ETFs Are Eating the Financial World and They're Not Done Yet

because I'm very excited about today's topic. Probably one of the biggest stories, themes, whatever you want to call it in finance right now, and that is the rise, the seemingly inexorable rise of the E t F exchange traded funds, completely changing the way how people invest, being able to invest in an index, or a strategy, or all kinds of other stuff just simply as buying a stock, completely revolutionizing the industry, striking terror in the hearts of many managers.

People say, E t F s arey this godsend that have made investing much cheaper and simpler for the average person, enabling more complex strategies. Other people say it's going to be the end of capitalism and that it's the road to Marxism. Nothing quite causes controversy like E t F. Some people think they're going to be the source of the next systemic risk. So there is literally an endless amount of stuff we could talk about with e t f s. And to do that, well, you have two

great guests who are also my colleagues. Joe Weber, he's the editor in chief of Bloomberg Markets magazine, and Eric bel Tunis. He is a E t F analyst for Bloomberg Intelligence. He's literally written the book about e t f s, knows all about how they work. And so today we're going to talk to both of them, or I'm going to talk to both of them about how E t F I've eaten the finance world and where they're going next, how they're going to evolve, how they're

changing the industry every single day. So without further Ado, let me welcome Joel and Eric. Thanks for having us, Thank you, thanks to both of you. So Eric, I want to start with you, but you know, both of you just jump in, let's have a conversation. I would like to make sure that I introduced things correctly because I think you know, I want to make sure that

I set it up. But when you look at the E t F world, and this is what you do at Bloomberg from the minute you get on to the moment you log off, and even after that, and even after that, you're thinking about E T S all the time. This is your life's work understanding this behemoth. Is that a reasonable characterization of what's going on? Yeah? I mean, you know, I remember I was in Bloomberg Data back in the early two thousand's and the only reason I

got E T S I was covering mutual funds. I had been been a fun reporter back in the day, and I got E T F assigned to me because a woman covering them. When on return he leave, it never came back. I remember it was two thousand and six. It was just right after g l D had launched, and it took me, you know, I can't remember exactly the timeline, but it just took me very quickly to realize that these things were going to be a big deal,

and I just saw an opportunity. So it was already familiar with funds, and I think that when you're familiar with mutual funds and hedge funds and clothes and funds and you start to sniff around the E T F, you realize this thing isn't just like one little notch better than the rest, it's like six notches better. It's a game changer. So I definitely, um, I guess life's work is seems strong, but I guess it is. Uh.

I have been doing it for a decade. So you mentioned something there that's very interesting, which is the g l D e t F, which is the Spider Gold Shares e t F. It tracks the price of gold. It launched in late two thousand and four. More or less, buying it gives you exposure very directly to the price of gold, and that seems very simple you by this. It holds gold. But it is revolutionary, isn't it Because prior to the existence of this e t F, if you wanted to have exposure to gold, it was not easy.

You had to go out and buy maybe by physical gold, and that was difficult, and it was this huge mark up. And then you have to figure out safe. How are you gonna you get a safe, You're gonna figure out how to still remember the password, remember the password, And suddenly this very complicated, costly, time consuming strategy is as simple as buying a share of Microsoft. I think what you're describing is two things that come to mind to me is convenience, I mean everything in this world, it's

a business. Usually convenience is a big part of why people like it. And the second thing is the democratization of investing. So the idea that the you know, being able to buy anything under the sun like it was shares of Microsoft, and everybody likes the way stocks trade, so you're essentially making everything trade like stock. So you know, the Bloomberg terminal has the yellow keys. All those things

now trade like equities. And the structure itself allows for some arbitrage which helps the nav stay close to the price, so you get a fair deal on what you're looking to get and you can and now it's level the playing field. And the other thing about it, it's democratized. That is, everyone pays the same price. In mutual funds, you have these share classes that are like a regressive tax system, and with the e t F, it basically everybody gets the institutional level feed. It's like the Sam's

wholesale club. The thing that I wanted to kind of point out, Eric was I was looking at flows here and you know Spy which tracks s actually was the very first e t F, which which you've actually written about for me and Bloomberg markets, but there are obviously other e t F s since then which that came out in So even though spies the biggest E t

F of all, there are other competitors, right. And one of the things that's happened this year when we look at flows is that even though the spy has is up for the year to date, flows are way down, right, and other SMP five products are up. What's going on there? Yeah? So the E t F industry, you know, I refer to it as a jungle as you know, droll because it's brutal. People are undercutting fees and there's similar products

and there's hardly any money. I mean, eat F industry only produces about six billion dollars a year in revenue. To put that into perspective, hedge funds make about sixty five billion a year in revenue, so and they have

less assets. So there's not much assets and people are calling and so spies outflows are a function of black Rock, who has i VV which is the other smp F t F Vanguard has one two came in at point oh four percent, so they lower their fee from point of seven to point oh four is five charges point o nine and just a couple of basis points was enough to completely change the flows. And SPY is not in any trouble. They don't, don't feel bad for it.

It's still spy will always appeal to like really hardcore trader, some big institutions. It It trades more each here than Japan's GDP basically, and there's you know, options market is massive, and so ultimately i VV has been stealing not institutional money,

but retail and advisor money. They care more about the feed because when you go in long term, the expense rat sue does matter way more than any little like extra basis point on the spread, which is I think an interesting thing to keep in mind here is that buying and holding e t f s is kind of a recent phenomenon, right because here to date it's been more of a trading strategy, which is always also the knock on e t f s because they're so easy

to trade with, people just trade with them constantly. But buying and holding because they're so cheap, it's sort of really catching on now, right. I called this the investor enlightenment age, where investors are finally understanding the importance of cost.

They're getting better at asset allocation. But the next phase of this is behavior, And I think there is some credence to John Bogel's criticism of heifs that the temptation to trade goes up a lot, unlike a mutual fund, where it's like just kind of it's just like too annoying to have to sell it and you get out the end of the day. But if you could trade intra day, the temptation goes up. And I think if you do too much trading, you basically completely kill all

of the cost savings. So I think the next baton is like, how do you basically not trade yourself out of the cost savings from using the et F in the first place. But there is some buying and holding. So there's two things here that I think are really important. And one is you know, again it's similar to the gold ETF. You think, oh, it's really simple. You buy the ETF. It just tracks the gold. That's not a

complex strategy. But when you think about how difficult it is to actually own golden story, it turns out that something very difficult has become very simple. It's the same for this, right, I mean, like, there wouldn't wuld be prior to the existence of this e t F. We think of an STP five index tracker as about as plain vanilla as it gets when it comes to investing.

But imagine the impossibility for the average person of replicating that on their own buying five stocks, if they wanted to trade that in and out, it would be essentially impossible being able to, you know, always trade in and out of this perfectly balanced index of five stocks. That would actually qualify as an extremely complicated thing to do. Um. You know, before we even get into more complicated ETFs. That alone would be a you know, investment vehicle that

the person you know, would be almost impossible. Now, we talked about this incredible fee compression that we're seeing and the idea of like people going crazy finding the e t F that offers the same thing for a slightly lower fee um, and this is a big part why these vehicles strike terror in the heart of of the financial industry, just because the extraordinary you know, this is

where people make their money, the extraordinary feed deflation. We're saying, Well, I think the other thing to mention there too, is that this is a first and foremost sort of an improvement on the mutual fund, right, which was an index thing already you can always buy it was, and you couldn't trade it into day. But then the vehicle itself went from you know, just whatever index you want to track,

to boy, we can make anything an index. And not only can we make anything an index, but we can look at oil, which you, as a retail investor, could never touch before, and all of a sudden, now you can dabble in things that are really crazy, I think from a retail's perspective, and as a consumer, I think that's the scary part, is that you can look at this and you can buy anything you want, even though

you might not understand. Well, let's talk about that, Eric, because one of the most you know, biggest phenomenons of the last year, maybe a couple of years, but it's really sort of taken on life of its own is people trading volatility products, so exchange traded notes similar to e t f s that track not a specific basket of equities or any or even a commodity, but volatility itself. Explained to us what those are and why they've become this subject of fascination. You know, the VIX in general,

it's like betting on fear. And I think that's just here's the thing the VIX in general, um, I call it media proof. And the E t N that tracks is VXX. That's the main When that goes long, vixed futures on the short end of the curve, that thing, because you have to roll the future is it basically will lose about a year just on that rolling. Uh. Some call it decay, but people still trade the you know what out of it every day and it's never

had one bit of good ink written about it. It's media proof because why when the market goes down like city SMP goes down two, the VIX would be up like say, I don't know, the xx would get up about half that nine So nine percent is more than is more than even a negative triple leverage inverse S and P five hundred. So I called it's the jackpot. When VIX works, it's like the payout from heaven. So that's one reason people go along the VIX E T S and the short one x I V which you

and I've discussed a lot. I think he called the magic money machine, if I'm correct, which I think is a perfect name for it because it just spits out money. Um. I sometimes call it the greatest of all time because it's had the best performance of any product ever in the existence of e t s. Seriously, if you're listening to this, if you're at home and you've never checked out the ticker x I V, bring it up somewhere. Take a look at this chart. It just goes up.

I mean, so the thing is is that I gotta be really careful. It's one day it's not gonna go up, So I don't want to be like representing that you're going to make money on this. However, here to four, since its existence in it goes up. Occasionally, it has these really sharp draw downs because when volatility does spike, it gets crushed, but it almost completely erases them very quick after. In uh, you know, since the beginning of

it started around twenty, it's up fivefold. So betting against volatility has been like, just this incredibly good trade and this vehicle has just made people an extraordinary amount of money. Yeah, I mean, this x I V ultimately takes advantage of what that a year loss in VXX that I talked about, that's a gain for x I V. So somebody just and that that's sort of the innovation of ets. People complain about this one thing and then all of a sudden there's a new ETF to like take advantage of

that complaint or correct it. And x I V. You know, it's controversial, but as long as vault stay is low, it doesn't make money on VIX going down. It makes money on basically the role, so it benefits from that. But it certainly is something that I think, like we're developing this rating system at b I where we're going to give every E t F a green, yellow or red light, and this would be a red light. Doesn't

mean you can't use. It just means that if your retail you really need to read the fine print and understand what you're buying. Because x I V on a bad day could go down in a day, right and it wouldn't even take anything that extraordinary for that to happen right like around. But I think breggs that it went down. I can't know in the exactly, maybe August it was down like thirty or over two days, um, And if it goes down more, it will just shut down,

it will close and redeem the money. Wow, I didn't realize that And Just to be clear, this is a strategy that the average person would never prior to this existence have any real way of playing like being I mean, there was just the ease with which one can now bet against volatility can't even be compared to the level of technical skill and knowledge that it would have required to make the same trade prior to the existence. I mean,

it's completely uncomparable, totally. This is why again I think a rating system like movies is what e t F s need, because I don't think you want to ban an e t F like X I V because for a certain group of investors it's great. It's a convenient way to do what you have you have to go basically short fixed futures. In this case, it just does it for you. But yeah, for for certain investors this

is definitely off the charts, potentially complicated. And the other one is like leverage gtfs, which use total return swaps, which ultimately you needed to have like a prime broker or Noah, you know, have connection with Golden Sacks to get a swap contract. Now any investor can basically access them through leverage e t f s. So the democratization has gone into some really complicated, potentially dangerous areas. There's

no denying that, all right. So we've talked about these very early E t F that you know seem quite simple but are in fact incredibly uh you know, complicated.

They make life a lot simpler. Now there's this obsession with you know, various products that we see today that would essentially be impossible for the average person to replicate on their own, but now the E t F to make it incredibly simple, even if the people maybe don't really understand what they're buying a lot of the time, necessitating a need for more clarity on some of the risks. Let's look forward. Where is this industry going next? I see two evolutionary lines. One is a race to zero.

So we talked about i VV and sp Y in that whole battle that also includes Vanguard and Schwab, and they're going to be in this few war that now has them down to like selling the whole stock market for point oh three. That's probably gonna be zero in a year or two. So on the one evolutionary line, it's great for investors. You're able to get your whole portfolioll be free probably within five years. That that's a

tough line to do business. And by the way, that's like taking on Vanguard and Swab is just almost like suicide. But hey, for investors, it's great. There's also that idea though, that you might get paid to own an e t F. Yeah,

there's some talk about that. It's possible that they might do like a negative expense ratio where they actually give you four or five basis points just to buy the thing um just because they want your assets, because then they could lend some securities out, or in Schwab's case, they'll they invest some in treasuries, make the interest basically whoever considered the biggest pile of assets. They feel like they could give free exposure everybody and make money in

other ways. That's why these companies would go that low. But the other evolutionary line, I think is the one where for me as an analyst, it's uh, it's exciting because that first one is very plain vanilla, but the other one is like everything that ever happened on Wall Street, ever, and every idea that anyone's head could be packaged into

an index, and that's what's happening there. That's like the experimental, innovative side where you see like like T. Boon Pickens is going to pack at his oil strategy into an E t F. Soon Gunlock made an E t F. Then you're gonna have things like this new E t F powered by IBM S Watson, the robotics CTF, all kind of wild stuff that can charge a little more

because the potential to outperform is higher. And that's where you see a lot of the bigger companies go eventually because they're just not going to fight vanguards, so they'll come out with some more like repackaged active and we've seen that, like you know, what is it Goldman SAX has launched ETFs based on what is it the recommendations of their what are the there's some Goldman et f s that are sort of based on their own internal research, right, yeah, so close. They had at Goldman sex v I p

Hedge Fund Research TTF. Now here's the thing that is a is a research report, but it's based on hedge fund holdings, so it's not quite Goldman's picks. Now you bring up a good point though, because this week, literally this week, and by the way, you brought up Marxism earlier, the group, the research group behind that Marxism claim that passive was the road to Marxism is now launching e t F s. So irony aside or hypocrisy aside. Uh, they're now going to basically do what you just said.

They're gonna put their top sixty or their sixty outperformed picks into an e t F. This is Bernstein, by the way, and you'll be able to buy it. Now. If this gets any traction, lookout for Goldman and JP Morgan to do that, which I think is great. That's uh, you know, Walt sell side, research is one of the last things to be democratized or broke, you know, turned into an e t F. On the flip side, that's

pretty proprietary stuff. So giving it away like that, I'm you know, I'm not sure if that would irk current clients. Another thing is, once you put all your calls in an e t F, we now know how good you are. Yeah,

you know. Eric. The other thing that that brings to mind when you're talking about research is sort of the implications of Method two in Europe, which is this you know, kind of hallmark piece of legislation that's gonna take effect January three, and there's a lot of speculation that e t F are going to be one of the biggest winners of that eventuality. Can you speak to that a little bit? What do you what do you what do you see happening when method goes into effect? So myfed two.

I know that some people just probably went to sleep, but it basically this myth. This is a rule that's just basically like in Europe. You know how here the investors will like sell you out for one basis point for the cheaper e t F. It's the opposite. In Europe. People have no idea what they're paying. So people pay two to five percent in a mutual fund fee, and then they get broker commissions on top of that, so they could be paying up to seven or eight percent.

And here we're arguing over seven basis points. So this is going to make all that transparent. People are gonna see line items of all the stuff they're paying for and their fund. One of those is research. That was the impetus. But the side effect of this is that once the cost or transparent, they think a lot of people will switch over to e t S because it's sort of like the d L rule here. Anytime regulations in any country step in and say, hey, we need

to make things more transparent. E T S and passive are going to win that fight, like almost every single time. Um, they thrive in the light, whereas when there's layers of fees that's sort of more the way the mutual fund industry has thrived without that transparency. So myf the two is bad for mutual funds, probably good for E T f s. And this is I think to put all of this in context, is why these things are going to continue to eat the world, right Eric, Because we're

talking there's a sizeable amount of money. How much money is wrapped up in ETFs right now? So three trillion US four point five globally and then and then you think about where this is going. And the most bullish projection is what Eric, but bullish or sober? Well, let's do both, Okay, So the most bullish is trillion in the in the next eight years, almost the size of the US stock market right now. Yeah, that's not the

sober one case, that wasn't obvious. Most sober estimates are ten to twelve trillion in ten years alright, real quickly, because we have to go but someone is going to be really curious, can you just real quickly summarize the argument that E T F could lead to Marxism? Sure? The argument is that if passives passive, so E T s and index funds, which also have three trillions, so passive has six trillion collectively in the US. Is that number grows to ten twenty trillion, passive will own a

lot of America's companies. So right now Vanguard and black Rock and their passive funds are the top two owners of about the S and P stocks, and that's going to grow, only grow. So the question is if an index fund is my big owner and I'm CEO, do I get a free pass? You know? Uh, what about the corporate governance here? And so that's sort of the and where's I guess if you had an active manager, they would be like keeping the CEO in the in

the company's feet to the fire. So there's some argument that the rise of passive will like sort of like hurt capitalism in that regard. I usually confront that with you know, like, first of all, like Steve John did not invent the iPhone because of a tiro price manager. Um, so capitalism is going to happen Anyway, the question is how good is Active at making sure the prices are

where they should be. And I do think there's some more interesting debate on that, but right now, Passive all told only owns of the stock market, so I think until we get to thirty forty, I just don't think it's that big yet. Well, we will be out watching out for if Marxism happens, and that will be very interesting. This is a great conversation because I feel like we

eat f are. Obviously everyone's heard of them by now, probably a lot of people have exposure to them, but it's like we can't state it enough in a way. How really like there are revolutionary technology as I see it, and I think the you know, talking to you guys, sounds like the revolution isn't complete. So Joe Weber of Bloomberg Markets Magazine, Eric bel tunis e T F analyst at Bloomberg Intelligence, thank you so much. That'll be it.

I you know, Tracy is not here this week, so you know, I have no one to no one to banter with like I normally would, but I really enjoyed that conversation, so uh no, it was really great talking to both of you and that has been another episode of the Odd Lots Podcast. You can follow me on Twitter at The Stalwart Joel I'm at Joel webbershow Eric I'm at Eric BELTONI. If you can spell that, you

can follow me. And you can also follow Tracy on Twitter, which you should do even though she wasn't here at Tracy Elloway. And our producer Sarah Patterson at Sarah patt With Two Teas. Thanks for listening.