ETF Prime: Dave Nadig on Ethics of Indexing

In a recent article, “The Ethics of Indexing Redux,” Nadig explored the idea of the growth of passive investing and the potential ramifications. These insightful takeaways were well worth exploring since Nadig and Geraci are proponents of passive investing overall.

Looking at the impact of passive flows and how price discovery is really working in indexes, Nadig has been keeping an eye on the progress of this line of thinking, which motivated the previously mentioned article. There were three key questions to explore – 1) Is the current dominance of passive strategy in flows impacting how markets function? 2) If so, is it possible to determine how in a way that might influence the decisions we make as investors? 3) Does pooled ownership create any winners or losers in a way that isn’t representative of that ownership?

Digging into where these questions come from, Nadig believes that while the logic being suggested by experts (and the math to back it up) concerning the efficient markets hypothesis is freaking some people out, many rational people already know this hypothesis has remained unproven for a while.

Looking at why there’s a higher multiplier concerning the money going into an index fund, Nadig notes that multiple explanations begin to set an understanding. Simply put, “If you are a market maker,” Nadig states, “And you have to sell somebody your Tesla that you have in inventory to make a trade happen, that is an easier thing to do in terms of your inventory management and liquidity across your book than to do that with 500 stocks all at once.”

So, it’s coming down to understanding that there are many ways to substitute for one big company within a series of stock holdings to find similar exposure, while it’s very difficult to find a substitute for the top 1000 stocks in the U.S.

As far as what to expect, if everything Nadig is saying ends up completely checking out (which is not to say something is necessarily wrong), it would mean the characteristics of markets are different than what to expect. “That means there’s a reason to expect that long term flows will continue to support markets regardless of short term volatility…until it doesn’t.”

“We need to be careful of those tipping points,” Nadig adds. Getting to either side of it would mean markets will move more than otherwise expected.

Later in the show, Geraci is joined by Greg Friedman, head of ETF management and strategy at Fidelity. The company has continued to build out its ETF business (they’re currently at over $30 billion). Additionally, they have gotten more aggressive at launching thematic ETFs, including, just recently, the Fidelity Crytpo Industry and Digital Payments ETF (FDIG ) and the Fidelity Metaverse ETF (FMET ). Speaking with Geraci, Friedman has thoughts on how investors should be viewing crypto in the longer term.

As far as what’s been driving the recent output of thematic ETFs, Friedman explains that it comes down to client demand and trying to solve their financial needs. There are all sorts of things, such as metaverse, crypto, and cloud computing, that people have a viewpoint on and want to be part of in some way. Fidelity is seeing this and wants to have a way to deliver a product that fits that demand while still feeling unique.

Looking at the overall strategy on the ETF side, Friedman notes that it comes down to feeling different and adding value. He states, “We’ve always been focused on choice value innovation.” The focus, in that regard, is on smart beta, active, and thematic investing.

Closing out the show this week, Geraci is joined by Kelly Ye, head of research at CoinDesk Indicies, who is around to discuss the future of crypto. She has thoughts on how things have proceeded recently, with crypto essentially getting chopped in half. There’s also discussion of what CoinDesk is up to, as they are building out a powerful indexing business.

As far as what Ye is looking at to determine which aspects of crypto are the most worthwhile, she notes how it’s important to think through their use case. Then it comes down to the technology behind it. This understanding will allow investors to do more homework to understand the fundamental drivers for the appropriate sectors.