Three Things I Think I Think – ETF Edition

by
Cullen Roche
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Here are some things I think I am thinking about ETFs.

1) Bloomberg ETF IQ – Let’s get this out of the way because it’s very very important. I am going to be in studio in NYC on Bloomberg ETF IQ tomorrow at 1:15 EST talking about Chicken Farming. We’ll be discussing three primary essential elements: 1. How to apply Python Dust to a chicken’s butt; 2. How to properly deal with a broody hen (useful info for men in almost any relationship); 3. How to train your chickens to respond to whistle calls (this is a real thing I’ve learned).

Also, I will do a short segment on ETFs. You should tune in even if you don’t own chickens.

2) Those Pesky Passive Parasites! Here’s another scary article about how passive investors are about to crash the whole world. I’ve touched on this many times before, but it’s a myth that seems to keep popping up so let’s do this all over again.

The basic narrative goes something like this – passive investors are parasites freeloading on the active investors and not contributing anything. In the process they are driving up equity valuations with their persistent buying without any care for market fundamentals. This creates the risk that the whole system will crash when we all realize wha those fundamental values really are.

This sounds kinda cute in theory, but is confused in reality and it all stems from the myth of the passive investor which I’ve spilled so much ink about.¹ As I’ve explained before, there really is no such thing as a truly passive investor. We all deviate from the global market portfolio for practical reasons. We are all “asset pickers”. But this goes deeper. You see, an ETF is an instrument that has a buyer and a seller. If the buyer is a buy and hold type (what we call a passive investor) then the seller must be more active. In most cases the other side of the trade involves not only a more active seller, but a market maker who is connecting the two parties in the transaction. In other words, there are layers of activity in all of this!

But the kicker here is that passive investors need active investors to create the liquidity that they require to be able to operate in the first place. So when we view the entire flow of funds in a trade transaction we can see that there are some passive elements and some active elements that add up to a relatively active process. There is some debate about the price discovery element in this process, but we shouldn’t imply that the entire process of indexing involves a mindless buyer or seller who doesn’t care about price when in fact the entire transaction requires more active participants who supposedly care about setting prices actively.

Further, it’s important to think of indexers as being a continuum of buyers and sellers themselves. There are millions of indexers across generations who are constantly withdrawing funds, contributing new funds, rebalancing, reinvesting, etc. This adds up to A LOT of activity! So, the bottom line is that it is largely incoherent to talk about “passive” investors as parasites when it is the passive investors who are fairly active in aggregate and create much of the demand that results in more active underlying management.

3) Attack of the Vegan ETF. So, there’s a vegan ETF. I like this sort of stuff conceptually. Socially Responsible Investing is good. At least in theory. The problem is that I worry that much of this is based on a similar misconception about how markets function. For instance, this ETF claims that every $1,000 invested will help save 13 animals from being slaughtered. This is based on the assumption that that’s money that isn’t being “invested” into firms that aren’t included in the index. So every $1,000 you put into the vegan ETF is money that doesn’t go into the “bad” companies. Except this ignores the fact that money is already in those bad companies.

Importantly, secondary markets are just places where we swap existing ownership. The actual company doesn’t care who owns the shares because the shares are always owned by someone. They already got their money at IPO and now the shares just float around from Joe to Jane to Jerry, etc. All this shuffling of shares has no real impact on the underlying firm. If Exxon Mobil (XOM) is polluting the environment with their operations then their secondary market shares will reflect the future expected cash flows the operations that pollute the environment. When you decide you don’t want to own XOM shares because you don’t believe in their business you literally have no impact on their actual business because you’re selling your shares to someone who does believe in that company.

Now, in fairness, the prospectus does say that some portion of the management fees will go to charity. That’s very awesome and it’s a good start, but I still think this is a flawed way to donate even if indirectly. In my view, the better position to take is the one that invests in the broader market in a lower fee fund that captures the profits of these bad firms because then you can take some of the profits you make from the bad guys and give it directly to the good guys. And since we know that low fee less active funds tend to beat high fee more active funds then this means you’ll have more money to donate to charity. And oh yeah, you get the tax deduction instead of passing that on to someone else cloaked as a management fee.

Now, that brings me to a point I’ve talked about before – “vice investing”. I’ve stated that there’s no such thing as a vice fund because one man’s vice is another man’s daily routine. You might think smoking is a vice, but to a lot of people smoking is very awesome. So I had to laugh when I looked up the top 10 holdings of this vegan ETF and found that they included famous vegan advocacy firms such as JP Morgan, Wells Fargo, Bank of America, Microsoft, Google and Apple. Just kidding of course. These firms don’t do anything vegan at all. They just don’t fit the subjective criteria of “bad” that this firm used to construct the active index that they call passive in their prospectus (head explodes just a little bit with all of this). Though, in fairness, I guess Apple is kind of a vegan company because their company name is a fruit.

¹ – Some people think I am nuts talking so much about active vs passive and the importance of the terminology, but this is important stuff. When you get this wrong you are susceptible to all these crazy sales pitches and scary narratives about what might or might not happen. An operational view of the world helps because it results in a more objective understanding of the probable outcomes.