ETFs are both the present and the future of asset management. The combination of lower fees relative to mutual funds, tax efficiency, transparency, and intraday liquidity that they offer has led to rapid growth in the space. Although ETF assets still pale in comparison to mutual funds, it is hard to argue that they aren’t on their way to surpassing fund assets in the future.
Despite the popularity of ETFs, they still aren’t well understood by many investors. And that is understandable because what goes on behind the scenes to make ETFs liquid and tax efficient can be challenging to understand. For this week’s interview, we are lucky to have someone who has been on the frontlines of the ETF space since the beginning.
Chris Hempstead is the head of ETF sales at Deutsche Bank. Prior to that, he built the ETF business at KCG holdings. He has been around ETFs since they have existed, which gives him a unique perspective on both their history and where they are likely to go in the future.
Jack: Thank you for taking the time to talk to us.
Many areas of all our lives are getting more and more dominated by large firms these days. ETFs have certainly participated in that trend with Vanguard, BlackRock and State Street controlling the majority of ETF assets. Historically, situations where a few firms dominate an industry hasn’t been great for consumers, but in this case, it is hard to argue that is true since fees continue to fall and fees for some index ETFs are now approaching or have reached zero. As the industry moves forward, do you see anything that can stop the increasing market share of the large firms? What do you think the pros and cons are for investors of the large firms controlling such a large percentage of the assets?
Chris: One the greatest benefits of being a large player in this industry is distribution. The lower fees are certainly something investors are going to gravitate to, however the ease with which investors can trade and invest in low fee ETFs of the largest providers is one of the greatest pros. As the larger providers continue to grow and expand their product line, the assets will likely grow as well, however I am not convinced that their market share will increase.
As the industry grows so too will the number of providers. While we expect the notional amount of assets at the top providers to increase, the smaller providers eventually become bigger providers and the share of the total asset pool for the largest players begins to become diluted. As large issuers like Invesco, First Trust, Schwab and Wisdom Tree continue to grow either organically or by acquisition the market share of the top 3 will continue to be pressured.
What could be viewed as a con would be the concern that investors have a high concentration of assets with a small number of the largest providers and may be missing opportunities that are available with newer and smaller providers.
Jack: The dominance of the ETF space by the large firms has made things tough for small issuers. New fund launches were well ahead of fund closures in recent years, but that gap has narrowed and the numbers of closures and new launches were fairly close in 2018. Despite that, there still are many success stories of smaller firms that have been able to buck the trend. Firms like Ark, Pacer, and Cambria have been able to grow assets and expand their ETF lineups over time, and their products have gained traction with advisors and investors. I am wondering if there are any commonalities you see in the small firms that have been successful and the products they offer. What has been the recipe for success for small firms that have been able to grow assets and what do you think the outlook is for small firms going forward in the ETF space?
Chris: Without a doubt in my mind some of the best new ideas for ETFs are coming out of the newer or ‘smaller’ issuers. In order to compete with the largest funds and issuers, nimble providers need to differentiate their product line with strategies that are not available at the larger providers. The success in these efforts is a combination of good distribution of any kind, performance, timing and some luck. It is imperative that new successful ETF launches by pioneering firms establish a commanding foothold early in the life of the fund. Being first to market with an idea can afford an issuer permanent success if they can gather the assets and trading volumes before another fund is launched by a bigger firm with more distribution. In a sense, the better the idea the more intense to race is to raise assets quickly.
Again, the smaller players have the added pressure of establishing a clear lead as early as possible.
We do not expect the largest ETF managers to be the first to come to market with Bitcoin, marijuana or electric car ETFs. In time however, once those ideas are tested and proven, we would expect some kind of offering from all the major issuers. The common trait among smaller issuers with niche products is expertise in the sector, a captive audience and timing. Sadly, timing is probably the most important part.
Jack: Most investors understand that ETFs are both tax efficient and liquid, but many don’t understand the behind the scenes process that allows both of those to be true. The unique creation and redemption system used by ETFs allows for money to flow in and out in an efficient way and allows both large and small ETFs to maintain liquidity provided that their underlying holdings are liquid. Can you explain how this process works and how it helps to facilitate both liquidity and tax efficiency for ETFs?
Chris: This is a very hot topic right now as there has been some who question the practice of in-kind delivery of securities versus cash. In short, this is how ETFs and some mutual funds operate. Authorized participants create and redeem ETFs in accordance with the terms of their respective authorized participation agreements. The distributors insure that orders are in good form and not in violation of the agreements.
The simplicity of the in-kind transfer of securities is part of what is missed in many conversations. Market makers will buy equities when creating ETF shares and simply hand them over to the issuer. They are not buying them ‘for’ the issuer rather they are buying the stocks so that they can hand them over like a currency so that the issuer can manufacture brand new ETF shares in return.
In reverse, when a market maker is accumulating an ETF position, they will hand over the ETF shares to the issuer (as if it were a currency) and in return the issuer will hand over equities. This is not a barter system but it sure does work like one.
Investors in ETFs and other funds benefit from in-kind transfers.
Jack: The future for ETFs is certainly exciting, but it can be tough for your average investor to see where things are headed going forward. You have had a ringside seat to the development of ETFs from the beginning and I am wondering what most excites you about the future of the industry. Are there any trends or potential future developments that your average investor may not know about that excite you going forward?
Chris: I am most excited about the growth in the number of funds and unique ideas that continue to come to market and that are doing so with great success.
There are more than 100 funds that trade more than $100mm of notional volume per day. There are more than 230 that trade $25m or more per day. This is remarkable considering only a few short years ago there were only a few dozen funds with these kinds of daily volumes. And back then, just like today, there are many who think they cannot use an ETF if it doesn’t trade a lot. That is simply not true and the increase in the number of funds that grow into being widely held and having high trading volumes is evidence of that. I expect that in 5 years there will be 500 funds that trade $25m or more per day and 50 funds that trade more than a $1billion per day (only 8 today).
Investors should be excited about new thematic funds like defined outcome, 5G, Motif, ESG, disruptive, active non transparent, crypto etc. There are still so many new ideas coming to market and waiting for approval. Investors should be very excited about what’s here now and what’s coming in the future. It is a great time to be investing!
Jack: Many of our readers are individual investors and the proper way to trade ETFs can be confusing for them. Trading the most liquid ETFs doesn’t require much thought, but most ETFs don’t fall in that category. ETFs also introduce some additional complexity relative to stock trading because both the liquidity of the ETF and the liquidity of its underlying holdings both need to be considered. What are best practices individual investors should follow when trading ETFs and what are the most important things for them to look at when judging ETF liquidity?
Chris: Great question. Best practices are straightforward.
1: Find a ETFs that fit your desired investment need (strategy).
2: Review their trading and price spread behaviors as well as premium and discount in the market. You should have an idea of what is ‘normal’ with regards to bid/ask spread as well as premium and discount.
3: REMIND yourself that volume and last sale are only indicative of someone else’s trading. You should be concerned with NEXT sale. Next sale is your trade. Where can you buy and where can you sell? Are those price levels adequate and do they offer an affordable way to invest in the ETF without sacrificing performance by paying too much for execution?
This touches on what we call ‘IMPLIED LIQUIDITY’. Recently I watched as an ETF with an average volume of only 50,000 shares a day traded more than 3,500,000 throughout the day. What looks like 6,500% of adv in the ETF is really just 1.67% of the adv of the portfolio. THAT is how you should look at ETF liquidity. If you are not sure how liquid the underlying is, ask!
4: If conditions in the market are ‘normal’ and within your ranges of comfort, proceed to trading. We generally advise using limit orders to reduce the potential of experiencing price gaps. You should consider using a limit that would be high enough to expect an execution. Bidding the same prices as everyone else simply insures that you will wait there until a seller shows up. Also, we generally like to remind you that the widest spreads in the equity markets are at or near the opening. It is generally a good idea to wait until spreads normalize before entering the market. Usually by 9:45am equities are close to their normal spreads. If you can avoid trading on the opening print you may find that the quality of your executions goes up exponentially.
Jack: Thank you again for taking the time to talk to us today. If investors want to find out more about you and your work at Deutsche Bank, where are the best places to go?
Chris: You can always email me at email@example.com for information on how to work with DB on trading, launching or general ETF information.
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