At The Money: How Big Can Active ETFS Get?

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0:59When we think about ETFs, we tend to think about large, cheap, passive indexes. After all, those are the biggest ETFs from places like BlackRock, Vanguard, and State Street. But when we look at all the new ETF launches, they tend to not be passive indexes, not be cheap, and not come necessarily from those three big companies. They're active, and they are involved in all sorts of different areas that are off the beaten path. To figure out what this means for your portfolio, let's bring in Dave Nottig. He is the president and director of research at ETF.com and a ETF structural expert really since the inception of the entire sector.

1:50So Dave, we've seen an explosion in the growth of not just new ETFs, but primarily active ETFs in all sorts of niches. What are you seeing in this space? Well, you know, for a long time, ETF meant cheap index, right? I mean, you go back to SPY and then the first iShares products. And then even when we started getting into the big expansion of the 2000s, it was all just index, index, index. Then we got some smart beta where we tried to be a little bit more clever. And it wasn't really until the late 2010 cycle where Kathy Wood at ARK Invest launched ARKK and really put herself out there as the portfolio manager.

2:33in a way that I don't really frankly remember seeing since the dot-com boom. It's been a long time since we'd had superstar managers on CNBC talking about pounding the table for a single stock. And Cathy did that and obviously had enormous amounts of success, has had some performance hiccups along the way. But that sort of went a little bit dormant during some of the pandemic when people really discovered trading. What we've seen now is this resurgence, particularly to folks I mentioned, Dan Ives, Wedbush, people know him, and Tom Lee from Fundstrat with his granny shots ETF, both of which have pulled in huge money.

3:11Billions of dollars? Billions and billions of dollars for the reasons you would expect, because you've got smart people talking on podcasts and TV and on their own air and their own newsletters telling you why they own what's in the fund. I know that sounds so dumb, but that's why people love superstar managers, because they can look and they can see Tom Lee on screen and he can sit there and say, yeah, this is why we like Bitcoin here. Here are the three firms we have in our fund because of it. We might be wrong. We might be right. There's a level of authenticity to that that I think is really appreciated.

3:45I also think the fact that they've doubled the S &P this year doesn't hurt. So to put some flesh on the bones here, Kathy Woods during 2020 was a huge Tesla and Bitcoin bull. The fund ARK put up giant numbers, triple digit gains. Dan Ives has been an Apple and an Nvidia bull pretty much for as long as I can remember. He's been a whole lot more right than wrong. And Tom Lee has been very constructive exactly when it paid to be constructive and stay bullish. All three of those managers have really big followings. What does the resurgence of brand name active managers mean for the ETF space? Well, I think, first of all, I think it's great for the ETF space because I think the dichotomy that we'd had where people thought of active as being a thing that happened somewhere else.

4:41and ETFs were only passive wasn't helpful. I think we are moving towards a world where all of your exposures, for the most part, are going to be in an ETF wrapper. So by all means, we should get active managers as part of this mix. And now we've got lots of them. We've got a bunch of active funds from PIMCO was early. We've got lots in the bond space, everything from Cumberland Advisors to State Street with DoubleLine and Jeff Gundlach, lots of active managers in lots of different areas. I think that's very healthy for the industry. For the individual investor, it doesn't necessarily make your life easier because as much as I happen to like all the people we have talked about, Dan, Dom Lee, Kathy, like personally as people I would have dinner with, the math is not on their sides as an industry, right?

5:27As an industry, we have to point out active managers categorically underperform over time. Doesn't mean they all do, but it means that you've got to be the special person who managed to pick the right active manager at the right time. That is a tough business. And even active managers running these funds will tell you trying to time when to get in and out of their own funds is going to be tough. So that's the problem is that active management is tough to evaluate. Yeah. And to put some numbers there, half of all active managers underperform in any given year. You go out to five years, it's 80 % underperform.

6:03Ten years, it's 90%. So it's a tough road to hoe. But let's talk about what makes active ETFs somewhat different than active mutual funds. And that data I referenced were all mutual fund data. Mutual funds have to do a regular filing each quarter about their largest holdings. There has been a lot of back and forth about how transparent active ETFs have to be versus other active funds. What's the state of the art today? What is the regulatory environment? So there are solutions if you're an active manager and you don't want to tell everybody what you're doing every day. There are solutions and there's plenty of funds that have been launched on them.

6:48Fidelity has their versions. T-Row Price has been one of the more successful funds out there. They have a pretty popular blue chip strategy called T-Chip, which is semi-transparent, meaning they're not telling you the whole portfolio every day. They're telling you once in a while, and they're giving the street just enough information to make a good market, not knowing all the information. So it's sort of a kludge, a bit of a hack to be semi-transparent. This solves a problem for some asset managers. It doesn't solve a single problem for an individual investor, right? So I've never heard an individual investor say, golly, I wish I knew less about what I owned, right?

7:25It just doesn't happen. Let's talk about why it's a problem for fund managers. Fund managers don't buy a stock on a Monday and then they're done. If they say, hey, we like XYZ, they're buying that stock, trying to take advantage of drawdowns, buying it over days, weeks, even months. So there is a price advantage to the investor if the fund manager can be a little less transparent. Fair description? That's certainly the argument that the active management industry, who does not want to disclose what they're doing, would give you. So you have articulated that side of the argument well. Well, my counter to that would be if your strategy requires you buying securities where your action is going to move the market absent disclosure or absent obfuscation, then that strategy probably doesn't belong in an ETF because you've got bigger problems.

8:20That means that you're in something small or a liquid or micro cap, at which point already my question would be, how do you plan on running a$10 billion ETF with that strategy? Because you can't really close an ETF. So if you are a special situations manager, if you're a really sort of obscure, niche-y, finding those stocks nobody else knows about manager, you do not belong in the ETF industry. I'll just flat out say it. As simple as that. The mutual fund structure, or even better, a liquidity cap structure like a CEF or an interval fund is actually a better structure for those kinds of investments.

8:57Everybody else, honestly, there's so much liquidity, I think it's tough to argue that somebody like Tom Lee is being particularly hurt by being transparent. He's at 30 % for the year. The S &P is up 15%. Right. And CEF stands for closed-end funds as opposed to ETFs. Yes. So let's talk about some other varieties of active funds that are a little bit out there. We see funds with options, futures, derivatives, inverse, leveraged, along with some wild income promises in an ETF wrapper. Tell us about some of those products. Yeah. The interesting thing about those is most of them are very mechanical, right?

9:37So if you're running a leverage strategy, you're not making any decisions, right? I've got Apple. I need 2x Apple. I'm going to go to my swap counterparty overnight, and they're just going to settle up my 2x swap. That's the whole management process. But technically, that's going to be an actively managed fund because you can't just automate that whole process. Somebody still has to make a call about whether or not you're teeing up the swap at this rate or that rate. Same thing with almost anything in the option space. Because the options are constantly changing, constantly repricing, and constantly rolling off, it's very difficult to create solid index product around actively or high frequency moving positions in the options market.

10:16So for convenience, as much as anything, almost all of those type products you mentioned are listed as active products. I refer to them as INOs, like active in name only, because there's no Tom Lee saying, I really want Apple options today. There's some guy, generally Jay Pastracelli at Tidal, sitting on a desk somewhere, pushing a button to say, yes, we want those options because the model says we need to roll. And that becomes active management. And consequently, I mean, it is active management. It has higher costs associated with it for a reason. Some of that is the profit that the issuer wants, but some of it is legitimately you need a trading desk with a bunch of people doing work.

10:55So let's talk about another niche, illiquid alts, things like private equity, private credit, private debt, real estate. Are we going to see those asset classes that really don't trade on their own because they're not public? Are we going to see those in an ETF wrapper? We're starting to. We're starting to. The canary in the coal mine here was some products from State Street. The big one's Priv, P-R-I-V for private, which has a bunch of Apollo private credit in it. Generally pretty short maturity stuff, two, three year kind of things. And fairly straightforward, understandable private credit. Intel needs to build a fab in Ireland.

11:38They go get a loan. Apollo gives them the loan. You get a slice of it. Nothing super complicated. nothing super interesting either. I mean, it's not, you're not getting 20 % yields out of or anything like that. You're getting some marginal increase in the yield you would get if you were simply investing in say junk or short-term corporates. So those products are starting to come to market. The concerns I have about them is they're just going to be untested. We're not going to really know how they're going to perform when the markets go hinky, right? And, and also what does that even mean? Like if we had a corporate bond blowout and we You saw a bunch of triple C stuff start, you know, defaulting.

12:16I have no idea what the impact on Apollo private credit issued in Ireland to Intel is going to be when that happens. I also have no idea how they're going to respond if half the fund decides they want out on that Tuesday. And now you've got a bunch of illiquid stuff, which can be up to 35 percent of the portfolio, that literally the only buyer is Apollo. So technically, they've got answers to all those questions. And I read all the answers to those questions, and I'm sort of not convinced. But it's one of those things that if you want to be out there on the edge, by all means, go ahead. But I think the private securities in the daily liquid vehicle has not really been through the ringer yet.

12:59So I remain very skeptical. So let's talk a little bit about crypto and how that's going to impact both investor behavior and portfolio construction. Last year, BlackRock, was it last year or this year? BlackRock introduced Ibit. Yeah. Yeah. So it's a year ago. Coming up on 100 billion dollars in assets, probably the fastest ETF ever to do that. What does this mean? And explain the concept of tokenization. Yeah. So what it means is all of these assets are going to be more and more available to the average Joe like us, who's just trading in their Schwab account or something like that. And because the SEC has said they're going to make it very easy, very soon we're going to have every major coin that people know about, a Solana, an Aave, whatever.

13:51There'll be a sleeve of that and an ETF that you'll be able to trade. That's all great. Having those building blocks is awesome also because it will now allow portfolio managers to create portfolios of those individual securities, which right now you can't even do. You can't even buy an index of the top 10 coins because there isn't a target for the top 10 coins to invest in. So that will be fun when we get that. And I suspect you'll see firms like Bitwise and BlackRock who've got some real bona fides in the crypto management space, start bringing pretty institutional active management products there.

14:25That's probably a 2026 side. Long term, though, if we want to talk 10 years from now, that's when crypto starts becoming an interesting competitor to the ETF space. I think we will eventually end up in a world where how you move your ownership of Apple around is going to happen not by going to the New York Stock Exchange and exchanging ledger entries to move around your Schwab account. Instead, you're going to have an actual token. You'll be able to look at the serial number of it. You'll be able to put it in a wallet and say, oh no, this is worth 100 shares of Apple. And that wallet will be able to directly move that security to your wallet without any exchange being part of the process.

15:08Most of it will happen like crypto happens now on giant exchanges because price discovery. But just like with Bitcoin, I could walk up to you when we could engage in a direct transaction, you're going to start seeing that with other securities. It's happening more in bonds and real estate now. To do it in equities is going to require some actual legislation, and we don't make so many laws these days, so that may take some time. Instead, what we'll do is we'll wrap a lot of stuff. So you'll probably hear about things like wrapped Apple and wrapped Cisco. And what that's going to be is a token that owns the security in some sort of trust pool, that's a baby step, but that's what we'll start hearing first.

15:47So be skeptical when people say we're tokenizing everything because it's going to be a decade. I had a conversation with Jose Menana, who is the head of wealth strategies at investment giant BNY, Bank of New York. And he was saying, hey, we went from T plus three to T plus one, meaning it used to take three days to settle a trade. Today, it's going to take one day. If we want to get to T plus zero, we have to really have confidence in both sides of the transaction. And theoretically, tokenization solves that problem. It does. Although think about how many big transactions in the world that we could be doing easier, we deliberately put brakes on.

16:27Think about buying a house. Wiring money. So there's escrow, there's secondary inspection processes. There's separate contracts around just the intention to buy and sell. So the bigger and more interesting a transaction gets, the less T0 is actually a good idea, right? I mean, the thing I always say about T0 is, did you really want T0 during the flash crash in 2010? Like, did you really want no recourse for that fat fingered billion dollar pennies on the dollar trade? No, you wanted this ecosystem that protects you from a bad actor spoofing something into the system. So we're going to have a lot to evaluate as a market what we actually want.

17:13The idea of slowing down markets has actually gotten a lot of traction, like speed bump markets, things like that, that are actually pushing against this idea of instantaneous settlement for anything. I don't even want instantaneous settlement for my bank account. I like knowing that I've got somebody I can call when something goes wrong. So you've written about volatility and liquidity laundering. Explain what this is. And are these really going to be ETFs? They already are, man. So volatility laundering is simply moving volatility from one bucket to another and charging something for the privilege of doing that.

17:47Right now, you can buy something like MSTY, which will give you 100 % income return on a micro strategy position through the magic of options, right? And it creates a synthetic long position. Then it does a synthetic covered call against the synthetic long position. And then it does a whole lot of return to capital to give you your money back and promises you this endless stream of high distributions, high percentage distributions. that is volatility laundering because what you are actually doing is you were trying to sell other people the volatility of micro strategy, which is probably not a fantastic idea because the vol of all is high in those cases.

18:28So you're being the person picking up the, in this case, quarters in front of the steamroller, not the pennies, but you're still exposed to micro strategy collapsing and going to nothing. That volatility laundering is what all of these option strategies are really doing. So really, to wrap this up, the bottom line is bring the same level of common sense and scrutiny to new ETFs that you would to any financial product. Make sure you understand what the product is, how it generates gains, the sort of risks you're incurring, especially with these exotic products, and the costs. Are these products worth spending 75, 100, 125 basis points more than what you would get for a plain vanilla passive index that seems to be dominating the asset allocation space and the space for ETFs.

19:24Be smart, be thoughtful, do your homework. I'm Barry Ritholtz. You've been listening to Bloomberg's At The Mind.