ETFs are famous for their tax efficiency. In 2017, of the 145 funds constituting the top 80% of U.S. ETF assets, a mere five distributed capital gains. Tax efficiency plus low fees make ETFs attractive investment vehicles.
Yet it is entirely possible for an ETF to have low all-in costs, including trading costs, expenses, tracking difference and tax liabilities, but still leak cash. It happens when a portfolio manager with a complex mandate adopts a low-tracking-difference-oriented trading strategy. A “smart” strategy may well lose its edge when it hits the real world.
Most of the leakage takes place on the trading floor, beyond observation to all but the most dedicated and highly equipped. Actually, the edge hasn’t been lost as much as transferred to traders. Let me explain.
Follow The Leader
Index tracking requires mimicking index behavior. Basic index rules require pricing at the day’s closing value. This means index additions and deletions also happen at the closing price. ETF portfolio managers with a zero-tracking-error mandate are pretty much forced to execute trades at the closing auction. They can’t trade ahead for fear of diverging from the index value. During a rebalance, they can’t not trade or they’ll start the next day with the wrong portfolio. That’s a vulnerable position in the capital markets. Market-on-close execution invites front-running.
The front-running that comes along with portfolio rebalances alters the index performance, because it increases the price of additions and decreases the price of deletions. The larger the AUM tracking of an index, the higher the risk of underperformance; that is, underperformance versus the backtest.
Indeed, that’s exactly what I documented when I took apart an ETF rebalance trade. The punch line to that article was that the combination of redemption activity and brokered market-on-close trades was on track to cost investors 0.24% per year in the example fund. That’s the difference between the day’s volume-weighted average price (when buys were being pushed up and sells pushed down) and the closing auction level, where they wound up.
Put another way, had the portfolio managers worked those trades themselves, they could have been on track to outperform their underlying index, as their sells throughout the day depress closing prices, and their buys inflate them. That’s how this series (which started with a question about those funny “heartbeat” flows) has come to the point where it’s really about understanding the impact of capital markets on index returns.
The Cost Of Complexity
The hidden cost of rebalancing is borne unequally across the ETF landscape because some funds rebalance frequently, while others need almost no tweaks. The broadest, cap-weighted funds can chug along for years with the same constituents, with occasional adjustments for IPOs, spin-offs and the like.
Turnover in equity funds is primarily driven by the need to maintain the desired active risk against the broad market. The biggest turnover funds are the “anything but market cap” crowd.
Here is annual turnover through May 2018 by ETF strategy for all U.S.-domiciled ETFs that draw from the total U.S. equity market. Turnover is calculated monthly and totaled, then averaged across the strategy.
|Strategy||Average Turnover (%)|
|Time Since Launch||122|