The Exchanges

Q Yeah. So you're in the mutual fund area, covering mutual funds, trading mutual funds in the eighties and the nineties. That's a huge period of growth and change in the mutual fund industry. What were the key trends that you saw evolve?

A Yeah, well, it, it got better because it went from you had to trade via sending a letter to the fund company to making a phone call to the evolution of the platforms. So then the Schwabs, the TDs, the Fidelities of the world said, look, we can make this a lot better for you. We can offer you a whole platform where you go to one place To make all your trades. So the late eighties, early nineties was a huge growth area. And the fund companies didn't mind it because they would take all that work and then pay for it. Now, the costs involved in trading also declined at that point. I mean, trading early on in those days might've been 20 or 30 bucks. You know, it's down to less than nothing today. And then also the evolution of the no transaction fee platforms. So if you want to get on The platform, and not charge the advisor or the individual investor, you'd have to pay a certain amount of basis points to the fidelity of the Schwab's of the world. That was a huge explosion in business for the, for those platforms, and for advisors that were RIAs, fee-only advisors, because in the past, they had to manage money directly with the fund companies.

AI assessment note: “went from you had to trade via sending a letter to the fund company”

Q What's happening with fees? So we know in the index side, all, it's, it's a compression race to get to the lowest fee you can, and Vanguard obviously has a big presence in the NTF space as well. What happens with the smart beta strategies?

A Well, there's fee compression there too. You can get a smart beta strategy at Goldman for nine basis points. You have pure beta strategies now for four. A lot of folks in the industry think it's just going to go to zero because you can make a little bit on the spread and securities lending is now playing a bigger role. So securities lending in some areas can be two to three basis points. And are you going to keep that yourself? Are you going to share with the shareholders? There's a big debate about that. But during bear markets, there's even more demand for securities lending. So that's something to kind of think about, which might come into play in the future.

AI assessment note: “Well, there's fee compression there too. You can get a smart beta strategy at Goldman”

Q What's the institutional presence in the ETF market? Is it Something that you can quantify?

A It's growing. I would say ballpark might be the 400 to five hundred billion area. Invesco PowerShares does a good job of surveying these folks on a regular basis, and a couple things that I can share with you is the percentage or allocation that's gone into pure beta ETFs continues to increase, and really in the last couple years, for the first time, they've started implementing smart beta strategies, a lot of institutions have, and My big question was, where'd that money come from? Did it come from money they were taking away from hedge funds? Some, but they're actually shifting money from pure beta cap-weighted strategies as well. So that makes a heck of a lot of sense.

AI assessment note: “ballpark might be the 400 to five hundred billion area.”

Q Well, we're going to talk a lot about a hot space, but as you know, I always love to figure out how someone got there. So why don't we just start with your early career and go from there?

A Yeah, well, I've got a few years on me, so I'll try to make it fast. So I grew up in the Boston area, went to Babson college and not a school. I started fidelity on the institutional side. I was lucky because my dad had been a broker in the sixties, so I knew what a mutual fund was. So rather than being in the bullpen with most of the guys and girls, I got to be, uh, in sales support for the institutional side. I supported the West Coast Vice President, and back then the institutional side basically meant five regional managers. One of the benefits is we could actually take smaller accounts, and there was a investment newsletter company in Huntington Beach, California, that had 45,000 subscribers paying 275 dollars a year To tell them when to buy and sell equity mutual funds based on basically a two under day average. So this newsletter evolved out of moving your funds from a, writing a note to the fund company to actually being able to call them on the phone and move from fund A to fund B. So that was a big revelation in the late seventies and the early eighties. And as you probably remember, newsletters were just through the roof, the magalogs in your mailbox and that type of thing. So heck of a lot of fun. But a bunch of people said, I'm not going to do this myself. Uh, I need somebody to do it for me, so hence they started a money management company. And I went out to talk …

AI assessment note: “I grew up in the Boston area, went to Babson college and not a school.”

Q Yeah. So I want to turn to something that, that I hate. So something you loved, which are levered ETFs. Yeah. Do levered ETFs have a place to add value really for anything?

A The bottom line is they do exactly what they're supposed to do on a daily basis. Right. And, and that's it. But for the average individual investor, it's dynamite. They're going to blow off a toe or something like that, because it just ends up promoting bad behavior. However, there are institutions, there are advisors who do a really good job using them, And even though the asset growth in inverse and leverage ETFs haven't really kept up with overall asset growth in ETFs in general, it, it doesn't matter because when you look at the underlying volume, it's tripled. So more and more advisors and institutions are using them. Self-directed investors , there's some that are more sophisticated in using them. Again, when you get into the two and three times leverage, if you're not using them over a short period of time, That negative compound, in effect, really works against you. But, you know, on the other hand, if all of a sudden there's a huge valuation opportunity in gold miners, and you see a huge sell-off in the market, seven or 10% in a given day, and you say, hey, look, I think there's a swing opportunity here. I'm going to go in for two or three days. Rather than buying the individual issues or buying an actively managed gold miner mutual fund, That's something that you can watch interday, and if interday something happens, you can get out as opposed to the mutual fund itsel…

AI assessment note: “there are institutions, there are advisors who do a really good job using them”

Q And would they ratchet them up if The funds were popular?

A Sometimes, but also they'd have to control assets. So sometimes a bunch of money would come in at one point, and they'd get scared, so they'd close them down. So there were little tricks that would happen in the industry, which would work in their advantage to a great degree, but what was funny is in the nineties, we had kind of a slow, steady, upward movement in the marketplace. Those advisors that wanted to move in and out of funds actually would get Handcuffed to some degree. If a fund company knew you were coming in and putting twenty million dollars, and then you were selling it six months later, they would actually work with the custodian. The custodian would say, they don't want that type of money, so you no longer can buy that fund. Which worked very, very well for them through the nineties, but then what happened is, in the early 2000, we get a bear market. Well, they're not going to be as picky as that. At that point, they're going to, they're going to take all the money, but that was the period, because ETFs started in 93. They had a pretty slow buildup, but many of those active managers that had used mutual funds in the past now realize that there was this new tool out there, ETFs, where They were very liquid and they traded in a day and the spreads were getting tighter and there's more volume there. So they were saying, fine, we're going to begin shifting over ther…

AI assessment note: “Sometimes, but also they'd have to control assets.”

Q There's always this question, certainly with the index fund movement, of what's going to happen in a downturn? Or do the people who own these really understand? It sounds like the last big downturn we had really fostered the growth Of these ETFs. Why do you think that happened?

A A couple things. I think with the amount of money that was in mutual funds, and a big thing we compare to as mutual funds, most advisors and most individual investors felt that if you have a money manager who's had a pretty good run, that they're also going to do a pretty good job for you in the downside. Inevitably, we know that that's not the case. So did people lose a little bit of trust or a little bit of confidence in their managers? Maybe. Was cost involved? I think so as well. The whole transparency thing. So we've had a huge shift also in the advisory world from commission to just fee-only RIAs as well. And with all the economics that are going there as everybody's fighting for every dollar, a huge amount of advisors in the world have broken away from the wire house firms and the independent firms to set up their own shop. It makes sense for them just to, if they're going to do the whole thing, charge a flat fee, be completely transparent with their models, and a lot of them who have done that over the last nine years, since the last bear market, it's paid off tremendously for them. They're making better money, their clients have less fees, they're more tax efficient, and if you bought just a group of ETFs for your clients and done asset allocation, worked out great. So now your question, where do we go from here? Because in the past, during that bear market, if you had…

AI assessment note: “did people lose a little bit of trust or a little bit of confidence in their managers?”

Q Yeah. This begs the question. Of, are there other problems waiting to happen? And usually it's not the same type of problem, but where are the risks in the ETF space today?

A So, my radar's up all the time, because we're huge fans of ETFs, and I feel obligated to the advisors and individuals that we try to educate on a regular basis, try to expose great opportunities, at the same time Where are the risks? One area that pops up is fixed income. People say, hey, we got a lot of money here. There's going to be a problem when there's a sell-off in the bond marketplace. It's all going to be on the ETF market. Ok, so a couple things. First of all, there's about seven hundred billion dollars in fixed income related ETFs. There's probably four trillion dollars in fixed income mutual funds. So just to kind of put things in perspective, if there's going to be a sell-off in funds, ETFs, there are going to be a lot more funds that are being sold than ETFs. Ok, number one. Number two, There are a lot of people who are trading bonds on a regular basis that said ETFs are the best thing that happened in the marketplace as far as price discovery. Price discovery in stocks is pretty easy. There's a high level of confidence. On the fixed income side, still kind of a little loose, but actually because there's more liquidity in the ETF space, we've seen better price discovery because ETFs have come into the marketplace. And part of that is because even though funds are Have been around for a longer period of time. There's not as much trading. Tends to be more trading in…

AI assessment note: “One area that pops up is fixed income. People say, hey, we got a lot”

Q The rock star guys, yeah. Do you think that fun flows will chase hot managers and create future rock stars?

A I think it will. I, I think we will see chasing hot managers. I would say robotics, for example. There's a robo-global that had been around for five years, hung under a hundred million dollars, and then all of a sudden people got it. And now they're at three billion, you know, in an, in another year. That's not going away. I think we're going to see that in the technology space. And we saw this in the technology space in the nineties. Remember the hot fund managers that were out there. They built fund companies all around different technology spins, huge amount of money. And then poof, it went, it went away, but it's not. It went, it went away, but it's not. Valuation seemed to be very much in line.

AI assessment note: “I think it will. I, I think we will see chasing hot managers.”

Q Yeah. So what are the big trends? If we look out, call it five years, maybe even 10 years in the space, what are we going to see that's different from what we see today?

A I think a couple things. First of all, ETF strategists are a whole ecosystem unto themselves. They are, in fact, advisors who manage money for their own clients and created portfolios of ETFs with Most, because of this bull market and stocks and the bull market and bonds, people haven't needed that. I think they will need that in the future, because you're going to need people to help guide you through the trends, the ups and the downs. So I, I think we'll see that. The ETF issuers are, in fact, creating their own portfolios as well, not only using their own ETFs, but using their competitors' ETFs within portfolios, and they'll make them available, too. So that's kind of the next wave of Kind of portfolio management in the, in the ETF space.

AI assessment note: “that's kind of the next wave of Kind of portfolio management in the, in the ETF space.”

Q So would you call that index or like systematic? There's some exposures. There's some defined exposure, right?

A So up until 2007, 2008, most of it was pure cap weighted indexes and the low costs, the major market indexes that you would know. And then there was a battle about fees and got lower and lower. Then As most of that cap-weighted index space got eaten up, you've got more players that came into the space and said, hey, factors are also important, whether it be volatility or momentum or value. So now there was a whole slew of those players that came in, introduced those options, and now multi-factors are also. So what we're doing is we're evolving kind of back to active management still now in an index form, and The cool thing about it is it's transparent. There's a discipline around it. There's no money managers that are making decisions in a black box. It's all open, and you can't violate the internal disciplines that are set up, or something would really pop to the surface, because the job is to follow the underlying index and have a very high correlation. If you don't, it's pretty notable.

AI assessment note: “we're evolving kind of back to active management still now in an index form”

Q have all these products that probably aren't that big. So as you look at that whole ecosystem of fund management providers, you've mentioned strategists, advisors, where do people who think that ETFs are going to continue to grow and explode over the next 10 years How do people plug into that and provide value to their clients, and who's, who are gonna be the winners in terms of the business?

A Yeah, so like you said, obviously the issuers, and there's more competition within that space. We're seeing a lot of M&A going on in the space already. There are a lot of managers who were late to the game, and rather than create it themselves, they'd want to go in and buy somebody. So it's hot right now, and managers are paying premium prices For established ETF shops, even if it's small. So look out for that. The platforms, the Schwab's, the Fidelity's, the TD's of the world, where they made a ton of money in the past in their mutual fund platforms, they now have no transaction fee ETF platform. So you can buy and sell ETFs through Schwab for no fee, and that's subsidized by the relationship with the ETF issuer. So they're paying to be able to have that, which is Great. I mean, I can remember meeting Chuck Schwab's manager, one of his, his money managers in San Francisco, and he told me the story about explaining ETFs to Chuck. Now, ETFs were very disruptive to Schwab, because Schwab had this mutual fund platform, and they were making a killing, and when Chuck came back, he sat everybody down and said, hey, we need to pay attention, because this is what we're all about. It's Tax efficiency. It's diversification. It's liquidity. It's low fees. We need to embrace that. It's going to be painful, and they did it, and they've, they've just done a great job. So I, I think that's an…

AI assessment note: “obviously the issuers, and there's more competition within that space... The platforms, the Schwab's”

Q And when you hear about it, you really hear this notion of this sort of liquidity mismatch. You hear mostly about high yield bonds and maybe emerging market high yield or emerging sovereign bonds. How does it reconcile that you have underlying instruments that are just not as liquid as the vehicle itself?

A Part of that is most of the indexes, and most of, so we're going to talk a little bit about active fixed income maybe in a minute, but most of the traditional index-based strategies and tools that are out there in the ETF space have very liquid underlying, and they do a good job in making sure that happened. Ok, now, there was an exception. 2015 had a little bit of a sell-off in the muni market. A lot of people can remember that. What was interesting is funds were being sold, individual issues were being sold, ETFs were being sold, and for the first time, and we hadn't seen this happen before, some redemptions were actually met in kind. So rather than getting the cash, you actually got the bonds themselves. Kind of cool, because funds have always had that in the prospectus. They can redeem in kind, and that's going to deter trading to some degree. But some of these desks, these authorized participants, didn't get the cash. They actually got the bonds themselves, and this was just a short period of time, but this is one way that we can, I think, have confidence that there'll be liquidity.

AI assessment note: “some redemptions were actually met in kind. So rather than getting the cash”

Q So you mentioned a very concentrated industry structure, right, of two trillions in the hands of a hundred funds. Is that market efficient? Meaning, if you just looked at the size of the fund for a particular strategy, is that highly correlated with the person who's doing the best job tracking the index?

A Very good, very good question. I think the greatest thing here is we have competition. So even though it's kind of like the auto industry where you've got the big three, you know, you've got BlackRock, you've got Vanguard and State Street that really monopolize the ETF business, it's not as though we can't have competition. So now I think we've got this mid-tier of ETF issuers that are coming in, and they're saying, okay, I'm not going to battle in that pure beta space where you can charge five basis points. There's no money in that. Give it to the big guys. They can handle it all day long. I can come in and maybe through a factor strategy or a multi-factor strategy, or maybe through self-indexing, get a little bit of alpha there, and even charge 20 basis points and make some money off it, but if I can get some alpha, then those that are invested in ETFs are gonna give me a shot. It's been really tough to beat the S&P. In the last nine years, right? So we're not really yet in a period where active management can really show its worth, but I think we're going to be getting there, and that's really going to get us more back to full circle, where active managers are going to come in. They can show that maybe they're not going to give, give back as much in market declines. They can find areas where they can add added alpha, and then also when you get into areas like Technology. Onl…

AI assessment note: “I'm not going to battle in that pure beta space where you can charge five basis points.”

Q So are there strategies like a concentrated active manager that make more sense in an ETF, or do you think down the road any active strategy could find their way into the structure?

A Well, it's a great question, Ted. I'll tell you right now, we've had such a good run on ETFs that the individual investors are thinking, I'm not buying mutual funds. I'm going to buy ETFs. And they're not really looking under the hood. It's just, it's ETFs are cool, and mutual funds maybe aren't as cool right now. People talk about ETFs on the golf course. You know, what type of ETF are you going to buy? This and that. It's almost like picking stocks at market highs. The key is, it's a great wrapper for obviously indexing, for sure. For active, it definitely can be. But the biggest thing is the transparency. Because there's a trust involved, and there's a discipline involved, and especially for advisors and institutions, they don't want to be surprised. They've been at it before, they've seen it so many different times, where you have a manager who may have high conviction, said he's got a discipline, ends up falling in love with a stock, and really can't justify it based on their model.

AI assessment note: “For active, it definitely can be. But the biggest thing is the transparency.”

Q Okay. How about pricing distortions? So with more and more money coming into these ETF index funds, particularly in some, not the SPY, but in an emerging market bond index or something, you, you hear about if the particular bond is in the index, that price can get marked quite differently from a similar bond that's outside the index. How does the ETF ecosystem think about that?

A Well, first of all, and, you know, emerging markets have, as you know, they've come a long way in the last 10 years, and these countries, they want participation, they want money, so their accounting methods have stepped up, their technology has stepped up, and then the issuers that are putting these underlying indexes together are testing them to make sure the liquidity's in place. Is that always going to hold? Who knows? Is there exposure there? Maybe there is. Is there a chance that at one point in time we're going to see an underlying bank in an emerging market fail where that's going to affect the pricing? Probably, and that's the way the markets work. Today, would you stay away from an emerging market bond ETF because of the possibilities there? Man, the yields are great. The valuations are awesome, and I, I still can't believe in talking to advisors when we talk about the opportunities and Emerging markets, for example, both on the bond side and, and then the equity side, the, with the valuations, the diversifications in mind, somebody like a Rob Arnott, that I talk to on a regular basis, who personally has, 50% of his individual money in emerging markets, and said, you just don't see valuations like this, with P ratios around 12 right now. I think you're gonna see it's the normal markets, it's the ebbs and flows, and the cool thing about it is, Emerging markets have rea…

AI assessment note: “would you stay away from an emerging market bond ETF because of the possibilities there?”