ETF Product Development and the Chipotle Menu
Shuttering my highly ambitious ETF company has given me the opportunity to have candid conversations with ETF producers and users. While my colleagues and I struggled over new structures, new markets, and patenting ideas (albeit with mixed success), many in the industry have continued to see the role of the ETF sponsor as an aggregator of tickers and CUSIPs.
In a post Dodd-Frank-Volcker world, this narrow approach to product development seemed the wise decision. As one learns only from experience, it’s extremely challenging to message and market new instruments under the best conditions – add on highly uncertain regulatory timelines and outcomes, and it’s no surprise that the best ETF innovation over the last few years is the single digit expense ratio.
Surprisingly, a lack of material innovation has not slowed launches and ticker proliferation, and in fact, I see stalled innovation as a primary contributor to excess tickers. While structure and market innovation takes considerable time and expense, re-cutting indices in different combinations (repeated by a number of sponsors) can be done quickly and cheaply. So while almost every industry article touts thousands of ETFs, in practice we have relatively few.
ETFs and Chipotle Math
Chipotle claims that its stores present over 65,000 possible meal combinations (who knew a lifetime of lunch and dinners could be enjoyed without ever eating the same meal twice?). If you multiply the item counts of everything stuffed into a burrito (or taco or bowl), you get a silly number in the tens of thousands. As a practical matter, and not unlike our “in practice” ETF count, Chipotle serves 3 variations of essentially one thing.
ETF Product Development
Similar to Chipotle, any article on the ETF industry is usually preceded by a fund count in the thousands. Taken to the limit, the number of possible funds which one can construct from listed securities is almost incalculable; using only the 30 stocks of the DJIA, we can create over 1 billion long-only portfolios – although not many are worthy of their own fund.
Much of the industry’s product development has focused on arithmetic variations of indices: market cap weighted, equal weighted, low volatility, value focused, dividend focused…and more. Using S&P500 and DJIA U.S. large-cap as an example, if you compare the performance for all of the variations, you’ll generally find little practical difference in returns or volatility. While there can be benefit to a weighting-biased strategy, the performance differentials are easily dwarfed by execution, timing, or taxes.
Separate from the basic weighting schemes, factor weighting (a.k.a. smart beta) continues to look like fertile ground for ETF sponsors. While there’s likely to be clever work done in this area, a number of the factor weighting strategies look like an over-simplified substitute for active stock/sector picking; designers are trying to replicate classic active management within the narrow guidelines of conventional ETF regulatory relief. Cases where an ETF factor strategy is likely to underperform a non-ETF wrapper or where the strategy is self-defeating the ETF form (without fancy structuring, too much trading/rebalancing kills the ETF advantage) should be dismissed.
I’m hoping that the more athletic ETF sponsors see the ETF form as delivering something unique that the individual or institutional investor cannot otherwise replicate, and focus on tools and results which capitalize on the ETF (rather than chase investment strategies which defeat it). Also, if there are better vehicles for more active strategies (including direct variations of ETFs), why not advance them, even where they require an expansion of rules and regulations?
Magic Alpha is Making a Comeback
I’ve also had many conversations relating to component-hedging, and risk-reducing alpha-creating factor strategies. Because of the robust and amazing world of continuous ETF prices (even on the industry’s more arcane tickers), it’s easy to for many ETF engineers to believe prices are always tractable and continuous. I recommend that everyone in the fund industry revisit LOR, Mark Rubinstein, and portfolio insurance – not as a cautionary tone or because I think we’re in danger of recreating portfolio insurance, but because there are probably some immutable principles of interconnected markets which we shouldn’t forget. It’s also a great illustration of the often neglected reality that selling requires buyers.
A New Way to Think About the ETF
Even the most basic ETFs have an array of constituents who seek to profit from their arrangement with the ETF. Most see only the sponsor (SSGA, Blackrock) and the shareholders, but in practice there can be 10 or more other constituents including a stock exchange, a futures exchange, repo counterparties, (underlying) securities and futures market makers, index providers, swap counterparties, authorized participants, registered market makers, custodians, and others. Each ETF, through its arrangements and operations can choose to serve and favor different constituents.
If you think about an ETF as a functional issuer and investment company rather than a box of assets, sponsors can redirect the efforts of existing and new funds to deliver different outcomes. For instance, only certain ETFs have superior tax properties, often because of the selection and operation of specific underlying assets. Similarly, many ETF-friendly indices and new markets opportunities go unfulfilled so that funds fit into specific narrow regulations.
While all ETF users generally welcome the new fee compression, unless expense ratios can go through zero, I would urge sponsors to turn to true innovation.
I am already optimistic for an industry reboot following the post-election rally, and hopeful that some of the more athletic sponsors will begin to focus on better tools and new markets.