WEBVTT 00:00:00.000 --> 00:00:02.459 Welcome to the Deep Dive. Our mission here is 00:00:02.459 --> 00:00:05.480 simple. We take the complex, sometimes overwhelming 00:00:05.480 --> 00:00:08.179 stacks of financial research, legal documents, 00:00:08.380 --> 00:00:10.960 and market data, and we distill them down into 00:00:10.960 --> 00:00:13.640 genuinely useful knowledge, giving you the shortcut 00:00:13.640 --> 00:00:16.460 to being well -informed. Today, we are undertaking 00:00:16.460 --> 00:00:19.039 a deep dive into the financial vehicle that has, 00:00:19.140 --> 00:00:22.379 well, completely redefined modern investing, 00:00:22.640 --> 00:00:26.390 exchange -traded funds, or ETFs. And this is 00:00:26.390 --> 00:00:28.489 so much more than just a convenient way to track 00:00:28.489 --> 00:00:31.469 the S &P 500. Oh, absolutely. This is about understanding 00:00:31.469 --> 00:00:34.469 the mechanics, the sheer scale, and the fundamental 00:00:34.469 --> 00:00:37.810 stability, or as we'll see, the potential fragility 00:00:37.810 --> 00:00:40.520 of a multi -trillion dollar system. Okay, so 00:00:40.520 --> 00:00:42.600 let's unpack this right at the top. At its most 00:00:42.600 --> 00:00:45.420 basic, what is an ETF? It's an investment fund 00:00:45.420 --> 00:00:47.640 rate, a pool of money holding all sorts of financial 00:00:47.640 --> 00:00:50.600 assets. Exactly. It could be stocks, bonds, currencies, 00:00:50.820 --> 00:00:52.920 or even physical commodities like, you know, 00:00:52.920 --> 00:00:55.679 actual gold bars. But the crucial part, the real 00:00:55.679 --> 00:00:57.479 innovation, is that it's an exchange -traded 00:00:57.479 --> 00:00:59.579 product. Meaning you buy and sell it on a stock 00:00:59.579 --> 00:01:01.880 exchange all day long. All day, just like you'd 00:01:01.880 --> 00:01:04.489 buy a share of Microsoft or Amazon. And that 00:01:04.489 --> 00:01:07.030 right there is the core idea, isn't it? An individual 00:01:07.030 --> 00:01:10.129 investor gets immediate diversification, this 00:01:10.129 --> 00:01:13.370 whole basket of assets, but with the liquidity 00:01:13.370 --> 00:01:16.189 and the real time pricing of a single stock. 00:01:16.409 --> 00:01:18.530 It's the best of both worlds. You get to skip 00:01:18.530 --> 00:01:21.650 this massive research project of picking individual 00:01:21.650 --> 00:01:24.750 stocks and just get exposure to a whole sector 00:01:24.750 --> 00:01:27.650 or market with a single click. Our journey today 00:01:27.650 --> 00:01:30.109 is pretty ambitious. We really need to go beyond 00:01:30.109 --> 00:01:32.230 the basics. We're going to provide a comprehensive 00:01:32.230 --> 00:01:34.370 structural understanding of how these things 00:01:34.370 --> 00:01:36.890 are actually built. We'll also detail the functional 00:01:36.890 --> 00:01:39.409 differences that give them, frankly, a massive 00:01:39.409 --> 00:01:41.530 advantage over traditional mutual funds. And 00:01:41.530 --> 00:01:43.790 then we'll navigate this exploding universe of 00:01:43.790 --> 00:01:46.250 different categories from the plain vanilla index 00:01:46.250 --> 00:01:48.689 funds to these highly leveraged and synthetic 00:01:48.689 --> 00:01:50.969 instruments. And finally, and this is the most 00:01:50.969 --> 00:01:53.969 critical part, we're going to analyze the genius. 00:01:54.599 --> 00:01:58.620 yet sometimes fragile arbitrage mechanism. That's 00:01:58.620 --> 00:02:00.840 the real engine that keeps this entire system 00:02:00.840 --> 00:02:03.120 honest. To really appreciate what we're about 00:02:03.120 --> 00:02:05.420 to talk about, we have to establish the scale. 00:02:05.519 --> 00:02:07.459 I mean, this isn't some noosh corner of finance. 00:02:07.480 --> 00:02:10.039 This is central. It is absolutely central. If 00:02:10.039 --> 00:02:12.000 we look at the global market, just using data 00:02:12.000 --> 00:02:14.500 from the first quarter of 2023, the numbers are, 00:02:14.520 --> 00:02:17.180 well, they're astronomical. So give us the numbers. 00:02:17.360 --> 00:02:19.419 Put this into perspective for us. OK, so the 00:02:19.419 --> 00:02:21.560 U .S. market alone, which has always been the 00:02:21.560 --> 00:02:25.099 driver of this technology, holds $5 .4 trillion 00:02:25.099 --> 00:02:29.080 in equity ETFs. Just equity. Just equity. Add 00:02:29.080 --> 00:02:32.819 another $1 .4 trillion in fixed income ETFs. 00:02:32.819 --> 00:02:35.960 So that's what, $6 .8 trillion just in the United 00:02:35.960 --> 00:02:38.340 States. Wow. Then you add Europe. up, which holds 00:02:38.340 --> 00:02:40.120 another trillion in equity and about point four 00:02:40.120 --> 00:02:42.419 trillion in fixed income funds. Yeah. We are 00:02:42.419 --> 00:02:44.400 talking about an industry that is easily north 00:02:44.400 --> 00:02:47.039 of seven trillion dollars globally. Yeah. And 00:02:47.039 --> 00:02:50.139 it is still growing exponentially. And what's 00:02:50.139 --> 00:02:53.039 just as staggering to me is the dominance these 00:02:53.039 --> 00:02:55.419 funds have over daily trading. They aren't just 00:02:55.419 --> 00:02:57.419 sitting there holding assets. They are actively 00:02:57.419 --> 00:03:00.969 driving market activity. That's a fantastic point. 00:03:01.090 --> 00:03:04.009 In the U .S., ETF trading accounted for an astonishing 00:03:04.009 --> 00:03:06.770 32 % of the total dollar volume of stock market 00:03:06.770 --> 00:03:10.629 trading in Q1 2023. 32%. So one out of every 00:03:10.629 --> 00:03:13.030 $3 traded in the U .S. stock market is tied to 00:03:13.030 --> 00:03:16.300 an ETF transaction. Yes. It's proof that this 00:03:16.300 --> 00:03:18.599 product has become the market's default vehicle 00:03:18.599 --> 00:03:22.639 for expressing views, moving capital and managing 00:03:22.639 --> 00:03:25.599 risk. And even in Europe and Asia, where adoption 00:03:25.599 --> 00:03:28.219 was a bit slower, they still account for 11 and 00:03:28.219 --> 00:03:32.039 13 percent of total trading volumes. Significant 00:03:32.039 --> 00:03:34.979 numbers. And within this massive space, the power 00:03:34.979 --> 00:03:37.900 is heavily concentrated. We really need to name 00:03:37.900 --> 00:03:40.139 the three giants that dominate the U .S. market 00:03:40.139 --> 00:03:42.120 because their competition is what drives down 00:03:42.120 --> 00:03:45.300 fees for all of us. Precisely. The industry is 00:03:45.300 --> 00:03:47.939 completely defined by the big three U .S. issuers. 00:03:48.060 --> 00:03:50.819 You have BlackRock's iShares, which commands 00:03:50.819 --> 00:03:53.680 a 34 percent market share. The biggest. The biggest. 00:03:53.840 --> 00:03:56.000 Then you have Vanguard sitting right behind them 00:03:56.000 --> 00:03:58.699 at 29 percent and State Street Global Advisors 00:03:58.699 --> 00:04:01.520 holding 14 percent. So between the three of them, 00:04:01.520 --> 00:04:04.080 that's almost three quarters of the entire U 00:04:04.080 --> 00:04:06.719 .S. market. It is. And that collective dominance 00:04:06.719 --> 00:04:09.039 allows them to leverage these massive economies 00:04:09.039 --> 00:04:11.620 of scale, which results in the incredibly low 00:04:11.620 --> 00:04:13.759 expense ratios that have made ETFs so popular 00:04:13.759 --> 00:04:15.740 all around the world. OK, so let's start with 00:04:15.740 --> 00:04:18.579 those foundational elements. The legal framework. 00:04:19.500 --> 00:04:21.920 When you buy an ETF share, you're not usually 00:04:21.920 --> 00:04:25.000 buying a direct proportional piece of Apple stock, 00:04:25.139 --> 00:04:27.860 are you? You're buying a share in a specific 00:04:27.860 --> 00:04:30.879 kind of legal entity. That's exactly right. And 00:04:30.879 --> 00:04:34.129 the legal setup can be. A bit confusing because 00:04:34.129 --> 00:04:37.509 it's so varied. Globally, an ETF can be structured 00:04:37.509 --> 00:04:41.009 as a corporation, a trust, an open -end management 00:04:41.009 --> 00:04:44.029 investment company, or a unit investment trust. 00:04:44.310 --> 00:04:46.910 And those different structures have real -world 00:04:46.910 --> 00:04:49.430 consequences. They do. For instance, the very 00:04:49.430 --> 00:04:52.750 first and largest ETF, SPY, is a unit investment 00:04:52.750 --> 00:04:55.610 trust. That structure dictates certain legal 00:04:55.610 --> 00:04:58.149 constraints on how it operates. Meanwhile, a 00:04:58.149 --> 00:04:59.949 lot of the newer funds are set up as open -end 00:04:59.949 --> 00:05:02.250 management companies, which gives them more flexibility. 00:05:02.589 --> 00:05:05.209 So if the shareholder doesn't directly own the 00:05:05.209 --> 00:05:07.490 underlying stocks, what rights do they actually 00:05:07.490 --> 00:05:09.529 have? What do they own? They indirectly own the 00:05:09.529 --> 00:05:12.250 fund's assets, and that indirect ownership grants 00:05:12.250 --> 00:05:14.410 them several key rights. They're entitled to 00:05:14.410 --> 00:05:17.110 a share of the profits, so any interest or dividends 00:05:17.110 --> 00:05:18.870 that the underlying holdings generate. Okay, 00:05:18.889 --> 00:05:20.829 so you still get the income. You still get the 00:05:20.829 --> 00:05:24.300 income. You also receive mandatory annual reports 00:05:24.300 --> 00:05:26.839 detailing the fund's performance and what's inside 00:05:26.839 --> 00:05:30.579 it. And, crucially, if the fund were ever to 00:05:30.579 --> 00:05:33.439 be liquidated, you would be entitled to the residual 00:05:33.439 --> 00:05:36.379 value after all the debts are settled. It's a 00:05:36.379 --> 00:05:38.839 very defined legal relationship, even if the 00:05:38.839 --> 00:05:41.199 ownership is indirect. It's also really important 00:05:41.199 --> 00:05:43.699 to clarify what an ETF is not, because there 00:05:43.699 --> 00:05:46.199 are these similar sounding vehicles out there 00:05:46.199 --> 00:05:48.560 that function in completely different ways. Yes. 00:05:48.579 --> 00:05:51.199 The two that cause the most confusion are closed 00:05:51.199 --> 00:05:54.939 end funds, or CEFs, and exchange traded notes, 00:05:55.120 --> 00:05:57.300 ETNs. So what's the difference with a closed 00:05:57.300 --> 00:06:00.660 end fund? A CEF also trades on an exchange, like 00:06:00.660 --> 00:06:02.660 an ETF, but it has a fixed number of shares. 00:06:02.899 --> 00:06:05.569 Once they're issued, that's it. The size of the 00:06:05.569 --> 00:06:07.490 fund doesn't fluctuate based on investor demand. 00:06:07.730 --> 00:06:09.730 And that fixed supply is what causes problems, 00:06:09.970 --> 00:06:12.329 right? Right. It often causes CEFs to trade at 00:06:12.329 --> 00:06:15.709 these persistent, significant discounts or premiums 00:06:15.709 --> 00:06:19.110 to their actual net asset value, their NAV. An 00:06:19.110 --> 00:06:22.170 ETF, by its very design, is meant to avoid that 00:06:22.170 --> 00:06:25.129 exact problem. Okay. And an ETN? That sounds 00:06:25.129 --> 00:06:27.269 like an entirely different animal. It is. An 00:06:27.269 --> 00:06:29.170 ETN is a debt instrument. It's essentially an 00:06:29.170 --> 00:06:31.410 unsecured bond issued by a financial institution, 00:06:31.629 --> 00:06:34.870 like a bank. When you buy an ETN, you are lending 00:06:34.870 --> 00:06:37.350 money to that bank, and they promise to pay you 00:06:37.350 --> 00:06:40.009 the return of a specific index. So the risk there 00:06:40.009 --> 00:06:42.670 is not the market, but the bank itself. Precisely. 00:06:42.670 --> 00:06:45.670 The risk is credit risk. If the issuer, the bank, 00:06:45.730 --> 00:06:48.050 defaults and goes bankrupt, you can lose everything. 00:06:48.129 --> 00:06:49.870 It doesn't matter how well the underlying index 00:06:49.870 --> 00:06:53.449 performed. ETFs, because they're funds that actually 00:06:53.449 --> 00:06:56.670 own the assets, inherently minimize that specific 00:06:56.670 --> 00:06:59.129 risk. No, let's get to the primary selling point 00:06:59.129 --> 00:07:02.170 for most people. Cost. I mean, the low cost of 00:07:02.170 --> 00:07:04.730 ETFs is arguably the single biggest factor driving 00:07:04.730 --> 00:07:06.870 their growth. And it all starts with the expense 00:07:06.870 --> 00:07:09.310 ratio. The expense ratio is the annual fee you 00:07:09.310 --> 00:07:11.889 pay to the ETF issuer to... manage the fund, 00:07:11.970 --> 00:07:14.009 cover all the administrative costs, and provide 00:07:14.009 --> 00:07:16.629 investor services. And for the largest, most 00:07:16.629 --> 00:07:18.769 passively tracked indices, the ones from Vanguard 00:07:18.769 --> 00:07:22.189 or BlackRock, these ratios are incredibly low. 00:07:22.350 --> 00:07:24.329 How low are we talking? Sometimes as low as 0 00:07:24.329 --> 00:07:30.420 .03%. 0 .03%. When you hear a number that small, 00:07:30.660 --> 00:07:33.779 the immediate question is, how do these massive 00:07:33.779 --> 00:07:36.480 firms with billions and billions under management 00:07:36.480 --> 00:07:40.480 even survive, let alone profit enormously from 00:07:40.480 --> 00:07:43.019 a fee that tiny? That is where the power of scale 00:07:43.019 --> 00:07:45.879 really kicks in. If a fund manages, say, $100 00:07:45.879 --> 00:07:50.339 billion, that 0 .03 % fee still translates to 00:07:50.339 --> 00:07:53.000 $30 million in annual revenue. Right. And because 00:07:53.000 --> 00:07:55.660 these big index tracking funds are largely automated 00:07:55.660 --> 00:07:57.560 and require very little active human intervention, 00:07:57.819 --> 00:08:00.959 the operating expenses are tiny. That leads to 00:08:00.959 --> 00:08:03.339 high margins, but only on a massive, massive 00:08:03.339 --> 00:08:06.120 scale. This structure basically forces traditional 00:08:06.120 --> 00:08:09.399 mutual funds to compete on price or, well, perish. 00:08:09.819 --> 00:08:11.800 But those fees do start to climb pretty quickly 00:08:11.800 --> 00:08:14.279 once you step outside that world of passive indexing. 00:08:14.319 --> 00:08:16.620 Oh, they do. Specialized, niche, or actively 00:08:16.620 --> 00:08:19.439 managed ETFs, especially the ones dealing with 00:08:19.439 --> 00:08:21.660 complex derivatives or very technical strategies, 00:08:21.879 --> 00:08:24.660 they can have annual fees that go over 1%, sometimes 00:08:24.660 --> 00:08:26.600 even higher. It's a classic rule in finance. 00:08:26.779 --> 00:08:28.939 The more unique or complex the product, the higher 00:08:28.939 --> 00:08:32.240 the price tag. And crucially, how are those fees 00:08:32.240 --> 00:08:35.549 actually paid? I mean, does my brokerage just 00:08:35.549 --> 00:08:38.230 send me a bill once a year for it? No. And the 00:08:38.230 --> 00:08:40.830 beauty of the system is that the fees are all 00:08:40.830 --> 00:08:43.809 deducted internally. The issuer never bills you 00:08:43.809 --> 00:08:46.610 directly. They just deduct the necessary amount 00:08:46.610 --> 00:08:49.490 from either the dividends or the interest that 00:08:49.490 --> 00:08:52.350 the fund receives before that income is distributed 00:08:52.350 --> 00:08:54.789 to you. And what if there isn't enough income 00:08:54.789 --> 00:08:56.970 to cover it? If not enough income is generated, 00:08:57.169 --> 00:08:59.169 they'll sell a tiny portion of the underlying 00:08:59.169 --> 00:09:02.210 assets within the fund to cover the costs. So 00:09:02.210 --> 00:09:04.490 you, the investor, you simply see a slightly 00:09:04.490 --> 00:09:07.539 lower return. You never see an explicit fee getting 00:09:07.539 --> 00:09:09.539 deducted from your cash account. It's almost 00:09:09.539 --> 00:09:12.179 invisible. Okay, finally, oversight. Given the 00:09:12.179 --> 00:09:15.659 complexity here, robust regulation seems essential. 00:09:16.039 --> 00:09:18.220 Absolutely essential. In the U .S., these funds 00:09:18.220 --> 00:09:20.299 are under the very watchful eye of bodies like 00:09:20.299 --> 00:09:22.840 the SEC, the Securities and Exchange Commission, 00:09:23.139 --> 00:09:25.600 and the CFTC for the futures -based products. 00:09:25.820 --> 00:09:28.399 The Commodity Futures Trading Commission. Right. 00:09:28.559 --> 00:09:30.679 And they all have to adhere to these foundational 00:09:30.679 --> 00:09:33.220 securities laws, most notably the Investment 00:09:33.220 --> 00:09:36.940 Company Act of 1940. That act really defined 00:09:36.940 --> 00:09:39.919 how investment companies, including most ETFs, 00:09:39.919 --> 00:09:42.179 have to operate when it comes to disclosure, 00:09:42.379 --> 00:09:46.340 custody of assets, and shareholder rights. This 00:09:46.340 --> 00:09:48.960 deep regulatory history provides a necessary 00:09:48.960 --> 00:09:51.769 layer of investor protection. We've established 00:09:51.769 --> 00:09:54.929 that ETFs and mutual funds are cousins. They 00:09:54.929 --> 00:09:57.169 both pull money into these diversified baskets. 00:09:57.409 --> 00:09:59.389 But the differences in their operational structure, 00:09:59.509 --> 00:10:01.269 I mean, that's what fundamentally changes how 00:10:01.269 --> 00:10:03.570 an investor uses them. And this is where the 00:10:03.570 --> 00:10:06.730 real value of the ETF starts to emerge. The primary 00:10:06.730 --> 00:10:09.210 functional distinction, the truly massive difference, 00:10:09.409 --> 00:10:12.429 comes down to trading flexibility. This is the 00:10:12.429 --> 00:10:15.179 core aha moment. that has drawn millions of investors 00:10:15.179 --> 00:10:17.399 away from traditional mutual funds. I think we 00:10:17.399 --> 00:10:19.000 need to contrast the mechanics one more time 00:10:19.000 --> 00:10:21.059 just because it's so critical to understanding 00:10:21.059 --> 00:10:23.159 this. Okay. So when you place an order for a 00:10:23.159 --> 00:10:25.659 traditional mutual fund, your order is basically 00:10:25.659 --> 00:10:27.440 an instruction to the fund manager to either 00:10:27.440 --> 00:10:29.659 issue new shares for you or redeem your existing 00:10:29.659 --> 00:10:33.240 ones. But the price you pay or receive is only 00:10:33.240 --> 00:10:35.820 calculated once per day. After the market closes. 00:10:36.059 --> 00:10:38.840 After the market closes, based on the final net 00:10:38.840 --> 00:10:41.960 asset value. the NAV, of all the securities in 00:10:41.960 --> 00:10:44.000 the fund. So it doesn't matter if you place your 00:10:44.000 --> 00:10:47.840 order at 9 .31 a .m. or 3 .59 p .m., you get 00:10:47.840 --> 00:10:51.299 the 4 .0 p .m. price, period. Where is an ETF? 00:10:51.820 --> 00:10:54.879 An ETF trades continuously. It has a real -time 00:10:54.879 --> 00:10:57.419 price that fluctuates all day long, just like 00:10:57.419 --> 00:11:00.200 a stock. And this, well, this opens up an entire 00:11:00.200 --> 00:11:02.419 universe of sophisticated strategies that are 00:11:02.419 --> 00:11:04.659 simply inaccessible to mutual fund investors. 00:11:05.159 --> 00:11:06.779 And because they're treated like stocks, they 00:11:06.779 --> 00:11:08.820 get all the features that come with stocks like 00:11:08.820 --> 00:11:11.379 short selling and margin. Correct. You can sell 00:11:11.379 --> 00:11:13.440 an ETF short, which lets you bet against its 00:11:13.440 --> 00:11:15.940 price movement, or you can purchase shares on 00:11:15.940 --> 00:11:18.360 margin borrowing funds from your broker. These 00:11:18.360 --> 00:11:21.320 are powerful tools for tactical positioning, 00:11:21.519 --> 00:11:23.899 especially for hedging or for leveraged speculation. 00:11:24.259 --> 00:11:26.440 And they are completely off limits for traditional 00:11:26.440 --> 00:11:28.500 mutual funds. But I think the real operational 00:11:28.500 --> 00:11:30.500 advantage for most people comes down to the order 00:11:30.500 --> 00:11:32.720 types. This is about precision and how you execute 00:11:32.720 --> 00:11:35.120 your trades. Exactly. With a mutual fund, you 00:11:35.120 --> 00:11:37.080 only have market orders. You get the price at 00:11:37.080 --> 00:11:39.000 the end of the day, whatever it is. With an ETF, 00:11:39.279 --> 00:11:41.960 you get the benefit of limit orders. So you can 00:11:41.960 --> 00:11:44.179 be specific. You can be very specific. You can 00:11:44.179 --> 00:11:46.600 tell your broker, I only want to buy this ETF 00:11:46.600 --> 00:11:50.399 if the price drops to $99 .50. That ensures you 00:11:50.399 --> 00:11:52.940 don't overpay in a fast -moving market. And on 00:11:52.940 --> 00:11:54.940 the flip side, you can use stop -loss orders 00:11:54.940 --> 00:11:57.059 to protect your downside. You can automatically 00:11:57.059 --> 00:11:59.360 sell your position if the price falls to a level 00:11:59.360 --> 00:12:01.879 you've already defined, protecting you from steep, 00:12:01.960 --> 00:12:04.440 sudden drops. And those tools are essential for 00:12:04.440 --> 00:12:06.980 risk management. And they only work because the 00:12:06.980 --> 00:12:10.490 ETF has continuous, real -time pricing. For more 00:12:10.490 --> 00:12:12.450 advanced investors, there's also the world of 00:12:12.450 --> 00:12:16.149 options. A huge benefit. The ability to write 00:12:16.149 --> 00:12:19.250 or purchase options on an ETF is a massive advantage. 00:12:19.710 --> 00:12:22.210 This opens the door to advanced strategies like 00:12:22.210 --> 00:12:24.649 covered calls, where you can tell call options 00:12:24.649 --> 00:12:27.110 against your ETF shares to generate extra income. 00:12:27.929 --> 00:12:30.570 That entire segment of the derivatives market 00:12:30.570 --> 00:12:33.809 is built around ETFs, not mutual funds. That 00:12:33.809 --> 00:12:36.070 continuous trading ability also links directly 00:12:36.070 --> 00:12:38.610 to the second massive differentiator, which is 00:12:38.610 --> 00:12:41.940 cost efficiency. Yes, ETFs are just intrinsically 00:12:41.940 --> 00:12:44.659 cheaper to operate than mutual funds. Part of 00:12:44.659 --> 00:12:46.799 that is how redemptions are handled, which we'll 00:12:46.799 --> 00:12:50.039 get to later. But operationally, mutual funds 00:12:50.039 --> 00:12:52.440 have higher costs because they have to constantly 00:12:52.440 --> 00:12:54.620 manage their cash flows. What do you mean by 00:12:54.620 --> 00:12:56.740 that? Well, they have to maintain cash reserves 00:12:56.740 --> 00:13:00.000 on hand and constantly execute buy and sell transactions 00:13:00.000 --> 00:13:02.659 within the fund itself to meet this continuous 00:13:02.659 --> 00:13:05.159 stream of shareholder purchases and redemptions 00:13:05.159 --> 00:13:07.429 that happens every single day. All that trading, 00:13:07.509 --> 00:13:10.110 that constant turnover drives up their internal 00:13:10.110 --> 00:13:13.490 costs. Precisely. And on top of that, ETFs generally 00:13:13.490 --> 00:13:16.230 avoid these high marketing, distribution, and 00:13:16.230 --> 00:13:18.850 accounting costs that are known as 12B1 fees. 00:13:19.029 --> 00:13:21.570 Can you explain 12B1 fees? They just sound like 00:13:21.570 --> 00:13:23.889 cure friction for the investor. They pretty much 00:13:23.889 --> 00:13:25.870 are. They're marketing fees that are authorized 00:13:25.870 --> 00:13:29.529 under Rule 12B1 of that same 1940 Act. They're 00:13:29.529 --> 00:13:31.889 annual fees, often around a quarter of a percent 00:13:31.889 --> 00:13:34.110 to one percent, paid right out of the fund's 00:13:34.110 --> 00:13:36.679 assets to cover distribution costs. So paying 00:13:36.679 --> 00:13:39.340 brokers to sell the fund? Exactly. Compensation 00:13:39.340 --> 00:13:42.399 for brokers who sell the fund shares and for 00:13:42.399 --> 00:13:44.940 marketing expenses. Because ETFs are typically 00:13:44.940 --> 00:13:47.000 just bought through a brokerage on an exchange 00:13:47.000 --> 00:13:49.320 rather than being sold through a financial advisor. 00:13:49.539 --> 00:13:52.480 They largely bypass the need for these expensive 00:13:52.480 --> 00:13:55.320 distribution channels. And that saving is passed 00:13:55.320 --> 00:13:58.720 directly to you, the investor. And speaking of 00:13:58.720 --> 00:14:02.220 sales charges or loads, that's another clear 00:14:02.220 --> 00:14:05.179 win for the ETF structure. Traditional mutual 00:14:05.179 --> 00:14:07.840 funds often carry these loads. A front -end load 00:14:07.840 --> 00:14:10.399 is a sales commission you pay when you buy in, 00:14:10.559 --> 00:14:13.100 and a back -end load is a deferred charge if 00:14:13.100 --> 00:14:16.240 you sell out too soon. And ETFs. ETFs fundamentally 00:14:16.240 --> 00:14:18.960 do not have sales loads. You might pay a small 00:14:18.960 --> 00:14:21.399 trading commission to your broker, although these 00:14:21.399 --> 00:14:23.539 days most major brokers offer commission -free 00:14:23.539 --> 00:14:26.399 ETF trades, but you never, ever pay a direct 00:14:26.399 --> 00:14:29.210 sales charge to the fund company itself. We should 00:14:29.210 --> 00:14:31.409 mention the one tiny fee that does apply, though, 00:14:31.490 --> 00:14:33.970 just for completeness, in the U .S. Yes, the 00:14:33.970 --> 00:14:37.730 Section 31 transaction fees. These are tiny fees 00:14:37.730 --> 00:14:39.789 that the National Securities Exchanges have to 00:14:39.789 --> 00:14:43.309 pay to the SEC to fund all the regulatory oversight. 00:14:43.850 --> 00:14:47.049 It applies to all security sales, ETFs included, 00:14:47.269 --> 00:14:50.309 and as of 2023, it was something like $8 for 00:14:50.309 --> 00:14:54.330 every $1 million you sell. So, basically negligible 00:14:54.330 --> 00:14:56.929 for most people. Completely negligible. but it 00:14:56.929 --> 00:14:59.429 is technically there. Okay, the third major difference 00:14:59.429 --> 00:15:01.929 is transparency. Given how complex some of these 00:15:01.929 --> 00:15:04.570 funds can be, knowing exactly what you own seems 00:15:04.570 --> 00:15:08.129 vital. And ETF transparency is near total. Issuers 00:15:08.129 --> 00:15:10.409 are generally required to publish the exact portfolio 00:15:10.409 --> 00:15:13.309 composition online every single day. Every day. 00:15:13.450 --> 00:15:15.370 Every single day. This continuous disclosure 00:15:15.370 --> 00:15:17.860 is essential. Not just for you, the investor, 00:15:17.980 --> 00:15:20.139 but for the authorized participants to do their 00:15:20.139 --> 00:15:22.399 arbitrage job, which we'll cover later. You can 00:15:22.399 --> 00:15:24.320 contrast that with some actively managed mutual 00:15:24.320 --> 00:15:26.700 funds that might only disclose their full holdings 00:15:26.700 --> 00:15:28.919 on a quarterly basis, leaving you partially in 00:15:28.919 --> 00:15:31.279 the dark for months at a time. And finally, the 00:15:31.279 --> 00:15:33.779 most celebrated advantage, particularly for long 00:15:33.779 --> 00:15:35.860 -term investors and taxable brokerage accounts 00:15:35.860 --> 00:15:39.059 in the U .S., the tax advantage. Now, this is 00:15:39.059 --> 00:15:41.620 a bit complicated, but it is a huge driver of 00:15:41.620 --> 00:15:44.340 value. This is really the financial magic trick 00:15:44.340 --> 00:15:47.419 of the ETF structure to understand it. We first 00:15:47.419 --> 00:15:49.879 have to understand why mutual funds are so tax 00:15:49.879 --> 00:15:52.539 inefficient in a taxable account. Okay, let's 00:15:52.539 --> 00:15:54.860 detail that tax trap. Lay it out for us. Okay. 00:15:55.279 --> 00:15:58.240 Imagine a mutual fund has owned stock A, B, and 00:15:58.240 --> 00:16:01.899 C for 10 years, and they've all appreciated significantly. 00:16:02.200 --> 00:16:05.740 They have huge built -in gains. Now, an investor 00:16:05.740 --> 00:16:08.580 comes along and redeems their shares. The fund 00:16:08.580 --> 00:16:10.980 manager needs cash to pay that person out. So 00:16:10.980 --> 00:16:12.539 they have to sell something. They are forced 00:16:12.539 --> 00:16:14.639 to sell some of those appreciated shares, A, 00:16:14.779 --> 00:16:17.779 B, or C, to generate that cash. When the fund 00:16:17.779 --> 00:16:20.919 sells and realizes the capital gain, it is legally 00:16:20.919 --> 00:16:23.440 required to distribute that capital gain to all 00:16:23.440 --> 00:16:25.639 the remaining shareholders. Even people who just 00:16:25.639 --> 00:16:27.460 bought the fund yesterday and haven't sold a 00:16:27.460 --> 00:16:29.820 thing themselves. Exactly. Even those who haven't 00:16:29.820 --> 00:16:32.519 sold anything. So an investor who held the fund 00:16:32.519 --> 00:16:34.820 for long -term growth is suddenly hit with a 00:16:34.820 --> 00:16:37.279 tax bill because someone else decided to redeem 00:16:37.279 --> 00:16:40.059 their shares. So you're realizing a capital gain 00:16:40.059 --> 00:16:42.799 and paying taxes on it for an event that was 00:16:42.799 --> 00:16:45.120 completely outside of your control. That's the 00:16:45.120 --> 00:16:47.860 trap. It's an adverse event you can't control. 00:16:48.139 --> 00:16:51.200 With an ETF, this whole dynamic is largely avoided. 00:16:51.460 --> 00:16:54.440 And the reason ETFs avoid it is directly tied 00:16:54.440 --> 00:16:56.720 to that process of creation and redemption we 00:16:56.720 --> 00:16:59.559 mentioned. Precisely. As an ETF investor, you 00:16:59.559 --> 00:17:02.120 generally only realize a capital gain when you 00:17:02.120 --> 00:17:05.259 sell your own shares for a profit. The redemption 00:17:05.259 --> 00:17:08.140 process that ETFs use, this in -kind transfer, 00:17:08.319 --> 00:17:10.220 allows the fund to get rid of its appreciated 00:17:10.220 --> 00:17:12.339 securities without actually triggering a sale, 00:17:12.460 --> 00:17:15.160 and thus without realizing a taxable capital 00:17:15.160 --> 00:17:17.319 gain that would be passed on to the remaining 00:17:17.319 --> 00:17:20.069 shareholders. That mechanism is the tax shield. 00:17:20.250 --> 00:17:22.910 It is the tax shield, and it's arguably the most 00:17:22.910 --> 00:17:24.930 important element for long -term investors. We 00:17:24.930 --> 00:17:26.849 have to mention the fascinating anomaly here, 00:17:26.910 --> 00:17:29.490 which is the Vanguard case. They somehow managed 00:17:29.490 --> 00:17:31.869 to give their mutual fund holders and their ETF 00:17:31.869 --> 00:17:34.950 holders the exact same tax benefit. Vanguard's 00:17:34.950 --> 00:17:37.200 structure is unique. In fact, it was patented. 00:17:37.359 --> 00:17:39.859 They structured their ETFs as just another lower 00:17:39.859 --> 00:17:41.980 cost share class of their existing mutual funds. 00:17:42.059 --> 00:17:45.000 So they're legally the same pool of assets. They 00:17:45.000 --> 00:17:47.839 are. And because the ETF shares are treated legally 00:17:47.839 --> 00:17:50.519 as part of that same mutual fund, they can use 00:17:50.519 --> 00:17:53.769 the mutual funds ability. to redeem certain high 00:17:53.769 --> 00:17:56.910 -cost tax lots when the big institutions redeem 00:17:56.910 --> 00:18:00.670 ETF shares. This process efficiently strips out 00:18:00.670 --> 00:18:03.349 capital gains from the whole portfolio, benefiting 00:18:03.349 --> 00:18:05.769 both the ETF shareholders and the mutual fund 00:18:05.769 --> 00:18:08.190 shareholders. It's an incredibly tax efficient 00:18:08.190 --> 00:18:11.220 system. So if ETFs started out as these simple 00:18:11.220 --> 00:18:14.140 index trackers, the universe has just exploded 00:18:14.140 --> 00:18:16.099 in the last decade and now covers everything 00:18:16.099 --> 00:18:18.799 from passive investing to highly sophisticated 00:18:18.799 --> 00:18:21.900 and frankly, pretty risky derivative bets. We 00:18:21.900 --> 00:18:24.160 need to categorize this explosion of choice because 00:18:24.160 --> 00:18:27.019 not all ETFs are created equal. Not at all. And 00:18:27.019 --> 00:18:29.420 we should begin with the bedrock index ETFs. 00:18:29.640 --> 00:18:31.440 These are the passive funds that just track a 00:18:31.440 --> 00:18:34.019 specific benchmark, whether that's a broad equity 00:18:34.019 --> 00:18:36.799 index, a niche sector, or a fixed income market. 00:18:37.000 --> 00:18:39.400 And for these passive funds, there are two main 00:18:39.400 --> 00:18:42.299 ways that managers use to mimic the index's performance. 00:18:42.799 --> 00:18:46.440 The ideal method is full replication. This is 00:18:46.440 --> 00:18:48.660 where the fund holds 100 % of the securities 00:18:48.660 --> 00:18:51.480 in the exact proportion that the index dictates. 00:18:51.640 --> 00:18:54.650 This guarantees near -perfect tracking. But that's 00:18:54.650 --> 00:18:57.670 not always practical. It's not. For massive indices 00:18:57.670 --> 00:19:00.210 that contain thousands of stocks, some of which 00:19:00.210 --> 00:19:02.829 are not very liquid, full replication can become 00:19:02.829 --> 00:19:04.849 administratively cumbersome and very expensive. 00:19:05.450 --> 00:19:07.869 So in those cases, they turn to the second method, 00:19:08.029 --> 00:19:10.009 which is representative sampling. How does that 00:19:10.009 --> 00:19:12.490 work in practice? With sampling, the ETF will 00:19:12.490 --> 00:19:15.690 invest, say, 80 to 95 percent of its assets in 00:19:15.690 --> 00:19:17.970 the core securities of the index. The remaining 00:19:17.970 --> 00:19:20.829 5 to 20 percent might be invested in high liquidity 00:19:20.829 --> 00:19:24.049 derivatives, cash or other securities that the 00:19:24.049 --> 00:19:25.910 friend's advisor believes will help it maintain 00:19:25.910 --> 00:19:28.349 its objective while keeping costs down. Can you 00:19:28.349 --> 00:19:30.150 give an example of a fund that does this? A common 00:19:30.150 --> 00:19:33.289 one is VTI, which tracks the CRSP US total market 00:19:33.289 --> 00:19:36.650 index. That index has nearly 4 ,000 stocks. It 00:19:36.650 --> 00:19:38.769 would be incredibly difficult to own all of them. 00:19:39.069 --> 00:19:41.910 So sampling sacrifices a tiny, tiny amount of 00:19:41.910 --> 00:19:44.269 tracking precision for a huge gain in operational 00:19:44.269 --> 00:19:46.730 efficiency. And the diversity of these index 00:19:46.730 --> 00:19:49.829 funds is just vast now. Beyond the classic S 00:19:49.829 --> 00:19:53.170 &P 500 trackers like VOO and SPY, what other 00:19:53.170 --> 00:19:56.170 common examples show the kind of low -cost exposure 00:19:56.170 --> 00:19:58.549 you can get? Oh, the spectrum is immense. You 00:19:58.549 --> 00:20:01.769 can get small -cap exposure with IWM, the iShares 00:20:01.769 --> 00:20:04.769 Russell 2000 ETF. You can get international access 00:20:04.769 --> 00:20:07.970 with VXUS, the Total International Stock Market 00:20:07.970 --> 00:20:11.420 Fund. Or you can make specific sector bets, like 00:20:11.420 --> 00:20:15.079 with XLK, the technology select sector SQDR fund. 00:20:15.259 --> 00:20:17.900 So you get low cost, precise exposure to emerging 00:20:17.900 --> 00:20:20.700 markets, developed economies, or just one slice 00:20:20.700 --> 00:20:22.819 of the U .S. economy. Yes, and that's exactly 00:20:22.819 --> 00:20:24.900 why this product is so disruptive. Okay, moving 00:20:24.900 --> 00:20:27.839 away from just pure passive replication, we get 00:20:27.839 --> 00:20:30.119 into the world of factor and actively managed 00:20:30.119 --> 00:20:33.599 ETFs. Factor ETFs are what's often called enhanced 00:20:33.599 --> 00:20:36.240 indexing. They move a little bit beyond just 00:20:36.240 --> 00:20:38.619 passive market cap weighting by targeting measurable 00:20:38.619 --> 00:20:41.200 characteristics or factors that academic research 00:20:41.200 --> 00:20:44.519 suggests can provide better long -term risk -adjusted 00:20:44.519 --> 00:20:46.599 returns. What are the main factors that investors 00:20:46.599 --> 00:20:49.799 are looking for here? Standard ones are size, 00:20:49.900 --> 00:20:52.420 small cap stocks tend to outperform over time 00:20:52.420 --> 00:20:55.140 value, so cheap stocks relative to their fundamentals, 00:20:55.319 --> 00:20:57.839 and momentum, which is stocks that have recently 00:20:57.839 --> 00:21:00.240 performed well. And there's also quality and 00:21:00.240 --> 00:21:03.210 low volatility. Right. Quality means companies 00:21:03.210 --> 00:21:05.329 with strong balance sheets and consistent earnings. 00:21:05.829 --> 00:21:08.930 And low volatility is, well, stocks that fluctuate 00:21:08.930 --> 00:21:11.890 less than the market average. By tilting the 00:21:11.890 --> 00:21:14.490 portfolio towards these factors, the fund tries 00:21:14.490 --> 00:21:17.589 to generate alpha, or excess return. What's the 00:21:17.589 --> 00:21:19.569 trade -off? The trade -off is that these funds 00:21:19.569 --> 00:21:22.230 carry slightly higher expense ratios than pure 00:21:22.230 --> 00:21:24.609 passive funds, and their performance can actually 00:21:24.609 --> 00:21:27.039 be more volatile over the short term. And then 00:21:27.039 --> 00:21:29.380 you have the purely active ETFs where all the 00:21:29.380 --> 00:21:32.180 decisions are discretionary. A human manager 00:21:32.180 --> 00:21:34.779 is executing a specific strategy instead of just 00:21:34.779 --> 00:21:37.859 hugging a benchmark index. And the inherent conflict 00:21:37.859 --> 00:21:40.019 here, as we discussed with transparency, is that 00:21:40.019 --> 00:21:42.000 if an active manager has to post their entire 00:21:42.000 --> 00:21:44.799 portfolio every single day, every competitor 00:21:44.799 --> 00:21:46.559 out there from hedge funds to high frequency 00:21:46.559 --> 00:21:49.339 traders could potentially see their moves and 00:21:49.339 --> 00:21:52.079 front run their strategy. So how are fund managers 00:21:52.079 --> 00:21:54.200 getting around this massive front running risk? 00:21:54.440 --> 00:21:57.000 A couple of ways. Some, especially in the fixed 00:21:57.000 --> 00:21:59.339 income or income generation space, just have 00:21:59.339 --> 00:22:01.599 a lower turnover rate. They might only trade 00:22:01.599 --> 00:22:04.359 weekly or monthly. So the daily disclosure is 00:22:04.359 --> 00:22:06.559 less of a big deal. And the others? Others use 00:22:06.559 --> 00:22:08.880 custom legal structures like the patented active 00:22:08.880 --> 00:22:11.420 shares structure. This allows them to disclose 00:22:11.420 --> 00:22:14.299 a kind of proxy portfolio daily while keeping 00:22:14.299 --> 00:22:16.220 their real high conviction trades confidential. 00:22:16.700 --> 00:22:19.240 This innovation was really necessary to attract 00:22:19.240 --> 00:22:22.250 star act. managers into the ETF wrapper. And 00:22:22.250 --> 00:22:24.589 are there major examples of successful active 00:22:24.589 --> 00:22:27.549 ETFs that show this model can work? Oh, absolutely. 00:22:27.809 --> 00:22:30.430 The space is dominated by income funds. The J 00:22:30.430 --> 00:22:34.049 .P. Morgan Equity Premium Income ETF, JEPI, is 00:22:34.049 --> 00:22:36.710 a huge one. It uses options overlays to generate 00:22:36.710 --> 00:22:39.529 high income. Its success proves that active management 00:22:39.529 --> 00:22:42.750 can really thrive inside the ETF structure, especially 00:22:42.750 --> 00:22:44.970 when it's focused on a defined goal like income 00:22:44.970 --> 00:22:47.529 rather than just high turnover stock picking. 00:22:47.880 --> 00:22:49.700 All right, now we enter the Financial High Wire 00:22:49.700 --> 00:22:53.359 Act, leveraged and inverse ETFs, or LETFs, and 00:22:53.359 --> 00:22:55.339 these are fundamentally designed for short -term 00:22:55.339 --> 00:22:57.880 traders. You really can't stress the short -term 00:22:57.880 --> 00:23:01.279 nature of these funds enough. LETFs use sophisticated 00:23:01.279 --> 00:23:03.740 derivatives, usually swaps and futures contracts, 00:23:04.099 --> 00:23:07.299 to magnify or invert the daily performance of 00:23:07.299 --> 00:23:10.539 an index. They're designed to deliver, say, 2x 00:23:10.539 --> 00:23:13.500 or 3x the performance of the S &P 500 on a single 00:23:13.500 --> 00:23:17.180 day. So if the S &P goes up 1%, the 3x fund is 00:23:17.180 --> 00:23:20.359 supposed to go up 3%. It sounds great on paper, 00:23:20.539 --> 00:23:23.480 but the risk is massive for anyone holding them 00:23:23.480 --> 00:23:26.299 for longer than 24 hours. And this is due to 00:23:26.299 --> 00:23:29.220 a phenomenon called volatility drag. Or volatility 00:23:29.220 --> 00:23:32.099 tax. And this is the most crucial and often the 00:23:32.099 --> 00:23:35.259 most misunderstood technical aspect of LETFs. 00:23:35.319 --> 00:23:37.880 The drag happens because these funds have to 00:23:37.880 --> 00:23:40.279 maintain a fixed leverage ratio every single 00:23:40.279 --> 00:23:42.599 day. What does that rebalancing actually entail? 00:23:43.099 --> 00:23:45.319 Well, if the market goes up, the fund is suddenly 00:23:45.319 --> 00:23:48.619 underleveraged. It only has, say, 2 .9x leverage 00:23:48.619 --> 00:23:51.119 relative to its new, bigger principal. So it 00:23:51.119 --> 00:23:52.660 has to buy more assets at the end of the day 00:23:52.660 --> 00:23:55.220 to get back to 3x. If the market goes down, it's 00:23:55.220 --> 00:23:57.279 instantly overleveraged, so it has to sell assets 00:23:57.279 --> 00:23:59.279 to reduce its exposure. That sounds like you're 00:23:59.279 --> 00:24:01.460 constantly being forced to buy high and sell 00:24:01.460 --> 00:24:03.779 low in a volatile market. That is the core of 00:24:03.779 --> 00:24:06.980 the problem. This mandatory daily rebalancing 00:24:06.980 --> 00:24:09.480 means the fund manager is mathematically forced 00:24:09.480 --> 00:24:12.339 to trade against the prevailing trend to restore 00:24:12.339 --> 00:24:16.009 that fixed ratio. When markets are choppy, This 00:24:16.009 --> 00:24:18.609 path dependency leads to substantial compounding 00:24:18.609 --> 00:24:21.289 losses over time. It just erodes the principal 00:24:21.289 --> 00:24:24.150 value. So even if the underlying index finishes 00:24:24.150 --> 00:24:26.990 flat over two days, the LETF can be down? It 00:24:26.990 --> 00:24:29.109 can be down significantly. A fund might be up 00:24:29.109 --> 00:24:32.589 10 % one day and down 10 % the next. The 3x fund's 00:24:32.589 --> 00:24:34.829 loss on day two will be calculated against a 00:24:34.829 --> 00:24:37.390 smaller principal. The absolute dollar loss will 00:24:37.390 --> 00:24:39.869 be greater than the absolute dollar gain. They 00:24:39.869 --> 00:24:42.609 are purely speculative instruments. Okay, shifting 00:24:42.609 --> 00:24:44.490 our focus geographically for a moment, let's 00:24:44.490 --> 00:24:46.329 touch on synthetic ETFs, which are much more 00:24:46.329 --> 00:24:48.609 common in Europe. A synthetic ETF doesn't bother 00:24:48.609 --> 00:24:50.390 with physical ownership of the underlying stocks 00:24:50.390 --> 00:24:53.009 at all. Instead, the fund enters into what's 00:24:53.009 --> 00:24:56.349 called a total return swap contract with a counterparty, 00:24:56.349 --> 00:24:58.710 typically a major investment bank. And what does 00:24:58.710 --> 00:25:01.329 that swap do? The counterparty, the bank, agrees 00:25:01.329 --> 00:25:03.549 to pay the ETF the exact return of the index. 00:25:03.750 --> 00:25:06.369 In exchange, the ETF pays the bank the returns 00:25:06.369 --> 00:25:08.730 generated by the collateral that it holds. This 00:25:08.730 --> 00:25:11.049 structure immediately introduces a new kind of 00:25:11.049 --> 00:25:13.710 risk, doesn't it? Counterparty risk. It does. 00:25:13.950 --> 00:25:17.269 That is the key concern. If the counterparty, 00:25:17.269 --> 00:25:20.450 the bank. defaults on its contractual obligation 00:25:20.450 --> 00:25:24.130 to match the index return, the ETF loses that 00:25:24.130 --> 00:25:27.450 performance. Now, European regulation, UCI says 00:25:27.450 --> 00:25:30.450 it's very strict, and mandates that the counterparty 00:25:30.450 --> 00:25:32.230 has to fully collateralize their obligation. 00:25:32.630 --> 00:25:34.549 But there's still a risk. There's still a risk 00:25:34.549 --> 00:25:36.470 concerning the quality and the liquidity of that 00:25:36.470 --> 00:25:38.730 collateral, especially during a major financial 00:25:38.730 --> 00:25:41.730 crisis. It just introduces a layer of complexity 00:25:41.730 --> 00:25:44.390 and a reliance on third parties that physical 00:25:44.390 --> 00:25:46.849 ETFs are designed to avoid. Let's move to asset 00:25:46.849 --> 00:25:48.930 -specific funds. Now, starting with commodity 00:25:48.930 --> 00:25:51.730 ETFs, you have the physical funds like GLD for 00:25:51.730 --> 00:25:54.210 gold, which own the actual metal. But then you 00:25:54.210 --> 00:25:56.029 have the futures only funds, which introduce 00:25:56.029 --> 00:25:58.410 entirely different financial physics. Right. 00:25:58.529 --> 00:26:01.430 Funds like the United States Oil Fund, USO, primarily 00:26:01.430 --> 00:26:05.210 use futures contracts and they face a major structural 00:26:05.210 --> 00:26:07.250 risk related to the market's term structure. 00:26:07.569 --> 00:26:09.569 This just refers to the relationship between 00:26:09.569 --> 00:26:11.990 the price of a near month futures contract and 00:26:11.990 --> 00:26:14.319 the price of a far month contract. This is where 00:26:14.319 --> 00:26:17.140 we need to clearly define contango and backwardation. 00:26:17.400 --> 00:26:19.559 Contango is the primary risk for these funds. 00:26:19.740 --> 00:26:22.160 It means the futures curve is upward sloping. 00:26:22.259 --> 00:26:25.019 The contract expiring next month is cheaper than 00:26:25.019 --> 00:26:27.359 the contract expiring six months from now. So 00:26:27.359 --> 00:26:30.380 when a fund like USO has to roll its position, 00:26:30.619 --> 00:26:33.660 sell the near month contract before it expires 00:26:33.660 --> 00:26:36.539 and buy the next month's contract, it's perpetually 00:26:36.539 --> 00:26:39.349 selling low and buying high. That's it. That 00:26:39.349 --> 00:26:42.549 process, the high cost to roll, just destroys 00:26:42.549 --> 00:26:45.950 fund value over time. It often causes the ETF 00:26:45.950 --> 00:26:48.589 to significantly underperform the actual spot 00:26:48.589 --> 00:26:51.410 price of the underlying commodity. So even if 00:26:51.410 --> 00:26:53.410 the spot price of oil is rising, an investor 00:26:53.410 --> 00:26:56.130 in a futures only ETF can still lose money because 00:26:56.130 --> 00:26:58.450 of that constant negative roll yield. Absolutely. 00:26:58.940 --> 00:27:01.039 The opposite scenario, backwardation, where the 00:27:01.039 --> 00:27:02.779 near -month contracts are more expensive, is 00:27:02.779 --> 00:27:05.240 beneficial. But Contango is often the dominant 00:27:05.240 --> 00:27:07.259 structure in markets like oil. It makes these 00:27:07.259 --> 00:27:09.680 funds very complex and volatile for long -term 00:27:09.680 --> 00:27:12.980 holds. We also have currency ETFs, which have 00:27:12.980 --> 00:27:15.299 made it much easier for retail investors to get 00:27:15.299 --> 00:27:18.099 into foreign exchange trading. They have. These 00:27:18.099 --> 00:27:20.779 are sophisticated trusts that hold cash and short 00:27:20.779 --> 00:27:23.700 -term debt in foreign currencies. They let investors 00:27:23.700 --> 00:27:26.579 bet on, or hedge against, the spot changes in 00:27:26.579 --> 00:27:29.220 major currencies like the euro or the yen, while 00:27:29.220 --> 00:27:31.140 also earning the institutional interest rates 00:27:31.140 --> 00:27:33.859 available in that foreign market. It bypasses 00:27:33.859 --> 00:27:35.799 all the complexity of setting up a foreign currency 00:27:35.799 --> 00:27:37.740 account yourself. Okay, here's where it gets 00:27:37.740 --> 00:27:41.140 really interesting and highly complex. Cryptocurrency 00:27:41.140 --> 00:27:44.359 ETFs. The recent approvals have created two very 00:27:44.359 --> 00:27:46.920 distinct types of crypto exposure. The first 00:27:46.920 --> 00:27:49.960 type we saw were the futures -based crypto ETFs. 00:27:50.000 --> 00:27:52.440 They just track the performance of futures contracts 00:27:52.440 --> 00:27:55.380 that trade on the CME. But the more recent and 00:27:55.380 --> 00:27:57.940 much more disruptive category is the spot crypto 00:27:57.940 --> 00:28:01.259 ETF. And that invests directly in the asset itself. 00:28:01.519 --> 00:28:04.160 Right. It buys and holds actual Bitcoin or Ether. 00:28:04.559 --> 00:28:06.420 tracking its real -time price. And the regulatory 00:28:06.420 --> 00:28:08.559 shift for these spot funds, particularly for 00:28:08.559 --> 00:28:11.579 Bitcoin, was massive in 2024. The approval of 00:28:11.579 --> 00:28:14.839 11 spot Bitcoin ETFs back in January was a landmark 00:28:14.839 --> 00:28:17.619 decision. It really gave institutional credibility 00:28:17.619 --> 00:28:19.980 to the entire asset class. The market response 00:28:19.980 --> 00:28:22.759 was just immediate and overwhelming. BlackRock's 00:28:22.759 --> 00:28:26.200 Bitcoin ETF, the iShares Bitcoin Trust, amassed 00:28:26.200 --> 00:28:29.799 $10 billion in assets in just four months. By 00:28:29.799 --> 00:28:33.390 May 2024. By May. It just demonstrated that there 00:28:33.390 --> 00:28:36.230 was this massive pent up institutional and retail 00:28:36.230 --> 00:28:38.769 demand for a product that was wrapped in the 00:28:38.769 --> 00:28:41.869 secure, regulated ETF structure. But these new 00:28:41.869 --> 00:28:44.150 structures, which are combining ancient trust 00:28:44.150 --> 00:28:46.630 laws with brand new digital assets, have run 00:28:46.630 --> 00:28:49.450 into some strange, unexpected custody problems. 00:28:49.829 --> 00:28:53.190 Most notably, this dust problem. The dust problem 00:28:53.190 --> 00:28:55.910 is a fascinating byproduct of blockchain technology 00:28:55.910 --> 00:28:58.710 meeting traditional finance. When you're transacting 00:28:58.710 --> 00:29:02.009 with Bitcoin. minuscule residual amounts of other 00:29:02.009 --> 00:29:04.170 tokens, sometimes including non -Bitcoin assets 00:29:04.170 --> 00:29:07.049 like NFTs, can end up in the ETS custody wallet. 00:29:07.230 --> 00:29:09.529 Just from the transaction itself. Exactly. Because 00:29:09.529 --> 00:29:11.730 of the high volume of transactions, BlackRock 00:29:11.730 --> 00:29:13.829 alone reportedly ended up with something like 00:29:13.829 --> 00:29:16.450 $20 ,000 worth of these residual non -Bitcoin 00:29:16.450 --> 00:29:18.650 assets just sitting there. So why is that such 00:29:18.650 --> 00:29:20.150 a headache? I mean, why can't they just sell 00:29:20.150 --> 00:29:22.569 the tokens and pocket the small profit? They 00:29:22.569 --> 00:29:25.809 can't. There are severe legal and tax implications. 00:29:26.410 --> 00:29:29.170 If the fund sells these random residual tokens, 00:29:29.450 --> 00:29:31.750 that realized capital gain would need to be passed 00:29:31.750 --> 00:29:34.170 on to all the shareholders. That would trigger 00:29:34.170 --> 00:29:37.250 unexpected tax complexity and could even jeopardize 00:29:37.250 --> 00:29:40.349 the ETS legal status as a pure Bitcoin investment 00:29:40.349 --> 00:29:42.710 vehicle. So what do they do with it? The costs 00:29:42.710 --> 00:29:45.109 and complexity of trying to distribute tiny amounts 00:29:45.109 --> 00:29:47.869 of random tokens to millions of shareholders 00:29:47.869 --> 00:29:50.569 are prohibitive. So the firms are forced to just 00:29:50.569 --> 00:29:53.410 hold them. perpetually in separate cold storage 00:29:53.410 --> 00:29:55.970 wallets. That just speaks volumes about the complexity 00:29:55.970 --> 00:29:58.710 of trying to fit a cutting edge digital asset 00:29:58.710 --> 00:30:02.150 into a 1940s regulatory framework. It absolutely 00:30:02.150 --> 00:30:04.970 does. And we saw a very similar regulatory constraint 00:30:04.970 --> 00:30:07.769 imposed on the recently approved spot as Ethereum 00:30:07.769 --> 00:30:11.210 ETFs. That constraint was that the Ethereum ETFs 00:30:11.210 --> 00:30:13.569 are prohibited from claiming rewards from the 00:30:13.569 --> 00:30:16.190 proof of stake process. What does that mean for 00:30:16.190 --> 00:30:18.490 an investor? So Ethereum operates on a proof 00:30:18.490 --> 00:30:21.069 of stake model, which allows holders to stake 00:30:21.069 --> 00:30:23.410 their tokens and earn a yield, almost like interest 00:30:23.410 --> 00:30:26.250 or dividends. The SEC specifically prohibited 00:30:26.250 --> 00:30:28.630 the spot ETFs from staking their Ether. And the 00:30:28.630 --> 00:30:31.029 result of that is? The result is an estimated 00:30:31.029 --> 00:30:33.890 loss of around 3 % of potential returns every 00:30:33.890 --> 00:30:37.579 year. This lost yield creates a competitive disadvantage. 00:30:38.119 --> 00:30:40.980 If you as an individual can stake your own Ether 00:30:40.980 --> 00:30:44.660 and earn 3%, the ETF has to compensate for that 00:30:44.660 --> 00:30:47.640 lost revenue, probably by charging higher expense 00:30:47.640 --> 00:30:50.359 ratios to customers compared to what an unstayed 00:30:50.359 --> 00:30:52.680 fund would cost. OK, finally, we have to look 00:30:52.680 --> 00:30:55.640 at thematic ETFs. These are the funds that promise 00:30:55.640 --> 00:30:58.700 exposure to big macro trends, everything from 00:30:58.700 --> 00:31:02.579 climate change to genomics to AI. Thematic ETFs 00:31:02.579 --> 00:31:04.640 are really compelling because they offer a narrative. 00:31:05.180 --> 00:31:07.900 Investors want to own the future, whether that's 00:31:07.900 --> 00:31:09.900 disruptive technologies or ethical investing, 00:31:10.019 --> 00:31:13.019 ESG. However, they come with a significant risk. 00:31:13.420 --> 00:31:15.759 opaque selection criteria. Meaning it's hard 00:31:15.759 --> 00:31:18.279 to know what's actually inside. It can be incredibly 00:31:18.279 --> 00:31:20.579 difficult to objectively define what constitutes 00:31:20.579 --> 00:31:23.200 a company that's involved in, say, the gig economy. 00:31:23.480 --> 00:31:25.559 And that leads to funds that are often more about 00:31:25.559 --> 00:31:28.839 marketing than genuine focused exposure. And 00:31:28.839 --> 00:31:31.059 the market enthusiasm around themes like artificial 00:31:31.059 --> 00:31:33.500 intelligence has led to some regulatory scrutiny, 00:31:33.700 --> 00:31:36.619 specifically these charges of AI washing. That's 00:31:36.619 --> 00:31:39.519 right. The SEC has brought charges against investment 00:31:39.519 --> 00:31:42.339 advisors who exaggerated their involvement with 00:31:42.339 --> 00:31:45.220 AI just to capitalize on the massive enthusiasm 00:31:45.220 --> 00:31:48.150 around the sector. It really highlights the risk 00:31:48.150 --> 00:31:51.190 that while thematic funds offer these exciting 00:31:51.190 --> 00:31:53.809 narratives, you have to apply a high degree of 00:31:53.809 --> 00:31:56.230 scrutiny to make sure the underlying holdings 00:31:56.230 --> 00:31:59.190 actually match the fund's advertised theme. But 00:31:59.190 --> 00:32:01.309 despite the risks and the definitional challenges, 00:32:01.650 --> 00:32:04.829 one thematic category has seen explosive structural 00:32:04.829 --> 00:32:08.690 growth globally. ESG environmental, social, and 00:32:08.690 --> 00:32:12.049 governance ETFs. The demand signal for ESG is 00:32:12.049 --> 00:32:14.720 unmistakable. It's driven by investor demand 00:32:14.720 --> 00:32:16.599 for products that align their investment goals 00:32:16.599 --> 00:32:20.079 with their ethical or social values. ESG ETFs 00:32:20.079 --> 00:32:22.440 have grown substantially, reaching over $640 00:32:22.440 --> 00:32:25.359 billion in assets by late 2024. And that's a 00:32:25.359 --> 00:32:27.960 global phenomenon. It is, but the growth is especially 00:32:27.960 --> 00:32:30.119 pronounced in Europe, where regulatory frameworks 00:32:30.119 --> 00:32:32.319 often encourage socially responsible investing. 00:32:32.400 --> 00:32:34.720 It just confirms that for a large segment of 00:32:34.720 --> 00:32:37.279 the investor base, value alignment is now just 00:32:37.279 --> 00:32:39.920 as important as cost in return. OK, we've established 00:32:39.920 --> 00:32:42.440 that ETFs have this dual nature. They're a fund 00:32:42.440 --> 00:32:44.720 of assets and they're a share trading on an exchange. 00:32:45.160 --> 00:32:48.619 The entire seven plus trillion dollar edifice 00:32:48.619 --> 00:32:51.640 is built on the mechanism that ensures the price 00:32:51.640 --> 00:32:54.019 of that traded share stays anchored to the actual 00:32:54.019 --> 00:32:57.200 value of the assets inside. And that mechanism 00:32:57.200 --> 00:32:59.740 is arbitrage. The whole system is completely 00:32:59.740 --> 00:33:02.819 dependent on the efficacy of this engine. I mean, 00:33:02.819 --> 00:33:05.019 if the market price of the ETF share its market 00:33:05.019 --> 00:33:07.759 value deviates significantly from the net asset 00:33:07.759 --> 00:33:10.319 value, the NAV, the intrinsic value of what's 00:33:10.319 --> 00:33:13.160 inside, then the product fails its core mandate 00:33:13.160 --> 00:33:16.109 as a low -cost tracker. And this engine runs 00:33:16.109 --> 00:33:18.450 on these specialized entities known as authorized 00:33:18.450 --> 00:33:21.589 participants or APs. So who are these powerful 00:33:21.589 --> 00:33:24.809 firms and what is their role? APs are large institutional 00:33:24.809 --> 00:33:27.089 broker dealers and market makers. You should 00:33:27.089 --> 00:33:28.750 think of the major investment banks. They're 00:33:28.750 --> 00:33:30.730 the only entities that can transact directly 00:33:30.730 --> 00:33:33.319 with the ETF issuer. And they're not buying or 00:33:33.319 --> 00:33:35.759 selling individual shares. No, they deal in massive 00:33:35.759 --> 00:33:38.359 blocks called creation units, which are typically 00:33:38.359 --> 00:33:41.579 50 ,000 shares or more. Their entire role is 00:33:41.579 --> 00:33:43.660 to provide liquidity and ensure that price stays 00:33:43.660 --> 00:33:46.119 true. And the most important tax -efficient feature 00:33:46.119 --> 00:33:48.460 of this whole relationship is the in -kind exchange. 00:33:49.119 --> 00:33:51.640 This the financial genius of the whole structure. 00:33:52.109 --> 00:33:54.869 When an AP goes to the issuer to create new ETF 00:33:54.869 --> 00:33:58.069 shares, they don't give the issuer cash. Instead, 00:33:58.369 --> 00:34:00.750 they deliver the exact basket of underlying securities, 00:34:01.130 --> 00:34:03.910 the required proportion of Apple, Tesla, Amazon, 00:34:04.109 --> 00:34:07.089 whatever it is that makes up the fund. This is 00:34:07.089 --> 00:34:10.349 an in -kind contribution. So why is that in -kind 00:34:10.349 --> 00:34:12.710 transfer so essential for those tax advantages 00:34:12.710 --> 00:34:15.670 we talked about earlier? Because no cash is exchanged 00:34:15.670 --> 00:34:18.230 and no assets are ever sold by the fund itself, 00:34:18.570 --> 00:34:21.670 the fund doesn't realize a capital gain. This 00:34:21.670 --> 00:34:24.050 completely avoids the situation that mutual funds 00:34:24.050 --> 00:34:26.630 face, where selling appreciated shares to meet 00:34:26.630 --> 00:34:29.170 a cash redemption triggers a taxable event for 00:34:29.170 --> 00:34:31.349 all the remaining shareholders. The in -kind 00:34:31.349 --> 00:34:33.650 process allows the fund to grow or shrink without 00:34:33.650 --> 00:34:35.969 imposing any tax liability on its long -term 00:34:35.969 --> 00:34:37.969 investors. OK, so let's walk through exactly 00:34:37.969 --> 00:34:40.989 how the APs use this ability to perform arbitrage 00:34:40.989 --> 00:34:42.989 and prevent the share price from going rogue. 00:34:43.150 --> 00:34:46.050 All right, scenario one, the premium. Imagine 00:34:46.050 --> 00:34:48.349 there's strong investor demand and it floods 00:34:48.349 --> 00:34:50.579 the market. pushing the ETF share price up to 00:34:50.579 --> 00:34:54.019 $100. But the actual NAV of the underlying stocks 00:34:54.019 --> 00:34:57.980 inside is only $99. The ETF is trading at a premium. 00:34:58.360 --> 00:35:00.880 And that $1 difference, that's the risk -free 00:35:00.880 --> 00:35:03.300 profit opportunity. That's the arbitrage spread. 00:35:03.599 --> 00:35:06.460 The AP recognizes this spread instantly. They 00:35:06.460 --> 00:35:08.780 swiftly assemble the underlying basket of securities 00:35:08.780 --> 00:35:11.940 needed, that $99 worth of stocks, and they deliver 00:35:11.940 --> 00:35:14.940 it to the ETF issuer to create a brand new creation 00:35:14.940 --> 00:35:18.539 unit of 50 ,000 ETF shares. So they get these 00:35:18.539 --> 00:35:20.780 newly minted ETF shares from the issuer. They 00:35:20.780 --> 00:35:22.780 do. And then they immediately sell those new 00:35:22.780 --> 00:35:24.960 ETF shares on their open market at the prevailing 00:35:24.960 --> 00:35:27.179 market price of $100. Pocketing a dollar per 00:35:27.179 --> 00:35:29.960 share. Exactly. They profit $1 per share instantly 00:35:29.960 --> 00:35:32.860 and risk -free. And critically, this action, 00:35:32.940 --> 00:35:35.179 the instantaneous sale of 50 ,000 new shares, 00:35:35.320 --> 00:35:37.559 increases the supply of ETF shares on the market. 00:35:37.780 --> 00:35:39.980 This increase in supply acts as a counterweight 00:35:39.980 --> 00:35:41.800 to that initial demand, and it drives the market 00:35:41.800 --> 00:35:44.420 price back down toward the NAV of $99, eliminating 00:35:44.420 --> 00:35:46.860 the arbitrage opportunity. This creation process 00:35:46.860 --> 00:35:49.500 results in what we call ETF inflow. Okay, now 00:35:49.500 --> 00:35:52.039 for the opposite. Scenario two, the discount. 00:35:52.670 --> 00:35:55.130 For whatever reason, the ETF share price drops 00:35:55.130 --> 00:35:59.210 to $98, but the NAV of the stocks inside is still 00:35:59.210 --> 00:36:03.030 $99. Now the ETF is trading at a discount. The 00:36:03.030 --> 00:36:05.829 AP sees this opportunity to buy cheap. They go 00:36:05.829 --> 00:36:08.789 out and buy up 50 ,000 of those discounted ETF 00:36:08.789 --> 00:36:12.170 shares on the open market for $98 each. They 00:36:12.170 --> 00:36:14.369 then take those creation units back to the issuer 00:36:14.369 --> 00:36:16.210 for redemption. And they don't get cash back 00:36:16.210 --> 00:36:18.289 from the issuer. They get the underlying stocks. 00:36:18.530 --> 00:36:20.590 They get the in -kind basket of underlying securities, 00:36:20.789 --> 00:36:23.190 which is still worth $99. They just paid $98 00:36:23.190 --> 00:36:25.869 for a $99 basket of goods. They can then immediately 00:36:25.869 --> 00:36:27.929 sell those received stocks on the market for 00:36:27.929 --> 00:36:30.420 a risk -free profit. And that action, the AP 00:36:30.420 --> 00:36:32.400 pulling shares off the open market for redemption, 00:36:32.699 --> 00:36:35.760 reduces the available supply of the ETF. Right. 00:36:35.860 --> 00:36:38.539 And that decrease in supply pushes the market 00:36:38.539 --> 00:36:41.780 price back up toward the NAV of $99. This is 00:36:41.780 --> 00:36:45.320 what we refer to as ETF outflow. So the APs aren't 00:36:45.320 --> 00:36:47.000 doing this out of the goodness of their hearts. 00:36:47.000 --> 00:36:49.199 They're doing it for a guaranteed instantaneous 00:36:49.199 --> 00:36:53.260 profit. But the systemic effect is that the ETF's 00:36:53.260 --> 00:36:55.940 price remains remarkably close to the actual 00:36:55.940 --> 00:36:58.619 value of its holdings, which ensures the product 00:36:58.619 --> 00:37:01.599 is functional and trustworthy. This sophisticated 00:37:01.599 --> 00:37:04.639 automated trading is the absolute lifeblood of 00:37:04.639 --> 00:37:08.400 the entire ETF ecosystem. If the APs ever stop 00:37:08.400 --> 00:37:10.800 performing this arbitrage, the system breaks 00:37:10.800 --> 00:37:13.719 down. The ETF seems like such a modern digital 00:37:13.719 --> 00:37:16.059 invention, but its roots actually stretch back 00:37:16.059 --> 00:37:18.239 decades, and they're marked by legal challenges 00:37:18.239 --> 00:37:20.400 and some early failures. That's right. The very 00:37:20.400 --> 00:37:23.460 first attempt was way back in 1989 with something 00:37:23.460 --> 00:37:27.039 called Index Participation Shares, or IPS. They 00:37:27.039 --> 00:37:29.320 were designed to track the S &P 500. And they 00:37:29.320 --> 00:37:31.000 didn't last long. They were very short -lived 00:37:31.000 --> 00:37:33.179 because the Chicago Mercantile Exchange successfully 00:37:33.179 --> 00:37:35.840 sued, arguing that the structure was too similar 00:37:35.840 --> 00:37:37.880 to a futures contract and should therefore be 00:37:37.880 --> 00:37:41.039 regulated by the CFDC, not the SEC. The courts 00:37:41.039 --> 00:37:43.179 agreed, and sales were halted almost immediately. 00:37:43.500 --> 00:37:45.599 So the concept was sound, but the legal wrapper 00:37:45.599 --> 00:37:47.960 was wrong, and Canada actually fixed this first. 00:37:48.360 --> 00:37:51.719 Yes. Canada launched the Toronto Index Participation 00:37:51.719 --> 00:37:55.179 Units in 1990, and that provided the first successful, 00:37:55.500 --> 00:37:59.059 continuously traded index product. But the birth 00:37:59.059 --> 00:38:01.780 of the modern, globally successful ETF that we 00:38:01.780 --> 00:38:04.619 know today, that happened in 1993, and it was 00:38:04.619 --> 00:38:06.440 driven by a team at the American Stock Exchange, 00:38:06.760 --> 00:38:09.800 including Nathan Most. That's the one. They designed 00:38:09.800 --> 00:38:12.260 the Standard & Poor's depository receipts, or 00:38:12.260 --> 00:38:14.920 SPDRs, the famous spiders, and launched them 00:38:14.920 --> 00:38:18.539 in January 1993. Crucially, they structured it 00:38:18.539 --> 00:38:21.519 as a unit investment trust, which very carefully 00:38:21.519 --> 00:38:24.119 navigated all those legal issues that had killed 00:38:24.119 --> 00:38:27.559 the IPS. And SPY was an immediate hit. An immediate 00:38:27.559 --> 00:38:29.860 hit. And it is still the world's largest ETF. 00:38:30.199 --> 00:38:32.199 It really defined the market for years to come. 00:38:32.320 --> 00:38:34.619 And the pace of innovation was just rapid after 00:38:34.619 --> 00:38:37.659 that. In 1996, the World Equity Benchmark Shares, 00:38:37.659 --> 00:38:40.340 or BBS, which later became iShares, they came 00:38:40.340 --> 00:38:42.699 along and they offered easy access to foreign 00:38:42.699 --> 00:38:44.800 markets and used a slightly different, more flexible 00:38:44.800 --> 00:38:46.900 mutual fund structure. The market matured so 00:38:46.900 --> 00:38:49.559 quickly. By 1998, you had the launch of sector 00:38:49.559 --> 00:38:52.119 -specific funds, the sector spiders, which allowed 00:38:52.119 --> 00:38:54.340 for tactical bets on specific industries within 00:38:54.340 --> 00:38:57.730 the S &P 500. And you had the Dow. And then the 00:38:57.730 --> 00:39:01.329 tech boom. Exactly. By 1999, we had the QQQ, 00:39:01.469 --> 00:39:04.309 tracking the Nasdaq Q100. And the first bond 00:39:04.309 --> 00:39:07.329 ETFs didn't even come along until 2002. This 00:39:07.329 --> 00:39:09.610 just showed that the ETF wrapper could be applied 00:39:09.610 --> 00:39:12.469 to virtually any asset class, not just large 00:39:12.469 --> 00:39:15.469 cap U .S. stocks. However, this massive growth, 00:39:15.650 --> 00:39:17.929 which was all fueled by the efficiency we've 00:39:17.929 --> 00:39:20.889 been discussing, has introduced some really serious 00:39:20.889 --> 00:39:23.670 concerns about systemic risk, market concentration, 00:39:23.769 --> 00:39:26.769 and most critically, price stability during a 00:39:26.769 --> 00:39:29.510 crisis. The concentration risk is a highly debated 00:39:29.510 --> 00:39:32.610 topic. I mean, when funds like the SPDR gold 00:39:32.610 --> 00:39:35.449 shares, GLD, grow to hold tens of millions of 00:39:35.449 --> 00:39:37.849 ounces of physical gold, their buying and selling 00:39:37.849 --> 00:39:40.449 activity is no longer trivial. It can significantly 00:39:40.449 --> 00:39:42.409 influence the price of the underlying commodity 00:39:42.409 --> 00:39:45.030 itself, creating this kind of feedback loop between 00:39:45.030 --> 00:39:47.269 the ETF and the physical market. And the highest 00:39:47.269 --> 00:39:49.510 levels of global finance, they've issued explicit 00:39:49.510 --> 00:39:51.750 warnings about the leverage that's embedded in 00:39:51.750 --> 00:39:53.869 some of these products. The International Monetary 00:39:53.869 --> 00:39:56.710 Fund, the IMF, have warned that the proliferation 00:39:56.710 --> 00:40:00.449 of leveraged and inverse ETFs in particular introduces 00:40:00.449 --> 00:40:04.130 serious financial stability risks. If the equity 00:40:04.130 --> 00:40:07.269 markets suffer a prolonged decline, the volatility 00:40:07.269 --> 00:40:10.090 drag and the mandatory rebalancing of these funds 00:40:10.090 --> 00:40:13.110 could actually exacerbate market movements, leading 00:40:13.110 --> 00:40:15.449 to a cascade effect throughout the entire system. 00:40:15.690 --> 00:40:17.829 And beyond that, the flexibility of the ETF structure 00:40:17.829 --> 00:40:20.610 has at times been exploited for manipulation. 00:40:20.809 --> 00:40:23.989 Yes. Analysts have cited instances. particularly 00:40:23.989 --> 00:40:27.170 during the 2007 -2009 U .S. bear market, where 00:40:27.170 --> 00:40:29.750 institutional investors allegedly used ETFs in 00:40:29.750 --> 00:40:32.590 conjunction with massive short selling to concentrate 00:40:32.590 --> 00:40:34.869 selling pressure on specific underlying stocks, 00:40:35.250 --> 00:40:37.690 effectively amplifying downward market momentum 00:40:37.690 --> 00:40:40.710 and artificially depressing prices. The structure 00:40:40.710 --> 00:40:42.969 itself is agnostic, but the strategies that can 00:40:42.969 --> 00:40:45.269 be employed can be problematic. But the moments 00:40:45.269 --> 00:40:47.670 that truly exposed the system's fragility were 00:40:47.670 --> 00:40:50.250 the two flash crash incidents. The 2010 event 00:40:50.250 --> 00:40:53.139 was just terrifying. The May 2010 flash crash 00:40:53.139 --> 00:40:56.159 exposed just how brittle the electronic trading 00:40:56.159 --> 00:40:59.440 systems were. I mean, prices of ETFs and other 00:40:59.440 --> 00:41:01.960 securities became completely unhinged from reality, 00:41:02.179 --> 00:41:04.519 with many trading near zero for a few moments. 00:41:04.659 --> 00:41:07.400 And that led to new regulations. It did. New 00:41:07.400 --> 00:41:09.639 regulations known as single stock circuit breakers 00:41:09.639 --> 00:41:11.699 were put in place to halt trading during these 00:41:11.699 --> 00:41:13.769 periods of extreme volatility. Unfortunately, 00:41:13.909 --> 00:41:15.650 those circuit breakers proved to be insufficient 00:41:15.650 --> 00:41:18.190 because the system failed again five years later. 00:41:18.369 --> 00:41:22.170 What happened during the August 24, 2015 flash 00:41:22.170 --> 00:41:24.710 crash? This event was arguably more damaging 00:41:24.710 --> 00:41:28.050 to the ETS reputation. Hundreds of EPFs saw their 00:41:28.050 --> 00:41:30.769 prices just collapse and decouple entirely from 00:41:30.769 --> 00:41:33.449 their underlying NAVs. And the reason this happens 00:41:33.449 --> 00:41:35.849 is the failure of the arbitrage mechanism itself. 00:41:36.380 --> 00:41:38.800 So explain how that crucial arbitrage mechanism 00:41:38.800 --> 00:41:41.119 fails when it's under stress. Well, the entire 00:41:41.119 --> 00:41:43.559 system relies on the APs being willing to step 00:41:43.559 --> 00:41:46.179 in and capture that discount. However, during 00:41:46.179 --> 00:41:48.500 moments of extreme canic -driven volatility, 00:41:48.920 --> 00:41:51.219 the underlying prices of all the component stocks 00:41:51.219 --> 00:41:54.400 are moving so rapidly that the APs can't accurately 00:41:54.400 --> 00:41:57.019 calculate the NAV in real time. The risk is too 00:41:57.019 --> 00:42:00.179 high. Their risk model tells them that the potential 00:42:00.179 --> 00:42:03.239 loss from holding that volatile underlying basket, 00:42:03.360 --> 00:42:06.139 even for just a few seconds, outweighs the potential 00:42:06.139 --> 00:42:09.380 profit from the arbitrage. So they simply withdraw. 00:42:09.619 --> 00:42:12.199 They stop making markets. And when the APs withdraw 00:42:12.199 --> 00:42:14.659 their bids, they stop offering to buy the creation 00:42:14.659 --> 00:42:17.400 units. The engine that stabilizes the price effectively 00:42:17.400 --> 00:42:20.360 stalls. With no one willing to arbitrage the 00:42:20.360 --> 00:42:23.000 discount, the ETF price is left to the whims 00:42:23.000 --> 00:42:25.780 of panicked retail traders, causing the price 00:42:25.780 --> 00:42:28.469 to trade at a deep... liquidity driven discount 00:42:28.469 --> 00:42:31.070 to its actual intrinsic value. And that moment 00:42:31.070 --> 00:42:33.829 led analysts at Morningstar to claim that ETFs 00:42:33.829 --> 00:42:36.769 are a digital age technology being governed by 00:42:36.769 --> 00:42:39.469 depression era legislation. I mean, that is a 00:42:39.469 --> 00:42:42.070 brutal assessment of the regulatory lag. It highlights 00:42:42.070 --> 00:42:44.449 the core tension, the speed and the complexity 00:42:44.449 --> 00:42:47.409 of the modern ETF market have completely outpaced 00:42:47.409 --> 00:42:49.630 the systems that were designed to regulate traditional 00:42:49.630 --> 00:42:52.210 investment products. And that leaves a seven 00:42:52.210 --> 00:42:55.030 trillion dollar industry reliant on a voluntary. 00:42:55.719 --> 00:42:58.340 profit -driven arbitrage system that we know 00:42:58.340 --> 00:43:00.800 for a fact fails when liquidity is needed most. 00:43:01.239 --> 00:43:03.440 While the U .S. market may be the birthplace 00:43:03.440 --> 00:43:06.719 of all this, Europe has also embraced the ETF 00:43:06.719 --> 00:43:09.480 structure wholeheartedly, but with some different 00:43:09.480 --> 00:43:11.599 regulatory constraints and some different usage 00:43:11.599 --> 00:43:14.360 patterns. Oh, absolutely. European ETF assets 00:43:14.360 --> 00:43:16.480 under management have just surged dramatically 00:43:16.480 --> 00:43:19.320 from only about 100 billion at the end of 2008. 00:43:19.920 --> 00:43:24.420 AUM jumped to 760 billion by March 2019. It just 00:43:24.420 --> 00:43:26.519 reflects the global acceptance of this structure. 00:43:26.880 --> 00:43:28.960 And the European funds are governed differently. 00:43:29.260 --> 00:43:31.940 They are. They're typically governed by UCITs. 00:43:31.960 --> 00:43:33.860 That's Undertakings for Collective Investment 00:43:33.860 --> 00:43:36.219 and Transferable Securities. It's a regulatory 00:43:36.219 --> 00:43:38.940 framework that offers very strong investor protection, 00:43:39.239 --> 00:43:41.579 especially when it comes to the collateral requirements 00:43:41.579 --> 00:43:44.019 for those synthetic products we mentioned. We 00:43:44.019 --> 00:43:47.380 have some crucial data from EDHEC surveys on 00:43:47.380 --> 00:43:50.019 how European institutional investors are actually 00:43:50.019 --> 00:43:52.480 using these products. And it shows a really clear 00:43:52.480 --> 00:43:55.360 evolution in their strategy over time. The initial 00:43:55.360 --> 00:43:58.099 adoption. if you go back, was often driven by 00:43:58.099 --> 00:44:00.659 passive, long -term, buy -and -hold strategies. 00:44:00.880 --> 00:44:04.480 That was cited by 51 % of users. However, by 00:44:04.480 --> 00:44:07.900 2019, the usage for tactical allocation had slightly 00:44:07.900 --> 00:44:10.699 surpassed it, reported by 53 % of respondents. 00:44:11.059 --> 00:44:14.110 And that shift is highly telling. So what does 00:44:14.110 --> 00:44:17.250 that shift from long term holding to tactical 00:44:17.250 --> 00:44:20.489 allocation really imply about the role of ETFs 00:44:20.489 --> 00:44:23.150 in European portfolios? It implies that investors 00:44:23.150 --> 00:44:25.150 are leveraging the diversity of the product, 00:44:25.289 --> 00:44:28.889 all the sector style and factor ETFs to make 00:44:28.889 --> 00:44:31.070 quick, low cost adjustments to their portfolio 00:44:31.070 --> 00:44:33.570 exposure. So they're using them to time the market. 00:44:34.000 --> 00:44:36.039 In a way, yes. If they want to rapidly dial up 00:44:36.039 --> 00:44:38.000 exposure to, say, the German technology sector 00:44:38.000 --> 00:44:40.380 or quickly hedge against rising corporate bond 00:44:40.380 --> 00:44:42.920 yields, the ETF offers the most cost -effective 00:44:42.920 --> 00:44:45.260 and immediate way to execute that move. It's 00:44:45.260 --> 00:44:47.639 a precision instrument for market timing. It 00:44:47.639 --> 00:44:50.239 sounds like low cost is the key driver that enables 00:44:50.239 --> 00:44:53.199 that tactical usage. It is the overwhelming factor. 00:44:53.599 --> 00:44:56.619 Cost was cited as the major criterion for selecting 00:44:56.619 --> 00:44:59.760 a provider by 88 % of the respondents in those 00:44:59.760 --> 00:45:03.820 EDHEC surveys. Furthermore, 74 % of investors 00:45:03.820 --> 00:45:06.480 who were planning to increase their ETF use cited 00:45:06.480 --> 00:45:09.219 lowering costs as their primary motivation. The 00:45:09.219 --> 00:45:11.699 pressure on fees is just intense, and the ETF 00:45:11.699 --> 00:45:13.239 is winning because of its structural efficiency. 00:45:13.880 --> 00:45:16.860 And looking forward, where is this increased 00:45:16.860 --> 00:45:19.159 ETF allocation actually coming from? What is 00:45:19.159 --> 00:45:21.519 it replacing in their portfolios? This gives 00:45:21.519 --> 00:45:23.519 us a critical insight into the future of asset 00:45:23.519 --> 00:45:25.920 management. The investors indicated that their 00:45:25.920 --> 00:45:28.599 increased ETF allocation is directly replacing 00:45:28.599 --> 00:45:31.820 more expensive alternatives. A significant 71 00:45:31.820 --> 00:45:34.920 % reported that their increased ETF use was replacing 00:45:34.920 --> 00:45:37.159 assets that were previously managed by active 00:45:37.159 --> 00:45:40.019 fund managers. And 42 % said it was replacing 00:45:40.019 --> 00:45:42.800 other more expensive passive products. So the 00:45:42.800 --> 00:45:45.460 message is crystal clear. The ETF is structurally 00:45:45.460 --> 00:45:47.440 cannibalizing both the traditional passive and 00:45:47.440 --> 00:45:49.019 the traditional active management industries. 00:45:49.519 --> 00:45:52.019 Absolutely. And the top areas of demand just 00:45:52.019 --> 00:45:54.199 confirmed the thematic trends we discussed earlier. 00:45:54.760 --> 00:45:56.940 Investors are seeking more products focused on 00:45:56.940 --> 00:45:59.579 ethical and socially responsible investing. ESG, 00:45:59.679 --> 00:46:02.800 and on advanced factor or smart beta indices. 00:46:03.320 --> 00:46:06.679 The European market, guided by that UCI regulation, 00:46:07.480 --> 00:46:10.780 is actively seeking sophisticated exposure, but 00:46:10.780 --> 00:46:13.480 in a low -cost, transparent wrapper. So what 00:46:13.480 --> 00:46:15.980 does this all mean for the contemporary investor? 00:46:16.320 --> 00:46:19.139 We've successfully dissected the financial vehicle 00:46:19.139 --> 00:46:21.719 that has really become the dominant technology 00:46:21.719 --> 00:46:24.500 for accessing global markets. I think the synthesis 00:46:24.500 --> 00:46:27.400 is this. ETFs have revolutionized finance by 00:46:27.400 --> 00:46:30.019 expertly blending the diversification, the low 00:46:30.019 --> 00:46:32.139 cost and the passive nature of traditional funds 00:46:32.139 --> 00:46:35.159 with the sophisticated order execution, the continuous 00:46:35.159 --> 00:46:37.659 trading and the unique tax efficiency of individual 00:46:37.659 --> 00:46:40.559 stocks. And this entire system, as we've learned, 00:46:40.619 --> 00:46:42.800 is powered by the genius of that. that authorized 00:46:42.800 --> 00:46:45.480 participant arbitrage mechanism. It is. Our mission 00:46:45.480 --> 00:46:48.820 was to provide you, the learner, with a comprehensive 00:46:48.820 --> 00:46:51.199 understanding of the mechanics, the structural 00:46:51.199 --> 00:46:53.820 benefits, and the expansive and occasionally 00:46:53.820 --> 00:46:55.960 risky categories of this critical investment 00:46:55.960 --> 00:46:58.699 vehicle. You should now understand how an ETF 00:46:58.699 --> 00:47:02.420 works, from the 0 .03 % expense ratio all the 00:47:02.420 --> 00:47:04.920 way up to the largest systemic risks. But we 00:47:04.920 --> 00:47:07.400 should leave you with one final provocative thought 00:47:07.400 --> 00:47:09.519 that really links the engine of stability we 00:47:09.519 --> 00:47:11.840 discussed in section four with the... Agility 00:47:11.840 --> 00:47:14.599 we observed in section five. OK. The seven plus 00:47:14.599 --> 00:47:17.579 trillion dollar global ETF industry is structurally 00:47:17.579 --> 00:47:20.440 and functionally dependent on the constant, diligent, 00:47:20.579 --> 00:47:23.599 profit driven arbitrage of the APs to keep prices 00:47:23.599 --> 00:47:26.579 honest. Yet history shows us in moments of extreme 00:47:26.579 --> 00:47:29.019 market stress, those terrifying flash crashes, 00:47:29.139 --> 00:47:31.539 the APs acting rationally to protect their own 00:47:31.539 --> 00:47:34.179 capital, withdraw. They disappear, causing the 00:47:34.179 --> 00:47:36.840 entire price stabilization engine to stall. So 00:47:36.840 --> 00:47:39.199 the question that every investor and every regulator 00:47:39.199 --> 00:47:42.960 has to consider is this. How robust is a global 00:47:42.960 --> 00:47:46.079 financial system when its dominant, most interconnected 00:47:46.079 --> 00:47:48.539 investment technology relies on a mechanical 00:47:48.539 --> 00:47:52.400 engine that we know under duress fails precisely 00:47:52.400 --> 00:47:54.880 when its stabilizing function is most critical? 00:47:55.360 --> 00:47:57.559 Does the structural dependence on arbitrage mean 00:47:57.559 --> 00:48:00.000 that the growth of ETFs while providing all this 00:48:00.000 --> 00:48:02.619 efficiency simultaneously accelerates systemic 00:48:02.619 --> 00:48:05.320 risk and volatility during the next crisis? That's 00:48:05.320 --> 00:48:07.579 the question. A profound question of fragility 00:48:07.579 --> 00:48:10.079 versus efficiency to mull over until our next 00:48:10.079 --> 00:48:12.039 deep dive. Thanks for tuning in.