ETF Expert Corner
Bloomberg’s Eric Balchunas on New ETF Book
March 15th, 2016 by ETF Store Staff
You can listen to our interview with Eric Balchunas by using the above media player or enjoy a full transcription of the interview below.
Nate Geraci: I'm now pleased to welcome to the show Eric Balchunas, Senior ETF Analyst at Bloomberg. Eric has been with Bloomberg for 16 years now. He's done over 500 segments on Bloomberg TV and Bloomberg Radio. He writes for bloomberg.com and recently he released his first book, it's called “The Institutional ETF Toolbox”. Eric is now joining us via phone from Philadelphia. Eric, welcome to the ETF Store Show.
Eric Balchunas: Hey it's great to be here, I'm a big fan of the show so it's a pleasure.
Nate Geraci: Well thank you and we're certainly thrilled to have you on the show today. We know you follow ETFs as close as anyone. To begin here today I'm curious how did you first become involved with ETFs?
Eric Balchunas: I started my career as a reporter for Institutional Investor and worked on fund action back in the late 90s, but then I went to do PR for a while, and anyway long story short I ended up working for Bloomberg as a PR guy but then I moved to the data office and I went into the fund area. There I did mutual funds for a while, I did hedge funds, closed end funds and then I got ETFs in 2006 because somebody basically left, so I took over the data area for ETFs and very quickly realized these things were going to be a big part of the future. They weren't just evolving the mutual fund by one step or two, they were six steps beyond some of these other investment vehicles that I saw. I basically started becoming consumed with reading and listening to everything I could get my hands on and becoming an expert in this area and really championing the ETF product and other areas inside Bloomberg whether it's to sales or news or R&D. I'm a bit of a jack of all trades inside Bloomberg covering ETFs.
Nate Geraci: Eric, we've had quite a few individuals on the show over the years who have been involved with ETFs since the earliest days. Just a couple of weeks ago we had Ben Fulton on the program, he's considered one of the founders of the ETF industry. As you mentioned, you've been involved with ETFs for going on a decade now, which if you go back in many respects ETFs were still in their infant stages back when you first began covering them. What has the last 10 years been like as you've watched ETFs grow into what they are today?
Eric Balchunas: I can't say it's a surprise. I knew it would come, it's come every year. We haven't had that year of a trillion dollars in flows but each year now it's about 250 billion and I thought that ETFs really went mainstream about 2013. I could tell because I was getting questions from all kinds of reporters inside Bloomberg all of the sudden. Now they are mainstream, they are really part of the conversation and in researching this book I was fascinated by the fact that ETFs are now used by literally everybody, whether it's a pension, an endowment, a hedge fund, an advisor, a retail investor, everybody uses them and everybody gets something different out of them. They have so many benefits that they really appeal to all different kinds of investors for all different kinds of reasons and the beauty of them is that they're democratic in that whether it is a pension or my grandmother, they're paying the same fee and they're sharing in each other's liquidity. It's really an interesting move forward for investments. It's been really interesting to watch. I always equate it to digital music. ETFs have done to the financial world what digital music did to the music world in terms of providing a much better, cleaner portal to get what you're after.
Nate Geraci: Now with all of your ETF experience you did decide to write a book on ETFs. This was just recently released, it's called “The Institutional ETF Toolbox”, it's now available through amazon.com. I thought we'd spend the bulk of our time today discussing this book. It explores how institutions use ETFs and how they or any investor can use ETFs better. Jason and I mentioned this in the first segment, but I know one of the main reasons you wrote this book was because you believed and I quote, “The pace of innovation and new ETF products has outrun the education by quite a ways”. Was that the ultimate goal of this book to sort of bridge that gap?
Eric Balchunas: Yes, that was the main goal. I do seminars and presentations, I write articles, it's basically what I've been doing is trying to bridge that gap. The stat I love to throw out there is that this decade, we're on year six of this decade, there's been one ETF launched every day on average, 1,000 new ETFs have launched this decade alone which is more then the past two decades combined. As you know they're becoming a little more sophisticated, they're also getting cheaper, the designs are getting better and what I found was that most people still tend to flock to the top 25 most traded ETFs like SPY, IWM, EEM, but the fact is there's been so much innovation whether it's lower fees or more interesting design to help you get what you're looking for, that I also wanted to help people unlock the toolbox so they can go deeper and get products that were better for them and stop relying on products that came out in the 90s, which are great. They serve a purpose but it's a bit like using the iPhone 1, so I thought even institutions were hung up on using the same 10 or 12 products. I really have been studying and writing about the toolbox for a while, so I wanted to develop a way to show people how you can go deeper and access these amazing new products.
Nate Geraci: Well Eric you touched on this earlier, but the first sentence in your book right out of the gate was that it is widely known that ETFs have democratized investing by giving the little guy, the retail investor, the same access as the big guy, the institutional investor. The interesting twist to this is that ETFs were originally developed for the big guy, for the institutional investor. You have a great back story in the book on how ETFs came to be. Can you talk a little bit about that because in a sense ETFs were created by accident for institutional investors, but now individual investors are reaping the benefits.
Eric Balchunas: Yes absolutely, so in chapter three I go over the story of the first ETF because when I teach classes on ETF mechanics and creation redemption students love it when I tell the story, it's much easier to understand then if you just drill it in academic terms. Basically the story is that the ETF was born out of the 1987 crash, the SEC wrote a post-mortem report on how they thought that the stocks that were trading in New York were becoming contaminated from all the volatility in the futures market. There had been too much basket trading going on so they thought, well what if there was a basket trading product that would buffer the futures market from individual stocks? I won't go into any more detail then that but basically the SEC sort of came up with the idea or the sketch for the ETF. Two guys from the AMEX Nate Most and Steve Bloom were basically looking to increase equity trading because the American Stock Exchange, it was in third place at the time so they were hungry. They read this report and dropped everything and tried to build a basket trading product and they ended up going to Bogle, he turned them down and they thought of a design based on commodities warehouse receipts so they ended up coming up with a product that really was designed to get volume on the AMEX.
They wanted institutions to come in and do big trades and have a lot of volume. What they didn't really see and anticipate was things like the tax efficiency, that was a happy accident and they didn't see how great they would be at asset gathering. The ETF is at once a volume generator and an asset gatherer. I think it was Barclays in the late 90s that saw ETFs as a tool for retail and advisors, so in a way they were first used by institutions then they sort of got used by retail and advisors. Now a lot of institutions are starting to warm up to them again because of their intense liquidity and the fact that the prices are coming down so cheap that they're rivaling separately managed account costs that the institutions are used to getting. Now you have institutions sort of ironically coming around full circle and revisiting ETFs as a sort of product that they can use in their portfolio management as well, but certainly I'd say just over half the assets are retail and advisors.
Jason Lank: Eric, Jason Lank here, I want to point our listeners to an excerpt from your recent book and it's titled The ETF Files, How the US Government Inadvertently Launched a $3 Trillion Industry that recently came out in Bloomberg markets. One of the lines from this excerpt and it's a terrific back story, it reads like this. Such a product might even have prevented the crash by providing a liquidity buffer between the futures market and individual stocks. That's what you're mentioning. What would a liquidity buffer be and what would it do?
Eric Balchunas: Here's what it would do, this could get very complicated quickly, but there were program traders who were arbitraging the futures market with individual stocks. They were using index futures. The thing was they were looking ... When they arbitraged they had automatic sell orders for all 500 stocks in the S&P at the same time. The idea of a liquidity buffer would be instead of basket trading by selling all 500 or 1,000 stocks at once, what if you could sell a basket product and then the well capitalized market makers and specialists would be able to have that be an intermediary between futures traders and individual stocks. They thought that would provide a little bit of a release valve and a middle spot in between the derivatives market and individual stocks. That is sort of what they do and at the end of the article if you note, if you think about it, if you look at ETF trading, about 90% of the trading in ETFs does happen over the exchange without using the creation redemption. In a way they have achieved that goal of giving a whole new liquidity avenue that doesn't involve the underlying stocks.
Jason Lank: Eric I want to expand on the discussion about liquidity and maybe bring this forward. It's interesting that this product, the genesis involves perhaps adding liquidity to the market to smooth things out so to speak. As we move to 2016 into next year some of the whispers that we hear in the industry that perhaps ETF are a bubble or maybe they're not as liquid as they might be and that might cause a problem. How do we reconcile some of those whispers with the fact that they were originally designed to provide liquidity?
Eric Balchunas: That's right, when the SEC is looking at them and in fact the SEC chairman who I interviewed, he was saying look, we were really thinking about baskets of stocks and we think no one would argue that equity ETFs are fine. I think where the concern is things like high yield bonds. This is a bit I compare to Jurassic Park. High yield bonds don't trade a lot so it's an archaic over the counter system and then you try to put that into a lightning speed equity product like an ETF and you have a liquidity mismatch. That's generally what investors should look at. I always say if you wouldn't buy or sell high yield bonds then don't buy or sell the ETF that has them. Most people who are trading high yield bonds understand that and they understand okay, I'm going into the ETF because it's liquid, it's convenient, I understand that risk but mostly there hasn't been any major problems. I think a lot of it is a little bit media driven, I have covered ETFs now for 10 years and in my book one of the advantages that I put that people don't talk about a lot is battle proven. Whether it's oil futures, gold or junk bond ETFs, they've now been around for a decade. They've seen flash crashes, real crashes, paper tantrums, all kinds of stuff and after those things they come out and they gain more assets. Investors are becoming more comfortable that they can handle these intensely stressful environments along with the day to day trading as well.
Nate Geraci: Again, we're visiting with Eric Balchunas, Senior ETF Analyst at Bloomberg and author of the new book “The Institutional ETF Toolbox”. Eric you talk in the book about how institutional investors who have access to some of the most efficient and cost effective investment vehicles on the planet are increasingly turning to ETFs. You do note that ETFs are still a small percentage of institutional assets overall but certainly growing at a fast clip. I'm curious, in the research for your book what did you find were the ETF benefits most coveted by institutions that you think translate best to the individual investor?
Eric Balchunas: Right, so institutions love liquidity because institutions are in private equity, they're in hedge funds, they're with active managers, there's gates, and they’ve got to make phone calls to get out of them. They love the fact that they can stay liquid with an ETF, so they use it as an adjustment mechanism. That might not be the most important thing to retail investors who are normally in there for low cost and tax efficiency. Some of the benefits where they cross over in my opinion, are things like the fact that they're fiduciary vehicles, the fact that they're 40 Act funds is huge because that makes them not derivatives. A lot of people think ETFs are derivatives. They're not, they're actually more like a mutual fund in the regulation and institutions like that too. They would rather use something that has that safety behind it. In addition you have things like the fact that they have no emotion. The emotionless quality of ETFs is awesome. For retail investors they like it because it's passive management, it's low cost just like Vanguard, it's the way to go long-term. Institutions like no emotion because a lot of times they might use ETFs actively and if they're an ETF strategist or an asset manager, they might be buying and selling China or healthcare and the fact that that thing is passively managed is great because they can count on it. There's not a portfolio manager making picks, so the lack of emotion is huge. Finally I would say the standardization, just like a USB port or a gas pump, ETFs have standardized investing. They've gone out and they've taken everything from oil futures, to physical gold, to bonds, you name it and they have made it all trade like an equity which is what most people prefer trading. The fact is they've standardized everything and both institutions and retail like that benefit as well.
Nate Geraci: As it relates to ETF costs, you cover this topic quite a bit in the book. You call the continued ETF price declines fee innovation. You say it is a technological marvel that ETF issuers can offer these products at such low cost. Where does that fit into the equation? Do you think that's been the single biggest benefit of ETFs?
Eric Balchunas: Certainly one of them. Look, I mean we've seen all the studies. The biggest problem with active management is the costs. They're way behind the starting line, that's why I equate it to ETFs playing with a lead because they don't cost a lot. They tend to outperform active managers that's one. Number two really the fee innovation, I mean the fact is that you can now get a well-balanced global allocation portfolio for under 10 basis points and in some cases in the equity area the tracking on ETFs is now zero, like VTI the Vanguard Total Market has pretty much zero tracking error. Therefore you're literally getting free exposure. They make up the five basis points in fees by securities lending revenue, but the fact is I do think though that the fee innovation and the fee war that people talk about is much more the Vanguard effect. If Vanguard is in a category, the cheapest ETF is five or six times cheaper than in a category they're not. For example, in the sectors, the sector ETFs are now 10 basis points, 11, 12, but then you go to gold miners or biotech where Vanguard isn't, and the lowest fee is 40 or 50 basis points. Same thing with junk bonds and certain other areas Vanguard isn't. The fees are much higher, so Vanguard I equate to Wal-Mart coming to town. When they come to a category there's a mashing of teeth from the other issuers but they all end up having to lower their fees to compete. Vanguard deserves a lot of the credit for how low fees are.
Nate Geraci: Again we're visiting with Eric Balchunas, Senior ETF Analyst at Bloomberg and author of the new book “The Institutional ETF Toolbox”. Eric, along the lines of ETF costs, you talk in the book about how you met with Vanguard's Jack Bogle and how you brought up to him that people who know the most about Wall Street and investing seem to lean towards using index funds and ETFs over active management. You said Mr. Bogle agreed, he said directors of mutual fund companies are buying Vanguard funds for their kid's college plans. I'm just curious, what was this interaction like? Obviously Mr. Bogle's a legend of investing.
Eric Balchunas: Oh it was great, it changed me. Sitting with Bogle one on one, I've read about him, I love and know Vanguard but it was special. I hung out with him for two hours and I threw everything at him. I'm more of an ETF guy then an index fund guy so I threw out questions like “well what if you just buy and hold a broad market ETF”? I got him to admit he's like “that's fine” and he even admitted that ETFs are slightly more tax efficient then index funds. His big complaint and I agree with him because if you look at the numbers, he thinks nobody's buying and holding them. If you do he says that's great, but the fact is if you look at the numbers and I'll throw the numbers out. ETFs have $2 trillion in assets but they trade $20 trillion worth of assets a year, in other words they basically have a turnover 1,000% a year. Stocks only turnover about 300%, 400% tops, so ETFs are literally trading two or three times more then stocks are. He's worried that all that trading is really just forking over money to Wall Street and he has a point because if you look at the asset weighted average bid-ask spread and you take all that trading volume. Wall Street or market makers make about $9 billion a year on ETF trading. The issuers only make $6 billion out of the asset weighted expense ratio. That's his point, it's a valid point, if an investor starts to become hooked on trading it's probably not a good thing. I think that's really what he's worried about, but the fact is minus that, he doesn't really have too much of a problem. He just worries about the trades, he's more anti-trading then anti-ETF but I got to hanging out with him, and it was something I'll never forget.
Jason Lank: Eric, on the subject of the trading, is there any way, has anyone ever broken out institutional trading versus the individual investor? I think Jack's criticism, Jack Bogle's criticism is very valid, but if we were to lift the covers up and see that the vast majority of trading is institutional, that wouldn't necessarily indicate that they're being overtraded. Is that data out there?
Eric Balchunas: Kind of, so in my book the way ... Listen, one thing institutions love about ETFs is they're anonymous. Nobody knows who's doing the trading, I don't know where, but one way to tell, there's a trick you can use and this is an ETF analyst trick I'll put out there. If you look at the daily turnover in an ETF, the higher the turnover the more it's being used by institutions. For example, Vanguard as a whole turns over .5% a day but then something like the Brazil ETF turns over 20% a day, so probably a little more institutional usage there. Makes sense, single country, lots who aren't buying that long term. Then you look at other issuers, SPDR has a lot higher turnover because it's in SPY and some of their sectors. Then look at stuff like in the VIX area like VXX, it turns over 100% a day which is mind boggling, but that's good. That's the product you want a lot of turnover and that's what makes ETFs such a fun thing to cover is because it's a wild world. Mostly in Vanguard and Schwab they have the lowest turnover so that would lead me to believe that's mostly buy and hold investors and the other way you know that is because if you have a down month, let's say the market goes down 3% in January or for a stretch of time, Vanguard and Schwab will take in money even in that down month. That leads me to believe that that's more drip drip money coming in from advisors and retail as opposed to hot money which tends to use more of the highly traded products like the Qs and SPY. I do believe you can suss it out but you can't really fine tune. I think you have general ideas though that there are plenty of people buying and holding.
Nate Geraci: All right Eric we have just a couple of minutes left here. Before we let you go today I have to ask you about a great piece you wrote a while back where you made the point that while ETFs offer investors a lot of benefits, many of which we've hit on today, there are some more exotic ETFs out there that aren't for every investor. Maybe the industry could do a better job of labeling those ETFs and I loved your proposed solution, you offered sort of a tongue and cheek solution and this is also covered in your book. You said look, everyone understands movie ratings so perhaps we should assign those ratings to ETFs. As an example you had the iShares Core, S&P 500 ETF rated G and the Velocity Shares Daily 2 Times VIX Short Term ETN rated NC-17. Can you maybe talk a little bit more about this? Why do you think this is important?
Eric Balchunas: I do because a lot of people, even home offices of advisors will basically label an ETF safe or dangerous, it's one or the other. The fact is it's much more nuance then that. I thought that a five tier system would be great and unlike rating systems that give you star ratings for outperformance that doesn't make sense in ETFs. What you don't want is for a customer to have a nasty surprise, so I thought movies have advanced information whether it's violence or nudity or whatever, they have several reasons a movie could have a higher rating. Same like ETFs, you have unusual tax consequences, you have illiquid holdings, you have hidden costs, so essentially you could have some smart beta products that have extra volatility might be PG even though they hold basket equities. PG-13 could be something like senior loans or China A shares or MLPs which have a really nasty tax and then R would be leveraged, oil, ETFs that track futures and suffer from steep contango. A lot of these things would make someone understand okay, this is R. The oil ETF is a great one. A lot of retail people are buying the oil ETFs not understanding how badly they could get hurt. A system that has advanced information that alerts you to how much you need to read the fine print or stop yourself would be great and you need five levels, it can't just be safe or dangerous. When the SEC goes to look at banning certain ETFs, they're all fine, you need to know how risky they are and an investor can then quickly research, okay I understand, I'll still buy it.
Nate Geraci: Well Eric we'll have to leave it there. Congratulations on the new book and we certainly appreciate you joining us today and we'd love to have you on the program again down the road, thank you.
Eric Balchunas: Thanks again Nate.
Nate Geraci: That was Eric Balchunas, Senior ETF Analyst at Bloomberg. Again the title of his new book is “The Institutional ETF Toolbox”, it's now available at amazon.com and you can also find Eric's work at bloomberg.com and on Bloomberg Radio and Bloomberg TV. I'd also recommend following Eric on Twitter, he's a great follow. His twitter handle is @ericbalchunas. The last name is Balchunas.