The ETF Market: A Zine

Dave Nadig has forgotten more about ETFs and how they work than I will ever know. He co-founded Cerulli Associates in the early 1990s, went on to be Managing Director at Wells Fargo Nikko before selling the firm to Barclays to form BGI, before THAT got bought to become Blackrock/iShares as it exists today. In the early 2000s Dave joined what would become ETF.com, where he helped build their ETF Data and Analytics business which was sold to FactSet in 2017 or so.  Most recently Dave was part of the team that formed and sold VettaFi to the TMX group from 2020 to 2023. Dave is currently an “independent financial futurist” and will tell you what that means as soon as he figures it out! 

You can read this note on Dave’s superb substack, Echo Beach, and he’s also at [email protected] and on Twitter at @DaveNadig. As with all of our guest contributors, Dave’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

Every year for the last while, I’ve done a 90 minute deep dive presentation for the good folks at Kitces.com. Michael Kitces is the patron saint of actual financial planning. His site pretty much the only place on the internet you’re going to find 10,000 words on the disclosure obligations of “Fee Only” advisors or changes to required minimum distribution rules.

Very little of Kitces.com’s work is about investing, so I’m always a bit chuffed to be “the ETF guy” in the mix. (If you’re a Kitces member, my session is live on October 15th, and we’ll do some tool demos and live Q&A then!)

For everyone else, here’s the meat of what I’m presenting.

Zines

I have grown weary of AI-generated hyper-smooth images and soulless perfect AI grammar. So I stopped doing that and now all I’m doing when someone asks for a “deck” or a “presentation” or a “standup” is making Zines.

Zines, short for “FanZine” if you like, are small self produced publications from the Punk Rock & DIY music scenes, and/or Gamers and SciFi nerds. The Zine I’ve been making this year is called “85bb65” and here’s the cover of the one for Kitces, which I’m gonna flip through for you:

Bias

Here’s a hill I have decided to die on. I deliberately went on sabbatical until this fall to avoid having to be a “pundit” or “talking head” or “TV guy” or “blogger” or whatever during an election year. Part of that is just to avoid the silly game we all play of pretending we’re all unbiased. Here’s the Bias Page I’ve been including in presentations this year:

My big Bias — the Prior for almost everything else I am noodling on — is that I think Western-Style Democratic Capitalism has been an incredible force for good in the world. I think public capital markets can make magic happen, getting people to harness collective cognition and resources for big ideas that individuals can’t tackle on their own, from highway systems to moonshots. But I also think we’ve broken a lot of it, and need to be clear-eyed about that.

Fundamentally I think Advisors are a big part of how things get better — or at least angle towards the sun. Advisors are the stewards of their clients good fortune. Good advisors not only help their wealthy clients get more wealthy, they help them live better, more meaningful lives. I’m just enough of a doe-eyed optimist to think that if the people with all the power (the rich) find meaning in their lives that they’ll do better things with that power and we all win.

Most advisors have evolved into ETF-based investing, and the vast majority of them are using some form of model portfolio. As such, they’re usually invested in perhaps a dozen individual tickers across all their clients, and honestly, they’re not out scavenging for the new hotness each day.

Yet all the while they’re bombarded with ETF-stuff, day in and day out. And heck, I’ll own it — a lot of it’s come from me over the years. But things ARE different this time. The ETF market has grown up.

No Matter Where You Go, There You Are…

The second spread in the Zine is a set of four charts from ETFGI, Strategas, Me and Tidal, which I wont wade into in depth here. The points are pretty simple:

• ETFs have become a behemoth of $10 Trillion in assets across some 4,000 products.
• That growth has come largely at the expense of traditional active equity mutual funds, although the worst of that outflow seems to have abated a little. As every asset manager on the planet finds a way into the ETF market, the “horse race” between mutual funds and ETFs matters less and less.
• Traditional Mutual Funds will exist forever thanks to 401ks, or until someone rewrites the entire US retirement system.
• The industry is on a massive product development binge, launching 650 ETFs this year so far with an open/close ratio of 3:1.
• Over 40% of industry revenue comes from products that aren’t cheap beta.
• There are more ETF Brands now then there were ETF Tickers 20 years ago.
• Buckaroo Banzai is a deeply underappreciated genre-busting classic.

ETFs: Too Efficient?

One of the most shocking charts I’ve seen in the last year is the top one from this excellent study from BCG: It simply shows that 90% of the revenue growth — across all of asset management, for nearly 20 years — has come from market performance. All the net new money since 2005 has had a deminimis impact on the overall bottom line.

ETFs and Passive Investing are a huge part of the reason, and this has been great for investors! ETFs have absolutely cheated the old contractor adage of “Good Cheap or Fast, pick any two.” ETFs are been excellent, hyper-liquid and super-cheap.

So what gives? Well any big complex system — like the market — that becomes over optimized becomes fragile. It loses its ability to adapt to changes. The problem is that big, fragile systems tend to break in unpredictable ways. I can point to things I’m worried about—leverage, clearinghouse overload, the increasing opaqueness of derivative chain counterparty risk, passive-flow effects — but ultimately nobody can tell you what’s gonna break next. All I can say is — market structure feels fragile, and that means, pay attention.

The ETF Magic

It’s nearly mandatory that I do a Creation/Redemption slide, but honestly, if you’re reading this blog, I can just point you videos of me explaining this at Epsilon Theory, or on Masters in Business, or for Ark. ETFs, through creation/redemption, are hybrids of the best part of equities and the best parts of funds. A mashup just like a Duck Billed Platypus:

ETFs are the the platypus of investing: strong, useful, weird, multimodal, and lethal. (Platys are the only venomous mammal that can kill a human — they have sharp elbows).

There’s nothing really interesting about the ETF vehicle itself from a portfolio perspective. An ETF, a mutual fund, a CIT an SMA and Direct Index account all tracking the same strategy will yield nearly identical portfolio returns.

Put another way, folks get in trouble with ETFs not because of ETFs, but because they make a corollary mistake. I get a lot of emails from advisors and randos (and lurk on Reddit a lot), and I can tell you, the tragic tales of ETF woe are nearly 100% user error.

Rethinking “ETF Due Dilligence”

Once upon a time, I recorded videos on this for ETF.com and leaned in hard on the unique ETF things to worry about. Honestly, it’s not even worth it any more. 95% of ETF due diligence is now common sense. Instead, I think it’s worth stepping back and reframing how you pick investments from the get go:

I’ve been heavily influenced by the work of Iain McGilchrist’s monumental tome on brain lateralization, The Matter With Things. Forget everything you thought you knew about “left brain/right brain” unless you really wanna read all 1,500 pages. Tom Morgan did as brief a summary as I can find.

Here’s how it relates to building a portfolio: We need both halves our brain to do anything well, and they are good at different things. A bird, for instance, will have their right brain open to the whole universe, watching for predators, while their left brain is intently focused on discerning seeds from sand.

The big insight is that good decision making requires BOTH of these things. And being an advisor requires you to do both things all the time: YES, the specifics of your individual investments, their expenses, their pattern of returns, their obvious and hidden risks, those are all important, and by all means you should turn your left-brain nerdiness on full blast.

… AND, none of those things matter if you’re not keeping the bigger picture in mind. Some of that bigger picture is very client specific: keeping in mind your clients actual needs and goals, things they do and don’t want out of their portfolio. But it’s also really important to have context to the real world as you and your clients see it.

Right Brain Perspective: The Ravine

This is the kind of stuff I’m talking about. It matters if you/your clients have really strong views on (as an example), climate change. If you think that’s the clear and present danger and it’s important to your client that your portfolio be “climate aware” then that’s actually the over-ride. You have to hold that context in your right-hemisphere whilst still teasing out basis points and micro-spreads.

But this kind of impending doom has its own nefarious toxicity. There’s *always* a ravine, and Wall St. is full of folks who’ve been pointing it out for the last 1,000% up. There are lots of ways to react to this sense of unease — you can Ostrich or yell about it on the internet, in which case you’ll likely have a sad and uneasy life. Or you can simply accept it and make the best of things.

When it looks like rain, do you scream at the clouds and complain on Twitter? Or do you make sure you know where the rain gear is and go hiking anyway. I talk to a lot of advisors who seem somewhat trapped between concern and conviction, between angst and action.

The trick is to hold this context in your mind mind (perhaps the right side) while still paying attention to the small stiff. All the time.

Left Brain Perspective: The Nitty Gritty

My favorite metaphor for ETFs is “sharp tools in the drawer.” Just like cooking, you can get almost anything done with a few simple tools – Knife, Spoon, Fork. That’s essentially the Morningstar portfolios, of which my Favorite is Christine Benz’s 3-ticker saver strategy.

Of course, most folks who use a financial advisor have slightly more complex situations and (let’s just say it out loud) it’s hard to be a financial advisor if you buy three vanguard funds and check in on them every congressional election or so.

So you end up with a slightly more interesting drawer full of tongs and spatulas and a few single-use gadgets, and that’s awesome. Tweaking your bond exposure with duration and credit, or fine-tuning sector exposure to counteract career risk, they’re a lot of great ways to use those extra sharp tools.

But the ETF industry isn’t launching that many basic tools anymore — they don’t need to. Instead, the ETF industry has become like the gadgets aisle at kitchen store in the mall — full of complex, sometimes difficult to identify tools that might be just what you need, but could also potential take off a finger. Someone out there might need the dedicated garlic peeler; I just crush the garlic with a frying pan.

And if you need a frying pan, that garlic peeler isn’t doing you any good.

Selection Criteria

Once you’re comparing frying pans or chef’s knives, these are the criteria I’d use to make a choice.

• Efficiency: Yes, expense ratio, and… I highly recommend ignoring wild fee waivers. If a fund’s run rate expenses are 3% but they’re capping at 1% until the end of the year, are you *really* going to remember to double check on New Years Day? If the fund company really believes in it’s expense structure they can offer a unitary fee like the big boys. And there’s always an alternative — don’t just pick based on what you know.
• Transparency: I’m a stickler on this one. If you go to the fund website and your fancy new alts fund lists “Cash” as its only holding, move along. New, complex products demand better from issuers, and if they cant articulate exactly what your exposure is (not the CUSIPs, the actual exposure as it lands in your portfolio), every single day, they don’t deserve your money.
• Liquidity: Yes, volume and spreads, but also – do you understand where liquidity could dry up and how it would impact you? If you’re not willing to ride out the next lockup in High-Yield Munis or Junk Corporates, don’t buy those ETFs.
• Kaizen: ETFs have improved in quality every single year since 1993. For every ETF in your portfolio, ask yourself if it will get better? You *want* your ETF to adjust over time… a tweak in methodology, a rethink of buffer zones for rebalance trades, a clear path towards lower expenses or better trading. And clear, regular communication about the strategy along the way. I find it shocking how many issuers launch products and then never touch them — or really talk much about them — after the launch window.
• Weirdness: Most of the new products launched in the last few years are complex — they have swaps, derivatives, counterparties, potential liquidity mismatches and sometimes paradoxical patterns of returns. Some products, like those promising tax advantages or asset recategorization, may face regulatory scrutiny. If what your looking at seems either “really different” or “too good to be true” look a lot harder.

Who to Trust?

Once upon a time, it was really hard to get decent ETF data. Immodestly, Matt Hougan, Elisabeth Kashner and I solved that problem in the mid 2010s at ETF.com, built out what we thought was the best data in the world, and then sold it all to FactSet.

Since then, the “Big Three” in portfolio data, Bloomberg, Factset and Refinitiv/LSEG, have all become excellent, and if someone else is paying the tens of thousands of dollars, I highly recommend them all. The ETF Team at Bloomberg is obviously amazing, and I’m still in withdrawal from losing my terminal (Will work for BB).

The good news is that the publicly available cheap-or-free tools (deep links) at ETF.com, Koyfin, ETF Action, VettaFi and Morningstar (minus the star ratings, which are silly for beta) are all solid. Much of the core ETF data is licensed back from FactSet, and each outlet has it’s own pros and cons (I’ll be doing a live demo of some of this for Kitces in October). My go-to every day has rapidly become ETF Action (no-affiliation). Their daily data-packs in my email box are a staple and highly recommended.

Your platform of choice (Schwab, Fidelity, Pershing, Whatnot) likely has pretty reliable data these days as well, although often lacking real depth. And if you have international needs, folks like TrackInsight, ETF Global and ETFGI are all excellent these days.

But my big takeaway here is to remain skeptical. ETF data is ugly and requires real work to clean. If you see something on a chart that looks impossible, like say this:

Not what actually happened in JNK (sorry ETF.com)

Then it probably is.

Parsing the Future with Ideas!

Here you’ve made your allocations, picked your funds, and along comes a bunch of wild headlines about various “stuff” going on in ETFs. Stuff like this.

The vast majority of this is noise to any normal investor, with a few exceptions.

Macro IDEAS: Sure, there are potentially opportunities in and round different global macro ideas (I’m reluctant to call them themes): sectors, labor and migration, China, AI, and so on. If you believe you have the axe in one of those idea’s more power to you, but don’t assume just because the industry made an ETF for the idea, it’s a good idea for you. Ideas are not strategies or forecasts — they’re ideas.

Market IDEAS: The ETF industry is full of new ways of skinning things, from Crypto to different ways to repackage volatility to YOLO strategies chasing single stocks. Yes, there are genuine concerns about passive flows. And, the Mutual Fund players and RIAs with big SMA businesses will try and wedge their way into your portfolio. And of course, the product marketers will find ways of creating ever-more hot-sauce concentration for your trading pleasure: Mag7 still too diverse for you? Don’t worry, you can go as narrow as you want.

But the biggest idea you’re about to be sold a lot of is Private Equity/Credit:

I have been asked about getting private equity and credit into ETFs every single week this year so far (baring a few weeks off the grid hiking!). I’ll just put the marker down here again: this is a bad idea. YES, it is the case that we have broken market capitalism so badly that the majority of what we would recognize as actual capital allocation and risk taking happens privately. NO, that is not a good thing, and it does not mean we should shove all that private capital into daily-liquidity structures like ETFs.

The money currently trapped in private markets is desperate for liquidity so it can invest back into greener deals where there’s more profit runway. That money will push, and push, and push until it finds a new pile of money to sell to. Don’t fall for it. Be super skeptical.

I Wanna Launch My Own ETF!

I’ll conclude with an inside-back-cover question I often get from Advisors, which is “how can I get into this business!” I was going to do a whole piece on this:

But then Corey Hoffstein launched an hour long masterclass on the entire process:

Corey covers things pretty well, but I’d highlight the biggest issue facing newbies:

Distribution

Launching an ETF may have gotten a lot easier and cheaper over the last few years. but it’s harder to sell than ever before. No matter how good your product is you have to do at least one of these:

• Convince institutions to make long term allocations. This implies you already have great institutional relationships, or have a partnership with someone who does.)
• Convince non-wirehouse, independent financial advisors to buy your new and untested product. This is extraordinarily difficult unless you have found a truly magical niche solving a novel problem. Most advisors allocate through models, and don’t take “flyers” on anything. At a minimum, this requires amazing storytelling and boots on the ground.
• Crack open wirehouses. This is mostly a waiting game, unless you have a special in with UBS or Wells Fargo or whomever. There is no secret sauce to get past a “$100m in assets” checkbox or “3 year track record” hurdle.
• Get mindshare in retail. This has been the game for the last few years for all of the new levered, single stock, derivatives based products. Retail doesn’t necessarily mean GameTop YOLO traders, it also includes dentists buying buffered products in their IRAs. In all cases, however, it means having some sort of strategy to get mass appeal — whether that’s TikTok videos, Crypto-bros or SuperBowl ads.

How do you do any of that? Product differentiation, really strong storytelling and communication, palatable marketing-oriented compliance and a way to get the message out.

If you don’t have that on lock… good luck.

… and thus.

So where does this leave us? With a mature, innovation-challenged market with increasingly difficult distribution dynamics.

For Advisors? This is good news. Everything you need is out there, is cheap, and likely in a size and format that’s goldilocks-like “just right” for your clients needs. You just need to be careful.

For Individuals? Be careful. “ETF” is not a label that implies any kind of safety, other than the regulatory structure itself. All the real risk is what’s inside the kitchen drawer.

For Issuers? Good luck. It’s crowded out there. Get your messaging right, and really understand your market and your competitors.

And remember … more isn’t always the answer.

(With apologies to…)