Episode #87: Mike Venuto, Toroso Investments, “I Would Suggest Seeking Out High Active-Share, Global Growth Themes”
Guest: Michael Venuto is an ETF industry veteran with over a decade of experience in the design and implementation of ETF-based investment strategies. He is the Managing Director of Tidal Growth Consultants as well as Co-Founder and Chief Investment Officer of Toroso Investments, LLC. Previously, he was Head of Investments at Global X Funds where he provided portfolio optimization services to institutional clients. Most recently, he is behind the launch of the Toroso ETF Industry Index, which measures and monitors the performance of publicly traded companies that derive revenue from the Exchange Traded Funds ecosystem.
Date Recorded: 12/13/17 | Run-Time: 57:52
Summary: Mike briefly walks us through his background, which includes a fun story about a baffling situation years ago when the gold mining company, Newmont Mining, was falling in price despite gold rising in price. Mike tells us the culprit turned out to be the new ETF “GLD” – Mike realized he needed to learn far more about ETFs.
Next, the guys dive into ETFs. Meb starts broadly, asking where we are in the ETF evolution. Mike tells us we’re still quite early. The growth rate has been largely the same over the last 10 years (a little over 20%); but that growth rate is compounded over a larger base now, so it feels like the growth is greater. And in terms of where ETFs are going, free beta is getting saturated. The next move in ETFs will be people thoroughly detailing the differences between two ETFs that appear largely the same at first blush (nowadays, people tend to see similarly-themed ETFs as somewhat the same).
Meb pushes deeper on this idea, wanting to know more about this next evolution in ETFs. Mike tells us that myriad factors are a part of any given ETF beyond its expense ratio. For instance, there are the spreads, how well an ETF tracks its index, whether the ETF lends out its shares and what it does with that revenue, then there’s the share price itself. All these factors can make two ETFs that appear similar on the surface actually quite different.
This dovetails into the idea of “active share” – basically, the measure of an active ETF that differs from its index. Mike tells us about a tool at Toroso called Smart Cost that helps embrace ETF transparency. The tool helps answer the question “how much am I paying for the smart portion of an ETF?” Mike goes on to tell us that the overall expense ratio is not the most important cost consideration – instead, it’s how much am I paying for the smart portion? He gives us an example, comparing it to its benchmark, then calculate its “price per unit of difference.” The tool shows the amount of the ETF you’re buying that is different – and this helps determine the true value of any given ETF.
Meb echoes much of this, saying that in order to justify actively managed fees, an investor wants an ETF that looks truly different than its benchmark. Otherwise, you’re just paying top dollar for cheap beta. The conversation bounces around a bit, including some other tools Mike uses, but eventually Meb asks about something Mike is doing that’s on the forefront of tracking the entire ETF space.
It turns out, Mike has created an index that enables investors to track the growth and exposure of the overall ETF ecosystem. This includes not just the issuers, but the exchanges, the data and index providers, the back-office companies, and so on – the entire overall ecosystem. So, Mike has created an index that tracks the growth of all these companies.
Next, the guys move into the “fringe ETF” space. Mike predicts we’re going to see more “characteristic” based indexes. Rather than capture a factor, they systemize how to target characteristics – e.g. a spin-off, or insiders buying a stock, or great brands. This leads into a conversation about “structural” factors, where you create a different form of behavior. An example would be a put-write fund.
The guys touch on a few topics before moving onto cryptos. They discuss whether crypto has any real legs, and what the potential could be. Mike has some interesting thoughts here.
As the interview begins to wind down, Meb asks for Mike’s favorite ideas going into 2018. Mike tells over the next 10 years, it could prove difficult to achieve the type of beta returns we’ve enjoyed over the last 10 years, so he suggests seeking out high active, global growth themes. Find a PWC or McKinsey study about “things that are going to change the world” then invest in those industries (think robotics). Mike goes on to mention the Internet of Things and the electrification of cars.
Meb agrees on the potential for a challenging return environment. He walks us through why using the 60/40 portfolio with current bond yields, and what equities would have to return to keep us at “average” returns. Given our lofty valuations today, that seems tough.
There’s way more in this episode: The Permanent Portfolio… whether gold bugs should be concerned about the rise of crypto… how Meb has a new army of enemies in the form of Litecoin crypto investors… and how one of Mike’s friends bought a pizza years ago with Bitcoin – probably the most expensive pizza that friend will ever purchase. And of course, there’s Mike’s most memorable trade.
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Links from the Episode:
- 00:50 – Introduction to Mike and his background into the ETF space
- 3:21 – Mike’s top-line takeaway of the ETF space and where the industry is going
- 5:40 – Will anything speed the race from mutual funds to lower-cost ETFs that are doing essentially the same thing?
- 7:54 – Meb’s tweet on Hedge Funds
- 8:14 – Looking at the factors that investors will be considering when choosing funds
- 11:28 – Tools on Mike’s website and understanding the real expense ratio of funds
- 14:15 – StockCharts
- 15:34 – Understanding the number of ETFs that own a certain stock and whether that is distorting the overall valuation of stocks
- 16:21 – “Index Funds Rule the World, But Should They Rule You?” – Zweig (WSJ)
- 18:32 – Any areas that are under-owned by ETFs?
- 21:05 – Looking at Mike’s index and fund that tracks the ETF space
- 25:50 – Fringe and alternative ideas in the ETF space
- 32:29 – Sponsor: HealthIQ
- 33:36 – Any ETFs that target multiple assets?
- 34:44 – Will the crypto-space become a big part of ETFs?
- 37:49 – ETNs (Exchange Traded Notes)
- 39:23 – The alternative assets that are coming out in the crypto space and what Mike thinks will actually make it to market
- 43:14 – Favorite ideas going into 2018
- 46:22 – Thoughts on stocks being up every month in a single calendar year
- 47:20 – The permanent portfolio and how Mike interprets it today
- 49:12 – Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies – Faber
- 50:49 – Will crypto currencies eat away at commodities or precious metals?
- 52:34 – Most memorable trade/investment during Mike’s career
- 56:30 – Connect with Mike – com or @michael_venuto
Transcript of Episode 87:
Welcome Message: Welcome to The Meb Faber Show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: Welcome podcast listeners. It’s right around a holiday time. Today, we have a great show with you with a true market vet. He’s the managing director at Tidal Growth Consultants, Co-founder, CIO of Toroso Investments. He’s an ETF specialist. More than a decade of experience in designing, implementing ETF-based strategies. He’s also an author, writes a lot on etf.com. Welcome to the show, Mike Venuto.
Michael: Thanks for having me, my friend, Meb Faber.
Meb: Yeah, men.
Michael: I’ve been looking forward to this a long time.
Meb: Good. Well, for those who are listening who may not be as familiar with you, I’ve known you for a long time, and would say you’re one of the brightest people in the ETF space. Give us a quick background. How’d you go from being a NC State Wolfpack to being where you are currently today?
Michael: Yeah. So I like to say the investment business was more attracted to me than I was to it. You know, I did go to NC State and studied philosophy, religion, and you didn’t debate in chess, and I was your sure kinda philosophy nerd. I came to New York to do a paper or write a book on the craziness of Wall Street. And in order to do that, I took an internship on the New York Stock Exchange with 40 other young folks. And five days later, there was only 10 of us left and I fell in love, moved into the hedge fund world, the brokerage world.
And at the hedge fund kinda group that I worked at, we had a concentrated position in Newmont Mining in 2005, and we watched it go down while gold went up. And we realized that it was the launch of GLD,
the State Street gold product that was changing how investors looked at gold mining companies. And we realized, from that point on, we had to know ETFs even if we didn’t buy them. So that became my job as it often does at a small boutique hedge fund, mutual fund, research shop.
And the way I really got involved was by becoming a private equity investor in ETF startups, and index companies at exchanges, and basically the ecosystem supporting this growth essentially as a hedge through our business. In 2012, I decided to take that research process and apply it to ETFs. And that was the nexus of Toroso Investments.
Meb: Very cool. All right. Well, I know you guys just moved into a partial new world headquarters there. Let’s start broad. You know, most of our listeners are pretty familiar with ETFs, but when it comes to the ETF industry, kind of give us your topline takeaways. Where do you think we are in the evolution? You’ve kind of seen it since the genesis in the ’90s and the evolution. Give us kind of like this state of ETFs and where do you think it’s going?
Michael: So I think we are still quite early. I know people like to say, “It’s growing so fast, it must be a bubble,” all those things. The reality is the growth rate is actually about the same as it’s been for the last 10 years, a little over 20%. The difference is we’re compounding off of a larger base, right? It’s 20% on 3 trillion is a lot more than 20% on 500 million. So it feels a lot more saturated.
What I think we are seeing is the saturation of the race to zero or the free beta. You know, you and I talked about this a lot. I think it’s the best thing Vanguard has done for us all is given us the ability to get free data from everybody essentially, you know, Black Rocks got it now, State Street just did their deal, and they did the deal with TD Ameritrade, even Franklin Templeton is coming out with free beta. So I think that part is probably gonna come to an end over the next year. And, you know, you’ll be able to get your free beta from whoever you want to get it from, but now, you’ve got to start to think about what’s actually in in ETF.
And five years ago, when I started Toroso, that was really what I thought was gonna be our value prop. And although it made a lot of value to me and the advisors we work with, it wasn’t something that everybody else cared about yet because the market’s going straight up, and any ETF that you bought that said equity, they went straight up as well. The next kind of move in our minds is people actually saying, “Well, what’s the difference between this dividend ETF and that dividend ETF? And how do I compare them? And how do I make a good decision? And how do I justify that decision as a fiduciary? And what’s the real cost versus the stated cost on the expense ratio? And what am I actually paying for?” And so that’s a big key that I think is going to help boost the industry to the next level, as well as the innovations, all the new things that we see coming.
Meb: All right. So there’s a lot to unpack there. And one of the things I think a lot about is, you know, is there sort of a Netflix blockbuster moment where all of a sudden, you know, mutual funds fall off a cliff, or these high fee funds that charge 2% plus per year for what you can essentially get for free. My favorite example is there’s an S&P 500 mutual fund that still charges 2.3% per year. So there’s a lot of these legacy funds that are super high fee for no reason so that you have this race to zero. Is there anything you see that is like on the horizon? And my answer to this is I don’t know. But is there anything you see that causes these flows to accelerate, or do you think this is sort of just a 10, 20-year generational change?
Michael: So I think there is this misnomer that ETFs have destroyed mutual funds. I think what they’ve destroyed more is hedge funds. I think there are investment ideas and assets that in order for them to work, need a little less liquidity or a little less transparency. And many of those ideas have flowed from hedge funds into mutual funds. And then you have mutual fund ideas that don’t require the lack of liquidity and lack of transparency then it flowed to ETFs.
ETFs, if you look at the 40 Act world, they’re about 18% of the assets and growing. So there’s a long way to go, but at the same time, mutual fund assets are still up, right? They may not be getting massive flows anymore, but there’s more mutual fund assets this year than they were last year. You can’t say that on hedge funds, right? ETFs are surpassing that. So I don’t think that there is this watershed moment. You know, we try to do some research on the growth of mutual funds when they first came out, and it’s a little bit spotty because the data was not so good back then, but it appears they grew faster versus annuities, and insurance products, then ETFs have grown against mutual funds. And even today, annuity still exist despite Ken Fisher’s advertisement, you know?
Meb: Well, that’s funny. You know, it’s funny you mentioned it about the hedge funds. I was just tweeting yesterday, I mean, one of the world’s most famous hedge fund managers just announced John Burbank’s Passport of these shutting down his main fund. And there’s just a laundry list of these hedge fund managers, Hutchin Hill, all these guys that are just, and it makes me a little bit sad, I don’t know why, because the CEO…
Michael: Yeah. No, we don’t wanna lose the ideas, right? We still want them generating good ideas.
Meb: All right. So let’s talk about a little bit more about this evolution. So you’re getting a race to zero for the beta stuff. And when we say beta, listeners, it’s talking about, like, the ability you could buy S&P 500 for essentially like five basis points, so 0.05%. So with all intents and purposes, it’s free. And in many asset classes, there’s been a few holdouts like commodities, but all of a sudden, you have a new issuer coming out and listing a bunch of 20 basis point commodity fund.
So the buy and hold beta is quickly going to zero. But like you mentioned this, and we talked a lot about this, the next evolution of how advisors and investors will be thinking about in selecting funds probably has a lot to do with more than just expense ratio. So maybe talk a little bit about that, whether it’s talking about smart beta, and all the other costs in active and passive, kinda take it and run with it.
Michael: Yeah. So the SEC, the regulator that oversees the 40 Act or the ETF industry mandates that we talk about our expense ratio. There’s a lot of other things that go into the trading of an ETF, and the cost of actually buying and selling one that aren’t mandated to talk about. So one being the spreads, you know, how much between the bid and ask price are you paying, another being how well they track their index. So, you know, it’s a little known high thing that a lot of these ETF issuers lend out the securities to the hedge funds that are diminishing out there to short them, and they receive a substantial amount of money for that.
Some of the big issuers give 100% of that back to the fund, which minimizes tracking error. Some of the big issuers and even more now take a percentage of that and put it in their pockets. So those are things that are affecting that price that get left out. Another thing that people forget about is the share price because everybody thinks we hear the headlines, we trade for $5 or $10 on TD or Schwab, but a lot of the institutional buyers trade pennies per share, they pay a penny per share that they purchase.
So the share price itself has an effect on the cost of doing that business. So it’s very, very difficult to state what the real cost is because the real cost is unique to the buyer. Each buyer has different aspects about themselves, and their portfolio, and their structure, and where they’re buying it, that matters. So it’s impossible to advertise the true cost. And that’s why you’ve really got to look at it with multiple inputs to understand what you’re really paying.
Meb: And so a good example, listeners, is the short lending. So there’s a number of funds say, it’s a fund that has 20 basis point expense ratio, you know, that fund issuer, to the extent that they share the short lending, if they have more than 20 basis points in short lending revenue, you’re actually getting paid to own that fund. And that’s pretty cool. You actually own a fund that has a negative expense ratio, it’s paying you to own it. The problem is it’s really hard to find that information. Morningstar, to my knowledge, doesn’t really report it in a way that it is particularly useful, so it requires quite a bit of digging, and then it’s hard.
So, all right. So let’s unpack a little bit, you know, kind of even more. Let’s go a step further. So you’ve talked a lot about this. You have some pretty awesome tools on your website that I’ve used over the years, that I haven’t seen in many other places. By the way, listeners, if you’re a financial adviser, you can hit Mike up and ask for access. Maybe he’ll feel the holiday spirit and give you permission. But something like a smart beta fund, walk me through how that might not necessarily be the expense ratio, you’re truly thinking about in how you have to think about this whole, sort of, active share, sort of, idea.
Michael: Yeah. So we do use these tools that we’ve designed where we look at things in a way that embraces that transparency of the ETFs. One of my favorite things to say are ETFs are so transparent that nobody looks, they just accept the name. And yet, they’re giving you so much information, it’s just about aggregating it. In terms of advisers accessing these tools, we actually call it the Toroso Thinking. We invite all kinds of advisers to use these tools and engage with us in this process. So I’m happy to have people reach out. It’s not something we sell, it’s something that we use to help this industry grow.
The one that you’re referring to is what we call our smart cost. Smart cost is thinking about how much am I paying for the smart portion of an ETF. So they love the term smart beta, it’s essentially saying, it’s better than or smarter than traditional beta. So the overall expense ratio is not the most important thing. The most important thing is what am I paying for the smart portion? So let’s take an example of, poet, power shares has a rappy weighted Russell 1000, very S&P-like fund that charges about 39 basis points.
Now that 39 might sound great, it might sound too much, but how do you know without knowing what you’re actually getting? So what we do is we compare it to its benchmark or to the S&P to see how different it is, and then calculate per unit of difference, the difference in price. So at 39 basis points, we’re buying something that is actually 72% the same as the S&P. And using the largest S&P fund that’s at 9 basis points, what we can discover is for the smart portion of that ETF, you’re actually paying a 106 basis points.
Now, you’ve got something to look at, that 39 is irrelevant. This 106 is what you’re buying that’s different. And those are the kinds of ways we try and illuminate for people what the value prop is within an ETF.
Meb: You know, it’s funny, and then one way to look at this for some of the older funds is you can go type, I know stock charts has good Total Return comparison where you can type in two symbols, compare them over time, you’re like, “Wait a minute, this fund that’s been sold on this concept of, you know, smart beta or looking totally different,” literally, you cannot distinguish from the S&P 500 chart. Like, it’s the exact same thing, but it’s in a much higher cost. So it underperforms by 50 basis points a year or something.
So I think you’re seeing this evolution in our space of, you know, to be truly active, you know, or to justify active fees. And to allocate to it as an advisor standpoint, you want something that looks really different or that is concentrated in a way that actually that the fees you’re paying, at least, are worthwhile.
Michael: Absolutely. In the mutual fund world, they talk about the active share and the cost of that active share. In the ETF world, we’re looking at it as smart cost because it’s the cost of a smart beta portion. And the only way that you can add value is by having some form of active share, and that active share should be reasonably priced. I tend to think of it as a rule of thumb that the smart cost should be equal to or less than the stated expense ratio because they should be giving me the beta part, the overlap through the benchmark for free.
Meb: One of the other tools that you guys have, and there’s like six, so we’re not gonna cover them all today, but I liked playing around with was, was one of the tools allowed you to look at basically the ownership of any stock by ETFs industry as a whole? So, you know, is there a stock that’s owned by all the ETFs? Are there stocks that are under owned by ETFs? Talk to me a little bit about because you hear in the media so much now, “Our ETF is in a bubble,” how is that distorting the overall valuation and stock flows in ETFs? Talk a little bit about that concept and what do you think about some of those ideas. And is there any opportunity there for investors?
Michael: So this is a subject that I’m glad is starting to get some attention. I actually did an interview with Jason Zweig that was in the Journal this past weekend specifically about this. And we had multiple conversations about, is there an opportunity to build a fund around all the companies left out of ETFs? Which I think has a lot of investment there because they don’t have that constituency-base. But in terms of how the tool works, what it does is it looks at all the ETFs focused on U.S. equities and calculates on average, how much of the market cap of each of those stocks is owned by ETFs.
The number today is about 6.8%. So just to be clear, on average, ETFs own about 6.8% of the market cap today of every U.S. stock. When I started this five years ago, that number was 2.67%. Now, the tool goes a step further in that we can put in Apple or National Retail Properties, and it will tell us specifically how much of the market cap of those companies are owned. And the things that you can define from this are places where there’s, call it, self-fulfilling momentum, where the asset flows are pushing up things. So for example today, REITs, real estate investment trusts are by far the most over owned by ETFs in terms of individual stocks. It averages around 15%, which is more than double all the other places.
Meb: Why do you think that is by the way? Any ideas?
Michael: Yeah. When you go and look at its sweet spots, right, REITs have high dividends. They’ve been relatively low volatility. And the Vanguard though he has of their real estate ETF has drawn so much assets. So it appears that most investors, when they invest in REITs have gone passive, therefore, we worry about the price discovery of those underlying securities. A similar thing we’ve seen with MLPs about two or three years ago, and it’s the type of thing where when it unravels, it unravels more rapidly because of that ETF’s self-fulfilling momentum.
Meb: Well, we had REITs, I mean, last crisis, REITs declined, what, 70%? I mean, 80%? It was some obscene drawdown, interesting. All right. And as the quant in me, I mean, this isn’t something that, you know, is particularly that easy-to-go back test or think about, but what about the under owned? Are there any particular areas of the world that seemed under owned by funds, or can you even tease that sort of data out?
Michael: Absolutely. So I’ll give you three examples. Number one, stocks with low flow. So Carl Icahn’s company. Basically, his family office/hedge fund is publicly traded, and he owns 90% of the flow. As of right now, it’s only in two ETFs, and they represent almost no exposure. So companies with very heavy insider ownership, the extremes. In fact, this is the reason that Sears for better or worse, was thrown out at the S&P because Lampert own so much of this stock.
Number two, capitalization. So microcap stocks are very much left out of the ownership. Like, if you look at, they call it, the market cap of the market, large cap on average is only about 4.5%, 5% owned by ETFs. Midcap is more like 5% or 6%, and then small cap is up at 9%. Then you go to microcap and it drops to like under 1%. So you can see…and then the third one is stocks that are hard to categorize or are set up strangely tracking stocks.
So like Lenore [SP], Lenore [inaudible 00:20:11]. There’s a Lenore class A, and a Lenore class B? One of them is 10% percent owned by ETFs, the other is doesn’t even registers. And ironically, the one that’s not owned by ETFs is the share class that’s doing better this year, which doesn’t happen often.
Meb: Man, it’s so interesting. There’s probably a product in there somewhere as the long, the under owned, and short, the over owned. I mean, we talk about a lotta…I saw Goldman launched this hedge fund VIP product, which makes absolutely no sense to me but it’s raised a bunch of money. And I joked that it’s probably they’re doing it as a reason to have something too short. But they’ve put it out and it’s raised money, so who knows?
But that goes in minds, the 13 Fs for the most owned stocks by hedge funds, but is it’s the same concept in reverse where they’re buying stuff that is the most over owned, which makes zero sense to me, but who knows? But, you know, you also look at…you’re kind of on the forefront of a trend. You’re behind the creation of an index, and now it’s a fund as well that tracks the entire ETF space. Talk to me real quick about the kind of thinking there, and then we’ll get back to some weird and fringy ideas.
Michael: You know what? I love how our conversations are circular because the answer to this question actually goes back to the first question you asked.
Meb: Let me interrupt you real quick, which is I’m known to do. Circular is a compliment. That’s another way of saying completely disjointed, fragmented, it’s Meb’s train of thought, which is basically just like atom bouncing around a room and hitting other things. So if we had a good editing staff, Jeff Coff, we would probably put this conversation in a linear manner. But, okay. Talk to me about this sort of concept, you know, this beautiful circular thinking we have.
Michael: Yeah. So it’s more like a gyre. It’s certainly been progressing. So the first question you asked is how did I get involved with the ETFs in the industry, and it was really from a private equity standpoint. You know, myself and my old firm were the Angel investors and emerging global advisors, we were very, very involved with WisdomTree back when it was Pink Sheets and traded by appointment, and a number of other ETF startup things.
And so that private equity exposure is also how my business partner, you know, Trias got involved. He was a private equity investor in a fund, which hasn’t been done before. He did it from his family office, helping to create Lithium ETF. So both of us came at the ETF industry by owning the companies that were aligned with the clients, and we saw the trend. Clients want low costs, transparent, tax efficient, and we wanted to participate in that.
So about, I don’t know, 18 months ago, Guillermo looked at me and said, “How do we create an index that allows other people to track that growth and that exposure?” And we set ourselves upon the path of figuring it out. And the first question we asked ourselves is why hasn’t this been done? And that really answered how to do it. We think it wasn’t done because everybody thought of it as just the issuers. And, you know, there’s 18 or so publications that you could look at, but it’s not just about the issuers, it’s about the ecosystem.
The exchanges are extremely involved in this growth of the ETF industry. The data and index providers, MSCI and S&P, have rebuilt their business models from selling data to essentially being an asset manager with basis points because of ETFs. The back-office companies like Bank of New York, and U.S. State Court, and SCI have reinvented their business box. And then finally, we all hear about the spreads and the cost of trading. There’s multiple public companies that are living off of that because the volatility in the market had disappeared and they’ve focused now on the ETF trade. So we built an ecosystem. We got some really cool people to work with us like Burton Malkiel and Linda Zhang. And they helped us steer that universe, and now we have an index that tracks the growth of these companies.
Meb: Awesome. I love the idea. Maybe we’ll do a reverse merger into a shell company just so we can get Cambria. Although, I don’t think we would meet the market cap requirements. By the way, Venuto, do you know…
Michael: Maybe in six months or so.
Meb: Can you name the most famous reverse merger company of all time? Does any come to mind? If you were to guess the most famous stock you’d probably guess it. Berkshire Hathaway was a reverse merger.
Michael: Oh, yeah. That’s right, that’s right. It was like paper or something, wasn’t it?
Meb: Yeah, yeah. They went public. Listeners, that’s when a private company goes public by merging into a public company shell. You see this a lot, by the way, in the shadier world of like Utah and Vancouver companies doing it for probably blockchain now companies in marihuana and everything else fringe anyway. By the way, does a private fund exist currently on the ETF space? I don’t even know the answer to that.
Michael: I’ve seen multiple people try and do it, but I haven’t seen a real successful one. There are two or three private equity firms that have focused there and had a lot of success.
Meb: Good. Maybe you and I can talk about that offline. All right. Next. So, you know, as we’re talking about…and by the way, the ticker is TETF. You guys check it out, it’s cool, fun. As we talked about kind of fringe and different ideas in the ETF space, let’s talk about some other ones. What are some other, you know, kinda interesting ideas about, you know, where this world is going in the ETF space. How many thousand funds now do we have in the U.S?
Michael: It’s like Bitcoin prices. By the time I tell you the number, it’ll change.
Meb: I heard that there’s a great joke I retweeted that the son like had recommended to his dad they buy one bitcoin and he’s like, “Are you crazy, $16,500? How could you possibly justify $14,300? Like, there’s no way I can invest $2,800,” you know, just because the volatility bouncing around. Pretty nerdy joke. All right. So talk to me about fringe stuff. You know, what else…You and I both are always brainstorming crazy weird ideas. Talk to me about some of the more interesting ones, either you’ve seen, or you think should exist, or you think are really, really stupid.
Michael: Sure. So I think before that, we gotta tell the listeners that this is a bit of an inside joke for Meb and I. And about three or four years ago, we were sitting there, someone in Spain and he says to me, “Here is the fringe guy.” And I didn’t know I was the fringe guy. So I’ve embraced it. But I think a lot of fringe stuff is really where the future is. And some of the fringe stuff I’ve talked about in the past are characteristic-based indexes. Indexes that instead of trying through capture of factor, they think a characteristic that historically has been captured by active managers, and they systemize how to get it.
So spin-offs is an example. That’s when a large company spins off the business unit as another public company. There’s tons of research about the value created in that situation. I talked about the KNOW before, that’s the one where it’s about insiders buying a stock, and the value that can produce. And Meb, you’ve done much of amounts to work on which hedge fund holdings to hold and not just the top one, that’s another great example of a characteristic.
And I see the world moving more and more of those things out there. We recently helped the one focused on brands come to market, customer satisfaction, you know, the ACSI funds. So there’s a lot of that really cool, what I like to call it, eat those beta, characteristic beta that I think it was fringe when I first started talking about it five years ago. Now, it’s just lumped in the smart beta category.
Meb: it’s funny because there’s some areas on the market that to me, it’s always surprising that haven’t been really cannibalized in that space. I mean, when you think about hedge funds, like, a classic whether you call it systematic or alternative beta strategy, like, manage futures, you know, where it’s rules-based. Most of us could probably come up with some very basic indexes that could get most of the muscle movements down, and there’s these mutual funds that have dozens, if not, you know, $100 billion in assets based on a lot of this manage future’s concepts that to me, it seems like you could get out for a pretty low cost. And so there’s still to me, some areas that although, I think JPMorgan just launched one last week.
Michael: Yeah, event-driven.
Meb: Yeah. There’s a number of areas that are still, you know, not having got Vanguardized, but the…and increase what, you know, I kind of see as these investable pinch marks. So you mentioned whether it’s M&A or spin offs. Well, all of a sudden, for every spin off and M&A fund in existence, that’s the hurdle, that’s the high hurdle rate that you got to beat because if you can’t beat the beta index, it’s gonna be tough. We should have done like a Shark Tank episode, where I said here I’m gonna pitch you for a terrible ideas. You tell me what you think about them. I wish we should have just pitched each other.
Michael: That’ll be out next podcast. Next year, we’ll do Shark Tank.
Meb: We should have you on monthly. There’s so many funds. And, you know, I think one of the biggest challenges for so many investors, and I even put myself in this category, it’s just so hard to keep up with all these new product launches and all these interesting funds. I mean, there’s times when I’ll be flipping through etf.com magazine, or whatever it maybe, and say, “Wow, that’s a cool fund. I’ve never been heard of that,” and, you know, have to dig in because there’s just so many launching every day that it’s more and more interesting. Any others off top of your head that you think are either areas right for disruption, or that you think are pretty cool entrance in to our world?
Michael: Yeah. So there’s a new area that I’m calling structural factors, it’s a work in progress name, but it’s the idea that you can create a form of behavior using the ETF structure. So examples would be a put-write fund, right? So we know the return streams of a put-write fund, but it’s not a factor, it’s not a traditional thing that happens from the underlying behavior of the equities. The equities are being expressed through writing a poet, and it creates a different form of behavior. One that’s kind of new that I’ve been looking at is the idea, and I know it’s…you normally not for mass consumption, but the leverage DTS, the three times, four times, now four times as of yesterday. But there’s a new one that’s actually 1.25. For every dollar you put in, you’re getting $1 and 25 cents of exposure.
Then the thing that makes it a little more mainstream is you don’t have the massive decay that you have when you have a leveraged product. What I like about it is its precision. Structurally, it’s giving me essentially a high beta exposure. It’s always gonna give me a 1.25 beta. And so if I think the market’s going up, I don’t have to figure out what should go up more, I have a precise structured return that does it for me. That idea of precision from structure is something new that I haven’t seen before in the ETF world that I see coming out.
I think you’ve done something with tail risk that I think is very much like that. The QuantShares market neutral ones that have been around for a long time, they do something like that, too. They use the structure to create a return stream rather than hope the underlying securities produce that return stream desired.
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Meb: I don’t know the answer to this and you might not either. Are there any ETFs currently that…so if you’re just talking about, like, a two-times leveraged or whatever that target not just one asset but say likes…is there like a 60, 42 times leveraged, or I mean that kind of goes into risk parity I guess. Are there any kind of combo assets that are leverages or is it all single asset at this point?
Michael: It’s all single assets at this point, but probably not a surprise to you. I did test this. I tried the idea of the permanent portfolio using four leverage DTS, or really three leveraged in cash. With the idea that the inverse correlation of the assets would prevent the decay, I would say it worked to some degree and didn’t work to other degrees because you can’t really leverage cash. So I think it would probably work better with a risk parity strategy, kind of, like what Cory talked about on bearings a couple weeks back, the leveraging up, you know, 110 long treasuries or 120 long treasuries plus equity. I’m getting too fringe, I know it. You can stop me.
Meb: No, we haven’t even gone full fringe yet because we haven’t even gotten to cryptocurrencies. There’s been a lot of drama lately with the futures, just started trading in the past week, and the prices of all of these cryptocurrencies have been bouncing around all over the place. I’ve made an enemy of the entire…one of the crypto coins, I don’t know if you saw this on Twitter, but I was…
Michael: Well, the Litecoin thing?
Michael: Oh man, you set off some stuff for Litecoin.
Meb: Oh, man. Well, it’s up like how many hundreds of percent since then? So I’m gonna call it the…
Michael: Yeah, 400%.
Meb: …the Jeremy Schwartz effect where, listeners, we joked on Twitter that seemed to me like a very obvious joke that I was hanging out with Jeremy Schwartz, the CIO of WisdomTree in Zurich and I tweeted we were having fun and having a cocktail. And, oh, by the way, Jeremy was disclosing how they’re working on a Litecoin ETF, which as everyone who knows it’s impossible because there’s no way to custody it, but the entire…it was like the ALT right or left coming after me, but of Litecoin, they just went crazy on Twitter.
So, FYI. Anyway, so talk to me about the crypto space. Is this something that you think is a lotta just sound and fury? Do you think it’s something that is actually has a lot of opportunity? And then how in the world did you possibly structure some of these ideas into the ETF format?
Michael: Yeah. So in light to your joke earlier, it’s changing so rapidly that it’s like difficult to really have an opinion. I will say that for our clients, you know, the advisors we work with and give recommendations to, we did recommend that GBTC, the George, Boy, Thomas, Charlie, the Grayscale trust, about October of last year, and it wasn’t because we became cryptocurrency cheerleaders, right? I’m still not willing to put on that skirt and pick up those pom-poms.
I probably believe it as a revolution, but I don’t know that as investable as everybody else thinks just yet or at least the price thinks. We did it because at that time it was just an outcome play. A year ago, you could look at this and say, it’s either zero or it’s a 3% or 400% return from where it was, and the premium wasn’t that high. And so we looked at it and said, “This is not a question about whether or not to buy it. It’s simply a question of position size.”
Fast forward to about August of this year is when we stopped recommending it because we felt the premium got too high, and we felt it’s likely that our beautiful ETF industry here is going to figure this out in some way, shape or form, and eat away at that premium. So until two or three days ago, the way to get in and out was GBTC in a custody account, in a Fidelity or Schwab account.
Today, you now have futures. You also have the ability of Fidelity and JPMorgan and a few other places to buy the Swedish ETNs that are, you know, gathering assets at a pace that are…and saying…
Meb: And by the way, listeners, ETN is Exchange Traded Note, which is a that you don’t actually hold anything, but it’s a credit obligation with some bank. And historically, the risk is that the bank could default or just not honor the note. So while people used to be a lot more nervous about ETNs, I think a lot of it’s gone away particularly if you have multiple counterparties. I don’t know who the Swedish ETN counterparties with, do you know by any chance?
Michael: It’s a Swedish bank.
Meb: I wonder how they lay it off. Are they just actually just going and buying a bunch of Bitcoin or because there’s no futures didn’t trade until…I wonder what they’re doing. How they’re taking the other side of that trade?
Michael: They were buying bitcoin or Ethereum. They’ve got an Ethereum one as well. I think it was very difficult for them to keep up. You know, the Ethereum one’s gone from like 10 million to 200,000 or 300,000, or a couple hundred million in the last three or four months. You know, it’s been a rocket ship. It’s a little bit complicated for a U.S. investor because they list it in Euros or Krona. So on top of dollar to bitcoins, now you’ve got to add in another currency or basket of currencies. So it’s not so black and white and easy to get exposure to. Although I find it kind of interesting because it doesn’t have the premium and discount issues. Another thing that’s been really interesting is there’s a whole subculture now of publicly traded companies that are involved in this space.
Meb: And into the extent, you mean involves in it, you mean like picks and shovels like building a hardware rigs or it’s actually they’re owning and trade…Like, what do you mean involved? So I’ve seen a handful of blockchain style ETFs filed. I think we’re up to about 16 funds that are filed. Tell me about what you think is gonna actually come out or has the potential to actually make it to market?
Michael: Yeah. I’m not waiting soon because there’s so many moving pieces there. But I’ll give you an example of kind of an involved company that probably would not be in a passive version of this. So one of the names that people have caught on to is, Hive. It’s a Canada-based company that essentially was a SPAC that took…a SPAC is a special purpose acquisition vehicle. It’s companies that kind of list with a blank check with the intent to find something to invest in.
So this SPAC became a company that owns a whole bunch of cryptocurrency mining. They literally produced Bitcoin, Ethereum, Litecoin, all those things that Meb likes to create bubbles in. So they don’t just create it and sell it, they sometimes hold it. So you’re literally buying something that has that ability. That is not a company that we got interested in. But what we did get very interested in is ironically from our TETF index.
One of the companies would keep an eye on that was very small is they publicly traded asset manager that has ETFs. It’s U.S. global down in San Antonio, Frank Holmes’s company. And, you know, they have an airline ETFs and a gold royalties ETF. So we were very adamant about being on their conference halls and understanding, even though it had a market cap that would not qualify for our index.
What we found was they had taken a pretty sizable state in Hive as a SPAC personally for the company about 10% directly and 7% indirectly through one of their hedge funds. So their 17% stake in Hive is worth substantially more than the overall market cap of their current business and well above where it’s trading. So that’s kind of a unique situation where ETF research kinda intersected with cryptocurrency or blockchain research.
Meb: And so if you had to predict, put on your SEC commissioner hat, what do you think that’d be the first funds that come out? Do you think it’ll be futures-based, just straight-up crypto funds, or do you think it’ll be something else?
Michael: I think there’s a chance for the futures-based. I think more likely, it’ll be more of the picks and axes traditional equity. I think the hardest part…I mean you’ve launched ETFs, I’ve launched ETFs, I don’t think people appreciate how good our regulators are because they put us through the wringer when you do these things. Every little word in the name, they critique, and I think they’re gonna have trouble with the terms and what they mean. They are very, very good at protecting the public. They don’t want anything to be the slightest bit misleading. And so they’re gonna be very, very strict on it. And I think that’s a good thing.
Meb: Yeah. I did. I think the one area you’ve seen some commentary on a lot of these initial coin offerings, that’s a whole another topic. But man, they seem awfully similar to security offerings to me. But we’ll see, the SEC is kinda punted on that for now, except for some a couple particularly egregious ones. All right. We got to start winding down here. Talk to me, what are some of your favorite ideas going into 2018? I know you’re not doing a lot of sort of predictive, but are there any themes, or ETFs, or ideas, or concepts that you think are worth looking into or worth doing a little more homework? You’ve already mentioned about five during the podcast, but anything else that’s particularly on your brain?
Michael: So I think there’s a lot of evidence that the next 10 years it’s very difficult to have the rates of return from traditional beta that we’ve had for the last 10 years, right? Like, the idea that the fundamental support annualized returns north of 10%, 15 % on large cap or small cap after where we are seems pretty low. I’m not as good of it, you got that stuff as you, and the west, and the other guys. But to me, if you’re going to seek out things, I’m gonna suggest seeking out high active share global growth feeds, you know? Go pull up a Pricewaterhouse or a McKinsey study that says, “Here’s what’s going to change the world, and you’ll see them.”
And a lot of that has done well this year. But what I’ve watched all years, things like robotics, you know, robo watching that PD that looks very high, watching that the ETF go up and the PD come down because the earnings just keep coming in. And I think we’re at the early innings of a lot of this stuff. Internet of Things, the electrification of cars, I mean, all of those things, I think we’re gonna move from those being fringe things to the only things you can add to a portfolio to really make a big difference. You either have to construct an entire portfolio out of traditional smart beta things, tilted index, risk factors to make a difference, or you gotta use your traditional data and add in 10%, 15%, 20% of global growth themes to actually have a return that will keep up with what you need for growth.
Meb: Yeah. It’s great advice and it makes sense. I think for so many investors, it’s hard. I mean, so many advisors listening to this, you know, you’re basically describing career risk and looking different, and having a portfolio that it’s tough for a lot of people speaking from experience as both a manager and an investor, but you have to. I mean, if you look at 60/40 portfolio and you plug in the 2% U.S. bond yields, two and a half, and by the way the U.S. bond yields are some of the higher in the developed world. You know, to get to that 8% corporate pension expected returns, you need like 12%, 14% on the equity portion to get there. And you can’t do that with a lot of the plain vanilla. So interesting, we’ll see.
By the way, by the time this comes out, we may well have had the first calendar year where every stock market month is up. What do you think about that, Venuto?
Michael: You know, I saw you tweet that out. And then I was doing a review with one of our institutional clients and I looked out at the bottom of the report where it has the upside and downside capture. And the downside capture had an N/A, which I’ve never seen before.
Meb: Yeah. It’s funny.
Michael: Because it’s been year with no downside, you know? And like I thought…I kept rerunning the Morningstar report thinking there was something wrong. And then I remembered your tweet. Yeah, like, it’s funny, but it’s…I don’t know, I’ve seen a lot of research that says, “The bull market can still go,” and I see a lot of research that says, “It can’t.” And I come back to where I start, right? Like, I don’t really care. I fail to everything from using the permanent portfolio and then taking on the fringe ideas. And, you know, I barbell my risk, and whether it’s another bull market or another fair market, I have my process and I’m quite happy with it.
Meb: And by the way, permanent portfolio for listeners, this is a decades-old investment approach that’s originally, I think, a quarter each, stocks, bonds, bills, and gold. Did you do any sort of more modern interpretation of that through stocks like a global equities as bonds carry weighted or like how do you think about a modern framework of permanent?
Michael: So I absolutely stick to the 25s, equally waiting, cash, commodities, equities, and fixed income or bonds, more on the longer duration, right? So to me, that is the permanent portfolio. Everything else is playing with it or basically attempting to get the risk parity from the permanent portfolio. The place where we look to add value is through security selection. And it’s not so much about going fringe, it’s about solving for the objective. So the objective for the equity portion is to achieve growth. So I do focus U.S. but I look for things that can add value there above and beyond just owing the total market. Maybe it’s a tilted index, or a conscious index, or something along those lines.
The one that is the most interesting to me is the commodities portion because the original pieces was 20% gold, 5% silver, but where everybody forgets in Harry’s original book is the purpose. The purpose was to protect against inflation. And that’s actually how we got the GBTC a year and a half ago. Because we took that 25% that was gold, we peeled off 1% of it, and put it in GBTC.
Meb: So many people think of the word cryptocurrencies, I think a much better description would be crypto commodities. But I haven’t really, that’s another podcast. You know, what’s interesting is when we did our “Global Asset Allocation” book, the permanent portfolio was, I think it was either the only one or one of like two that…I think it was one of two portfolios out of the 15 or 20 in the book that had positive returns in every decade.
So the 1970s were a huge disaster for almost any portfolio with the exception of permanent. And I think it is the Marc Faber, but Marc’s portfolio looked a lot like the permanent portfolio. And that’s a really interesting takeaway for a lot of people. It’s one of the most consistent equity curve lines across the board out of all the portfolios in the book. Anyway, random tidbit.
Michael: No, it’s extremely interesting. It’s just, you usually have to accept that when the market is having irrational exuberance, you’re gonna be behind. Like, because it’s not talked about as much right now, one of the worst years for the permanent portfolio ironically was 2015 because gold and bonds went down. It’s whatever two components have a bad year at the same time, and it’s rare that it happens.
But like, the beauty of the permanent portfolio, the base index of, you know, equating gold bonds, cash in STY, its return for an OE is only a negative 4.8. That’s a great building block upon which to build up an asset allocation or a portfolio. To me, if you have that kind of anchor, it’s a lot easier to take risk on global growth teams, their structural factors that can add value to a portfolio.
Meb: And you mentioned earlier that the crypto portion was kind of eating away at the gold portion. Do you just see that as something is like looking into the future as a development, you think would continue that part of this crypto world, you know, is a reasonable replacement for some of the commodity or precious metals portion?
Michael: I think the jury is still out. Most cryptocurrencies are not like Bitcoin. Bitcoin’s value theoretically is not its transaction value, but its store value because it is truly the only deflationary asset. Not only is there a finite amount of it, but we experience this thing called bit rot basically with the transactions that are occurring, we’re losing about 2% or 3% of the bitcoin in a year. Like, people are losing their private keys, so it’s actually deflationary. Could you imagine that? Like, it’s just like a guy who has like an ideal farm and he accepts bitcoin and forget that he accepted it, you know?
Meb: Oh my God, dude. I was hoping we somehow had like ten subscribers in there because it would literally be worth like $1 million. And I don’t think we do. But I got bored with it. I just took it off because it’s like no one uses this to actually pay for anything. We had it on there for a couple months. In 2013, so whatever it was trading at in 2013, but I don’t know. I need to do a little more due diligence. That’s probably worth the time to look into.
Michael: You might have a private key and go store it somewhere with, you know, three or four colleagues on it. I have a friend up in Boston who bought a pizza with…I mean, 2012. And it’s the most expensive pizza anyone’s ever bought, right?
Meb: I love that story. So you can tell that story with almost anything, whether it’s GE stock, or Uber, or anything. I love it. All right. We’re gonna start winding it down. Looking back, you’re probably the last person to answer this question. It’s our 2017 question. We got to think of something new for next year. What’s been your most memorable trade, good or bad, or investment in your career personally?
Michael: Starting my own company.
Meb: And is that a good or a bad trade?
Michael: Yeah. So I had a client when I started the company who…when I went to him, I said, “I’m starting my own company, you know, what do you think?” He’s like, “You’re a smart kid.” I think I was only 34 when I started to write, so I guess…yeah, that’s about right. And he told me, “Starting a company is like having a baby. For the first nine months, you don’t even know what it looks like, you know? And for the first five years, you’re just cleaning diapers and everything. And you know there’s joy for the future, and you’ve created something beautiful, but it takes a long time to actually, you know, go fishing with them or watch a dance recital.” So I would say that it’s been the best trade of my life, but it certainly has not been the easiest. And I’m happy to be here talking to you today enjoying it again.
Meb: Well, I tell you, man, we talk about this a lot. But if you look back in our old blog links and like half the companies are gone, and whether it’s entrepreneurs, or markets, or companies, and someone’s talking about this even the other day. You know, you think about the…a lot of people think the invincible tech companies of today, the Apples, the Googles of the world, and you look back at the last cycle of the Microsoft’s, and IBM’s of the world. And before that, it was Kodak and whatever. I mean, it’s such a big compliment to survive. It’s so hard for a money manager or an entrepreneur, so kudos and cheers to us surviving another year.
Michael: Yeah. I mean, it’s like, I remember feeling really good when I saw your press release about hitting a billion. Like, that’s just…it’s not the dollar amount, it’s the sustainability because I think this is good for the listeners, you know? Asset management is one of the few industries in the world where we’re actually aligned with the customer. What we make goes down when we do a poor job, and what we make goes up when we do a good job. We don’t try and sell you something and extract the most money out of you in exchange for the least product. That’s what every rigid seller is doing…
Meb: Well, speak for yourself, there’s plenty on Wall Street that they try to…There’s kind of two types of firms. There’s the firm’s that say, “What’s a reasonable price? Keep the lights on.” And then there’s the other type of firm which is, “How much can I possibly charge for this and get away with it?” And some of those that 2.3% S&P 500 mutual fund is in the latter category. So not everyone on Wall Street.
Michael: I agree.
Michael: Yeah. I’m just saying the business model itself is aligned. It’s a big part of why ETFs are growing is because they’re aligned with client.
Meb: You’re gonna do any fishing in Florida over the holidays?
Michael: I don’t have a plan as of yet, but I always find a golf course for the best in the lake and catch something.
Meb: Your boys are old enough to enjoy it yet?
Michael: Absolutely. My youngest, he’s obsessed. I actually took him down to Wall Street yesterday, and I got a little picture up there with the Wall Street Bowl and explaining to them the Freedom Towers and everything because I was down there at the time while I was at the NYSC at that time. So it was a great experience yesterday. My wife took my daughter to see the Rockettes. I got out of it by teaching my kids, my boys a whole bunch of stuff about Manhattan and the history.
Meb: I love Manhattan this time of year. It’s a little cognitive dissonance to be out in Los Angeles where people are wearing shorts, and going surfing, and playing volleyball. I’m not complaining, but you rarely see any snow here. Venuto, it’s been awesome, it’s been a lot of fun. Thank you. Where can people find more information on you, your companies, what you’re up to, your writing, where do they go?
Michael: So a couple things. One, torosoinv.com. It’s full of research. If you’re interested in being part of our Think Tank, just reach out to us there, we’ll get you access to the tools. There’s also a great place to sign up there for our weekly newsletter on the ETF industry. It includes a lot of these data points that Meb was talking about, you know. The launch is the ownership influence, the growth of the industry, who’s doing what, who are the players. It’s not a sales piece, it’s actual content to help you understand the industry.
On top of that, I mean, one of the thin tweak tips, I’m on Twitter constantly giving information about what’s going on in this space.
Meb: And what’s the handle?
Meb: Perfect. Well, look, we’ll add all these to the show notes. Venuto, thanks so much. It’s been a blast.
Michael: It’s been fun, my friend.
Meb: Listeners, we’ll, again, add all these links on the show notes, mebfaber.com/podcast. You can always find the archives as well. We’re approaching 100 episodes. So if you haven’t yet, leave us review, good, bad, whatever. And you can always subscribe the show on iTunes or any other podcast app. Thanks for listening, friends. Happy holidays, and good investing.