The ETF Revolution, Version 2.0
OK, let me tell you a story of innovation and incentives.
I promise it’s very relevant to what I do for my clients. More to the point, it might be equally helpful in keeping you out of trouble, too, if you’re out there on your own.
Do you remember going on amusement park rides when you were a kid?
There was one I loved.
You would ride a small car on a track along a dark corridor. Along the way, these cut-out characters would pop out from all directions. Some were zombies, others were space mutants, and occasionally, a little girl with pigtails and a lollipop in her hand would pop out. The whole idea of the ride was to shoot down the mutants and the zombies while leaving the innocent pigtail-and-lollipop girl alone.
I’ve been thinking about this a lot over the last week or so.
The Graph - ETF Revolution 1.0
There is this graph that’s floating around in my world. It shows the breakdown of assets investing in mutual funds and ETFs. Before I tell you what the graph shows, let’s get the jargon sorted out.
Mutual funds are investment vehicles that allow investors to buy into an asset class (like US stocks) or a strategy (like value investing) with a single investment.
These were made street legal by legislation passed in 1940. These '40-Act' funds are managed by an asset management company that aggregates investor assets to pursue the strategy the fund is designed for.
Net-net, these funds have done a lot of good for investors since they were invented: they allow you to benefit from diversification and professional management—and we have reams of data going back decades telling us that’s a step up from picking a handful of stocks on your own.
You can think of a mutual fund as a box that you can put things in, things like stocks and bonds. They’re like your brokerage account, except they’re an account with a bunch of owners, hence the term mutual fund…
Now ETFs. Sometime around 30 years ago, enterprising asset management firms realized they could create a new type of fund that fit nicely within what the 1940 Act allowed them to do, but they would fix the one thing that made mutual funds annoying to some people.
They could be traded on exchanges throughout the day just like stocks, as opposed to once at the end of the day like the old mutual funds. Did I mention ETF stands for “Exchange Traded Fund”? Now you know why…
People like freedom and flexibility, so “trade whenever” was viewed as better than “trade once-a-day” from the start.
But the real kicker was that ETFs that held stocks and bonds could be run in a more tax-efficient manner than the old mutual funds. The details are arcane, but it’s because of a process called the creation-redemption process that allows some taxes to be moved “outside the box.”
Now back to “The Graph”…
Data: Morningstar, as of August 2024.
Since the early 1990s, ETFs have grown in popularity relative to mutual funds. At this point, ETFs are roughly 30% of all assets held in '40 Act Funds overall. It’s been explosive, but ETFs have a long way to go if they’re going to munch their way through the remaining 70% or so like Cookie Monster.
You see, so far, the ETF market is dominated by plain-vanilla “Core and Bore” funds that are based on things like the S&P 500 and managed by giants like Vanguard, Schwab, BlackRock, and State Street.
The next crop of enterprising asset management types knows that it’s silly to try and “out-BlackRock BlackRock.” (If you were starting a consumer retail business, would you try to beat Amazon at its own game? Right, I didn’t think so.)
Thirty years in, the door has been kicked wide open, and alternative strategies (think more complex than buying the S&P 500) are flooding into the ETF space. Makes sense. Complex has its own appeal to an investor looking for something new and it certainly can lead to “better economics” (aka higher fees) for the asset manager.
The challenge we face now is fairly straightforward once you’ve wrapped your head around (i) this little bit of history and (ii) the issue of incentives in asset management:
How do you figure out what’s a welcome innovation and what we’ll politely call “unhelpful complexity that happens to transfer fees from your account to asset managers?”
In short, how do you sort out the space mutants from the innocent pigtail-and-lollipop girl?
Navigating ETF Revolution 2.0
Here’s a framework for ya…
Some will be “good ideas” (in a general sense), based on a sound investment premise though the details might matter. These are things that provide proper alternative return drivers or where financial engineering can solve a real problem for people.
An example could be bringing diversified carry, value, and momentum returns into the mainstream of investing at a reasonable price and with reasonable tax implications.
Another could be products that align with the floor-and-upside needs of many investors (See my father-in-law’s book Worry-Free Investing for background).
Silly ideas may well be predominantly an effort in marketing. Under this umbrella probably lives most of “thematic” investing.
An easy marker here might be anything that invests in “the Future of” anything—the future of music, the future of robotics, or the future of everything for the boldly-minded. Cathie Wood’s trajectory is worth reviewing here. But that’s just the beginning.
Conflicted ideas have the potential to help investors inflict self-harm. You see, capitalism is 100% the best force we have to pull this whole wagon forward, but sometimes incentives are overwhelming and followed too narrowly.
Let’s work by analogy. Let me ask you this: if you’re an ER doctor and a “patient” comes in because they want narcotics, do you give them what they’re after?
See, there is a line somewhere out there, and you can find yourself on the wrong side of “giving people what they want.”
Dangerous ideas could end very badly. Under this heading live many instances where there is a fundamental mismatch between the ETF “box” and what people are trying to shove in there.
Liquidity is key here. Remember that ETFs are designed for high liquidity—you can buy and sell at will throughout the day. What if the thing inside the box has no market to speak of?
What happens when people get spooked and they demand their money now? Please don’t answer this. Nobody likes the answer. That’s when things break, and it can get ugly fast.
Financial Reporters Touching All Parts of the Elephant
There has been some top-notch reporting and writing recently touching this story from different angles. I encourage the hungry minds to read on…
It’s fabulous application in telling apart mutants, zombies, and innocent kiddos:
Denitsa Tsekova & Vildana Hajric: ‘100%’ Yields Are Fueling a Retail Boom in New Quick-Buck ETFs
Justina Lee & Vildana Hajric: Tax-Busting Tactic Loved by Tech Millionaires Is Coming to ETFs
Jason Zweig: Is This ETF Your Knight in Shining Armor?
Matt Levine: Private Credit Wants Everyone’s Money.
tl;dr version on this last one: Private credit is basically regulatory arbitrage (unregulated version of an otherwise-regulated activity) and consists of illiquid private loans. I have all sorts of opinions about what happens when regulatory arbitrage is done in the trillions of dollars. I wrote about this topic here.
Long way around the block to say, it’s tricky out there. I hope you navigate ETF Revolution 2.0 wisely.
Disclaimer: This content is for educational purposes only and does not constitute financial advice. Treussard Capital Management LLC is a registered investment advisor. Please visit our website for more information and full disclaimers. Always consult with a qualified financial advisor before making any investment decisions.