Inside Today’s ETF Boom: What’s Actually Safer | Wesley Gray

There is massive growth right now in ETFs and people are investing ETFs than stocks. There are more ETFs than stocks right now. Our guest today is Wesley Gray, who's deep in the ETF world. He'll tell us what's going on with ETF investing and what are the things you should watch out and what are the potential opportunities in this space. I'm Siamak and this is Market Insider. Wes, it's great to have you on, welcome. Likewise, honored to be here. Can you tell us what's happening right now with ETFs? ETFs are all about, generally speaking, low cost, tax efficiency, and transparency. And as you know, young people love that. And so they want their assets delivered in the ETF wrapper and finally everyone in our business got that memo and so that's why you're just seeing this massive transition out of old wrappers into the ETF. It's just every asset manager, every advisor, ultra high net worth, people just want to get their capital or deliver their ideas through an ETF wrapper. And is there a lot of them being made right now? Yes, it's the fastest growing asset management vehicle out there by far. I don't know the exact quote on numbers, but there's, I'm guessing, at least multiple thousands last year and I'm sure there'll be the same this year. And people always make the comment like, oh my God, there's only 10,000 stocks, but 50,000 ETF ideas. And I would say, well, stand by, because there's 10,000 stocks, there'll probably be 100,000 ETF ideas before this is all said and done. And how is this possible? Because this is supposed to be a basket of stocks, right? Can you tell us more about them? How are people making these things? Yeah, so generally speaking, and what we focus on, I guess we'll call it the old school, boring, traditional ETF, which is also growing at 100% a year. But exactly to your point, an ETF is basically an easy, efficient way to access a basket of securities so you don't have to go do the individual trading all the time, right? However, there's been a lot of recent innovations through using swap markets and other more complex derivatives. And we talk about whether these are good or bad ideas, but you can now buy ETFs that do, for example, double or triple lever in individual security or maybe just a handful of securities, which was not the original intent of what ETFs were supposed to do, but give an entrepreneur an opportunity and get a lot of demand, and all of a sudden, voila, you now have products in the marketplace that were never really envisioned in the first place. And in terms of when people buy these because they're a basket of equity, how much leverage do people have and how regulated each ETF is? Generally speaking, I guess we'll call them like traditional ETFs, are very, very safe because this is a highly regulated business and everything operates under the Investment Company Act of 1940, which is there's a million rules and a million lawyers involved to basically do anything. You have independent boards of trustees that are set as the fiduciaries to these funds, and they're in charge of overseeing us because we're considered the wolves near the hen house. So I would say, generally speaking, consumers and clients of ETFs can have a lot of confidence that you're not going to have the money stolen, they're super regulated, and they're going to deliver exactly what they say they're going to deliver. However, what they say they're going to deliver is going to be outlined in the prospectus, which is the disclosure document. And so the problem that most people run into, like SPY or like SP500 is easy because if you read the prospectus, it says, hey, we're going to invest in the SP500 securities and track that index. And we do it low cost, et cetera. No problem. The problem is when people buy certain ETFs that are super regulated and they're super secure. However, did you actually read the prospectus? Because they're going to disclose all the warts and all the problems and all the reasons why you probably shouldn't buy it. And so we just want to make sure that even though everything's disclosed, you got to always make sure that you know what you're buying and what's in it. And you're not just randomly buying things because that's usually what causes problems for folks. Not the regulation or the disclosure, just a lack of actually digging into the details to understand what you're buying. And what about the fees? Are the fees similar in each one of them or are there some that have high fees? Yeah, fees are the most important thing to consider in any investment, to be frank. And they range from literally free. There's ETFs out there you can buy that cost zero. BNY has a few of those. And then you're over very, very cheap like Vanguard, Nice Shares, what have you, all the way up to very expensive ETFs. And generally speaking, just kind of evergreen advice, when in doubt, don't buy expensive. Sometimes that's appropriate, sometimes it makes sense, but just as baseline rule, if it's really cheap, you're usually going to be protected. It's hard to screw that up. It's when you start getting into the more expensive funds, we'll call it over 75 basis points or over 1%, we want to be extremely due diligence and careful about assessing whether that makes sense or not. These fees are disclosed, right, openly? Yes, so again, part of the 40 Act and all the regulation, ETFs are very, very transparent for the most part. There's an asterisk on that with fees. So the only exception we can talk about is once you get into swaps and derivatives and much more esoteric, complex products, usually the ones you want to buy in the first place, there are opportunities for indirect cost that aren't disclosed that we want to be mindful of. But for the vast majority of ETFs, you read that prospectus, it'll tell you exactly what the fees are, and there's a ton of rules that ensure that that's the case. And what's the benefit of getting into the ETFs? So the primary benefit, generally speaking, is again, all else equal, lower cost. So usually the equivalent exposure in ETF is going to be much lower cost than private accounts, a mutual fund, a hedge fund, et cetera. So again, that's an all else equal statement, which economists love to throw out there. But yeah, generally cheaper. The other thing is they're definitely going to be more transparent because ETFs have to disclose, the vast majority of ETFs have to disclose their holdings every single day. So you're going to know exactly what the manager's doing and why, because you can literally pull it up any day on their website. And then the third benefit, which is also huge, if you pay taxes, is the ETF structure effectively has a deferral mechanism that's very unique to ETFs, where essentially an ETF, generally speaking, doesn't have to end up distributing capital gains, where pretty much all other vehicles do. So, if you have taxable money, you'd want to be in the ETF structure for that part of your capital, usually. It's not a panacea, but that's the main reason. So much lower costs on average, transparent, which is great. And then if it matters to you, the tax efficiency is generally much better inside of ETF wrapper. Can you explain the tax benefits for people that may not understand the ETFs, how it works? Yeah, sure. So, I'm just going to way oversimplify this. This isn't exactly how it works, but just to kind of make it super easy. So, let's say that we want to buy Microsoft, or we buy Microsoft. We buy it at a dollar, it goes to $100. Now, in all other places in the marketplace, if I want to switch to, say, Exxon, I'm going to have to pay taxes to do that, right? If I'm in my own personal trading account, if I sell it, I'm going to have to pay taxes and then take the money and go buy Exxon. In a mutual fund, I'm going to have to do that. In a hedge fund, I'm going to have to do that. Pretty much everything, except for an ETF structure, you'd have to pay taxes on. ETFs, just the way they were structured, this was set up literally 40 years ago now, and just how the tax code's set up. They are going to be able to transact that same idea there. Like, I want to get rid of Microsoft and transition to Exxon, but they can do it through baskets. And we don't need to go into the details of how baskets work. It's just all that the consumer needs to know is that when you trade through baskets, it's considered a tax-free transaction. So an ETF is going to be able to actually transition the fund from Microsoft to Exxon without having to have a taxable event. So that's obviously a very unique benefit. And where that comes into play is if you're a long-term investor, you know, if you just buy an ETF and hold it, you're going to get a compound with limited tax drag until the end when you sell it. Then you're going to have to pay a bunch of taxes, but, you know, tax deferral is pretty much the best thing you can do in the marketplace with respect to tax efficiency. Do you think this ETF space is going to replace a lot of other products as it's going? Like, would people need to have financial advisors or would the financial advisors do the work on their ETFs? Or do you think this is going to change the way that your industry works? So that's actually a complex question, and I can't predict the future. It would be interesting, especially with AI, you know, what it can do, because it talks about how they're going to replace all the white-collar labor. But one of the beautiful things about ETFs is they have democratized access to a lot of complicated, like what used to be complex, esoteric product sets and ideas that you just could not access unless you're like a gazillionaire. Right now, you can literally go type a ticker in your Schwab account and be the proud owner of just about anything. So to the extent that you're a DIY investor and you're willing to put the time in and educate yourself, which is easy to do on the internet or even with, you know, AI these days, ETFs do allow you to go directly to the marketplace and access amazing capabilities at limited cost. You don't need an advisor. Now, that said, some people need a coach, right? Just like if you say, hey, I have a goal to lose weight. Great, I'm going to eat less and work out more. Why do we need a coach? Why do we need a training? Well, there's still a massive training business out there, a massive coaching market out there. So I think it's a similar analogy here where if you have the discipline, you have the time, you know, ETF market has literally democratized access to like low cost, really high quality food and workout equipment, but you still got to do the work. However, if you need a coach or you need some training or you just need some confidence or you just need someone to yell at you to do the right thing, that's kind of the equivalent of like the advisory market. I feel like it'll always be out there. I'm not exactly sure what services they'll provide, but I think it'll be analogous to like, like you still need a coach to help you lose weight, even though we kind of know what the answer is and the tools are freely available out there or very cheaply available out there. Very interesting. Now, in terms of the ETFs that are risky, can you tell us more about those? Yeah, so the easiest way to just red flag, if you're not super, I guess, complex or educated on this, is really high fees. If you see something over 1%, just avoid and you'll keep yourself out of a lot of problems. The other thing you could do is just go Google, you know, XYZ ETF perspectives. And if you can read the investment objective section and understand it at a high level and it makes sense to you, no problem. If you read the investment objective section and you're like, this is insane and sounds like some Elon Musk would have to understand, just walk the other way, right? Because that's where all the complexity, all the chaos, all the brain damage is going to be. And it can make sense to go down that path, but for 99% of people, you probably just don't need it. So fee, over 1%, probably just avoid. And if it's under 1% and it seems reasonable and you kind of like the idea, at least do me the favor of just Googling or chat GPT in the perspectives and just read the first page. And if you can understand it, continue further. If not, just avoid. And if you do those two rules, I think you'll keep preventing yourself from a lot of problems. You mentioned people get into trouble, sometimes they're preventing troubles. Is it that people are expecting a lot of returns out of these things? Is the expectation of returns too high? What are your thoughts on that? Yes, YOLO. So stepping back, anytime people start getting emotional or excited, like if you ever feel like you're excited or emotional about an investment about to make, you're going to screw it up with high probability. You should never be in an excited or emotional state when you make an investment because it's high likely that you're being influenced to do something bad or you're just going to make a stupid decision. So that's just, if you've sensed that in your brain, stop. Hey, go drink some coffee or go on a workout or whatever. Don't make an investment decision if you're excited or emotional or something's making you happy, right? Because on the flip side of that, our whole business, even though it's insanely regulated, is about storytelling. And we want, not us, but generally speaking, people want you to feel like you're going to be able to get a free lunch. Oh, you can make so much money. You can YOLO on this thing. And yeah, there's a little bit of risk, but don't worry about it because you could be a billionaire. You could be a millionaire. Like again, those are also the products that are usually the most expensive and the most complex. And weirdly, they're the ones that are most likely to screw you over, right? So just avoid, because that's where the marketplace, like, you know, we colloquially call them like DGen or retail, like you want to sell to like the degenerate gamblers and the YOLO types. Like if you're in that category, that's fine. But at least if you're going to make that decision, do so in a way where you're not excited, you're not invested in the ego of it all or like anything. You're just thinking about this very systematically, very deliberately, just to make sure that if you do want to go YOLO, which there's nothing wrong with that, you're just doing it from a rational mind perspective, not from an excited perspective. Because that's what the sellers of those products are generally hoping for because that's how they're going to take advantage of you. So if excited, walk the other way is the easy advice. We're hearing that when people buy these ETFs and a lot of people are buying SPY and other ones and big ones for long-term and they're holding them. But there are some people that argue that when you buy those you're not really buying the equities, you're just buying into another entity. So can you tell us more about the legal side of it? Yeah, so the legal structure is you actually are an owner. All an ETF is for most ETFs, like normal ETFs, there's different ones if we get into crazy option derivative things. But you're talking about like good old fashioned blocking and tackling, Vanguard fund, iShares fund are kind of like things we do. What is going on is you own the right to the basket of property that that ETF owns. So there is no credit risk directly on an ETF because what happens is those assets that are held by an ETF, there's a bunch of rules in the 40 Act, they're going to be held at a custodian that is segregated from a broker dealer. So it's literally like your Goldman Sachs, U.S. Bank, BNY, JP Morgan, what have you. They have to keep those assets safeguarded and segregated in a separate account where they, I mean, unless someone like breaks in the U.S. Bank with a machine gun, I guess, it would technically be possible but this is the safest level of asset custody you can possibly have. That is required for an ETF. So you don't even have broker dealer risk for the most part because those assets that are held within the ETF are held at a segregated custodian. So if you're buying normal, typical ETFs, I mean, nothing is guaranteed, nothing's 100% obviously in anything even with like a custodian like I just mentioned there but it is the safest vehicle you can possibly have and I would say it's equivalent to owning directly the 500 stocks or owning the ETF. They're equivalent risk. There's no difference. You know, one or the other, it's from a property theft perspective or counterparty perspective. And does the money as if I were to purchase like X amount of SPY shares right now, would the money immediately go to those companies or would it take a day or how fast is it? So yeah, so how it works is everything in equity is clear in the U.S. clears with a firm called DTCC. It's like the Central Clearing Custody House and this is for every transaction that's equity-based. So if you buy an ETF or bonds also, corporate bonds or just Microsoft or anything, it's gonna go through the exact same process, right? There's gonna be a trading settlement clearing process. So the equivalent, if you go buy Microsoft, how cash moves and how the equities move around, it's the exact same process effectively for an ETF when you buy ETF shares. It goes through DTCC, it clears, it settles, et cetera. So there is, again, going back to like, is this some way that I can, you know, behind the scenes somehow get screwed over or have someone steal my money? The answer is no and it's equivalent risk. So if DTCC goes down and like they can't clear trades, well, guess what? Whether you bought Microsoft directly or you owned it indirectly through an ETF, we're all going down in flames and you might as well just get your gold and get your guns because none of this matters anyways, right? We're in a major problem if DTCC were to fail on clearing a trade. Now, do you think this space is gonna grow very fast still and do you think there's opportunities for people? What kind of opportunities do you see? I mean, I can't predict the future. I can just predict what's in front of my face and just in our own business, we're gonna 100% again and we're not the only people in the business. We talk to everyone. Everyone is like, oh my God, the level of ETF creation demand, we can't even keep up with it. So at least for at least, you know, next 12 months, I don't, I think this thing is gonna keep growing for all the reasons we already mentioned. Where does that create opportunities? Well, there's kind of two opportunity sets. On the client side, you can be sure that if something is esoteric, overpriced, or hard to access, there are active entrepreneurs trying to figure out how can I deliver that exposure cheaper, more transparently, more tax efficient ETF. So that's great news. You're just gonna have more opportunities to access esoteric stuff that may not be in the marketplace. People are gonna keep fighting to put in an ETF wrapper. On the other side of this, to the extent you're, you know, you fancy yourself as like a good investor or someone who maybe wants to start up a business but you want to do it in the new ecosystem, I mean, there's lots of opportunities, as you can imagine, where if you have good ideas, good intellectual property, and you think you can outperform or tell a great story to the marketplace, the power of having a ticker that anyone on the planet can buy inside of your Schwab account, you know, it's a very scalable business if, you know, you can put all that together. So I'd say there's lots of opportunities, obviously, on the business front. And then there's a lot of opportunities on the client side just through more product proliferation and lower cost, more transparency, and better taxes. And Wes, do you have an example? So from what it seems like, there was other kind of investments that a lot of really wealthy people had access to where they could probably make hedges. Can you give us a scenario, an example, where these kind of investment opportunities were out there but now everyone can have access to them? Sure, so one of the hottest themes right now is like option overlay funds, which is a simple example, is instead of just buying the S&P 500, you know, because that may be too risky and it's just like, eek, I don't like that, what if I could own the access to S&P 500 returns but I'm willing to sell off some of the upside to cover some of my downside, right? It's like called a call spread, but basically you can structure the return to kind of be more amiable to what you want as a client. Insurance companies have done this forever in like Boli-Coli and like different wrappers, but it's like way overpriced, tons of hidden fees, et cetera. Now, you know, JP Morgan, Innovator, a lot of firms have brought this to market. You know, they're called outcome funds or whatever. You can now access, I don't even know, there's probably 5,000 of these different funds out there where you can now get really complex derivative overlay strategies on top of a generic exposure and they can shape your outcome and that can be delivered transparently, tax efficiently, and generally speaking, pretty affordably. They call it, you know, 25 bips to 75 bips, whereas in the old days to try to get that through an insurance company, you're gonna have a 2% load and you know, God knows what other fees and it's gonna be totally not transparent. There's an ETF for that and that's everywhere in the marketplace right now and they're continuing to innovate on that. Wesley Gray, CEO of Alpha Architect and ETF Architect, it was great to have you on Market Insider. Thanks for having me. It was a pleasure to be here. What do you think about the growth in the ETFs? Make sure to let us know in the comments. I'm Siamak and this is Market Insider. We'll see you next time.