As an ETF strategist and all around avid ETF enthusiasts, it may seem odd that we here at Newfound Research have a suite of traditional open-end mutual funds. And these aren’t legacy funds. We just launched these in the last 12 months or so.
What gives? If we’re ETF folks, why didn’t we launch our strategies as ETFs?
I mean, at first blush, ETFs are great:
- Just like open-end mutual funds they are highly regulated
- They allow small investors to participate (arguably even lower minimums than open-end mutual funds)
- They are easier to operate from the asset manager’s perspective (pooled assets versus thousands of separately managed accounts)
So if they share so many common themes, why don’t we launch ETFs?
Many people presume it is because we don’t like the transparent nature of the create/redeem process. That as an active manager, we want to hide what we’re holding. Nothing could be further from the truth! Just read our weekly commentaries! We’re pretty open!
But there is a key issue that keeps us away. It is an inherent conflict between me as the fund advisor and the ETF purchaser.
I call it the conflict of liquidity.
Here’s the crux of the issue: I want to see zero volume in the ETF and the ETF purchaser wants to see an effectively limitless pool of liquidity.
My aim, as an asset manager, is to set expectations so well and to manage the portfolio with such expertise that once invested, investors will never want to redeem their capital. Hence, I want to see no sellers. Just buyers.
But, with an ETF, buyers only means that nobody can buy unless the buyer is large enough to do a create.
So we’re in a bit of a pickle.
Investors will want to see a healthy amount of liquidity in the ETF before diving in. Financial advisors, in particular, will want to make sure that they can open new client accounts with ease.
But it isn’t just for opening accounts that advisors will want to see a healthy amount of liquidity. Advisors are going to want to make sure they aren’t getting killed entering or exiting their allocations at rebalance. And increased liquidity often corresponds with decreased bid/ask spreads (try sorting the table below on volume to see spreads decline).
So again, investors and financial advisors want to see lots and lots and lots of liquidity.
And I don’t. Because I don’t want people exiting my strategy.
Now consider the following tactical ETF offerings:
|ETF||Price||Bid / Ask||Spread||Avg Volume (3m)||Avg Dollar Volume (3m)||YTD Average Discount||YTD High/Low Discount|
|GTAA||24.39||24.09 / 24.31||0.90%||975||23,780||+0.02%||+0.51% / -0.28%|
|GMOM||24.35||24.27 / 24.35||0.32%||10,602||259,642||-0.01%||+0.12% / -0.16%|
|TUTT||24.17||24.00 / 24.02||0.08%||29,491||712,797||+0.25%||+0.68% / 0.00%|
|DWAT||10.292||10.31 / 10.36||0.48%||4,922||51,188||+0.43%||+1.15% / -0.07%|
|MATH||30.39||29.87 / 30.09||0.73%||3,084||93,722||+0.39%||+1.22% / +0.09%|
|EFFE||24.65||24.53 / 24.63||0.40%||12,213||301,050||+0.07%||+0.42% / -0.56%|
So, as an example, an advisor looking to enter into DWAT not only will end up paying 48bp to cross the bid/ask spread, but also ends up with an ETF that is trading, on average, 43bp above what the underlying basket is worth. Now, the premium to NAV is moot if it remains, but if it collapses back to NAV – that’s a significant price to pay. So you’ve got the expense ratio plus a 48bp entry fee plus a 43bp of potential loss if the premium collapses.
And with a 3-month average dollar daily volume of about $50k, a significant amount of care is going to be needed to execute any significant order size. Now, it’s likely that the underlying positions are all quite liquid, meaning that the execution could be done with little cost if care is taken (i.e. don’t, for the love of everything, enter a market order). But if you’re only executing $30k … good luck getting a market maker to really pay attention and bring that bid/ask spread down.
And, not to keep saying it, but again, as the ETF advisor, I don’t want liquidity. I don’t want people selling out of my strategy.
It would be one thing if I could snap my fingers and have the ETF be at several billion in AUM and embedded in several home-office models around the country. At that point, I am sure account openings and closes would more or less net each other out and create the necessary amount of volume.
But below that point of saturation – where most new ETFs live – the liquidity cost of being an early participant can be quite high.
With a mutual fund, we don’t need secondary liquidity for small accounts to open and close, we avoid the costs of the bid/ask spread, and investors get priced to NAV at close.
So unless the client is going to be buying and selling our strategies over short time periods (which, again, we don’t want) – there isn’t much benefit to the ETF structure over the mutual fund (ignoring, for a momentum, the potentially significant tax benefits of the ETF structure).
We think ETFs are phenomenal. For now, we use them exclusively in our portfolios. That said, we believe the supposed benefit of intraday trading with ETFs – one of their key differentiators from mutual funds – is eclipsed by the significant trading costs from bid/ask spread, deviations from NAV, and low secondary liquidity. These costs are what makes it so difficult for truly active ETFs – especially those from boutique managers – to gain significant traction.