ETF Investing

Transitioning from an ETF to Direct Indexing? Bad Idea.

Many investors face the complex decision of whether to transition from a diversified ETF to direct indexing. When is this switch a poor investment choice? My findings suggest that many investors are better off avoiding it. Direct indexing remains attractive even with a decent amount of embedded capital gains, up to approximately 40% of initial investment, for investors in the highest marginal income tax bracket.   However, for lower-tax investors with a marginal income tax rate of 22%, ETFs often prove more advantageous: when embedded capital gains exceed 10%, a consumption-focused investor is better off staying in an ETF.  While the other benefits and costs of direct indexing are difficult to quantify, my results indicate that it is far from a universal solution. Investors with high embedded gains and lower tax rates should approach direct indexing cautiously.

The democratization of investing and the evolution of ETFs

The implications of the competitive landscape for ETFs are mixed. On one hand, they have truly democratized investing. Investors now have access to the benefits of financial markets in one instrument that provides diversification at very low fees. Recently advertised fees on broad-based bond funds have fallen to 3bps. On the other hand, ETF providers have been able to satisfy investor demand for increasingly specialized products even though the evidence suggests they underperform. Are investors becoming worse off due to the effectiveness of the marketing strategies by providers of specialized ETFs?

Wes Talks with Belle about Creating Your Own ETF

In this episode host Belle Osvath, CFP® talks with Dr. Wesley Gray the founder of ETF Architect and Alpha Architect, about how advisors can create their own ETFs which can be used to help manage client funds and taxes. They discuss the creation process, the cost, and what type of advisory practice would benefit the most from their own ETF.

What are the Best Times for ETF Investors to Trade?

The expense ratio aside, the cost of transacting in an ETF depends on the size of the bid/ask spread at any point in time during the trading day. The ETF investor should make evidence-based trading decisions since the bid/ask spread can range from 1 basis point (bp) to several hundred bps. What are some intelligent guidelines for ETF investors--avoid the open, avoid the close, and what about everything in-between? This article provides data on the effect of the time of day on the average bid/ask spread for ETFs.

Mutual Fund to ETF Conversions: To Proxy or Not to Proxy, that is the question

ETF conversions are accelerating and we are seeing more and more mutual funds converting into ETFs. The reasons for mutual fund to ETF conversions are obvious: tax efficiency, transparency, and lower operating costs. But how does this work? What are the pro/cons? This post provides a glimpse behind the curtain and a practical guide for any asset manager considering a mutual fund conversion. Below we outline the laws behind a mutual fund conversion, options for mutual fund conversions, and the nitty-gritty behind how to optimize a mutual fund conversion.

Why Advisors (and Family Offices) Should Consider Creating their Own ETFs

Independent RIA firms seek to do what is "right" for the client, which often boils down to minimizing fees and taxes and increasing transparency/education (i.e., ETFs). But the "right" solution for an advisor's clients might not be available 'off-the-shelf' in the ETF market, or the advisor can't use ETFs because they are stuck "managing around" legacy portfolios and tax problems.

What's the solution? Allow advisors to create their own ETFs, which can be customized to deliver the specific investment program the advisor desires and allows an advisor to offer unique solutions for legacy tax issues tied to low-basis securities.

Should Levered and Inverse ETFs Even Exist?

In this article, we explore Levered and Inverse ETPs (exchange-traded products); their purpose, the circumstances in which they tend to succeed and fail, and the research questions associated with them.

Can You Keep Your Track Record After an ETF Conversion?

Here is the bottom line: converting into the ETF structure can bring a lot of benefits to the table, but porting your official track record over to an ETF can be challenging.

However, even if the facts and circumstances of your situation suggest that porting your official track record into an ETF is impossible, all is not lost. Retail consumers, institutional investors, platform providers, gate-keepers, and so forth, will likely be aware of your previous performance and reputation as an asset manager/advisor and they can often read between the lines. For example, if an advisor has been running the "ACME US Dividend Strategy" for 20 years, and this same advisor launches the "ACME US Dividend ETF" with the same investment process and investment objective, it doesn't take a rocket surgeon (or a brain scientist) to figure out that the ETF is probably a more tax-efficient version of the old strategy.

Arbitrage and the Trading Costs of ETFs

This article examines ETF creations and redemptions around price deviations and finds that the expected arbitrage trades are relatively rare in a broad sample of equity index ETFs. In the absence of these trades, price deviations persist much longer. Creation and redemption activity appears to be constrained when exchange conditions would lead to a costlier arbitrage trade, and the size of the price deviations mainly impact the likelihood rather than the amount of trading. The authors also find some evidence that creations and redemptions are less likely to trade on price deviations when they would be required to trade the underlying stocks against broad market movements. Their results suggest that several factors may discourage the built-in ETF arbitrage mechanism and that investors may receive poorer trade execution in these conditions as a result.

Options Hedging & Leveraged ETFs in Market Swings

Earlier this year, GameStop stock rose like crazy in only a few hours with the effects of broker-dealer options hedging spurred by retail investor buying pressure. And from February to March 2020, options trading activity was also pointed to as a contributor to stock swings in the Covid-19 selloff. The market dropped 30% and then recovered quickly over the following weeks. It has been documented that the need for market makers to hedge their positions with options (given rapid changes in stock prices) can contribute to market and stock price swings. However, might there be other factors also at play in these types of stock and market fluctuations? 

Can Market Maker Capital Constraints Result in Mispricing of ETFs?

Capital constraints of financial intermediaries can affect liquidity provision. We investigate whether these constraints spillover and consequently cause contagion in the degree of market efficiency across assets managed by a common intermediary. Specifically, we provide evidence of strong comovement in pricing gaps between ETFs and their constituents for ETFs served by the same lead market maker (LMM). The effects are stronger for ETFs that are more illiquid and volatile, when the underlying constituents of the ETFs are more costly to arbitrage, and for LMMs with more constrained capital. Using extreme disruptions in debt markets during COVID-19 as an experiment, we show that non-fixed income ETFs serviced by LMMs managing a larger fraction of fixed income ETFs experience greater pricing gaps. Overall, our results indicate that intermediaries’ constraints indeed influence comovements in pricing efficiencies.

Shorting ETFs: A look into the ETF Loan Market

We find that exchange-traded fund (ETF) lending fees are significantly higher than stock lending fees. Two institutional features unique to ETFs play significant roles in explaining the high fees. First, regulations restrict investment companies, such as mutual funds and ETFs, from owning ETFs. As these institutions are key lenders, their absence reduces the lendable supply in the ETF loan market. Second, while the create-to-lend (CTL) mechanism alleviates supply constraints when borrowing demand increases, its efficacy is limited by the associated costs and frictions. Our results speak to the limits to arbitrage in the ETF markets.

ETF Tax Efficiency isn’t Always Efficient

Compared to mutual funds or separately managed accounts, ANY benefit from redeeming in-kind is a bonus. That being said, not all ETFs and situations are created equal when it comes to tax efficiency, and the "golden rule" always applies - when given the option, the IRS wants to create scenarios where they receive tax dollars now instead of later. Here are some big-ticket items that cause inefficiencies (read as taxes…), many related to the “golden rule” above.

Should I launch an Active ETF or Index ETF?

summary, there are no right answers when it comes to launching an active or an index ETF. However, by understanding the basics of the regulatory landscape and the costs/benefits of each approach, both consumers and ETF operators can make more informed decisions. Thanks for reading!

How to Start an ETF? Resources and FAQ

We get the following question at least 1x a day: "How do I start an ETF? Because we have so many requests for information on the topic of "How to Start an ETF?", Wes asked that I compile a list of materials on the topic and a "FAQ" to address all of your burning questions.

ETF Liquidity Risks? A Discussion

Because of the complexity inherent to ETF trading in the secondary market, there are frequent misunderstandings about the relationship between the liquidity of the underlying [...]

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Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. Full disclosures here.

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