Episode #109: Matt Hougan, Bitwise Asset Management, “Anyone Who Tells You They Know What’s Going to Happen in Crypto Is Probably Lying to You”
Guest: Matt Hougan is the Global Head of Research and Development at Bitwise Asset Management Inc., creator of the world’s first cryptocurrency index fund. He was previously CEO of Inside ETFs, the world’s leading ETF education company, and before that, CEO of ETF.com which was the world’s first institutionally oriented, ETF-specific ratings and analytics service.
Date Recorded: 6/18/18 | Run-Time: 1:13:59
Summary: After a quick, fun story about Matt’s first job…as a 9-foot tall seal mascot for a minor league baseball team…Meb asks about the state of the ETF industry – where we are today, and where we’re going.
Matt tells us that ETFs have become a dominant force in investing. Since the financial crisis, some $2 trillion of capital has flowed into ETFs. In comparison, the mutual fund industry has seen $0 inflows during that time. In terms of issues that are shaping ETFs and will continue to do so over the coming years, Matt points toward fee wars, distribution networks, and the growing reality that it’s getting harder for smaller companies to get a foothold within the ETF space. Overall, Matt believes the days of fastest ETF growth are in front of us.
Referencing back to the capital flows differential between ETFs and mutual funds since 2008, Meb asks if there will there be a Netflix/Blockbuster moment when the lion’s share of assets leaves mutual funds and flows into ETFs. Matt believes the stream of asset migration will become a flood in the next bear market. He tells us the only thing that has kept mutual fund asset levels up is the bull market of the last decade. That’s created lots of embedded capital gains which many investors haven’t wanted to realize. Yet when a bear market finally hits… Matt believes we’ll see accelerated flows out of mutual funds when we suffer our next 20% market drop.
Next, Meb brings up something which Matt has tracked for since 2008 – the world’s lowest cost ETF portfolio. He started by taking the lowest-cost ETFs representing six major global asset classes. He was curious how much it would cost in order to get full global exposure. In 2008, the combined, blended fee to own the world was 16 basis points. Today, it’s down to just five basis points. Matt and Meb agree this is a great time to be an investor.
This bleeds into a discussion of direct index investing, which, Matt tell us, might be the next evolution of investing beyond ETFs. If you’re less familiar with direct index investing, it’s a way to own indexes, yet without paying a fund management fee, while enjoying the potential benefits of tax loss harvesting. This leads to an interesting discussion about implementing direct investing via robos, as well as the tradeoff between tracking risk and the potential for tax alpha.
The guys touch on a few more ETF ideas – broad concerns about the ETF market, active versus passive ETFs, and the use of artificial intelligence in replacing discretionary managers – but it’s not long before Meb switches the conversation to crypto. Though ETFs are Matt’s first love, he’s long been interested in cryptocurrencies, so he was excited at the chance to join Bitwise, creator of the first currency index. Giving us an overview of the crypto world, Matt tells us “an index-based approach is the only sensible approach to the crypto market, because anyone who tells you they know what’s going to happen in crypto is probably lying to you.”
At Meb’s request, Matt then describes how to put together a crypto index. Matt tells us the goal is to capture the broad-base crypto market. There are 1,500 cryptos out there, but most of the market cap is concentrated in the top 10-15 currencies. There are many challenges to creating an index, including such basics as “how many Bitcoin are there?” (Do you the current number, or what the number will be x years in the future?) Matt goes into interesting detail for us.
What follows is a great conversation for any listener curious to learn more about the crypto world. You’ll hear about Matt’s ideas for other crypto indexes and ways to approach the market… how Meb got in hot water with crypto investors… what the future may be for crypto and its related technologies… the growing institutional interest… when we’ll see a crypto ETF… where crypto fits into a traditional asset allocation… the impact of government regulation… and why cryptos won’t go the way of the tulip bulb.
Finally, you’ll hear Matt’s answer to “if you had to buy one crypto and not touch it for 10 years, what would it be?” And of course, there’s Matt’s most memorable trade. This one lost him about 90%.
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Links from the Episode:
- 2:20 – Matt’s first job
- 6:01 – The story of ETF.com
- 8:12 – Broad overview of the ETF space
- 11:11 – When will ETF investing actually overtake mutual funds?
- 11:53 – Research Affiliates work on ETFs
- 13:49 – “World’s Lowest Cost ETF Portfolio” – Hougan
- 17:05 – Direct indexing
- 19:48 – How do people access direct indexing products?
- 24:33 – Are there legit concerns when it comes to ETFs?
- 29:35 – Matt’s work with EquBot
- 32:29 – Access to data is one thing, but how it’s analyzed will make the difference moving forward
- 34:26 – Unscaled: How AI and a New Generation of Upstarts Are Creating the Economy of the Future – Taneja
- 35:03 – Ric Edelman Podcast Episode
- 35:15 – Matt’s shift into the crypto space
- 38:15 – Putting together a crypto index
- 42:45 – Qualitative filters
- 45:04 – Any factors they are considering for analyzing currency value?
- 47:50 – The next few years of crypto currencies
- 51:52 – The challenges for big banks getting into the space
- 53:44 – Opportunities in crypto futures
- 55:39 – Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings – SEC
- 57:19 – Where does crypto fit into a traditional asset allocation?
- 1:00:02 – What are the long-term drivers of value in crypto?
- 1:04:27 – Demographic trends in crypto trading
- 1:06:16 – Impact of government regulation on the space
- 1:08:20 – One crypto to own for the next 10 years without selling?
- 1:09:39 – Most memorable investment?
- 1:11:40 – Jimmy Kimmel and Ted Cruz 1-on-1 basketball game
- 1:12:40 – Follow Matt at Bitwise Investments for their free research series, @matt_hougan
Transcript of Episode 109:
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. After a short European podcast break, I’m glad you guys missed this. We had a couple people email in and said, “Where are you? Did you miss an episode?” We’re back the day after Father’s Day. We have a great show for you with an ETF and crypto expert, the rare duo expert on crypto and ETFs. Previously, he was CEO of Inside ETFs, if you ever been to the most famous ETF conference in the world, as well as etf.com, my favorite maker of pens. I just traveled Europe with an etf.com pen. But he recently left the ETF world to join Bitwise Asset Management, which is the management of the first cryptocurrency index fund. We’re thrilled to have him on the show. Welcome Matt Hougan.
Matt: Thanks for having me, Meb. Excited to be here. And those are classic four colour pens. I’m glad you brought those up.
Meb: You know, I missed the conference for the first time in probably 10 years this year, largely because last time we went, we got positioned, our booth, directly next to the Janus gong. And it took me a year to recover. Not a gong, what are you…like a strongman carnival thing. What are those called?
Meb: Anyway. So I was unable to restock. The reason the etf.com pens are so great, listeners, is if you remember from my childhood, I assume they still have them, but they have the four colour clickers on the top. So really, you have four pens in one. Anyway, I need to bulk up on them. Anyway, Matt, so we got a lot to talk about today. But I figured before we get into the ETF, some crypto, I remember hanging out with you in a little hillside or cliffside restaurant somewhere in Spain. And I think I was drinking a lot of wine. But I remember you having…if we go back for origin stories, one of my favorite all-time first jobs. Maybe we could start there and then kind of progress with your career. But you wanna tell the listeners what your first job was?
Matt: Sure. That’s quite a setup. Yeah. My first real job out of college was as a nine-foot tall seal. I was slug of the Sea Dogs for the Double-A Portland Sea Dogs. At the time, they were affiliate of the Florida Marlins. They’re now an affiliate of the Red Sox. And my job was essentially to dance the YMCA dance in a seal costume at the opening of car dealerships or local neighborhood parades. I did manage to play once in a celebrity basketball tournament, dressed up as a nine-foot tall seal with slippers which was quite an experience. But yeah, that was where I cut my teeth as a career serving, as a minor-league baseball mascot.
Meb: Well, the good news for you is that probably existed pre-online video where you…if you did that this day and age, you would definitely be on the internet somewhere. But talk to me a little bit, like a nine-foot tall seal, you’re certainly not nine-feet tall. How does that actually work? Is all the material up above you and some sort of scaffolding structure? Like, what’s the process in getting one of those?
Matt: It’s a great question. The answer is, so you have a body and a head, and you look out essentially the mouth. And so you have, like, a two and a half, it’s about two feet of extra head because the head, of course, is inflated like the size of a balloon. And then you have a baseball cap on top. But you actually stop at about, you know, at my height, six feet. So I’m looking out the mouth at six feet. And then you have this extra head on top of you. The head is an important thing because if you don’t know much about mascot and culture, the one original fit in mascot because if you lose your head, because then it ruins the spell that’s cast over children. They realize it’s just some skinny college graduate in there and not actually a nine-foot seal. But you always wanna make sure you have your head on.
One of the risk I endured at my basketball game where there was this mean mascot who was a pirate for the local hockey team. And he tried to rip my head off, which is just beyond the pale on the mascoting community. We almost came to blows on the floor. But luckily, I was able to keep the head on, and my team won the game. So it ended up being a good night.
Meb: Good for you. Is that something you even like apply or try out for? Do they have tryouts for the mascot or do you have to kind of…?
Matt: I had an inside edge. My wife worked, who was my girlfriend at the time, worked at the baseball team. They needed another mascot. I was extremely poor at the time. It paid $50 dollars an hour, which I thought was more money than I would ever make doing anything. So I just went in and did it. Now, I should say for clarity, I was the backup mascot. I wasn’t the on-field mascot. I was the mascot at the celebrity events around the community. So I never actually got to be on the field. I wasn’t at the top of the mascoting game. I was in the minor leagues of minor-league baseball mascoting.
Meb: Well, 50 bucks an hour, dude, that annualizes to like 100 grand. I mean, that’s a primo job. I know a lot of my unemployed sorta entertainment friends in LA probably die for that. Too bad we don’t have any local LA minor league teams here.
Matt: It’s a coveted job. It took quite a few years to get me back to that salary rate.
Meb: Yeah. All right. Well, fast forward, you eventually ended up in the ETF world. I don’t know that I know the origin story there either about either the founding or joining of what at the time, what was the precursor at etf.com? Tell us a little bit about that. I think you joined pre-financial crisis, right? But maybe give us the lead in.
Matt: Oh, yeah, yeah, yeah, IndexUniverse.
Meb: Oh, yeah, that’s right. That’s right.
Matt: Yeah. My 60-second career path was…the mascoting gig was a seasonal gig, and so it got to be winner. And I was even poorer than I was before. I read an article from active mutual fund that was actually the first transparent mutual fund run by our mutual friend, Dave Nadig. And it was written up in Barron’s. I thought it was a great idea, so I wrote a letter suggesting they hire me, despite my career background as a mascot. Dave, too, his eternal credit did, that got me into the financial industry. We ran that fund. For a couple years, it shutdown. I bounced around in a few different jobs.
And then I was living on the Coast of Maine in a little cabin on the water. And there weren’t many jobs in the Coast of Maine. And so I got a connection to a company called IndexUniverse which was founded by Jim Wiandt. Jim lived in San Sebastián, Spain. He was running the Journal of Indexes, a sort of quasi academic magazine about index investing, and had a website that accompanied that. And he needed a freelance writer, and he hired me to write a couple of articles. I think I wrote my first article on the Consumer Price Index and hedonic regression. And we just grew from there. We grew from two people until we peaked at about 76. I moved up the chain from freelance writer and eventually became CEO. And then we sold the business in 2015. It was a huge amount of fund.
Meb: That’s awesome. Wow, what a fun story. All the people you named, Dave and Jim, you know, if we had to ask, and we’ve had a couple of these guys on the podcast already, but, you know, that the four people that are my first go-to to ask anything about ETFs, it’s Matt as well as Dave and a couple other friends. Maybe Bal Kunis [SP] and Venuto. But that’s probably the list. So I don’t know, and many people don’t know more about ETF. So why don’t we talk a little bit about that because you’ve seen, not the full history because first ETFs in the U.S. I think late 90s would have been spider, I think. But you’ve seen the big growth spectrum. So maybe give us a broad overview where you kinda has seen the space, where do you think it’s going in the next decade in terms of growth, fee, whatever you wanna talk about? Just kinda your general 10,000-foot view of where you see things today.
Matt: Sure, yeah. I mean, I think this is in some ways the most exciting time for ETFs in the history of ETFs. And on the flipside, a lot of the early interesting work has already been done. So I think where we’re at today, ETFs are the dominant way that people get exposure to the market. There’s that recent financial planning survey where I think it was 87% of advisors said ETFs were their primary way of getting exposure to the market, which was higher than any other asset category. So they have become the dominant, and essentially, the only way people gain exposure. I was updating my slides for an ETF 101 presentation the other day and saw since the financial crisis, there’s been $2 trillion of inflows into ETFs. There’s actually been negative flows out of traditional mutual funds.
So ETFs have won, and that is going to stay true at least into the point until direct indexing becomes a big deal, so we can talk about down the line. So, you know, when you think about what’s going on in the ETF market right now, and the reason, maybe it’s not a day to day exciting as it was a couple years ago, even though there is more growth, it’s really become about a couple of big things, right? So one, the worse in every ingle instance that I can think of where a company has cut the fee on its ETF. It’s gone on to grab market share. That seems to be accelerating some of the data on that from this year is just incredible. Distribution seems to be another major driver. Any firm with significant distribution, it seems to be able to create raised assets among ETF. And then it’s become really hard on the other side of the scale for smaller companies to get much of a foothold. It’s no longer they build it and they will come industry to build it, market it, and sell it, and they may come particularly if it’s extraordinarily low cost.
So I think we will see the fastest days of growth of ETFs ahead of us. Everyone now understands what they are, how they work, how they trade, liquidity is better than it’s ever been before, the products are better than they’ve ever been before, the exposures are available to essentially every asset class in the world. So I think growth will accelerate, but I do think it’s going to be concentrated mostly in the big names, mostly in the lowest-cost products and we’re just gonna see fees continue to march down towards zero in the months and years to come.
Meb: All right. So there’s a couple things I’d like to unpack that you talked about here. Let’s start with the first one. You mentioned ETFs have won. But I think some cynics that would be listening to this say, “Well, Matt and Meb, that’s silly. Mutual funds have, I don’t know, let’s call it four times, five times the assets as the ETF space.” You know, I spend a lot of time thinking about this because you mentioned that the flows you said since 2007, $2 trillion versus $0 for mutual funds, which is astonishing. But is there gonna be like a Netflix blockbuster moment where all of a sudden, the money just whooshes out of mutual funds?
And I did a tweet the other day where I said…it was retweet of some research affiliates work where it mentions that mutual funds have about a 80 basis point disadvantage on taxes. Not even ignoring the cost, which is double ETFs on average, but taxes is another 80 basis points. Is this just gonna play out over 10, 20 years as a generational transfer? How does this actually play out, or do you think it, all of a sudden, this stream becomes a flood?
Matt: Yeah, I think it will become a flood. And I think it’ll become a flood in the next significant bear market. If you look at the mutual fund industry more broadly, as I said, zero inflows for the past decade, that’s despites thousands of people out there selling millions of dollars in marketing messages. And the best they’ve been able to do as an industry over 10 years is shred water. That is a remarkable example of non-accomplishment for all those people out there trying to sell traditional mutual funds. And I think the only thing that kept the asset levels up has been this enormous bull market that we’ve been in for the past 10 years. That’s also made some of those assets captive because of the embedded tax gains that are built into those positions. People don’t have a way to sell and transfer into lower cost ETFs without realizing capital gains.
So I think as soon as we see a major bear market, and this has been the case in every bear market over the past 15 years, you see a flood of assets move into lower cost ETFs, which is funny because a lot of active managers out there are saying, “Index is a bull market investment. And in the next bear market, active managers are gonna win.” History, data, common sense, and experience would suggest that that’s not true. So I do think you might have that blockbuster moment. And I think it’ll come about the time that you have a 20% pullback in the market.
Meb: Good. I’m cheering for it then now. That sounds great to me as ETF issuer. You have one of my favorite articles that you publish. I don’t know if it’s annually, quarterly, or just whenever someone updates their funds, and you’ve been doing it for probably years now. But you call it the world’s lowest cost ETF portfolio. And I don’t know how long you’ve been doing this, but I remember for a while. But maybe talk about that portfolio and how low costs are we down to these days.
Matt: Yeah, it’s been amazing. I launched that portfolio in 2008. And the idea was to take the sixth lowest cost or the lowest cost ETF in each of six major asset categories, U.S. stocks, international stocks, emerging market stocks, REITs, bonds, and broad-based commodities. And the rule is you had to get essentially full exposure to the total market in those categories and then you picked the single lowest cost ETF. And when I launched it in 2008, it cost 16 basis points a year on average, and you had some very cheap U.S. equity exposure, and then you had commodity exposure, which cost 75 basis points at the time. I thought that was amazing because for 16 basis points as a combined fee, you got exposure to thousands of stocks, and well over a thousand bonds, every major commodity, 40 different countries, dozens of currencies. It was sort of the portfolio a smaller mid-sized institution would die for, and you can get it for 16 basis points.
But that fee has come down from 16 basis points to today, it’s 5 basis points. So the blended fee on the portfolio to own essentially the world’s capital markets across stocks, bonds, and commodities is five basis points a year, which is the same as free. And I think it says two things. You know, one, it’s a way of showcasing even in the cheapest part of the market, how extreme the fee pressure has been. It’s gone from 16 basis points to 5 when 16 basis points was already an incredible deal. And on the other hand, it just shows you that basic allocation to global capital markets, which as we know, will tend outperform the majority of active managers is a commodity asset and is essentially free. It’s the greatest deal in the history of finance, and I think it’s a baseline portfolio for most investors, and to the extent that you deviate away from something like this extreme low-cost exposure, you have to do so with very careful bets with high active share bets with barbells of your portfolio, but it is an amazing statistic that you can get that kind of exposure that cheap.
Meb: Yeah, we’ve been saying for quite a while that…and I feel like you and I are probably in the minority here where, you know, I think almost the entire beta so that the buy-and-hold market cap weighted for sure side of the world is essentially converges on zero, and then you have this concentrated whatever alpha seeking that could potentially charge higher fees. And I think the base case sorta belief on the mutual funds being screwed is actually way understated, it’s where the things you mentioned before are not only being really expensive, but also being really tax inefficient even in comparison to ETFs is understated So it’s an awesome time to be an investor, but I think you can see a lot of big changes in the next 10 years. You mentioned direct indexing, maybe explain what that is to investors and what your thoughts are there?
Matt: Yeah, I love direct indexing. And it’s a great question. So let’s take the S&P 500. So the way most of us buy the S&P 500 these days is to buy an ETF like SPY, or IVV, or VOO from State Street, iShares, and Vanguard respectively. And that one fund takes care of the problem of investing in all 500 stocks in the S&P 500 for you. An alternate to that is what’s called direct indexing. And direct indexing, you essentially have your own account, an SMA, a separately managed account. And that account, instead of buying a fund, it directly invests in the companies that make up the S&P 500. And there are two advantages to that. The one is minimal, which is that you don’t have to pay a management fee like you do with those S&P 500 funds.
The other one has to do with tax loss harvesting. So when you buy an ETF, it does a great job in that most ETFs never pay capital gains distributions, at least equity ETFs. But it doesn’t actively harvest losses for you that you can use to offset other parts of your portfolio. But if you invest in a direct index that’s investing in the S&P 500, you have a chance to do some tax loss harvesting by swapping out positions. Maybe you only have Ford and you swap in to GM. If Ford is at a loss, then you swap back out when you want to go back into Ford. So you can optimize the portfolio and generate meaningful tax alpha if you will or deferred taxation by doing direct indexing. It also allows you to do things like customize your portfolio for social screens. If you don’t want to own guns, you can own the S&P 500 except for gun companies.
And when people talk to me about what could replace the ETF, because people, you know, to assume that the ETF is at the end of history is foolishness. So what could replace the ETF? At least in equities and at least in taxable accounts, I think the answer could be direct indexing. We’ve seen an enormous reduction in the costs of custody, and an enormous increase in the ability to do fractional share custody which you need to do because you might not buy a full share of Apple if you were direct indexing the S&P. So it’s now become possible. And I think because of the tax advantages it has, at least in taxable accounts, I think over the next 5 to 10 years, that could be a major new thing that develops in the market.
Meb: So the question there I think the listeners would ask, one is, is anyone doing it? How do we access it? Because the reluctance I think of a lot of people would say, “Okay. Well, some of the typical digital advisor, Robo-advisors doing it, but the problem is you also have to go now pay a 25 basis point fee. So I’d rather just go buy Spider at 3 basis points than pay 25, and get this potential benefit. Do you see brokerages starting to do this eventually, or what do you see the evolution of this sort of concept being? And one other comment I’ll make too is that the prospect of a lot of ETFs doing short lending for you and returning that revenue to the consumers. So maybe talk a little bit about kind of how this eventually plays out? Is it the brokerages doing it? Are you paying someone to do it? Do you have to do it on your own?
Matt: Yeah, that’s a great question. And I would say, you know, I’m not sure that this will be a thing. I just think it might be a thing. So right now as you mentioned, it’s mostly Robo-advisors doing it for folks. So at Wealthfront, you can have direct index exposure to U.S. equities. There firms like Appirio and Parametric that do it for financial advisors. The killer app to me is that social screening element. There’s a firm called justETF, which allows you to create a custom screen of your own personal values rather than buying an off-the-shelf ESG product. I think those are usually interesting.
I think the brokerages could end up offering this as a service, right? Similar to what we’ve seen already in places like Folio and Motif, but I think if a brokerage could offer you S&P like exposure, but screen for your own personal values with no fees, that would be interesting. The trade-off you’re making really is that you take some tracking risk against the index. In other words, if the S&P is up 10%, direct indexed exposure might be up between 9% and 11%. And so that’s a risk that you’re taking. And the payoff that you get for that is the potential tax alpha, right? So my Wealthfront account harvest this thousands of dollars of losses every year. And I think that’s interesting to people with taxable gains in other parts of their portfolio.
Now, what you said is absolutely true. With a traditional ETF, they can do share lending. And oftentimes, that share lending activity will actually raise more money for the fund than the expense ratio. So you mentioned earlier that expense ratios are going to zero. For many ETFs, the realized expense is actually less than zero. You’re getting paid to own that ETF, but you’re not getting the tax alpha, which is why I said that I think the place that this will apply is in taxable accounts where harvesting tax gains matters and only within equity because the bottom market is not liquid enough to allow it.
So yeah, if I imagine out 5 or 10 years, can I imagine Schwab or maybe more likely Robin Hood offering you the chance to get exposure to the S&P 500 for free with your own value screens and harvesting tax losses? Do I think that could be a multi-billion or trillion dollar market? I think it could be. I don’t think there’s any guarantee, but I think it’s an interesting thing for people to keep themselves abreast up.
Meb: Interesting. Yeah. I mean, I wonder to what extent your five basis point portfolio is already free at this point. I mean, I wonder how much short lending those funds if that’s already a negative expense ratio sort of portfolio. I’d wager it probably is.
Matt: Yeah, I think it probably is. I actually haven’t looked recently. I remember looking a few years ago and it was close, particularly for something like emerging markets where the expense ratio has come down to 10 basis points and the share lending revenue is often more than that, you’re getting free exposure. I think, you know, if it’s not today, it’ll be sometime in the next year or two where the realized expense ratio of the world’s cheapest portfolio is absolutely zero.
Meb: I love the digital offerings. And we’ve been commenting on these for a long time, and having used one myself as well as offering them to clients, I don’t see a future world where almost everyone doesn’t use some form of automated investing programs. The only challenge I think with the direct indexing is you’re kinda potentially taking a step forward and two back in the complication where…I remember talking to some friends that have some direct indexing sort of portfolios at various places, and they’re like, “Oh my God, I have to submit these taxes and I have, like, 200 transactions,” you know, or whatever it may be. So there’s that fine balance between just in a world where everything is almost free. I think Cliff Asness was talking about this where, you know, some ETF provider is like, they went from eight to four basis points or something like that. And they’re like, “We’re beating the competitors by 50% lower fees,” and you’re like, “All right. Well, you’re really just four basis points. It’s not that big of a deal.” And both are pretty awesome.
Matt: Totally agree.
Meb: So, you know, a lot of people you talk to the media, listen to media, you know, they have a lot of concerns about ETFs. And, you know, they say everything is not roses and sunshine, but there’s a lot of worries people talk about. So is there anything, you know, like the traditional, or do you have any concerns, one, and two, any of these questions about liquidity, in trading costs, and market structure that kind of get bandied about in the media? Anything that you think is a legit concern, and anything you think are totally just nonsense?
Matt: Yeah. Mostly, I think it’s nonsense. My biggest concern with ETS continues to be the fact that people can get exposure to complex areas of the market without necessarily understanding them. I continue to not…I’m not able to line up in my head why you have to sign an agreement saying you understand leverage and options before you can use those at a brokerage, but you don’t have to sign an agreement to buy an ETF on exchange that uses leverage or options. So I think there is still risk that people buy ETFs that they don’t understand particularly for the more complex areas of the market.
The other risks that get bandied about strike me as somewhere between unlikely and absurd. So the risk that people talk about, like the issues with liquidity in the fixed income space are on the absurd side of the spectrum. People get spooked by the idea that you can trade say junk bonds at tighter spreads than in ETFs, and exist in the underlying junk bonds. And they worry about those ETFs trading to a discount in the time of bond market trouble. But that argument doesn’t hold up under any sort of inspection because the alternate to that is the mutual fund structure where the mutual fund has to redeem at NAV, which the ETF is showing is overstated. And we know that that’s a legitimate risk in the market because we’ve seen what’s happened with mutual funds like Third Avenue during the meltdown. So those strike me as just on the absurd side of the spectrum.
The other side of the spectrum, the big argument we’ve been hearing a lot is that there’s too much money in indexed assets and that the economy is becoming inefficient because capital isn’t being allocated properly. And that honestly strikes me mostly as active managers whining. And there doesn’t seem to be any basis in fact. I think the papers that have been put out around airline pricing and things like that are not especially convincing. So I haven’t seen any major argument that’s made me worry about ETFs. I don’t know. Have you?
Meb: You know, most of the stuff, I just shake my head because it’s so nonsensical. I agree with pretty much everything you said. I believe that they should almost create two different categories for the funds and say, “Look, the plain vanilla ETFs are called ETFs. And these triple leveraged or these weird VIX products or whatever.” Just come up with a different name for them, you know, where…just be almost easily be like there’s a…this is the PGE world and this is the triple X-rated because, you know, lumping them all together as one kind of concept gives the PGE stuff a bad name.
And then, of course, there’s…look, people always talk about liquidity and when I say, “Man, ETFs are one fifth the assets of mutual fund still.” So are there pockets of if you’re investing in Small-Cap Greek ETF, which doesn’t exist, but if it did, could there be liquidity issues if someone put $20 billion in that fund? Probably. But in reality, the world’s become so much more complicated. Don’t even get me started on the index. Index meant something 30 years ago whereas now, you can create index for anything in the world you want. And we’ve seen that. So the whole kinda…I think it’s just very lazy thinking for most of the reporters, but a lot of it’s good headline. So anyway, we’re on the same side.
Matt: Yeah, yeah. And it’s been a recurring theme. It seems to pop up, you know, every three years or so. So I’m sure there’ll be another wave of recriminations in 2020. I mean, I can remember a handful of years back. There was a massive report from the Kauffman Foundation about how ETFs were destroying entrepreneurship in America. And a few years before that, there was a big scare around on fund. So it does seem people always try to poke holes at things that are going fast. But for the most part, I think it’s been a massive unmitigated good for society.
Meb: You know, it’s funny. I used to joke here in the shop, I didn’t say it loud enough publicly because I didn’t want them to take my advice. But I said, how dumb was the mutual fund lobby to kind of “allow the ETF structure to really get a foothold and grow the way that it has?” I said. They should have spent billions of dollars kind of campaigning Washington to either give mutual funds equal footing on the tax treatment structure or certainly to try to stop it. But thank the world and all the investors that it didn’t.
Okay. So let’s sort of transition a little bit. We’re gonna make one little pond jump before the cannonball into the crypto pool. But you’re also, I don’t know, this little side gig, but you’re on the board at a shop called EquBot. If you read the website, it talks about it being utilizing artificial intelligence to replace the portfolio manager, to process more market data, and generate unbiased investment decisions given a set of investment criteria. How’d you end up working with these guys? Is this kind of the next future of investing? Maybe talk a little bit about that and then we’ll segue on to our final topics.
Matt: Yeah, sure, absolutely. Yeah. You know, I’m just trying to skate to where the pack is going. I find the application of artificial intelligence into the active managed industry extremely exciting when you learn about what companies like EquBot are doing on a daily basis, and the sheer volume of data that they’re processing, and the sheer number of financial models that they’re applying to that, and the sheer computing power that they’re throwing at the problem of predictive pricing and where to allocate portfolios. It’s hard not to look out at the rest of the traditional active management industry and just feel bad for them. You know, it’s dead man walking out there.
So EquBot, not alone but they’re pulling all available 10-K, 10-Q market forecasts, GDP, etc., data, they’re running lots of predictive models on it, they’re looking at a million news articles and tweets a day. They’re combining it all to make a portfolio that has similar risks to the S&P 500, and hopefully, the potential to outperform it, and the return since the funds have launched have been good. But, you know, from my mind, I think every active manager to the extent that they survive is going to adopt AI and machine learning as the core of their process. And the question of who wins in that space and who captures whatever available alpha there is to artificial intelligence for however long that persists is going to be the one that asks the best questions of those machines and runs the best processes. But it is going to be the core of how active management is done. There’s absolutely no question.
There is no way for humans to keep up with the pace of volume of data out there. Right? There is–I think the stat is 90% of all data has been created in the past two years. You just can’t be a traditional analyst and not have an AI backbone and succeed in the world. So by being on the board, I get to see, you know, how they do it, what they’re doing, I find it all enormously exciting. I think the space is going to evolve quickly, and I think it’s going to be, as I said, the dominant way that people chase alpha in the market. And I think there’s a chance that there is capturable alpha available to AI right now that may persist for a number of years before efficiency squeeze it out of the market if that happens.
Meb: You know, it’s fun to watch because if you go back say 10 years, 15 years even, and kind of apply the lens of thinking about portfolios of equities in the U.S. and talk about these multi-factor ideas and you would pull up say a fund that AQR managed or LSV, one of these top quant shops and you would type it into Yahoo Finance at the time. I don’t even know they exist anymore, which is another huge whiff. That used to be the kind of just the go-to financial side. Type it in. You could see the holdings and they would be like a dozen other quant shops would own the same stock.
So kind of the concept being, you know, everyone had this sort of same data set, everyone had the same PhDs, and the CRIS data, and FactSet, and all that good stuff so they all kind of arrived at the same conclusions, it’ll be fun to watch to see kind of what other unique data sets or different ways of massaging the data will be on some of these concepts to see how you distinguish yourself from other competitors. Because in a world where everyone kind of had the same data before, you didn’t really have that separation. So it’ll be fun to see on what the next step is. I’m a curious watcher. I don’t know if, you know, Jeff was saying over here that, does more data necessarily mean better? And I think the approach that seemed of you talking about, which is actually it’s how you analyze it.
Matt: Yeah, that’s right. You have to ask sort of the straight run brute-force search for correlations with massive amounts of data. It doesn’t work because it doesn’t lead you to good conclusions. But if you have rational sort of entry points, you take a sort of Bayesian approach to it, then ask good questions and run good models, I think it can give you interesting answers. And one of the fun things about the market today, which has been, you know, there are books about this, I was reading a recent book called “Unscaled” about this. The way, you know, cloud computing and access to resources is now, even small companies, can gain massive scalable advantages and tap into massive computing power in a way they haven’t before.
But I think it’s gonna be really exciting. I think there will be a search for unique data sets. I think that’s obviously a giant and growing market. They’re interesting companies out there doing it. But I think it’ll be really fun to watch because I think this transformation is going to happen very, very fast. I would not wanna be a traditional qualitative stock analyst in today’s day and age. I think their days are numbered.
Meb: We had Rick Adelman on the podcast and we talked about the concept of jobs that are future-proof. And there’s certainly a lot in our financial world that are probably not gonna exist in 10, 20 years. All right. So we just spent 20 minutes, 30 minutes talking about how ETFs are the best thing since sliced bread. They’re gonna continue their 25% growth rate. They’ve been on for the past decade. They’re gonna dominate mutual funds, take all the trillions and assets. And seems like we’re in like the third inning of this game. But all of a sudden, you hear the tires screech, and Matt, for the longest time, you were kind of the ETF guy. But you decided to make a little switch. So talk to us a little bit about, you know, your kind of career path where you decided to maybe see a different opportunity in this, you know, kind of growing crypto world. Tell us about it.
Matt: So ETFs are, you know, my first love and I’m still heavily involved. I’m still the chairman of Inside ETFs, still designing agendas, still writing about ETFs, still staying up to speed. But, you know, we went through this process and we sold etf.com. And I went worked with Inside ETFs for a while. And I was looking, you know, kind of for my next thing to do. And one of the things I loved about the ETF industry and one of the things I loved doing in it was educating people about this asset class that they or this tool that they didn’t understand, that they had fundamental doubts about, that they didn’t have a matrix for how to evaluate or consider them. And, you know, I spent 10 years at etf.com doing that through webinars, conferences, writing, we built the first sort of institutional ETF analytics tool, we built an ETF rating system, an ETF classification system. And that was really fun and intellectually engaging.
And so as I started to think about what I wanted to do next, I started to look at other areas of the market where I thought there were potentially generationally important transformations taking place, and where the quality of information, and education, and analytic tools were not up to par, and where I thought I could add value. And crypto had interested me for a while. We had the Winklevoss twins speaking down at Inside ETFs. I think it was three or four years ago, Kathleen Moriarty who is the lawyer on Spider and the original lawyer on the first Bitcoin ETF filing is a good friend, and we had talked about crypto a lot. The idea of a decentralized store of value appeals to me on a philosophical level. And I ran into this company called Bitwise.
I was actually introduced to them by a former ETF analyst of mine, Spencer Bogart, who’s now a partner at a major VC firm in the crypto space. And it was, I learned, had created the first cryptocurrency index fund. And that just automatically appealed to me for two reasons. One, because crypto is a place where the quality of education content, and analytical tools, and valuation models is really poor, and a lot of work needs to be done institutionalized in the space and I thought I could help. And two, because an index-based approach is the only sensible approach to the crypto market, because anyone who tells you they know what’s going to happen in crypto is probably lying to you, and what most people sense and want to invest in is the idea that the crypto market in general will be more valuable in the future than it is today.
And if that’s your thesis, an index fund is the only way to guarantee that you’ll be rewarded if that thesis is right. So I really admired the team. I was intellectually excited by the opportunity that the research challenges offered. And I jumped at the chance to join them. And I’ve been here for a handful of months now, working on to reframe what I think will be the best indexes in the crypto space, the best way to get exposure to various parts of the crypto market. And it’s been hugely interesting and a lot of fun.
Meb: It’s certainly been an exciting time. Maybe as a framework to kinda start talking about a few different ideas, maybe describe…you know, you mentioned this kinda…I assume the first index was market cap-weighted. But you alluded too that there might be other indexes as well. Maybe talk about kinda the approach to put together a fund. You know, most of the listeners probably say, “I wouldn’t know the first thing if I wanted to go out and put together a fund of crypto investments. How would I even begin?” So talk about kinda how you guys do it. I know the news flow is always talking about exchanges getting hacked, and, you know, ways to store, and tax rate, all these things. Talk a little bit about kind of the concept of the fund and how that works.
Matt: First of all, I’ll talk about the index, and then I’ll talk about how we run the fund, and how they intersect. So the goal of the index is to capture the broad-based crypto market. So what some people don’t know, because they maybe only have heard of Bitcoin and Ethereum, is that there are 1,500 cryptocurrencies out there. The majority of the market cap is concentrated in the top 10 to 15, and the rest of the projects are highly speculative and they’re liquid. So the question is, how do you properly capture the top 10 or 15 cryptocurrencies and get broad-based exposure to the market?
Now, in the equity market, we all agree on how an index should be constructed. We all agree on what the price of IBM is, we all agree on what its market cap is, and we all agree, you know, how to do free float adjustments to take out of calculation shares that are held by treasuries, or governments, etc. In the crypto market, we don’t agree on any of that. We don’t agree on what the price of Bitcoin is, we don’t agree on whether we should use the number of Bitcoin that exists today, or the number of Bitcoin that will exist in five years, or the number of Bitcoin that will exist in 2050 because on it’s a planned inflation schedule, we don’t agree on things like what is free-floating crypto.
So the first step in generating a good index fund is to generate an institutional grade index. That means figuring out how you combine prices from 20 plus different exchanges that are trading in multiple currencies to arrive at the real-time price of each crypto asset. It involves calculating the forecasted inflation of each crypto asset so you can get a fair representation of its market cap. And then it involves putting in place rules that get to some other things like you spoke about exchanges being hacked, etc. So we have rules like a currency can’t just trade on one exchange because if that exchange is hacked, they will have nowhere for the liquidity to go. So it must trade on multiple exchanges.
We have rules about what counts as a recognized exchange so that you don’t include exchanges that are, you know, maybe under probe, or under investigation, or not in a regulated entity, or at risk. So you need some crypto native hacks to make the index robust. And once you do that, you come up with a list. It’s not actually the list of the 10 largest coins you would see on most coin counters, it’s sort of a more sophisticated institutional list. And then once you do that, you have to actually run the fund. And there, things are challenging again. So you have to do things like hold your coins in cold storage, which is to say figure out a way to take a code off of the internet and get it onto a computer that’s never been connected to the internet without any sort of malware or software hacks coming along for the ride. So you need deep software expertise. You need to find a custodian who will handle it. And then you need to run the fund and rebalance it regularly. So we created the category. We’ve created the first cryptocurrency index fund. It’s been up and running since November of last year. All assets are held in cold storage and the funds have been growing nicely. It’s an exciting product to be a part of.
Meb: And so you talked a little bit about this isn’t quantitative process and there’s been a lot of discussion over certain types of coins that may or may not be legitimate. I remember there was a parity coin named after internet meme. I think it was a Shiba dog where it got to like a billion of market cap. And the founder said, he was like…he said something about the cryptocurrency space that a currency with a dog on it which hasn’t released a software update in two years is valued at $1 billion dollars. So do you guys offer any sorta…I mean, do you apply any sorta subjective overlay where you’re like…and by the way, this may be a coin in your index, I have no idea, where you’re like, “You know, this coin is just garbage or this one is totally nonsensical.” Is that is that process…like, 1,500 coins, I mean, that’s gotta be pretty consistent ongoing process, right?
Matt: It is an ongoing process. So we have a couple of rules in place like that. You now, it has to trade in multiple recognized exchanges. Most of those exchanges have rules that limit the number of those crazier coins. We have unique sort of extraordinary circumstance rules, or if a coin is an obvious scam or an obvious joke, it can’t make it into the index. So there is a sort of extraordinary measures element to it and there’s some rules that try to mainstream it. But one interesting thing about the crypto market is that projects can go from obscurity and even sort of with the community not thinking much of them to being massively important. So the second largest coin that exists today is called Ethereum. And Ethereum is the smart contract platform for the crypto economy. Smart contracts are sort of auto-executing legal contracts that take place on the blockchain. And it’s the second largest coin, it’s probably $50 billion market cap.
A few years ago, that coin was trading at $1 that community thought nothing of it. People thought it was a joke and was never going to scale. So you don’t wanna be too smart about it, you just want to have rules in place that prevent obvious scams and rules that show that a broad array of market participants are looking at this coin and consider it legitimate, and then you let the market speak for yourself. It’s like any other market cap-weighted index. And history has suggested that trying to add too much active overlay to that can lead to bad results.
Meb: Talk to me a little bit about that. You may have referenced it and maybe misheard it. Is there a future where you guys run various types of indexes? I mean, I’m thinking, you know, in the traditional equity world, people going back to the old French Fama and even before that. There are number of other researchers that were writing about factors in the 1960s and the 50s where, you know, are there some factors that you could develop in the crypto space that would potentially have some value add versus say a pure mark cap-weighting? I’m thinking either trend following, momentum, valuation of some sort, any other ideas, are you guys kicking around any or any other sort of index as well?
Matt: Yeah, absolutely. Yeah. You should come over and see our whiteboard. I’ll throw out a few that I think are interesting that we may or may not launch products on in the future. So let’s take the easiest example which is equal weighting. It turns out that equal weighting has an enormous performance advantage historically in the crypto market. You now, I think in 2017, an equal weighted version of our index would have been up over 3,000%. Our index was up over 1,000%, but still 3,000% is a lot. And that’s because, you know, there’s high volatility, there’s massive return dispersion among the top 10 coins or even the top 100 coins. And so capturing that reversion to the mean turns out to be, at least historically, a very interesting strategy. And that’s been very successful in the equity space with equal weighted S&P 500 funds. I think they’re the most popular factor funds out there if you can call them that. It turns out that probably works in crypto as well.
Not surprisingly, momentum is an interesting strategy in crypto as well. We’re still doing the work on that to see exactly how momentum strategies should be applied to crypto. But I think there’s a high probability that momentum in existing crypto and a reasonable probability that you can capture it in a meaningful way. And then on the edges, I think there are a number of different things we’re investigating to see if there’s any, you know, sort of future performance capture by evaluating these things. There aren’t traditional factors in the sense that most of us think about it in the equity space, but there may be interesting sort of quality checks we can overlay.
So you mentioned Dogecoins, or Dogecoin, and how there has been no development activity there in the past two years. Something we were talking about today is could we monitor GitHub commits. GitHub is sort of where these projects are run and you can see how many times the software is being updated. And by monitoring GitHub commits, you can see, is the community actively improving these protocols and technologies as a signal of quality? I don’t know yet if that has any signaling quality but that’s the kind of stuff that we’re looking at on a daily basis.
Meb: So walk me forward a year, three years, five years. I’m kind of universally hated in the crypto space because I was over in Switzerland, another common friend, Jeremy Schwartz. And we were having a drink, and I forget why he was drinking some sort of weird soju drink that he had to drink from a spoon. But I posted a humorous obvious joke to my followers, but clearly not to the rest of the internet universe that I was having a good time with Jeremy and he let it slip that WisdomTree is launching a Litecoin ETF. And oh, dear God, did I get the hammer of the crypto space rust down upon me after? They thought it was a serious tweet until people with Jeremy started. I’m sure he got WisdomTree Investor Relations made sure he needed to clarify. But you’ve never seen people more angry. But Litecoin and then I think quadrupled after I wrote that. So maybe we were responsible and then is probably down by half or 80%, or whatever it is.
But walk me through kind of the future of the next few years, how you see the development of the space. You know, the fascinating thing to me as a…we’ve talked a lot about crypto. You know, we’ve been saying sidelines cheerleader where I’m not involved, but I’ve been kind of cheering it on but have not something I’m super interested in, personally got enough going on, but had mentioned how do you see it develop? What’s the kinda next few years of…? I was gonna say a lot of smart people have been entering, a lot of the huge hedge fund that we know, Pantera. You know, Burbank just announced that Passport is shifting to crypto, Morgan Creek, I mean, so many different firms. Talk to me about kind of the evolution next few years. What do you expect to see? What are kind of the milestones for broad acceptance, and development, and everything else?
Matt: Yeah, absolutely. Great question. I love that image with WisdomTree. I think up to now, crypto has been a high net-worth phenomenon and it’s supposedly been wealthy individuals, entrepreneurs primarily in tech centers, buying crypto in their own personal portfolios. And two things that are happening this year or the space surrounding crypto is institutionalizing. So instead of trading it by yourself on a crypto exchange, now it’s Jane Street, or Susquehanna, or Goldman, or DRW that’s acting as a traditional prop desk, OTC Desk to do trading on. Instead of just having one crypto custodian which is Kingdom Trust operating out of the countryside, you’re having companies like Bank of New York, and State Street, etc., moving into the space or at least investigating the space.
So I think one theme you’re gonna see this year is sort of the institutional groundwork for crypto coming into the fore. That means trading, portfolio management, custody, etc. And that’s happening right now. We get calls about it every day. The other thing that’s happening is we’re moving up the chain. So if it’s been a high net-worth market until recently, you’re starting to see family offices, multi-family offices and RIAAs, make their first allocations into the space. And we’re having conversations with those people every day. We’re still years away from pensions, and endowments, and big institutions coming into the space.
But if I look out in 2019, I think you’ll see a large amount of that RIAA, Family Office, Multifamily Office money come on board. And then as you look into 2020 and beyond, that’s when start looking at publicly available products like ETFs, ETNs, or other products that really make this go mainstream. So I think, you know, what’s happening right now is it’s moving from an edge case market with primarily high net-worth people to getting the institutional underpinnings to starting to have professional money into it to becoming a broad-based widely held institutional asset that’s available in publicly traded vehicles. And I think that’s what’s gonna happen over the next couple of years.
Meb: What’s the big gate when you talked a lot about a lot of these big banks like State Street and BoNY cossetting these assets? What’s the main hurdle for these guys and the complexity of that sort of process?
Matt: Yeah. Well, I think there are two hurdles. One is reputational risk. For better or worse, there are a wide variance of opinions about crypto. And these are very conservative institutions. And they wanna be slow, and careful, and methodical about moving into this space, which is one reason that some people think a family-owned business like fidelity could be a first mover in the space because it doesn’t have the same level of public scrutiny as a publicly traded entity. But I think there’s that reputational element that is a gating factor to that accelerating down the path.
And then, you know, there are technical sides to it, too. It’s not that it’s impossible to understand how to do cold storage or that it’s impossible to set up, you know, multi-sig authentication where you need multiple signatures to move assets. It’s just a new skill set, but that skill set is learnable or acquirable by any of these major providers. And I think the real gating factor is that reputational one where people just don’t wanna stick out their neck and say, “You know, we are the crypto asset manager, the crypto custodian of record,” because there’s concern around the market, the market is very volatile. It was up a billion percent in 2017, it’s been down sharply in 2018. I think it’s the reputational thing more than the technical impediment of how to do cold storage or how to do multi-sig authentication. If that is the gating factor, I’m happily to send our CEO over to visit any of these custodians and help them out. But I really think it’s more about the reputational side.
Meb: Custodians, if you’re listening, there’s your invite. Talk to me about the futures. And we’ll talk a little bit about products. I mean, Bitcoin futures came out, I haven’t tracked them recently so I don’t know if volume’s increasing or that’s getting to be a large market or not. Is that something where you see a significant amount of the trading moving to the futures exchanges or not at all? And talk to us why those handsome twins haven’t put an ETF out yet.
Matt: Sure. On the future side, yeah. So they launched and there was limited volume. That volume has picked up recently, it continues to pick up. I think the limitation on the growth there was they launched with, you know, extreme collateralization levels where you had to be basically one to one collateralized to use them. And the futures market is a leveraged market. If you didn’t wanna use leverage, you just go to the cash market. And so as those collateralization levels compressed and as people get more comfortable with them, I think volume will pick up there. It’s not the ultimate best way to own crypto because like gold futures, which is a good equivalent, it will basically always trade in perpetual contango of a couple percent a year.
So you’ll have a drag on your portfolio if you wanted to roll a position in the futures market forever. It’s better to hold the physical product. It’s cheaper to hold the physical product, etc. All that said, it may well be the case that the first ETF is a futures-based ETF because it is an exchange-traded future. It’s already within the regulatory system. And therefore, it may be more likely to be approved. They aren’t the same custodial issues, etc., that you have with, to use the ironic phase physical Bitcoin. On the Winklevii and the broader ETF efforts, everyone has basically filed for a Bitcoin ETF. And we are certainly intending to do so in the near future.
The SEC has been very clear about why it hasn’t allowed Bitcoin or crypto ETF. Dalia Blass who works there put out a great paper. I think it was December or January, outlining five reasons why she hadn’t approved it. And those reasons included concerns about custody, concerns about arbitragebility, concerns about price. I mentioned earlier, there’s no agreed-upon price for Bitcoin although that perhaps has been solved by the launch of futures, and concerns about market manipulation of the underlying market. It is a very new relatively immature market. There are concerns that a small number of wallets can sway the price one direction or the other. So I think the SEC is being rightfully cautious on allowing the launch of an ETF.
But having said that, those gating barriers are coming down. So like we said, custody, if it’s not already solved, then we think it may already be solved, will be solved very soon. Arbitrage really pretty much already is solved with the entry of folks like Susquehanna, and Jane Street, and Goldman into this space. The sort of walls are coming down and ongoing research is going on into looking into things like market manipulation. So, you know, we think there’s a good chance that an ETT will be allowed by the SEC in 2019, and an extremely good chance by 2020. So it’s not a matter of if, it’s a matter of when, but they’re being rightfully cautious. Again, we don’t want to go back to the beginning of our conversation. It’s not a good idea to allow sophisticated ETFs to be available to everyone before everyone has the means and availability to understand them. And so I don’t think it’s a big issue that there’s not an ETF yet, but I do think there will be an ETF in the next two years.
Meb: Good. We reserved the Hoddle ticker, so when you wanna email me and let me know. But, you know, it’s interesting. Well, I think that the Bitcoin ETF is interesting. I think the killer application is really what you guys are doing which is the broad-based index. So just tell me, let’s say there’s a traditional allocator listening to this podcast, whether it’s an endowment, whether it’s a RIAA, or wire house manager, or even a high net-worth individual, where do you see this fitting in into a traditional allocation? Is there a way you guys kind of talk about it to these investors? I think a lot of people would probably struggle with what sort of box this fits in.
Matt: Yeah, absolutely. I think most people that we talk to place it into their alternatives bucket. Crypto has the unique three-part combination of having high historical returns, extremely low correlations to other major asset classes: stocks, bonds, commodities, etc., as well as high liquidity, you know, daily in the case of Bitcoin, weekly in the case of our fund, so you can get access. So that is a rare combination, potentially high returns, low correlations, and high liquidity. Most people see it as a non-correlated asset that fits into their alternatives bucket.
We have a nice piece of research on our website about the role of crypto in a diversified portfolio. And even at extremely small levels, like a 1% allocation that you rebalance with a 50% tolerance. In other words, you sell if it gets to one and a half, you buy if it gets to 0.5. If you look at what that’s done to a portfolio over the last, say four and a half years, the impact is dramatic. It’s boost to the sharp ratio by about 25%. It’s added significant returns with no additional increase in risk. So even a small allocation, 1%, 2%, 3%, which is the allocation we’re seeing for most of our investors, has a meaningful impact on your portfolio as long as you’re diligent about rebalancing it. So that’s the message we’re trying to get out to folks.
Meb: One thousand percent return, we’ll certainly do that for you. You know, the response that I always tell people is I say particularly back in November, December, less of my friends are asking me about it today. But they’d say, “You know, Meb, try okay to crypto.” And I said kind of something along the same lines, I said, “Sure. Just do it as a percentage of the world market cap,” which is kind of in the ballpark of what you’re talking about. If you say, “I don’t know what the crypto space is now, but it’s about a half trillion, is that the ballpark?
Matt: Yeah, a little bit. Yeah. So that’s the ballpark.
Meb: Ballpark. So I said, “You can go put half a percent or whatever in your portfolio.” And then, “Hey, if it continues as a percentage of the market cap, you’ll never regret it. And if it goes to zero, well, you know, so what?”
Matt: Exactly right.
Meb: We’ve kind of seen a pretty crazy last year. And the naysayers would say, “Hey, look, last fall, Q4, was a mania. And cryptos are nothing but tulips.” And, you know, some people would probably use 2018 as saying, “Look, we told you so,” whereas the crypto enthusiasts are saying, “We fully expect this volatility and this is the necessary process, and watch out before the next stage.” What would be your kinda description as to why this is a sustainable trend, or asset class, or whatever you wanna describe it as for the next 10 years as you look out kinda really far? Like, how does this fit in into our world view? Is this something that eventually you see as currency replacements? Is it something you see as more traditional just different types of assets? You haven’t seen, in my mind, a lot of ICOs that have become really fully functioning companies and products that a lot of people are using yet, you know? It seems like it’s been a lot of speculation nowadays. Talk to us a little bit about the future.
Matt: Yeah. And I think of it kind of in three buckets when I think about long-term drivers of value. And so I’ll talk about each one. So the first one which is the easiest one to wrap your head around is as a store of value. And, you know, I think it’s reasonable to suggest in a digital age when we have, you know, Millennials becoming the largest share of investors in the world. And digital scarcity has made and made available, for the first time ever, which is one of the things that crypto did, that a digital store of value like Bitcoin could have a meaningful impact on the world, right? There is a reasonable case to be argued that a store value that’s decentralized that can’t be seized or hacked that is easily ported from one country to another, could be of interest. And I think that’s what you’ve seen in Bitcoin.
That sort of actually followed even the pathway that gold followed after we came off the gold standard where it had enormous volatility at the beginning, an enormous appreciation, and that volatility decreased over time, and the rate of appreciation decreased over time. That’s actually just what’s happened in crypto, enormous value creation, enormous volatility despite the recent volatility, that volatility is actually decreasing over time. So I think it’s following the pathway that store of the emergence door values have followed. And I think that’s a major use case that’s difficult to overlook.
The second big driver is the one you spoke to earlier will become a means of transaction or a platform for lots of decentralized applications, maybe a decentralized Facebook where I own my data, or a decentralized health records store where I can port my own health records by myself. And those are interesting optionality possibilities that accrue to the crypto ecosystem. So I think there are a thousand interesting projects out there. And as you said, there have been none that have gained widespread adoption yet, but I think there is a reasonable chance in the next 5 to 10 years that one or many of them will, I think, you could have an internet means of payment that’s digitally native. I think you could have decentralized systems where you port your own data from one to the other and you control that data set. Those all seem possible.
So when I think of the two primary drivers of value for crypto now, it’s that store value concept plus almost the early stage venture style investment in the optionality of future possibilities on these networks. And then the third major theme that I think it will arise over the next 5 to 10 years is really the securitization of other illiquid smaller assets, the efficiency that blockchain technology allows in terms of sort of tokenization of even small business assets or other things, I think, will allow for sort of a new form of capital markets to come into existence or at least potentially come into existence. So I think 10 years out, I think of Bitcoin or a few other coins being primarily stores of value that people use alongside gold or a replacement of gold as a nongovernment controlled store of value. I think there’s a possibility of these decentralized applications being really significant, and then the possibility of securitized tokens also being very interesting and something to keep an eye on.
Meb: Have you seen a pretty stratified or not sort of demographic interest in these investments? Has it mostly been…? I mean, your little echo chamber there living in San Francisco, but I have a lot of your requests and investors, has it been younger skewed, has it been older skewed, has it been what? What’s the, to the extend you can talk about it, is there any sort of demographic trends you’re seeing?
Matt: Yeah, it’s a great question. So I think the perception of the crypto market is that it’s 98% men and mostly 25-year-olds living in San Francisco. And that may be true when you look at someone like Coinbase, which is a leading brokerage in the space, which has 13 million accounts or something, most of which have small dollar allocations. What we’re seeing is a market that looks demographically not that unlike the ETF market, right? So the ETF market skews younger than the mutual fund market. It tends to concentrate in urban areas to some degree. And that’s true about our customers as well.
So they are maybe younger than the people who are investing in mutual funds, but they’re not 25 year olds, they’re my age and I’m 41. And they tend to be concentrated a little bit in urban areas, San Francisco, LA, New York, Miami, Austin, Dallas, Chicago, places like that, but it’s fairly widespread. It’s more widespread than you think. And I think as it moves from this edge case sort of original cypherpunk mentality to a mainstream asset class, you’re going to see the demographic that owns crypto aging. And you’re gonna see the move from just the coast to be more widespread across the country. We’re a step in that process, so we’re seeing it more than other parts of the crypto ecosystem are seeing.
Meb: A big criticism often for this world is the government side where you’ve seen some various countries kind of lay down the law or erect some barriers. Is this something you see as a potential stepping stone or barrier in the sense that…to the extent that the SEC I know was making some announcements about crypto. I think it was even Ethereum last week. Any thoughts in general on kind of the government involvement?
Matt: Yeah. We’ve actually been really pleased with the direction of regulation over the last six months. I think six months ago, there was concerns that there would be some sort of draconian crackdown on crypto, which we have seen in markets like China in the past. And now, outside of so-called privacy coins, which remain under a little bit of a regulatory uncertainty, all the developments have been extremely positive. For the most part, crypto at this point exists in a regulatory underhung where there’s a lack of clarity of regulation around crypto and more clarity would allow for more growth.
What happened last week was a perfect example. The SEC said that Ethereum, even if it was a security at the beginning of its existence, no longer is a security, which removed a huge cloud of uncertainty around a lot of ICO products that they wouldn’t be subject to sort of retrospective prosecution for how they were launched or at least they might not be. So generally speaking, the regulatory trends have been positive and we expect that to continue. There’s always a risk of a draconian regulatory crackdown, but we don’t see any signs of that. It’s all been moving in the right direction, which is toward more regulation but reasoned regulation of the space.
Meb: Can I ask you a question? I understand this is an investment advice. You’re not bound to this. It’s not part of your firm’s belief. If you had to name either a favorite coin or one that you had to purchase and not touch for 10 years, 10 years, is there something that comes to mind?
Matt: Ten years. Just with one. If it was just one coin, I would purchase Bitcoin because the store value argument is strong for me. If I were looking at more broadly and didn’t wanna make that obvious choice, what’s the more interesting coin? I think 0x, which is sort of creating a decentralized exchange is an interesting project. I don’t know much about the token economics but I think it’s an interesting project. I think if I were picking one out, I’d pick Bitcoin, that’s the boring answer. I’m a boring investor, though.
Meb: Hey, that’s…boring is good. I was laughing the other day. I was listening to a podcast as I was subject to a canceled flight coming back from Europe. So spent, I don’t know how many, two days in the airport hotel at Gatwick and I was listening to a podcast in the gym. And I can’t remember who it was, but he had a really funny analogy where he was trying to claim the United MileagePlus miles or a cryptocurrency. And he said, “You know, I’m gonna mine the crap out of some miles here by taking a lot of flights in the next six months.” Might be United. United, if you’re listening, I really need an upgrade status. I’m bottom of the barrel.
Matt, this has been a blast. A couple more final questions and then we gotta let you go because we’re already nearing one of our longest episodes ever. I could talk for another couple hours. As you look back on your history, you know, it’s been pretty on the frontier of a lot of exciting financial innovations. As you look to your own personal investments, has there been one that’s been the most memorable? It could be good, it could be bad, it could be anything in between, anything that sticks out?
Matt: Easy, easy. I bought JDS Uniphase when I was…I don’t even remember what they did. They were some high-flying tech stock in 1999. And I piled what was an unconscionable amount of money for me at the time, which was like 15 grand into JDS Uniphase without understanding one bit about it. And I think I lost 90% of my money in that trade. And that was the best 90% of my money that I ever lost because it taught me that just because something was hot and exciting, and because I pretended to know something about it that I shouldn’t be naive enough to put my money into it, and that trade was actually what put me on the pathway towards indexing, which has defined the rest of my career and success. So that’s an easy one, JDS Uniphase, and getting completely blown out on that trade.
Meb: JDSU, Jeff got very animated because he says, “Me too,” on that investment. So you and Jeff were companions on that one. But it’s funny, you know? I mean, we talked to so many investors on this podcast. And a lot of the young defining moments, particularly with losses, you know, about set so many people on their careers. For me, it was a similar thing with biotech options where it kind of pushed me more and more into being a quant instead of thinking I knew everything and could just discretionary pick a lot of these ideas. By the way, I just thought about this because I was thinking of last questions, and going back to your original job as a seal, did you see this recent one on one basketball matchup between Ted Cruz and Jimmy Kimmel?
Matt: I did not, I did not.
Meb: Well, we’ll link to it and I’ll shoot you an email. But Jimmy Kimmel was making fun of Ted Cruz’s, in general, I think about his basketball and he called him a greasy blob fish. And then Ted Cruz said, you know, basically, “Fine, I challenge you to one on one if you think you’re so good.” So they just had some charity event where they played. And Ted Cruz, to his credit, the sense of humor, had a blob fish mascot made. And they both donated much money to charity, but Ted won. And he’s horrible. I watched the video of it. And they, I think originally, were gonna play the 15 or 21 but it was taking so long because they were so bad. They eventually said we’ll change it to 11, and it ended 11-9. So totally unrelated to anything. Matt, if people wanna follow your writing, your tweets, anything else, where’s the home? Where’s the best places to go to track what you and Bitwise and everything else is up to?
Matt: Sure. If you go to bitwiseinvestments.com and scroll to the bottom of the page, you can sign up for our free research series. We put out research every month, sometimes more frequently than that with an institutional view on crypto, or you can follow me at twitter @Matt_Hougan. So either of those will get the job done.
Meb: Awesome, Matt. It’s been a blast. Thanks so much for taking the time today.
Matt: Thanks, Meb, it’s been fun.
Meb: Listeners, we’ll post show links to everything Matt mentioned today, his websites, Twitter, everything else. You can always find those at mebfaber.com/podcast as well as the archives. We’re over 100 shows now. If you wanna leave us a review, we read them all, we love them, we appreciate it, good, bad, everything in between, you can check out the show is on Breaker and rate the episodes, which is my new favorite app. Thanks for listening, friends, and good investing.