It sure isn’t the money that motivates a true craftsman. When you love what you build, the product itself is the reward. A true craftsman wants to build things the right way, products that will stand the test of time. And it doesn’t matter one bit if the masses can tell the difference. The craftsman knows, and that is all that matters.
Which is to say, in 2019, a financial product developer who fashions himself a craftsman and loves the products that he builds, those products are going to come out the finished end of the assembly line in one structure only: an ETF.
Those features that make the ETF elegant and efficient often work to the detriment of the product creator. Without 12b-1 fees there is no mechanism to pay for shelf space in an increasingly competitive market: better for investors, at the expense of the issuer. The intra-day liquidity feature gives investors more trading flexibility, but it also leaves the issuer’s daily inflows and outflows naked to a market – a market that often doesn’t differentiate between trading tools and buy-and-hold investments: liquidity and transparency features that are better for investors, at the expense of the issuer.
And then there is the index. Better for investors, at the expense of the issuer. I’ll explain:
ETFs typically track an index. Not in every case, but just under 90% of all US-listed ETFs do track an index. You can call them passive, and you can call them index funds, but most of the time they are neither. The index is a quirk in the system and a carry-over from when the ETF structure was synonymous with investing in broad benchmarks.
And now, if you want to manage an ETF that, say, uses proprietary consumer data, or captures mean reversion and a size tilt in a systematic way, more often than not, you’d create an index. And let me tell you: that index is a pain in the ass.
If you round up the various ETF rules and regulations, here are just some of the requirements that the index rule s bring along for the ride:
- Exchange listing diversification and inclusion requirements
- Intra-day calculation of underlying index values
- Dissemination of all index values to a major market data vendor
- Public disclosure of index rule set, which includes all reconstitution and rebalance implementation and timing schedules and contingencies
- Real time calculation and dissemination of IOPV/iNav
These requirements were created for good reason, and they all serve a purpose. They also bring a cost and an operational burden, and quite frankly, very few investors are aware of the benefits and protections they provide.
And don’t even get me started on the “indexes” versus “indices” debate.
But here’s the thing about the index: it forces fund companies to codify and crystalize their strategies, and to present them open-book to the world. It is a major win for transparency, and it pegs the portfolio manager, within a tolerance band of the tracking error, to the mandate.
Compare those benefits against a discretionary active fund where a manager is in a perpetual battle against the temptation to make a call and exceed their stated mandate, and it is obvious that the index standard represents best practices in fund management.
And how does the index requirement come at the expense of the issuer? Well, forget the operational costs and the endless regulatory requirements, and even the rules that say that if the intra-day dissemination feed of the underlying index stops ticking, that the fund itself must be halted, forget all that. Now the index – that added layer of protection that can simply be removed outright by changing the fund to a discretionary active fund – that index is under attack.
In a NY Times op-ed, an SEC commissioner argued that the index construction process should be more transparent, that there could be conflicts of interest, that the security selection decisions are being outsourced to the index company, and that “investors may not understand how the index works or whether it may be susceptible to undue influence”. And all of that is 100% correct.
But here is the thing: even though that is correct, we are talking about ways to improve a self-imposed discipline by the fund manager. To put it another way, the index creation process may be imperfect, but it is also a net benefit for investors. And what we have is infinitely better than having no index at all, which is how discretionary active works.
Systematic investing is the new active management, and as asset allocators increasingly look to rules-based process driven strategies to try to provide alpha for their clients, the index requirements, pesky and imperfect as they may be, protect managers from themselves, and ultimately protect the fund investors.
All investment funds should be held to the highest standards. ETFs are by far the best that we have. Look at the broader landscape and see load fees, performance fees, 12b1 fees, lockups and more. Voluntarily imposed indexes created to peg an investment to them as a costly way to provide more transparency and best practices to investors are not perfect, but they are as close as we have, and they set the standard. Let’s work to make that process better, but let’s do so without losing sight of the bigger picture: as far as the best way for investors to access investment strategies, index ETFs set the standard.
Posted By: Phil Bak 02/19/19
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