The Opportunity in Active ETFs

Last week on a trip to Philadelphia I had the chance to hangout with my friends at Alpha Architect to learn more about the ETF business from Wes Gray and his team. Here are a few takeaways:

Taxes matter. People are always worried about which strategy they employ, which stocks to buy and how to allocate assets within their portfolio. Taxes always seem to be pretty far down the list of worries for most investors. While it rarely makes sense to make an investment decision strictly because of the tax implications, you always have to consider the impact of Uncle Sam on your funds and overall portfolio.

The benefits to strategies such as tax loss harvesting can be over-stated (see Michael Kitces on this) but one of the most intelligent moves you can make as an investor is to defer taxes as long as you possibly can to allow your capital to compound before paying the tax man. This is why it’s so important for people to take advantage of tax-deferred retirement accounts.

Not all funds or strategies are created equal from a tax perspective. Index funds and ETFs that trade very little will have similar tax consequences because they don’t have many taxable transactions. Where you really have to pay attention to this kind of stuff is from funds that have a lot of turnover because you’re going to be stuck with that tax bill at year-end if you’re in a mutual fund. I think the tax advantages of active ETFs versus active mutual funds have actually been undersold and misunderstood as a huge benefit.

Alpha Architect works with a handful of large family offices and ultra-high net worth individuals and they shared with me that one of the biggest lessons they’ve taken away from these relationships is how important tax strategies have been as both a wealth builder and capital preservation tool for the wealthy. As Wes said, “You don’t need a PhD in finance to get really rich. Turns out all you need is long-horizon, a reasonable strategy, and an ability to defer taxes.”

The active ETF space is wide open. The entrenched players in the active mutual fund business should be making a huge push into the active ETF space to compete with index funds and ETFs in the now $3 trillion ETF marketplace. But most aren’t. The fees are simply too high to give up and the mutual fund distribution network (read more about it here) that’s been in place for far too long has too much at stake to completely make the switch to the ETF model.

These firms could make the switch from active mutual funds to active ETFs and offer huge benefits to their clients through lower fees, more transparency in the holdings, and lower taxes. In the business world it takes a forward thinking company and management team to willingly cannibalize existing products to make room for a new business line. Apple has been successfully doing this for years now in the tech space. Financial firms would be wise to do the same, but I have a feeling they’re going to have to be dragged kicking and screaming because it means lower margins.

The fees just aren’t nearly as lucrative in the ETF space. This is how an ETF provider like WisdomTree used the first mover advantage to go from $0 to $60 billion in AUM in less than 10 years. They didn’t have the baggage that the established firms had so they could scale quickly by offering active and smart beta ETFs at a much lower cost than active mutual funds and gain huge market share.

Education > Selling. Everyone is selling something, be it a product or a service. But there are many different ways to go about the marketing process, especially with the technology and communication tools we have at our disposal today. Firms no longer have to cold call potential clients all day when they can gain a far greater reach through a blog post, quote on a financial media website or book. Wes told me his book and blog have been their biggest sources of leads and new client interest. As investment products proliferate, education and communication are going to continue to rise in importance. Sales people will always be able to garner more assets than anyone, but to actually help clients you have to be able to educate them and effectively communicate your strategy.

Sophisticated strategies are becoming available to the masses. The staff at Alpha Architect is full of PhDs and Ivy League graduates. They could easily be offering 2&20 for their services in the hedge fund world, but instead they’re creating products that are available to a wider audience at much lower costs. This is a wonderful development for financial consumers and I think it will continue as more upstarts begin to challenge the old guard.

Check out the company’s website for more:
Alpha Architect

Further Reading:
Q&A With Alpha Architect’s Wes Gray Part I & Part II

Subscribe to receive email updates and my quarterly newsletter by clicking here.

Follow me on Twitter: @awealthofcs