This product influx and innovation is why the ETF industry is like the tech sector of the financial world. There is definitely a Silicon Valley, gold rush vibe. But the pace of innovation and new products has outrun the education by a mile. And it has created more noise. This is why ETF due diligence is going to be very important going forward. This is why we work to make the best functions on Bloomberg. This is why we do ETF events all over the country. This is why I’m writing this book.
The tricky thing with ETFs is that they wrap up everything under the sun, including futures contracts, options, and swap agreements on top of stocks, bonds, or commodities. This is also one of the reasons it is so intellectually satisfying to be an ETF analyst. They take you to every nook and cranny of the financial markets and the world. You have to be a mile deep and a mile wide.
Now, as useful as ETFs can be, there can be some nasty surprises underneath some of them. Some ETFs hold pretty illiquid stuff, not to mention derivatives. Also, some ETFs are much more volatile than they look. Some ETFs have hidden fees or unusual tax treatment. I will share how to spot those things and how a “nasty surprise” rating system for ETFs may be useful.
This book is about tools, not theory. I’m not going to teach you about portfolio management techniques or how to do asset allocation or what will go up or down or what model works best. I’m not that guy. There are literally hundreds of books on investing written by more appropriate people than I.
I am an ETF analyst, or guru, or geek – whatever you want to call it. I have spent the past decade managing ETF data and developing new ETF functions on the Bloomberg terminal, as well as writing articles for Bloomberg.com and Bloomberg Intelligence. This is in addition to my weekly segments on Bloomberg Radio and TV. While I don’t manage money or work at an ETF issuer, I’ve been eating, sleeping, and breathing ETFs for nearly a decade now. As such, I can offer an objective view and unique analysis.
I’m also not a fan of textbooks. I like reading books with a more conversational and informal tone. So that’s how I wrote this book. Financial analysis and humanity are not mutually exclusive! So while this book is chock-full of substance for institutional investors to learn from, it is written in a language that both novice and expert investors can understand. At least that’s my hope.
A few things before we start. First, there are simply too many ETFs to cover all of them in this book. That’s probably a good thing, or else this would read like an encyclopedia instead of a book. I purposely tried to hone in on stories and case studies to make larger points that can be applied to other areas of the ETF landscape. I also did my best to highlight both the popular ones and the up-and-coming innovative ETFs. With that said, the ETFs covered in this book represent over 80 percent of the assets and trends.
I also use a lot of numbers in this book, such as assets, returns, fees, and trading figures. By the time you read this, some of those will have changed. It’s like trying to hit a moving target. However, they won’t change that much and the figures are key in showing relativity and providing case studies.
Now, because I’m not a money manager or an ETF issuer, I wanted to bring in outside voices to accompany my data analysis. This is why I conducted more than 60 interviews for this book with institutional fund managers, ETF issuers, ETF strategists, market makers, advisors, and others. Their quotes are peppered throughout the book to give it a documentary feel with me as the narrator. Also, every single quote in the book, unless otherwise stated, is from an interview I did specifically for the book. In other words, all the material is fresh and original and it has not been used anywhere else.
I also purposely didn’t include their titles with their quotes in the name of brevity and informality. Suffice it to say though, I only interviewed people that I felt would help readers understand the topic better. You will see from the quality of their quotes that they know what they are talking about.
I spent a lot of time researching institution types, which was a bit like visiting different planets. You could spend years learning about them. For example, you could write an entire book on what is going on with state pensions right now, or how smaller endowments are faring with their alternative-heavy strategies. When you start asking questions and doing research, you end up seeing some loose threads here and there – more questions that pop up out of your original questions. I pulled some of these threads, but given that this is a book on ETFs, I left many of those threads alone in the name of brevity. However, a few of those threads could make for an interesting follow-up book!
And if researching each type of institution is like visiting a planet, getting information on what they invest in, and why, well, that’s like solving a murder mystery. You have a tiny bit of data available from public filings, but it is largely sketchy and opaque. Let’s just say researching this book taught me a lot about how little documents like 13F forms really tell you.
“Part of the challenge of all the reporting out there is it is incomplete. We all think if we look at what someone reports, we know what they are doing. But you really have no idea what they are doing.”
While surveys of institutional investors’ usage are pretty good measures of how those institutions use ETFs, they are not really good measures of how much institutions are using ETFs or use specific examples or anecdotes. In addition, most of the surveys are sponsored by an issuer, so they tend to just focus on how ETF usage is increasing amongst certain institutions, but the fact is, wider adoption is still in the very early innings as noted in the asset figures above.
As a result, it took a lot of detective work, which involved researching a wide variety of sources, but mostly talking to people. One group of investors whose interviews I thought were especially useful was ETF strategists, which are asset managers who run all-ETF portfolios. The reason I use them so much in the book is because they are master ETF users and their knowledge of the toolbox is unparalleled. I thought some of their insight and hard-won experience using ETFs would be beneficial to all investors.
The book includes all of this in an arrangement that I thought was natural to the topic. Just like an old-school vinyl album has two sides, with several songs on each side, this book will be laid out in a similar fashion, with two distinct sections and several chapters within each section.
The first section will be a dive into the “ETF phenomenon.” We will look at the advantages that make ETFs so popular. We will then look at their growth, not just assets, but in volume and product count. Then, we will learn about ETF mechanics via the story of how the first ETF was invented, followed by an examination of the myriad ways different institutions are using ETFs. The section will end with a thorough look at how to vet and select ETFs including a look at trading. All this will arm you for Section Two.
Section Two is a tour through the “ETF toolbox” with me as your tour guide. We will look at each asset class including equities, fixed income, and alternatives. We will spend some extra time in hot areas such as smart beta, currency hedging, China, gold, and liquid alts. The book will end with some parting thoughts from me as well as some resources for additional and ongoing education.
Now that we got that out of the way, let’s get started!
SECTION I
The ETF Phenomenon
CHAPTER 1
Why Are ETFs So Popular?
They say that as a customer you can only get two of these three things: fast/good/cheap. If it’s fast and good, it isn’t cheap. If it is good and cheap, it isn’t fast. And if it’s cheap and fast, well, it probably isn’t that good.
Turns out, I have found two things that prove this wrong: Vietnamese restaurants and exchange-traded funds (ETFs). Those are two times when fast, good, and cheap all tend to exist in wonderful harmony.
How this can happen requires a bit of background into what an ETF is.
Essentially, an ETF is the marriage of an index fund (passively managed with low-costs and diversification)