Dave Nadig: The Future of Indexing, Governance, and Financial Technology

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Our guest this week is Dave Nadig. Dave is Financial Futurist at VettaFi, a data and research firm that focuses on the ETF industry as well as nascent technologies like digital assets. Dave boasts decades of experience analyzing and writing about the investment management business both at VettaFi and before that at ETF.com. Dave is a sought-after speaker and frequently quoted in the media on matters pertaining to the ETF industry, market structure, and many other topics. He is also the author of a book on ETFs called A Comprehensive Guide To Exchange-Traded Funds. Dave received his bachelor's degree in Creative Writing from the University of Massachusetts Amherst and his MBA from Boston University.

Background

A Comprehensive Guide to Exchange-Traded Funds, by Dave Nadig

Futurism and Innovation

"Financial Futurist," by Dave Nadig, etftrends.com.

"Tokenize Absolutely Everything," by Dave Nadig, etfdb.com, Nov. 19, 2021.

Indexing

"ETF Prime: Dave Nadig on the Ethics of Indexing," by Dave Nadig, nasdaq.com, May 17, 2022.

"Dimensional's Conversion of Mutual Funds Into ETFs Pays Off," by Beagan Wilcox Volz, ft.com, July 14, 2022.

"Bloomberg: Dave Nadig on Single-Stock ETF Risks," by Aaron Neuwirth, etfdb.com, Aug. 19, 2022.

"ETF Edge: Dave Nadig Talks Direct Indexing," by Aaron Neuwirth, etftrends.com, Sept. 13, 2021.

"Commentary: Direct Indexing: A Point Solution for Global Crises," by Dave Nadig, jii.pm-research.com, May 19, 2022.

"Direct Indexing Is Like Customizing a Tesla, but With Your Portfolio, Investor Says," by Lizzy Gurdus, cnbc.com, Sept. 16, 2021.

"Are You in the Retirement 'risk zone'? These Investments Might Be Able to Protect You," by Robert Powell, MarketWatch, July 15, 2022.

Governance and Regulation

"Proposed Legislation Promises to Empower Investors. What to Know," by Lauren Foster, barrons.com, June 14, 2022.

"The INDEX Act: The Next ESG Battle Is for Your Vote," by Dave Nadig, etftrends.com, Aug. 5, 2022.

"VettaFi's Mid-Year Research Update: Big Picture," by Dave Nadig, etfdb.com, July 15, 2022.

"The Inelastic Market Hypothesis: A Microstructural Interpretation," by Jean-Philippe Bouchaud, arvix.org, January 2022.

"Yahoo Finance: Dave Nadig Discusses Investing Amidst Rising Rates, Crypto, and ESG," by Karrie Gordon, etftrends.com, April 14, 2022.

"The Tricky Politics of Anti-ESG Investing," by Liam Denning, washingtonpost.com, May 19, 2022.

Asset Allocation

"ETF Edge: Dave Nadig on Changes to the 60-40 Portfolio," Nasdaq.com, April 19, 2021.

"Don't Kill the 60/40 Portfolio: Vanguard Consultant," by Bernice Napach, thinkadvisor.com, Aug. 3, 2021.

"TD Ameritrade: Dave Nadig on ESG and Bond Trends," by Aaron Neuwirth, etftrends.com, May 3, 2021.

"Yahoo Finance: Dave Nadig on Alternative Allocations," by Aaron Neuwirth, yahoo.com, May 25, 2022.

Advice Market

"Yahoo Finance: Dave Nadig Putting Crypto in Focus," by Aaron Neuwirth, etftrends.com, May 19, 2021.

"Announcing the New Kitces AdvisorTech Directory and the State of the (Nerd's Eye View) Blog," by Michael Kitces, kitces.com, Jan. 31, 2022.

Crypto and ETFs

"Nadig Appears on ETF Edge to Talk Emerging Markets, Value Investing, Crypto, and More," by Evan Harp, etftrends.com, Aug. 29, 2022.

"Bitcoin Futures ETF: Lucy & the Football?" by Dave Nadig, etftrends.com, Aug. 31, 2021.

"How to Talk to your Client About NFTs," by Dave Nadig, etftrends.com, March 30, 2021.

"The Problem With a Bitcoin Futures ETF," by Dave Nadig, etftrends.com, Oct. 12, 2021.

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer at Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance and retirement planning for Morningstar.

Ptak: Our guest this week is Dave Nadig, Dave is Financial Futurist at VettaFi, a data and research firm that focuses on the ETF industry as well as nascent technologies like digital assets. Dave boasts decades of experience analyzing and writing about the investment management business both at VettaFi and before that at ETF.com. Dave is a sought-after speaker and frequently quoted in the media on matters pertaining to the ETF industry, market structure, and many other topics. He is also the author of a book on ETFs called A Comprehensive Guide To Exchange-Traded Funds. Dave received his bachelor's degree in Creative Writing from the University of Massachusetts Amherst and his MBA from Boston University.

Dave, welcome to The Long View.

Dave Nadig: Thank you for having me.

Ptak: It's our pleasure. Thanks so much for being with us. I wanted to start with futurism. Your title is financial futurist. I'm curious, knowing a lot of innovations don't pan out, what's the framework you've applied in trying to separate game-changers from what might be run-of-the-mill tweaks or what frankly look to be just kind of dumb ideas? What's the process that you've used?

Nadig: One of the great things about inventing your own job title is that you generally also get to invent how you do the job. And so, I got the double whammy here. The way I think about things is, whatever the topic is in finance—and I think finance is just frankly the most interesting sandbox in the human experience, which is why I've spent my whole career in it. I feel like there's three things to really understanding, and that's really the point of futurism, if you will. It's really understanding. And I think I start by trying to think about the past. So, let's say, we're just talking about stock trading and the mechanics thereof. You got to go back and start with the buttonwood tree. You have to really understand how stock trading came to be, and all of its little evolutionary steps until you get to the present. It doesn't mean you have to understand every word of every regulation written in 1927 or something like that, but you do need to have that context.

And then, once you have that background, then I think about looking at a given topic area like knolling. I don't know whether you know that word knolling. It's like when you take apart a typewriter and you lay out all the little pieces on a piece of paper and you take a really beautiful picture of it. I feel like you have to do that with the topic. So, again, if we were looking at stock trading, it's a matter of laying out, from birth to death what does a stock look like? How is it used as a funding source after an IPO, all the way to how companies dissolve or get rolled up inside other companies, and all the little steps along the way. And that just seems like the baseline. That gives you a clear understanding of the state of play.

And then, when you think about, well, where are things going? That's when I actually shift gears entirely and I start thinking about people, because people are the only reason things ever change. People confound whatever the status quo is. So, if you've got that knolled typewriter out in front of you, you then have to ask yourself, who are all the different people who need to interact with this? What are their motivations and objectives? What are the tools they're bringing today that maybe they weren't bringing yesterday? What technology is influencing how they're going to change their behavior? And if you take that people component and apply it to the system, I think you can make reasonable projections about where the market is going to be going. And I certainly don't think I have a particular angle on the crystal ball there. I just think that there are not a lot of folks who ask that last question: How are people going to confound this? And we run into it when we have hiccups in the market all the time. When we had Robinhood or we've got DeFi, or we have some Volmageddon, then all of a sudden, we start talking about people. I usually think that's a bit late.

Benz: Maybe to bring this into concrete terms, can you give us an example of a financial innovation that you think is going to be really important to investors and advisors in the future, yet where you're finding it hard to sell them on it? And then, maybe the flip side, what's something that you think is totally overhyped, some sort of financial innovation?

Nadig: Let me do that in reverse order. So, I think direct indexing is a great example of something that is both a really useful technological and investment innovation that also I think got a little bit overhyped, and I think I'm part of the problem there. I got very excited about direct indexing maybe a decade ago when you could start seeing the writing on the wall for how it was going to start rolling down from institutional SMAs where we never used to call it direct indexing, all the way down to the individual investor where now you've got Schwab rolling this out effectively at the $100,000 account-ish level. I think that gets overhyped because people don't realize that it's a tool, it's not a panacea, and I think that's true with a lot of innovations. We get excited about them and so we assume they're going to solve all of our problems.

To flip that forward, I would say tokenized asset management is the one where to me it's extremely clear. It's where the future of asset management heads. Effectively, when we trade stocks and bonds now, we are trading a kind of token. We don't call it that. But from a notional perspective, that's what it is. And so, the really interesting stuff being done in the decentralized finance and crypto ecosystem bridging over into these traditional asset classes, I don't think it's rocket science to look at that and say, 10 years from now the idea that we're going to be trading and settling through DTCC seems ridiculous to me. We're going to be kicking these COBOL servers until they're dead, and we've already got better ways of doing it. So, that's one of those things where I think there's just too much of a gap for people to cross for them to be able to say, “Well, of course, I'll be trading tokens in my Schwab account in 10 years.” To me, it seems obvious, but I think it will just take some time for people to realize it.

Ptak: Maybe to stick on the topic of tokenization, which I think is probably going to be foreign to at least the subset of our listeners. Could you try to place that in the context of, say, a financial advisor's practice and how maybe in five or 10 years, perhaps it's sooner than that, tokenization will change aspects of how it is they serve clients. Where do you think that it would be most apparent that tokenization is the breakthrough that you think that it could be?

Nadig: Well, interestingly, I think advisors are actually going to be one of the most interesting cases, just like they are for direct indexing. I think almost everything interesting seems to happen at the coalface of the financial advisor relationship. So, when I talk about tokenization, what I mean is, instead of buying a share of Tesla through the New York Stock Exchange and then going through overnight settlement and then having that ledger entry be moved over to my Schwab account or my Fidelity account, instead the thing that we will be trading will actually be a digital entity itself. You can think of it as a nonfungible token except instead of a picture of a cat, what you're referencing is the shares of Tesla held in some master account. This is precisely how, for instance, FTX Europe works right now. I can trade Tesla tokens at FTX. What I'm trading back and forth with other people is a token, which is instantaneously settled. There's no settlement process. There's no third party in the middle. It's literally just this digital item that I can move back and forth at the speed of light. And it represents a share in a pool of actual Tesla stock, which is held in a brokerage account in Germany somewhere. That's effectively the model I think we will end up with in the U.S. eventually. It's actually sort of the model we have now. People don't realize it. Right now, when you trade Tesla, you're not really trading Tesla, you're trading a ledger entry at Cede and Company in New York. But most people don't know that unless they're crazy dumb nerds like me.

I think that these things bridge naturally. And once you get to that point, when you have a tokenized Tesla, it allows you to do all sorts of cool things that you can do in DeFi right now, like run an entire portfolio through a smart contract, or just instantaneously and with extreme precision, rebalance. It enables things that right now sound ridiculous, like continuous rebalancing, but that become trivial once you're in a tokenized world.

Benz: For nonfuturists like me and Jeff, and I would guess a lot of our listeners, too, what or who do you recommend we pay attention to in order to stay more current but without being pulled down rabbit holes or being left hopelessly confused about some of these things?

Nadig: The rabbit holes are generally the fun part. So, I'm not sure I'm going to try to convince anybody not to go down the rabbit holes. But I think the most common answer there is that you have to keep a broad view. And that's sort of the name of your podcast. You have to have a long view and you got to keep a broad view. I think we all live in our own very narrow reality tunnels based on our friends, based on our colleagues, based on the media we consume, based on our references. Christine, you and I have kicked things back and forth on Twitter before because we're obviously both '80s kids. That's a reference set. It's a reference set that we have that gives us a kind of shorthand, and that can be incredibly valuable, but it can also be a real set of shackles that keep you tied into certain ways of thinking.

I think the thing that I do to try to really keep an open mind is consume media that I would never in a million years consume if I was just doing it for pleasure. I think a lot of us listen to the same music we listened to when we were in college. We watch the same movies we were watching in college, or at least the same actors. Think about how popular Maverick was. That's the ultimate thing or '80s-kid throwback there. So, I force myself to listen to only new music as much as I can. When I do consume video content, I try to only consume current stuff that's not targeted at 56-year-old white guys in New England. And I think that that's a really important part. Because even if you disagree with it, even if you don't particularly like it, it doesn't make it culturally irrelevant. It actually makes it culturally more important, because without that you just live in this ever-narrowing blinders world that I think it's impossible to see the hand in front of your face, much less what might be happening next year or the year after.

Ptak: Wanted to shift and talk about indexing. I don't think a conversation would be complete with you, Dave, if we didn't talk about indexing, a subject to which you've devoted much, much analysis and a lot of your career and writings. Years ago, and I suppose this is a form of futurism, you correctly foresaw that ETFs would take market share from funds. What do you think ultimately happens to the traditional open-end fund industry? Will it shrink into oblivion? Or are there some things that you think open-end funds intrinsically do better than ETFs that will sustain the industry?

Nadig: I think it's very much a horses-for-courses kind of situation, and I think it's important to remember that all of these wrappers—ETFs, variable annuities, mutual funds, direct indexing—all of these things are just regulatory hacks. None of them is in any way a purest form of investing. Even the way we think about the U.S. stock market, that is itself a regulatory construct. And there are other ways of doing that. And in fact, other companies and countries have other ways of doing that kind of common ownership. I think we get trapped with this idea that somehow these regulatory structures are manifest destiny. What's manifest destiny to me is that we will inevitably disintermediate, we will inevitably simplify, and we will inevitably reduce costs wherever possible. Those seem inexorable to me. It's sort of Mark Twain's death and taxes. Nothing in financial history has ever gotten in the way of that movement. Mutual funds go back to the 1400s and they've pretty much been getting cheaper and simpler and easier to access ever since.

So, the traditional mutual fund structure right now has a couple of regulatory advantages that I don't see going away, not the least of which is fractional shareownership, which makes things like 401(k)s doable and easy and 12b-1 fees, which allow you to fund things like recordkeeping. I think that as long as those are still real needs in the body corpus of American investors, then mutual funds are going to be just fine. I think there's $15 trillion in them sitting right now. There will be more than that next year just based on market movement, most likely just because money is going to go into the defined-contribution business. But I do think that mutual funds become more and more of a niche vehicle for retirement savings, and ETFs become the—if they haven't already—become the default vehicle for any other kind of non-tax-deferred exposure. That could change, of course, with the stroke of a pen. You could change the way the IRS taxes things. You could change the way ERISA works. There's lots of what-ifs you could do. But I don't really see much impetus for any of that to change much in the next five to 10 years. So, I think, as far as I can tell, mutual funds will remain the default case for 401(k)s.

Benz: Do you think a lot of fund companies will convert their open-end funds to ETFs? It seems like to this point they've been selective about what they will opt to convert.

Nadig: It's a question of what they can. I'm just going to pull something out of a hat—but if you're Gabelli, and you've got some giant mutual fund that's well situated in 150 large 401(k) plans, and it's got five or six different share classes based on which versions being taken places. That's a nightmare to convert into an ETF because somehow you have to deal with all of those existing holders who aren't necessarily ready to take whole shares instead of fractional shares. So, you got to solve that problem. And certainly, those are solvable problems. Lawyers make a lot of money solving those problems. But there's not a lot of reason to do it, which is why I think you've seen the path of the middle way here, if you will, which is that easy-to-convert funds— those that are not in tax-deferred plans—which often means funds that are tax managed, which is, for instance, the DFA funds that converted. Those were actually tax-aware funds. They were designed for taxable investors. That makes a ton of sense to convert and that's what we've seen most of the conversions in is those more tax-aware-type strategies.

I don't really see a huge need for a Fidelity Magellan to convert when they can simply want to clone strategy and that's what we've seen with most of those name-above-the-title, active management strategies from the mutual fund business. So, I think we're probably on the course we're going to see for a while. They'll definitely be acceleration. We're already seeing that this year. Dozens and dozens of funds have already converted this year. Most of them have done pretty well in terms of either gaining or holding some assets. But at the end of the day, people still have to want to buy it, and that's not always the case that the ETF investor is a natural buyer of a mutual fund that just happened to convert.

Ptak: Let's shift and talk about direct indexing, which you referenced earlier. So, I suppose we could view direct indexing, in a sense, as a threat to traditional indexing, in the same way that ETFs posed a threat, which was realized to mutual funds, traditional mutual funds. We talked about direct indexing previously on the podcast. I think that we've gotten some positive, some negatives. I think that more recently there have been questions about whether it is overhyped. It seems like you concur to a degree. But to what degree, do you think, direct indexing could take share from ETFs in the same way ETFs took share from mutual funds?

Nadig: I think it's going to be pretty much around the edges. The way I like to think about this is that where are the real value propositions in this investment management ecosystem? And the difference between whether you're getting your, say, S&P 500 exposure through a direct index, or through SPY, or through a mutual fund, or through an annuity product, or whatever, is largely just one of convenience and regulatory arbitrage. So, the value is actually the S&P 500, the intellectual property that goes into that collection of securities. It has some value. It's been adopted in many formats. It's a fungible exposure. It's traded as options and leverage with futures exposures. So, that makes it valuable. That intellectual property has value. So, whether that IP ends up expressed in an index through a direct indexing product, or it gets expressed through an active manager who is simply referencing that as a benchmark, the intellectual property still has the value.

People may migrate between vehicles based on what their specific needs are, but I don't think that that obviates the value of intellectual property. And I think that's true whether you're an active bond manager or whether you're a big indexer, I think that that intellectual property is what has value. The thing that's exciting about direct indexing is that it really strips everything down to the value of that IP. If I've got a direct indexing platform—let's say I'm with Canvas over at Franklin—and I've done my tweaked ESG strategy or I've done my tweaked factor-based strategy there, the value to me is not the fact that it's direct index, it's the intellectual property under the hood, and then some things that I can get away within direct indexing I can't elsewhere, like single-stock tax-loss harvesting.

So, I think there will be some eating around the edges, but that doesn't make me concerned for the "asset-management industry," because ultimately the asset-management industry needs to be about intellectual property and convenience, and if it's not solving either one of those things, then your business doesn't have a reason to exist.

Benz: Can you discuss what you see is the key imperatives for direct indexing, the key advantages? Is it personalization and tax optimization? Anything else?

Nadig: It's interesting. When I first started really digging into the direct indexing space about a decade ago, it was still pretty nascent. People were like parametric, which were doing what I would call slightly tweaked big indexes. It wasn't so much that they were making giant bets. They were just allowing you to invest, say, in the S&P 500 with some tweaks here and there. And at the time, when I would talk to the bigger advisor groups or some of the institutions that were using that product, you would hear things around tax-loss harvesting, of course, here and there; you'd hear about specific tweaks that perhaps an endowment had a no-fossil-fuels mandate or something like that, and that direct indexing made it fairly trivial to implement those things. And I assume that that would be the case as this hit the more rank-and-file advisor.

What's actually the case, which I've learned really in the last couple of years as I've gotten to talk to advisors that have really leaned in on some of the advisor-forward direct indexing products, is the number-one big use case is actually single-position management. It's the executive who has 25% of their net worth tied up in Google stock. And they've got to manage that down over time. And so, they work with their advisor to create a selling plan. They work with an advisor to create offsetting exposures so that they're not hyperexposed to tech or hyperexposed to ad services or whichever part of that business they may have career connection to as well. And it turns out that seems to be the killer app for a lot of advisors, that position management piece of it. Now, the fact that you also get some tax benefits because of the single-stock tax-loss harvesting makes that even better. But often it seems to be that big, concentrated, unsellable position that needs to be managed where DI is just an absolute silver bullet.

Ptak: What about the personalization piece? I hear you loud and clear that it sounds like there may be some other use cases that are more common, like single-stock management like you talked about. But for somebody that's trying to quantify the benefits that personalization might confer through a direct indexing solution of some kind—any thoughts on how it is they should be weighing the pros and cons of, I think it's something that's personalized; it confers X amount of benefit to me versus I just buy a set of ETFs off the shelf, and it's not as personalized, but maybe it's a little bit cheaper and simpler. How do you think they should reckon with that?

Nadig: I do think that it's reasonable to be a little bit paranoid about the complexity. The complexity issues are real. I remember five or six years ago, when some of these first plans started rolling out, one of the big blockers was that a lot of professional tax-management software that CPAs used couldn't handle more than 500 line items on the schedules. So, if you all of a sudden switched over to a direct indexing account, you could have a portfolio that now needs to be reported with 1,000 lines on your taxes, which is a nightmare. And I think it's reasonable to be cautious about some of that. The personalization component, if it's not for your particular financial situation, like we're talking about a single-stock rundown situation, a particular tax issue that you're dealing with. Most of the personalization seems to be around ESG issues, which again I think DI is a fantastic way to implement that because it really can be highly personalized. Depending on which platform you look at, I've seen versions of this where you have a slider on animal welfare and that could be the one thing that you actually skew your portfolio on is just animal welfare. You want to make sure you don't have any companies that are doing animal testing or whatever it is. And that's a really unique level of personalization that you're never going to get in ETFs. There are too many compromises you have to make when you're making a packaged product for everybody.

Whether that's worth the complexity of managing a DI portfolio is entirely up to the individual. I'll speak personally—I'm not sure I have a great use case for it with my portfolio. I think it would be clever and interesting to be in a DI platform, but I don't really need it. I have the most boring portfolio in the world. But that's not everybody. So, I really do think it ends up being—not to be a cop out here—it's a bit of a personal decision. How much does it matter to you to be able to express your values or your opinion directly into your portfolio?

Benz: You referenced your own portfolio, Dave. I'm curious what's in that boring portfolio, maybe in real general terms?

Nadig: In general terms, it's just incredibly cheap, boring, low-cost index mutual funds, and I've done that intentionally, frankly, since the mid-90s. As soon as I started playing in the ETF business, I made a rule that I just wasn't going to be owning and trading ETFs. It struck me as a way to end up in trouble someday by talking something I happen to own or not owning something I happen to like or whatever. And there is no reason for that. I have been in compliance regimes where all those things were monitored. I don't happen to be currently. But it's just made my life easier. So, it's not an endorsement. But I've had accounts at most of the major custodians over the years with various companies, 401(k)s and personal accounts and everything, as in sub-10 basis points cheap indexing, from stocks, bonds, to commodities.

Ptak: Wanted to shift and talk about governance and regulation, which are topics that you've written about recently. In fact, over the summer, you wrote, "I'd be shocked"—and these are your words—"I'd be shocked if we don't see at least some trial balloons floating in the next year on severely limiting or altering how asset managers vote proxies." What kind of trial balloons do you foresee, and net do you think they will be a positive for investors?

Nadig: We got the big one, which was the Index Act, which was floated in the Senate and will die with this Congress, I'm quite sure. But it wasn't even a trial balloon. That was something that theoretically could have gotten voted on and passed and signed. I don't think it would have happened. But the intent of the Index Act was to effectively remove the ability of index asset managers to vote the shares on behalf of their clients without explicit instructions, meaning BlackRock, State Street, Vanguard would simply not be allowed to vote in, say, Tesla's next proxy unless they had gone out to all of their shareholders and said, how do you want us to vote on this proxy question. On the surface, it makes a good sound bite. We're giving our votes back to investors… The way it was actually written was somewhat nefarious, and it was actually designed to be unimplementable and therefore the only safe harbor asset managers had was not vote at all, which would have taken about 25% of the votes out of circulation, more in the mid-cap space. If that happened, it would end up being tons of mid-cap companies would no longer be able to have annual meetings because they wouldn't get proxies anymore, they would not have a quorum to be able to even hold their meetings. So, there's lots of weird unintended consequences.

But that was just a first sell, though. I do think we will end up with some sort of change to the rules around proxy voting that hopefully at least allow asset managers to poll their investor base about what they care about. In my ideal world, they would actually have a way to do proxy delegation. So, for instance, if I'm in a Schwab fund, I'd be able to check a box that says, hey, I'm going to have the Sierra Club be my default voting block for any issues that come up. If the Sierra Club has an opinion, I want to follow them and if they don't, I'll vote with the House or whatever, however you want to think about it. It could be Center for American Progress, whatever you want as your default proxy system. That should be the way it works. Nobody really wants to vote 3,000 proxies a year. I think that's pretty well understood. But I do think that there's a middle way. There are companies solving this in Europe. A company named Tumelo is doing great work on this. In the U.S., we've got real regulatory issues that are not going to get solved by the stroke of a pen. The way the 40 Act is written, in my interpretation, it actually requires legislation, not just regulation, to change this. And once we get to the point of having something go through Congress, I just don't see it happening, frankly, in the next three to six years. I don't think there's a lot of impetus to make it happen. But I do think that there's a better way.

Benz: There were already sabers being rattled about Vanguard and BlackRock accounting for such a large share of the stock market. What do you think is the end game there, and could you envision a scenario where curbs are perhaps placed on these firms, or indexing more generally?

Nadig: Certainly, people want to. That is the stated intent of both Ted Cruz and Bernie Sanders. And when you get those two agreeing on something, it's definitely worth paying attention, because that tends to mean something is going to happen, but it also tends to mean that somebody is probably not paying attention to what's really going on on the paper in the middle. So, I do think that that attention is not going to go anywhere. I think most of the attention will focus on this issue of voting and governance. And I do think that those are solvable problems. I actually think that the right answer is that we just need to get voting way out more in front, and if people want to pick asset manager A versus asset manager B based on how they're going to vote, that's great. That's capitalism. Let people vote with their wallets about what kind of company they want managing their money.

The bigger issue, or I should say the market structure issue, around do index providers have too much influence into stock prices and flows, those are real issues. And as much as I've spent most of my entire career a little bit on defense for indexing just because, for most investors, it makes a ton of sense, and the math is there. There are real issues with the current market structure and the dominance not just of index funds but particularly target-date funds. There's been some really fascinating activity in the last couple of years, which suggests the endless bid of target-date funds and then the rebalance trades that come in continuously with target-date funds as they become less and less risky over time, but new money comes in at the front end of the curve that that actually has pretty significant market impact in terms of raising the market level in a way that doesn't make a ton of sense from a traditional efficient market hypothesis.

There's a paper called “The Inelastic Market Hypothesis” that I think does a pretty darn good job with the math. I followed math as hard as I could and re-created what I could of it, which was not all of it. And those are real issues, and I think those are things that for the next five or 10 years, we're really going to have to wrestle with. But I don't think they're necessarily the kind of things that you solve with the stroke of the pen. We're not going to unwind the index complexes that dominate corporate finance. Think about the idea of banning the S&P 500. How would you even do that? And think about the tens of trillions of dollars of notional in the derivatives market that would get affected. So, I don't think we're going to do anything that stupid, but that's what I worry about.

Ptak: Wanted to talk about a related topic, which is ESG. Do you think the rise of indexing is incompatible with the promotion of a more just, sustainable world, which I think is a purported goal of some who are ESG proponents?

Nadig: I don't think indexing and ESG or indexing and a just, sustainable world are incompatible. I do think that there is a strong role here for active managers. Let me put it that way. So, if you're a big believer that investing in climate change solutions is a long-term financial win, whether it's from a risk management perspective or just because that's the way the rest of the world seems to be going, they're great index ways to approach that belief system, whether it's buying a solar energy ETF or a net-zero ETF. So, I think, you can express ESG opinions effectively in index products.

Where I think it gets a little trickier is when you say, we've got a couple of things we're doing at once. We have a social justice angle that we believe in strongly. We've got a risk management and corporate governance and malfeasance thing that we think has real impact on portfolio construction and long-term returns, and we've got a whole other set of things that we're trying to get done around climate change. And you put all those things in one package and say, and here's your 500-stock index. People criticize that, and I think there's reason to criticize that. I think it's trying to do too many things at once.

I've likened it to, let's say you are a big believer in factor investing and you think factors are the one thing that really drives long-term equity returns. And you say, “Great, I'm going to be in a multi-factor portfolio and I'm always going to be invested in eight factors.” Well, guess what, you're basically in the S&P 500 at that point. If you say, “Oh, I'm just going to be a value investor.” Great, buy an index fund that's buying value stocks. If you're right, you'll be well taken care of. But an all factor, all model, all the time portfolio is kind of pointless. And that's where, I think, if you really want to invest that way, active management can be a huge benefit to expressing that opinion. I think ESG is similar. If you've got three or four potentially conflicting objectives, having a person, a team that you trust adjudicating that seems rational to me.

Benz: Does ESG as it's currently defined succeed in advancing key environmental, social, and governance objectives? Or do you think it's a red herring?

Nadig: I think we're at a crossroads is the short answer. I'm fine in saying that we're going to have to discover ESG 2.0, and a lot of that's going to come down to definitions, which is really boring. But I hate the phrase ESG. I don't really know that many people who love it. It is by definition bolting things together that may not have anything to do with each other. Whether or not you get sued because you bribe your competitors is utterly irrelevant to whether or not you have a large carbon footprint, But they're both ESG factors—one is an E and one is a G. And they're also probably irrelevant to whether or not you've got a diverse board.

So, ESG already by itself is conflating several objectives at once. And so, that's my biggest concern is that we've lumped these things together much like we tried to do with smart beta and say it's one thing, and ESG is never going to be one thing. It's always going to be contentious. There will always be people on the other side of these trades, and there should be. Because from a capital perspective, if we take something as simple as climate change, if we reward companies through ESG investing by buying more of their stock because they do good things, well, guess what, we're changing the cost of capital structure there and energy companies, all of a sudden, should return more. That's how cost of capital works. If you increase the cost of capital for your "bad industry," by definition, your cost of capital is a pretty good proxy for your expected returns—they should make more money. They'll be folks who are going to buy those things because of that. That isn't necessarily how the math is working right now, I suspect because there's a strong ESG-momentum effect, meaning more money is chasing more money is chasing more money. But long term, you would expect these things to have a certain back and forth in balance. I don't know whether that answered your question at all.

Benz: It did.

Ptak: I wanted to go back. You mentioned ESG 2.0, as you put it, I think a moment ago. Can you walk through that next iteration of ESG that perhaps you envision taking shape? It sounds like maybe one of the differences is, whereas today those things are mushed together—the E, the S, and the G—perhaps in the future, they will be separated and there will be greater focus brought to bear. Do you think that's one part of ESG 2.0?

Nadig: I do think it's part of really defining different objectives and different tools. A great example is what we're seeing right now between Strive and Engine No. 1. So, these are two companies both—I don't think Strive hasn't launched all their products yet—but effectively, what you're going to end up with is two companies owning the same portfolio with radically different voting perspectives. And I actually think that that's great on the surface. I think people should be having those different perspectives. But we're going to end up calling both of those things values-based investing in some format or another. And obviously, it's ridiculous to think that one company that is voting to drill, drill, drill and the other company that is trying to get folks on the Exxon board to get them to stop drilling and focus on carbon transition that those would both be "ESG funds" might seem ridiculous. But that is in fact the vector on which those two companies are playing the game.

That strikes me as interesting and important, and I think those are the kinds of conversations we need to have. Some of it will be around voting; some of it will be around avoidance—I don't want my money going to XYZ company I disagree with. There's pretty limited evidence that you actually move the needle very much by not investing, by effectively boycotting your capital. But it will make people feel better, and I think there's value in that as well. People are people. And I do think as a group, as society as we start doing those things, we will in fact change the cost of capital for these companies, and that does in fact move the needle.

As an example, I just did a really fascinating interview that should go up in the next couple of weeks with the Environmental Defense Fund and Microsoft talking about the specific things that individual companies do when they get that better cost of capital, because Microsoft scores incredibly well in most of those metrics. So, I really dug in with, “What do you do with that "extra money" that the market gives you?” And it turns out they do some pretty awesome stuff. They fund entire water systems for whole countries, and all sorts of things like that. And those really do move the needle. I do think that those change the world one step at a time. Is it the most effective way to do it? Would a more vigorous political response perhaps be better? I don't know. But this is the world we live in. We project power through money, and we project money through corporations.

Benz: Wanted to switch over to discuss asset allocation. As you know, until recently it had really paid off to stick with the classic U.S. 60/40 portfolio mix as U.S. stocks and bonds crushed almost everything else. It's a different story now. If you were to tinker with the 60/40, what would you add or adjust?

Nadig: Well, it's really different now than it was six months ago, wasn't it? That's really the challenge is that honestly for almost all of my career we've been in a declining interest-rate environment. Not entirely; I started investing in the '80s. But certainly, for most of the last 20 or 30 years, it's been a pretty much a one-way ticket. And a lot of what we think about in terms of the math of academic finance looks back on that period as gospel, that this is what bonds and stocks would do when they are held together. I think that that math is changing. And so, I'm extraordinarily reluctant to lean into academic finance—most of that's actually based on post-war analysis that we then tried to implement in the '80s and '90s. I think we're on the verge of a new version of academic finance. I mentioned the Inelastic Market Hypothesis is one of the potential perturbators of how we think about things. So, I actually object to the 60/40 portfolio on fundamental grounds, which is, I'm not even sure I believe the precis that got us to the 60/40 portfolio anymore.

Obviously, today, if you've got money to put to work in high-inflation environments where you can actually now get real yields out of the yield market, the math is very different than it's ever been in my investing lifetime, and I think it's reasonable for investors to ask why they own things. I think owning bonds still makes sense from a preservation of capital perspective and from an income-generation perspective. But I don't think it's the case that there's a magical mix with bonds anymore that somehow gives you the diversification free lunch that we all learned about in business school. So, I think it's going to be a really exciting couple of years for academic finance as we start wrestling what the modern bond market looks like in a world where we've got high inflation and yields available on the table. Things like leverage become much more interesting in this environment than they have been for the last 20 years, and a lot of folks were accidentally using leverage all over the place in their portfolios, and all of a sudden, that's going to get real expensive. I think those kinds of things, we're just starting to see how they pan out. Things like how people are doing short-term financing of market-making activities in the derivatives market. That all blows up and has to be reimagined.

Ptak: You mentioned bonds. I wanted to ask you about that. We've seen a spate of outflows from bond funds in recent months. In a way, it's unsurprising because bond funds have been losers as rates have risen. But have you been surprised that investors haven't been more tempted by higher yields?

Nadig: I think we'll get there. I think this is a natural taking-a-deep-breath moment for the markets. On the ETF side of the balance sheet, we've had some of the best months we've ever had in terms of Treasury inflows, all at the short end of the curve, not a lot going into the 20s. But there are a lot of short-term bond funds or SHY, or the two years, three years, the five-year durations. Those seem to be catching a bit more of a bid. And that seems more like parking than investing. People putting cash on the sidelines as it were, but now being able to get a little bit of yield out of it. I've been encouraged to see the success of funds like JPST, which is JPMorgan Short-Term ETF, because that makes sense to me, having an active manager really managing for maximizing yield but keeping the risk really low at the short end of the curve in this kind of environment. That is to me the ultimate case for active management, because this is not a time you just want to be sitting in the twos and then taking a nap for 90 days. Who the heck knows what could happen?

I also think that the ETF part of the fixed-income market is still so nascent. We still have so much room for product. There's still only a handful of bigger active managers in the space. We're just starting to get some of what I would consider core building blocks for more interesting strategies. We've had the on-the-run Treasury funds launched where you can just get the 10-year forever basically, and they'll rotate it for you. BondBloxx just launched the Target Duration Treasury stuff along with their corporate bond sector funds. Those to me are natural building blocks. We've had those in the equity side of the house in the U.S. for 20 years at this point. So, we still got a lot of catch-up to do.

Benz: You referenced feeling enthusiastic about active management in bond funds. We've seen one of the longest stretches of outflows from active bond funds. I think this has been the worst 12-month period for active fixed-income flows in 15 years. So, do you think that the same could happen to the active bond complex that happened to active U.S. large-cap funds?

Nadig: It's always hard to tease apart the why on something like that. You pointed out a couple questions ago that one of the reasons we've seen so many outflows in bonds is because we've been in a rising interest-rate environment and a really strongly rising interest-rate environment, and nobody wants to be holding the paper when that's happening. So, I suspect that that is most of it. But I also think that markets like this are where heroes get made. And we know that in the equity side of things all the time. When March 2020 rolled around, I think those of us who have been in the business for a while were just like, "Crack your knuckles because we're going to nominate seven or eight heroes off the end of this because somebody is going to call it exactly right, like coin-flipping, somebody is going to buy on the day that we bought them." I think we're going to do the same thing here in bonds, where we're going to look back and say, six months—I'm going to be like, OK, these three active bond managers extracted every basis point of value out of the bond market all the way up and avoided all the downturns; somebody got it right. And we'll find that out, and then those folks will get billions of dollars, and then they will probably not perform that well for the next year. We all know how that works. But I do think that we're going to see that.

This is the biggest thing that's happened in the bond market in my lifetime, what's going on right now. We've literally never raised rates as fast as we just raised rates. And we've certainly never done it in this world of accidental MMT and 8% inflation. So, it's exciting. It's a little terrifying. I'm really glad I'm not an active bond manager, but I'm not worried that somehow as a class they're all going to get new jobs. I think we're just going to nominate a new set of heroes.

Ptak: Wanted to ask you about the advisor market. I think you said before that the advisor market tends to lead the charge on financial innovation when it comes to things like portfolio construction and analysis. What's a current example where this is playing out right now?

Nadig: Well, it's interesting. The advisor tech space is just so big and so huge, and I think that certainly I tend to get hyperfocused on the portfolio pieces of it because that tends to be the most interesting. So, folks that are out there doing portfolio construction stuff or even just connecting interesting rails together—like Orion has been doing a lot of work with everyone from on-ramp on the crypto side to other folks that are doing weird ESG stuff and direct indexing. And so, there are a lot of these fintech or advisor tech aggregators that are really making this a whole lot easier for advisors to get access to new stuff, to get access to managers they might not have gotten access to. But that's actually not where most of the interesting development is going on.

If you look at the giant quilt—Michael Kitces has a great chart on this with like every advisor tech company out there—90% of those companies don't touch the portfolio. What they do is they help advisors run their businesses better, whether that's financial planning, whether that's risk management, whether it's just communicating with their customers. My favorite advisor tech company I've talked to in the last two years does one incredibly tiny little thing. It's this company called Knudge. And all they do is basically create an email tickler system for clients to do actions like update your will or close that account at Fidelity you don't need anymore. But they create an ecosystem around it that ties into the CRM system, the advisor works, so all of a sudden, these actions that need to happen outside of the advisors' control actually have a process to get done. That sounds boring. It sounds incredibly tiny. And for every advisor I've talked to who is using it, it's transformed their entire business, because this is the number-one problem a lot of advisors have is getting their clients to do the things they say they will do. So, all of those little things around the edges of the financial advisor practice are now the ones getting tackled by fintech companies, and I think that's super cool, particularly some of the behavioral finance stuff that's coming down the pike. There's a dozen companies out there building either models or education systems to help advisors solve those problems, to have better conversations with their clients, that to me is what gets me excited.

Benz: Earlier in the conversation at the beginning, you referenced emerging technologies like crypto and DeFi, which you think and write a lot about in your work. What relevance will these have to investors and advisors in five or 10 years?

Nadig: What I try to do is separate the idea of crypto as a thing one puts money in, hoping that the numbers go up and crypto, a set of technologies for how money moves and interacts. I'm uninterested in whether or not bitcoin goes to $40,000 again. It'd be great. I know lots of people are invested in it, and I like my friends to make money. That's all great. But from a does-it-matter perspective, whether this or that coin is successful, or this or that effort is successful, really won't matter. We're very much in the sort of dotcom era of tech investing and all that stuff. And there will big winners out there that we can all say, "If only I'd put my money in 20 years ago, blah blah blah…" That's not what I find interesting.

What's interesting to me is where the tech is going in terms of how money talks and how money moves. So, the things that are going on in the smart contracts part of the world—we talked a little bit about tokenization, that's a big part of it as well. But even if we look at things like how companies get funded, how bonds get issued. I think what's going on in blockchain bond issuance is fascinating. And we've seen examples: Santander, Singapore, El Salvador—there's dozens of examples now of really interesting and innovative products that usurp the way we think about securities. There are obviously huge regulatory issues around that, and Gary Gensler is happy to chat with us every day about that. But that to me is the interesting stuff is how we make these things interact.

This one blew my mind. The average advisor who is doing cash management for his client directly to the Treasury market, meaning he is either running a bond ladder or he is buying tens for his customers and then rolling them out every year, just basically managing direct bonds. I've had numerous advisors tell me that because of platform limitations that costs them something on the order of 20 basis points round trip, which is an insanely large amount, if you're curious. If you've never traded bonds before, it's an obscene amount of slippage to be able to manage Treasuries, which theoretically you can buy for free as an individual investor through TreasuryDirect. Those types of inefficiencies get crushed by crypto because there are no slippages. These are direct one-to-one transactions where everything is negotiated, and everything is transparent upfront.

So, the idea that you could just usurp any of that part of the ecosystem with crypto rails I find really exciting, and I do think that that changes the game. Maybe other people will get excited about 20 basis points. In our line of work, we're chasing indexes all day, a basis point actually matters. So, those are huge gaps in the modern market.

Ptak: What caused the crypto crash, and do you think it was foreseeable? And also, what do you think it portends for the future?

Nadig: I'm not going to hold myself out as the ultimate be all, end all on crypto asset prices. I think we had numerous things going on both this time and the last time crypto crashed, and it will also happen the next time crypto crashes. One is that because bitcoin and ethereum in particular are staked assets, meaning, yes, people own bitcoin and yes, people own ethereum–those are also the coin of the realm to participate in the rest of the DeFi ecosystem. So, if you want to play around in some offering that some fly-by-night guy is doing that you think is really interesting, or if you want to play in the NFT space, or you want to start writing smart contracts to do portfolio management—or whatever it is you think you're going to do that's interesting in crypto—the base currency, the base meat that you need to work with is most likely bitcoin or eth. And because of that it gets staked into a protocol, it gets staked into an ecosystem, and then that thing itself then gets restaked. So, it's a little bit of a rehypothecation problem where you end up with what essentially ends up being leveraged in the way we measure these things.

What that means is when something breaks, or simply when something stops being interesting at the end of the curve, like, NFTs, and all the air comes out of that, well, all this money doesn't just… It's not like people sell one thing. That creates a cascading effect. And so, what used to look like $1 trillion ecosystem overnight looks like $0.5 trillion ecosystem. Even though it may be the case that very few people sold any bitcoin or sold any Eth. You're just unwinding these layers of staking and these layers often of leverage in the system. So, we shook a lot of that out, and what that meant was a lot of people ended up with bitcoin they didn't want anymore, and so they ended up selling it. And they ended up with a lot of eth they didn't want anymore, and so they ended up selling it, and that drives down the natural price.

I think that's a big piece of it. That's not a unique observation. A lot of folks have pointed out that. And then, of course, it seems reasonable to suggest that we were in a bit of a speculative bubble as well. I think we can all see what happened during the pandemic, whether it was with meme stocks, or even sector rotation, or crypto, or real estate investing, or people buying fancy watches—there was a lot of money flush around the system and a lot of that money did end up in crypto and a lot of that money has gone away. And I think you get those two combo platters together of an ecosystem that relied on restaking and leverage, and a speculative bubble coming out of the pandemic, and a lot of the money in the system. I think the writing was pretty much on the wall. That doesn't mean anybody could have called it. It could have gone for another two years, or it could have ended in 2021.

Benz: What's your take on the ETF model portfolios that a lot of the big providers have used as conduits to their products? It seems like there are clearly benefits, but in some ways, it seems like déjà vu, where advisors might put a lot of their assets with a single fund company.

Nadig: I go back and forth on the model portfolio stuff. You guys at Morningstar do the best work tracking that space and thank you for that. It's a tricky one to even get your hands around, because we can have a VettaFi model portfolio by the end of this phone call. Nobody would put any money in it, but it would be another model portfolio we have to pay attention to. And so, because it is this unregulated intellectual property, this idea of what a portfolio looks like, it is the case that every issuer has a set of model portfolios, every brokerage firm has a set of model portfolios, every big advisor group often has their own set of model portfolios, some of which are heavily tracked and have tens of billions of dollars in them and some of which have no money attached to them whatsoever. So, I worry about model portfolios for that reason because they are effectively just unregulated intellectual property.

I think for a lot of advisors, they're a great shorthand. But you should approach a model portfolio the way you would approach any other asset-management product. Ask yourself whether or not you're a buyer of the intellectual property. I think it's very reasonable to be skeptical of a house model, particularly coming from an asset manager that's suggesting you put most of your money into their specific funds. I think that's obvious what they're trying to do. It's very transparent. I think most of the time those are fairly well-intentioned. When I've talked to asset managers who were doing that, they're not necessarily thinking that “Gosh, we're going to get billions of dollars in this exact paper portfolio that we're putting out there.” Or “We're going to get it listed on Envestnet and they're going to put their money directly into that.” Instead, a lot of those model portfolios are actually more like education tools to show advisors how funds fit together. And that is a question I get from advisors all the time when they move into the ETF space. I'll get DMs saying, “I'm a believer in ETFs now, but do I need five, do I need 50, do I need one? What's the right answer?” And of course, there is no magic right answer for anybody.

My concern about model portfolios would be they can often apply complexity in unnecessary ways because an asset manager or even an advisor wants to be able to show that they are "doing something" with their clients' money. And to be honest, most model portfolios that have more than five positions in them probably don't need the extra positions. They're probably there just to look good. But really doesn't make much difference if you break out your U.S. exposure into six different U.S. equity ETFs, or if you're just putting it in the one that rolls up to the way you wanted it in the first place? Probably not.

Ptak: For the last question we thought we'd have a little fun. You're an avid music fan. What have you had on heavy rotation lately?

Nadig: Oh my gosh. We got another hour? I'll give you a hot one that literally dropped today as we're recording this, which is a new album from Philadelphia artist Alex G, who is an indie musician from Philadelphia. I'm guessing he is about 30. Philadelphia has been on fire honestly. There are five or six really great bands coming out of there. But Alex G just dropped that album called "God Save the Animals." Really unique stuff. A little bit of folk-rock indie stuff going on, but actually, he comes from more of a mobi electronica angle. That's been my jam on pretty heavy rotation, certainly today, and the singles from that over the last couple of weeks have been phenomenal.

Ptak: Awesome tip. Thanks so much for that. And Dave, thanks so much for this conversation, which has been really fun and enlightening. Thanks for being our guest.

Nadig: Gosh, thank you so much for having me. I wish we could do another hour or two.

Benz: Thanks so much, Dave.

Nadig: Thanks.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)