Yeah, please.

Eric Balchunas: You’re right. I have, over the years, I think, become more empathetic towards, especially, active mutual fund managers. It’s hard, you’re right. Some people say that a mutual fund simply internalizes the costs and an ETFs externalizes it. But I think a lot of people prefer to have it externalize. They don’t want o pay for what other people are doing, right?

Steve Pomeranz: Yeah.

Eric Balchunas: They want to just sort of say, okay, the cost of the ETF is low, it doesn’t have a lot of turnover. It tracks the index and when I sell it, that’s on me. If I get a capital gains distribution that’s because I did it. It’s not like you’re just sitting there like a good soldier and, boom, you’re hit with a tax bill or extra transaction costs or “tax drag.” So I think the ETF just sort of is able to lower the cost in a net basis. And so I would say that active mutual fund is sort of like starting maybe ten paces away from the starting line, whereas an ETF is starting one inch. And so an active has to overcome a lot to just tie the ETF and then it has to do something special to beat it.

Steve Pomeranz: So it’s possible that many more managers could outperform a passive index. It’s possible except for the fact that the structure of the mutual fund itself, as you said, has them starting ten paces before the starting line. Very difficult for them to make up.

Eric Balchunas: Yeah, if you look, if you take the fees out and the transaction cost, you’d have a higher “beat” rate. I don’t know if it would be up to 50%, but it would certainly be higher. I think the other part of it is it’s just hard. Predicting the future is very difficult. And then you put the Fed into the equation. I think a lot of managers are complaining about fundamentals being a little more difficult because the Fed came in there and provided a lot of bond buying and so there’s a lot of cross currents that have made maybe the past beta not work out in the future.

Some stocks that should go up don’t. It’s just very difficult. And another argument I’ve heard a lot about again is as more people go passive, they are just sort of throwing their hands up. That leaves the smarter people active. So in other words, the casino is only now full of the smartest players. So it’s actually getting harder and harder because there’s less retail investors because a lot of them have just gone over to the passive or Vanguard side.

Steve Pomeranz: I see, yeah.

Eric Balchunas: So I’ve heard that makes it even tougher as opposed to easier.

Steve Pomeranz: Yeah, okay, interesting. So, by the way, I’m speaking with Eric Balchunas. He’s a senior ETF analyst for Bloomberg Intelligence. So what are some things to keep in mind when using ETFs that could go wrong? What’s the downside here?

Eric Balchunas: The number one thing, in my opinion, is don’t lose your mind trading; this is Bogle’s concern. John Bogle, the founder of Vanguard, who always had a sort of like an uncomfortable relationship with ETFs. He loves the index fund, obviously, he helped create it. But the fact that you could trade an ETF, he wasn’t hot about that.

And if you can’t withhold, withstand the temptation to not trade all the time, right, because you can trade any time you want during the day. Well, if you trade too much you’ll probably lose money and it will overwhelm all of the cost savings and other advantages of the ETF. The second one is, obviously, just not knowing what you’re buying. There are some ETFs where the name’s obvious, I say a lot of the plain vanilla ones. The S&P 500, the Total Market, fine, those are easy. But there are some where the name might not match up with holdings, and or the index waiting might be equal. That gives you a little extra volatility.

Steve Pomeranz: Yeah.

Eric Balchunas: So there’s definitely some things underneath that you should know. So if you don’t trade too much, you always look at the holding. And the final thing would be just learn how to trade. I mean, mutual funds, you don’t have to go on and put an order in. I think for the bigger, more liquid ETFs, you can put in a market order, meaning whatever the price is. But if you’re going to a smaller ETF that might not be as big, say below 100,000,000 assets. You may want to look at putting a limit order in just to make sure you get a price that’s fair because you are trading in a product that isn’t as traded. So, those are three tips for people to not shoot yourself in the foot using ETFs.

Steve Pomeranz: I know that’s one of our criteria when we decide on what ETF to buy is to look at the liquidity of the ETF to make sure that in a market movement, let’s say, a large market movement, either negative or positive, that there’s enough liquidity in there for us to sell it and to get out at a decent price if we need to do that. something that is very, very important. Since there are so many ETFs and they’re surely not created equal. My guest, Eric Balchunas, Senior ETF Analyst for Bloomberg Intelligence. And you can see him at Bloomberg.ETF IQ, if you just Google that you can see him. That’s Bloomberg TV, and also Trillions on iTunes where he hosts a podcast. Eric, thanks for spending the time, appreciate it.

Eric Balchunas: Thanks, it was a pleasure.

Steve Pomeranz: To hear this in any other interview again, if you have a question about what we just discussed visit our website at steveparmaran.com to join the conversation. And while you’re there sign up for our weekly update for a brief rundown of the important topics we’ve covered that week. Straight into your inbox. That’s StevePomeranz.com