Running An Index ETF Is Harder Than It Looks

April 28, 2017

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.

 

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