Leaving Cash On The Trading Floor

June 15, 2018

[Editor’s Note: The following originally appeared on FactSet.com. Elisabeth Kashner is director of ETF research and analytics for FactSet.]

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. 

Traders’ Dream

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 (%)
Copycat 339
Time Since Launch 122
Momentum 115
Multifactor 106
Active 103
Growth 69
Value 60
Fundamental 56
ESG 32
Equal 27
Dividends 26
Low Volatility 19
Vanilla 8

The difference is stark. Vanilla funds that include virtually every U.S.-listed stock, cap-weighted, barely touch the capital markets. The iShares Dow Jones U.S. ETF (IYY)’s portfolio managers are the champions of sitting on their hands, with annualized turnover of a mere 3.83% of the portfolio.

Contrast that with the turnover king, the Direxion All Cap Insider Sentiment Shares (KNOW), which, by FactSet ETF Analytics’ calculations, saw 912% portfolio turnover in the 12 months through May 2018. That’s quite a bit of exposure to slippage in the capital markets.

Slippage could well be the reason that “smart beta” ETFs have consistently failed to produce risk-adjusted outperformance versus broad, cap-weighted benchmarks or ETFs that track them. After all, if the foundations of the strategy remain sound, alpha should persist when packaged into indexes and ETFs, yet we have seen that, most often, it does not

Narrowness Has Its Price Too

Rebalancing slippage can also weigh down returns of slice-and-dice funds that target portions of the market. The style box has a surprising amount of movement, as companies grow from small- to mid- to large-caps, or shrink, or bounce between categories. A nine-fund suite covering the full style box sees much more capital market activity than a single total-market fund like the iShares Core S&P Total U.S. Stock Market ETF (ITOT)

A quick look down the market-cap spectrum bears this out. Among even the simplest style box funds—vanilla ETFs that cover the U.S. equity market—turnover rises as capitalization size shrinks. 

 

Focus Average Turnover (%)
Total Market 8
Large Cap 5
Midcap 16
Extended Market 37
Small Cap 23
Micro Cap 15

 

Perhaps this explains why cost-obsessed Vanguard uses the broadest possible funds in its target-date and personal advisory services products. While heartbeat flows can wash out capital gains, they can’t erase the impact of information leakage.

Avoiding trading is practically a religion at Vanguard. It explains much of Vanguard’s atypical behavior in the ETF industry, including not publishing daily portfolio holdings, the use of transition indexes to manage major index changes, the CRSP value/growth index methodology using “packeting” developed for Vanguard’s use, and the adoption of active management for its new suite of factor funds. 

The Cost Of Active Management

Vanguard has explained that its main motivation for active management in factor funds is not to avoid front-running, but to maintain high factor exposure by allowing for adjustments daily, rather than truing up only quarterly or semiannually. The new Vanguard factor funds have shown evidence of high turnover since their launch in February. 

The Vanguard U.S. Multifactor ETF (VFMF), the series asset leader, had 43.13% portfolio turnover between Feb. 26 (the first date that holdings are available to FactSet) and June 7, 2018. That’s 265.4%, annualized. Even with the ratcheted-up factor-based exposure, it’s hard to square sky-high turnover with Vanguard’s historic caution toward the trading floor.

Since their inception, none of Vanguard’s actively managed factor funds has had an outflow. That means these funds are at risk of making significant capital gains distributions. Without redemptions, these high-turnover products are on the same footing as mutual funds. No index to track means no capital markets leakage, but it also means no rebalancing flows that magically wash out capital gains.

Simplicity Vs. The Trading Floor

And there is the trade-off. On the one side lies the tax inefficiency and agency in the capital markets that comes with active management. On the other, complex strategies that avoid capital gains and keep explicit costs low, but that do so at the price of depressed performance. Sitting in the middle are the simpleton products: broad-based, cap-weighted index trackers with minimal rebalancing requirements. In many ways, big, dumb, cheap beta brings the best of both worlds. 

At the time of writing, the author held no positions in the securities mentioned. Elisabeth Kashner is director of ETF research and analytics for FactSet.

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