Q&A with Vijay Vaidyanathan, PhD, CEO at Optimal Asset Management

 

Q: What are the most important considerations when selecting an ETF? Should fees be considered?

A: For most investors, fees tend to be at the top of their concerns. While I do think that fees are important, I believe it’s a mistake to place it at the very top of the list of concerns. I think the choice of index itself (which is, in effect, your choice of investment strategy) should be the most important consideration, and fees second.

 

Q: What would you look at next after the choice of index?

A: Assuming you have made your choice of index and you are now down to comparing two funds that track that same index, I would look at three things, in the following order:

The first thing I would look for is the quality of implementation of the index you have just chosen. For example, the likelihood of under-performance to the index’s NAV due to liquidity constraints (e.g. using AUM in the ETF, trading volume and bid-ask spreads). This can be sizable and there are plenty of recorded cases of ETFs that trade at a significant loss to the NAV of the index. Most insidiously, this can happen at the worst possible time – i.e. in moments of market stress! (e.g. during the flash crashes of May 6th 2010 and August 24th 2015)

Second, I would in fact look at fees for your ETF. Fees do matter, but not as much as the choice of strategy, the liquidity of the strategy and the tax consequences (more on taxes, below)

Third, I would look at tracking error to the index. Note that this order is important, since an ETF that has a consistently low return compared to its index (perhaps due to high implementation overheads, or high fees) would appear to have a very low tracking error.

 

Q: Let’s go back to the choice of index or strategy. How should an investor decide “which index?”

A: All indices, even targeting similar exposures, are not equal, and I think the long-term investor should be aware of the well-documented flaws that are baked into the “vanilla cap-weighted” indices compared to more scientifically constructed indices such as Factor Indices or some of the Smart Beta indices. These more modern indices have typically represented something in the range of 1% to 2.5% of annualized excess return over the long-term. Saving a few basis points in fees are a poor justification for staying with the wrong index.

 

Q: Is there a point at which saving a fraction of a percent in fees doesn’t really matter? For example, because the switching costs outweighs the benefits, or as a result of tax considerations?

A: Well, the wrong index at a very low, or even zero cost, (such as in the case of the recent zero-cost funds from Fidelity) is still the wrong investment. I do think that it is telling that Fidelity is eliminating fees on the simplest of its funds, and you have to ask yourself why they are doing it only on the vanilla funds. Here’s how I think about it. First, these “free” products are simple – to the point of simplistic – and therefore are often poor choices for a long-term investor. Second, the tax impact of the shift, compounded by the future tax impact of staying in a pooled vehicle rather than a more modern vehicle such as Direct Indexing (which can benefit from internal tax loss harvesting as well as offset external gains) might not be worth it.

Fees undoubtedly matter, but going with the low-price leader for cost reasons alone is also almost always a poor choice. You constantly have to ask yourself why the fees are zero, and the answer is that in most cases, it’s a loss-leader to them so they can ding you with other more expensive products elsewhere or later. If something sounds too good to be true, you need to ask yourself why they are giving it away.

My point is that, if you are going to switch away from your ETF and take the tax bill, why not switch to something more modern, tax-aware and customizable (such as Direct Indexing), if you can?

 

Q: How would you go about the selection process for an index?

A: First, pick the strategy/index that best serves your long-term needs. In most cases, your best alternative is not the vanilla cap-weighted index. For example, you could pick a well-diversified multi-factor index that gives you consistent exposure to the rewarded risk factors across market cycles. A good choice is to simply equal-weight your exposure to Value, Low-Vol, Momentum and Quality. Then, look for a good implementation, considering the various factors discussed above, of that strategy that has the lowest after-tax cost for your account size. Today, I believe that is almost certainly some sort of a Direct Indexing solution, either through fractional share ownership, or through “narrowing” where you build baskets of between 50 and 200 stocks that mimic the index with acceptable levels of tracking error.

 

Q: Tell us some more about the advantages of Direct Indexing, particularly as it pertains to taxes. Should everyone try a Direct Index or are there some investors for whom standard ETFs are the best choice?

A: Pooled vehicles such as ETFs and Mutual Funds have some inherent tax inefficiencies (again, one of the motivations for Direct Indexing). They are simple implementation vehicles, and simplicity is good, but when it gets so simple that it is inefficient, that’s not good. For very small account sizes (say, less than $5000) the Fidelity zero-cost or a well implemented low-cost option such as Vanguard is probably just fine.

I’d say anyone over $5000 but under $100,000 should look at more sophisticated options such as a simple combination of low cost factor ETFs (such as offerings from Invesco or iShares), or a low-cost smart beta fund such as S&P Equally Weighted (e.g. RSP).

For anyone over $100,000, making a choice based on ETF fees is way too simplistic. These “over-$100k” investors would be best served by a Direct Indexing approach with low fees, long-term gains sheltering, internal tax loss harvesting and offsetting external taxable gains. These deliver more scientifically diversified portfolios, more customization and much better tax treatment.

 

Vijay Vaidyanathan, PhD is CEO at Optimal Asset Management and Research Associate with EDHEC Risk Institute, Nice France. Optimal Asset Management is registered with the SEC as an investment adviser under the Investment Advisers Act of 1940, as amended.