Running An Index ETF Is Harder Than It Looks

April 28, 2017

The recent hiccups around the VanEck Vectors Junior Gold Miners ETF (GDXJ) have highlighted something few people talk about: what index managers actually do. And I think it’s genuinely underappreciated.

There’s a belief in some circles that managing a fund that tracks an index is like riding a bicycle: Yeah, you need to learn, but once you do, it’s just on autopilot.

Nothing could be further from the truth.

In no particular order, here’s what goes right every day in a solid ETF shop—which nobody ever sees—and what could go horribly wrong.

Compliance & Tax Recapture

It sounds boring—unless you’re on the hook for it—but ensuring an ETF meets any of hundreds of potential regulatory requirements, all day, every day, is not as easy as it sounds.

The recent GDXJ stories are an example of a fund getting it right. Yes, the fund was forced to deviate from its index because the size of its positions started bumping up against a 20% limit on ownership imposed by Canadian regulations. What was missing from a lot of the coverage is that this was a huge win for good management.

Consider the alternative. If Van Eck had been asleep at the wheel and just let some of its positions cross over the 20% threshold, it could have been a disaster. A raft of lawyers would have waded into the fray, filing for exemptions, or complying with the rules and making tender offers to thousands if not millions of shareholders.

The fund would almost surely have had to close for creations in the chaos.

Daily Hurdles

The compliance burden for a big international ETF is enormous. From 2009-2013, Brazil—just to pick one example—was constantly changing the rules about foreign entities buying stocks, creating a near-daily shifting landscape for any ETF targeting that market.

Investing in China? You better make sure you’re staying on top of your (likely borrowed) renminbi qualified foreign institutional investor quota.

And that’s to say nothing of the combo-platter of U.S. regulatory issues even the simplest ETF faces: IRS diversification rules, SEC disclosure rules, exchange listing requirements, FINRA communications rules. It’s real work.

International funds have another wrinkle. Depending on which country an ETF is investing in, the dividends from the holdings may be subject to withholding. In many cases, those withholdings can be recaptured because of tax treaties between the U.S. and the target country.

How good you are at getting that money back can make a real difference, and who knows, you might be even better at it than the index provider itself outlines in its rulebooks.

 

Governance & Corporate Actions

If you manage an S&P 500 ETF, you have to deal with—guaranteed—at least 2,000 quarterly reports a year, likely with dividend payments.

That’s not to mention the countless other things that can cause headaches for fund managers: M&A activity, stock splits, special dividends, spinouts, and so on. Every index provider has a detailed guidebook on exactly how the index will respond to these corporate actions, and if you—as the ETF manager—get something slightly wrong, you can kiss your tracking difference goodbye.

And of course, how MSCI deals with a particular corporate action won’t necessarily be how FTSE/Russell or Standard & Poor’s deals with it.

And then there’s proxy voting. ETFs own a lot of stocks. And at least once a year, each of those stocks is going to have a proxy solicitation asking for approvals and opinions on a host of issues, from executive compensation to merger approvals. While the actual process and decision-making can be outsourced, increasingly, large ETF managers take this business very, very seriously, using their often-outsized ownership stakes to influence how the very companies they own on behalf of their investors are run.

Given that many individual investors never even vote their proxies on their individual holdings, this is, to my mind, a huge uptick for corporate oversight versus single-stock ownership. Again, it’s real work.

Cash Management & Trading

Regardless of the corporate action—dividends, splits, mergers and so on—the portfolio impact almost always involves a reinvestment trade.

Cash dividends are constantly piling up in any stock fund, and that cash needs to be put to work in a way that tracks the index as closely as possible. That sounds straightforward, but it often involves nuances most investors miss.

Trading has real costs for an ETF—it can generate capital gains, and even the biggest institutional trader incurs commissions and has to deal with spreads. Those effects don’t exist at the index level, so the ETF manager is in a constant battle to close the gap between the theoretical performance of the friction-less index and the very messy real world of buying and selling securities.

There are many tools that can be used to minimize these costs: negotiated rebalance trades, using futures or options to get temporary exposure, even using other ETFs to provide quick and cheap exposure pending a big reinvestment trade. ETF investors, oblivious to these nuances, simply expect it all to be done perfectly every day. No pressure there.

 

Securities Lending

If ETFs face an unfair benchmark in the perfect math of the indexes they track, they have one thing up their sleeve that no index includes: securities-lending revenue.

Depending on how much the market wants to borrow a particular ETF’s holdings, revenue from a well-run securities-lending program can add tens of basis points a year to the bottom line, often overwhelming the impact of the expense ratio.

Securities lending can be controversial.

BlackRock, for instance, is known for having an aggressive securities-lending program, managed by an in-house team. It takes 30% off the top and gives 70% of the revenue back to the funds. Most other firms outsource securities lending to a third party, and remit 100% of the “profits” to funds. In either case, it can make a huge difference, for very minimal risk.

Measuring Impact

So how do you know whether your fund manager is “good”? For the most part, ETF issuers are very good at what they do, and there’s a reason we take all of the accounting and compliance and corporate actions work for granted—because it’s extraordinarily rare for any ETF or mutual fund manager to mess these things up.

The more subtle things—the trading and the securities-lending activity—show up in performance directly, and you can measure it with tracking difference. Here’s the ETF.com Tracking Difference panel for the iShares MSCI Emerging Markets ETF (EEM):

 

 

If the fund were “perfect,” you’d expect the fund to be exactly 70 basis points behind the index it’s tracking—because that’s how much the manager takes out of the fund in fees.

But this panel suggests that in a median 12-month period, over the last two years, the fund is only behind by 62 basis points. That means 8 basis points are in your favor as an investor, likely from trading activity and securities lending.

In the best-case scenario, you were only behind by 33 basis points—meaning you were 47 basis points better off than you expected. And in the worst-case scenario, you were just 7 basis points off worse than expected.

 

Tracking Difference & Liquidity

In general, tracking difference will be very tight in big, liquid markets (it varies by just a basis point or two for the big S&P 500 funds), and will vary quite a lot in small, illiquid markets (frontier market ETFs can swing from a percent or two up or down). But when comparing apples to apples, tracking difference remains the best indicator of how well the manager is doing their job.

So how about GDXJ, where we had all these concerns about how it had to deviate from its index to avoid the Canadian regulatory bogeyman?

 

 

That’s a clean report card. In a median holding period, the fund has done 40 basis points better than the expense ratio would suggest. The “swinginess” (as good as +1.07% and as bad as -1.3%) is completely in line with an international small-cap ETF, which is exactly what this fund is.

The reality here is this: Running index funds isn’t as simple as it seems, and the scorecard across the industry is pretty stellar. How good is the average ETF manager? Do your homework, for sure, but the answer is mostly “very good indeed.”

At the time of writing, the author owned none of the securities mentioned. You can reach Dave Nadig at [email protected].

 

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