The ETF landscape has been undergoing significant change in recent years. Although the lowest fee products and the largest providers continue to dominate, several new trends have the potential to shake things up in the coming years. Proponents of things like ESG think they will change the ETF space in major ways. And supporters of Direct Indexing think it has the potential to upend the ETF industry as a whole. But there have been many things that promised to shake up the asset management industry over the years, and few have delivered the results that their proponents expected.
To get a balanced take on all of this and try to get at the reality of what the future might bring, we wanted to bring in an expert in the space. I can think of no one better than Nate Geraci. Nate is the President of the ETF Store and the host of the popular ETF Prime podcast, a show where he interviews ETF issuers, other thought leaders, and experts in the ETF business.
In this interview, we talk about the future of ETFs and how some of the new trends in the space might play out.
Jack: Thank you for taking the time to talk to us.
Before we talk about some of the specific new developments in the ETF world, I wanted to start by getting your general take on the industry landscape. At a high level, fees have been falling and the large players have been increasing their dominance. Do you see those trends continuing? Where do you think the industry is headed in the next decade? Do you see any downsides to the dominance of the largest firms?
Nate: The industry is in a unique situation right now. On one hand, there is no question investors have significantly benefited from larger players leveraging scale to drive down fees. Consider the investment landscape 10, 20, 30 years ago. Higher costs were embedded everywhere. It’s mind-boggling that investors can now build globally diversified portfolios for a handful of basis points. Fees aren’t the only thing, but simple math tells us lower fees are better than higher fees.
On the other hand, the amount of investor focus placed on fees has helped consolidate power in the hands of a few of the largest players. The problem is most ETF innovation is occurring at smaller issuers. We are now in a situation where the larger players can sit back and cherry-pick the best ideas incubated at smaller shops. As an entrepreneur, I know first-hand the blood, sweat, and tears that go into launching a new business or idea. It absolutely pains me to see larger issuers blatantly ripping-off someone’s life work and slapping a lower fee on it. But that’s the quandary right now. Investors are benefiting from a lower cost structure, which is a positive.
The question is, what happens to innovation longer-term? Look, I fully appreciate competition and every industry has copycats. As a matter of fact, investing is the ultimate copycat sport. How many investors try to replicate the best fund managers or stock pickers? But when smaller issuers have no way of protecting their intellectual property, it feels like an unlevel playing field. I’m not sure what the solution is, but at some point, this stifles ETF innovation. If enough prospective or existing smaller issuers decide they don’t want to function as BlackRock’s or State Street’s farm system, investors might have less choice. The rebuttal I hear on this is that most investors shouldn’t be using the niche or esoteric products coming out of smaller issuers. I don’t like that mindset. If we never tried innovating, maybe the index fund doesn’t exist today. Maybe ETFs never come to fruition. Who is to say an S&P 500 index fund will be the best way to invest 20 or 30 years from now? Nobody knows that with absolute certainty. We need to keep innovating and I’m not sure the current industry dynamics reward that.
The good news is I do believe the conversation is beginning to shift from fees to value. What are you getting for what you are paying? I think that’s a healthy pivot. Perhaps the next bear market shifts the conversation even further. The trend of falling fees will always be with us, though diminishing in magnitude. Hopefully, we can figure out how to keep innovation alive and well. My guess is corporate governance concerns – the consolidation of proxy voting power among the largest asset managers – might ultimately be the catalyst for some meaningful change here.
Jack: ESG is an area where the potential seems to have exceeded the results thus far, although that could be starting to change. The idea of an investor building a portfolio to reflect their views on the world or using it to try to help enact change is a very attractive one on the surface, but the implementation of that in reality can be more difficult. Some have made the case that if investors want to enact change in the world, their portfolio may not be the best way to do that. There are also varying opinions as to whether there is a performance price to pay for implementing ESG within a portfolio. What are your thoughts on ESG in general? Do you see it as a major growth area in the ETF space going forward?
Nate: Well, we all want a better world. I have two young daughters. I want them to live in a world with cleaner air, fairer pay, more corporate diversity, better consumer protections, etc. I think most people feel that way. I’m just not sold this can be accomplished through an investment portfolio. I have a working hypothesis that financial markets are a natural ESG screener. Over time, companies not doing the right things according to society’s standards – whatever those are in aggregate – will see that reflected in their stock prices. If society thinks a certain company isn’t conducting business properly, then consumers will stop buying from that company, its earnings will decline, its market cap will ultimately shrink, and the company will end-up with a lower weighting in most funds. This seems pretty obvious to me. A question I always ask of people advocating for ESG funds is whether they think active investors are blindly ignoring ESG risks and opportunities. Why would they do that? Any serious investor’s job is to evaluate all risks and opportunities presented to their investments. Do you think Facebook investors aren’t aware of the company’s data privacy issues or Amazon investors haven’t been following concerns over the firm’s labor practices? Of course, they’re aware. I believe the financial markets, driven by active investors, are the judge and jury, not ESG committees.
While I’m on an ESG rant, let me also add that I feel like there are a lot of contradictions here. People villainize certain companies in the context of investing – say Amazon – and then go home and buy a bunch of stuff from… Amazon. I’m sorry, that’s hypocritical. If people would simply stop using Amazon if they don’t like the company’s practices, guess what? Amazon’s earnings would go down and we’re back to my financial market as an ESG screener hypothesis.
Lastly, and then I promise I’ll stop my rant, speaking of Amazon, how many ESG investors would have been comfortable missing Amazon’s returns over the past 10 years? Amazon has been excluded from a number of ESG funds. Bloomberg’s Eric Balchunas does an excellent job of driving home this point: you might be surprised by some of the stocks excluded from ESG funds.
I think ESG ETFs are more marketing than substance.
Jack: Direct Indexing is an interesting threat to ETFs over the longer-term. The customization it offers can help investors to build a portfolio that more closely meets their specific needs, and some argue it can also increase tax efficiency over time. But on the other hand, ETFs offer investors the ability to defer tax indefinitely until they sell and standard indexes do work well for many people, so it seems like they may work better for many investors. You have been skeptical of Direct Indexing and have called it “active management in disguise”. Do you see Direct Indexing as a long-term threat to ETFs? Do you think it will become a valuable tool for your average investor or do you think the optimism surrounding it is mostly hype?
Nate: I do not view direct indexing as some sort of existential threat to ETFs. I do see it as a substantial threat to the ESG ETF subset, however. One of the issues with ESG investing I failed to highlight earlier is that mass-customized ESG funds aren’t one-size-fits
Besides ESG, another case for direct indexing is providing potential tax alpha to certain types of investors – notably, investors in higher tax brackets or with philanthropic pursuits. But, again, that’s only a subset of investors. For the vast majority, I believe ETFs and index funds offer a highly compelling value proposition that will be difficult for direct indexing to top. ETFs are low cost and already extremely tax efficient. Also, let’s talk about the “active management in disguise”. I don’t mean that derogatorily. The active versus passive debate is tired. Every decision in investing is active. If you can handle the potential tracking error of active management – great. If you can stomach always getting market returns and the ride that comes along with indexing – fantastic. But the fact is, when you start tinkering with indexes, guess what? That’s active management. Sticking with my Amazon example, what if you exclude Amazon stock via direct indexing and then Amazon becomes the gold standard for labor practices? What will your decision-making framework look like to add them back to your account? What if you sell Coca-Cola stock to harvest a loss and replace it with Pepsi Co to minimize tracking error, only to watch Pepsi substantially underperform? I can give you a thousand examples like this. Similar to the point I made on ESG, will investors be prepared to accept different returns when utilizing direct indexing?
Direct indexing will have its place, whether that’s within the ESG realm or for certain types of taxable investors, but ETFs will remain the most compelling option for the majority.
Jack: One of the hottest topics of debate within the ETF space in recent years has been the potential for the approval of a bitcoin or cryptocurrency ETF. So far, there have been many applications filed with the SEC, but no one has been able to get across the finish line. There is also debate over whether the approval of a cryptocurrency ETF would be a positive or negative for investors given the volatility of the asset class. What do you think about the potential for approval of a cryptocurrency ETF? Do you think it would be a good thing for investors?
Nate: Some people misconstrue my bitcoin ETF advocacy as an endorsement for investing in bitcoin. I want to be clear. From day one, I’ve said to think of bitcoin as a venture capital investment. It could be a home run or it could go to zero. Anyone that says they know where the price of bitcoin is going is a charlatan. That said, bitcoin has continued to hang in there. The longer it does, the more it proves the concept. Even if you’re not a bitcoin believer, ask yourself this: do you think money or stores of value will never evolve from where we are today? I think the answer is obvious. Otherwise, we’d all still be transacting and storing value using sea shells or glass beads.
My support for a bitcoin ETF is predicated on the belief that I think it offers a better mousetrap for certain investors. The retail public can currently access the Grayscale Bitcoin Trust (GBTC), which charges a 2% fee and trades at a 40%+ premium. A bitcoin ETF would immediately solve the premium issue. I just want the SEC to be consistent. If we’re so concerned about protecting investors, why is there a triple leveraged natural gas ETP or levered FANG ETNs or an ETF holding freight forward futures contracts? It doesn’t make sense. We have one government agency, the CFTC, which has approved bitcoin futures contracts, while another agency shoots down a bitcoin ETF. So futures contracts are ok for investors, but not an ETF holding the exact same thing? Explain that logic to me. I guess at the core, I believe investors should have choice and be allowed to make their own investment decisions. If you want to buy bitcoin directly, then do it. But some investors would prefer owning bitcoin via an ETF at their existing custodian. We know demand is there because GBTC currently has $3 billion in assets. Let’s give investors a better option.
Jack: Despite the dominance of the ETF space by the largest firms, some small firms have been able to achieve success. Firms like Cambria, ARK, Pacer and Alpha Architect have been able to raise assets and grow their businesses despite the headwinds they have faced. Are there any commonalities you see in how these firms have achieved their success? If you had to give some advice to small issuers regarding how to succeed in this difficult climate, what would it be?
Nate: An obvious common thread is the leadership and faces of these firms – Meb Faber, Cathie Wood, Sean O’Hara, Wes Gray. I’ve had the fortune of visiting with each as they have been on ETF Prime multiple times. They all strike me as highly intelligent, passionate about their business, they express strong conviction in their investment beliefs, and they’re able to sprinkle in some personality. I think personal branding is a huge equalizer in today’s investment world. A company shouldn’t be built entirely around a person’s brand, but I think a personal brand can absolutely help elevate a company. When I think of Meb, Cathie, Sean, and Wes – they are all willing to put themselves out there. Cathie and her Tesla call and the way ARK disseminates proprietary work online. Meb and Wes are constantly sharing research and ideas. I see Sean in the media all the time. They’re not afraid of being wrong or getting challenged. I think investors see that authenticity and it resonates. Would you rather have Meb or Wes manage your money or a large, faceless firm? Also, take a look at the product lineups these firms offer. They’re unique. They’re not launching me-too products. I think smaller issuers should embrace this model. Don’t be afraid to put yourself out there and let people see who you are and what you stand for. Be a differentiator. I think smaller issuers should leverage blogs, podcasts, social media, whatever they can to get their message out. Larger issuers have significant legal and compliance constraints. They might need to clear several layers of approval to get a tweet out the door. Smaller issuers have the ability to operate much more nimbly. Now, if we could just solve that intellectual property issue!
Jack: Thank you again for taking the time to talk to us today. If investors want to follow your work, where are the best places for them to go?
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