Every investing decision comes with a potentially pricey trade-off.
In managing portfolios for financial advisors, we talk often about ways in which we try to maximize the risk/return quotient for their clients. We diversify across a multitude of asset classes; we actively seek out lower-cost investments; and we try to hold the line on trading by sticking to our long-term investing discipline. Experience has shown that these practices alone can help to push the risk/ reward line higher.
But we also try to be realists about the trade-offs we’re making. In diversifying, we forgo the opportunity to dive headlong into mispriced areas. In sticking to lower-cost fare, we might deny clients access to talented active managers who nonetheless cost more. In not transacting, we arguably subject clients to short-term volatility and drawdowns that rattle them. Nothing is free.
Yet, investors frequently hear claims to the contrary. They’re told that they can trade for free or that they can get beta, liquidity, or even some extra income for nothing. In truth, as we will explain, these are trade-offs masquerading as no-brainers.
We’ve written of the insidious effect that 12b-1 fees have on fund expenses. They socialize the cost of distribution by keeping management fees (which are levied uniformly across share classes) stubbornly high. By their nature, 12b-1 fees do not scale—you’ll never see a fund’s 12b-1 fee falling as assets grow. Investors are denied the savings they ought to share.
Fortunately, exchange-traded fund investors have not had to contend with 12b-1, as such funds trade on exchanges rather than in supermarkets. Moreover, they’re geared toward institutions and fee-based advisors, not brokers who might have made a living by scraping off a few basis points here and there from a 12b-1.
But will things remain that way? In asking that question, I’m not suggesting that 12b-1 fees will spread over the ETF market the way they have traditional mutual funds. But with the move to no-transaction-fee ETF platforms, on which investors can trade sans brokerage commissions, you’ve got to wonder whether the market is approaching a Rubicon. Are pricier ETFs larded-up, directly or indirectly, by distribution costs on the other side?
Why would ETFs—which have boomed thanks to their simplicity and low cost—ever go down that path? Because distribution matters and, well, distribution ain’t free. And make no mistake, the recent crop of deals with retail brokerage platforms are only partly about removing cost from the investor experience—they’re also about harnessing the distribution weight that those platforms throw around. The platforms aren’t nonprofits or altruists, let alone dummies. They’re calculating that the uptake in no-transaction-fee ETF business will happily spill over into other areas, such as their own proprietary funds or related fee-based business. But it’s unlikely to be enough—either to cover their own costs or, more importantly, to fully monetize the value they believe their distribution ought to command. So, the question isn’t whether distribution hubs like brokerage platforms will seek to press those advantages, it’s how they’ll do so and who will shoulder the costs.
Fortunately, Schwab’s recent launch of its OneSource ETF platform did not see participating ETF providers raise their expense ratios, launch new higher-cost share classes, or foist new fees and restrictions on investors. Viewed in isolation, it’s hard to see the platform as anything but good. But what comes next? Will platforms settle for merely stabilizing their market share? Will ETF providers be willing to eat the cost of shelf space? Will traditional fund companies’ entry to the ETF market raise the stakes for visibility and, with it, the price of admission to no-transaction-fee ETF platforms? How will the shift to no-transaction-fee platforms affect investors buying the many ETFs that are off-platform and, thus, subject to brokerage commissions? You can win the battle and lose the war where distribution is concerned, a fact that shouldn’t be lost on advisors who are heralding the arrival of no-transaction-fee ETF programs.
Much ink has been spilled over ETFs’ inexorable push toward a 0% expense ratio, with some observers going so far as to suggest the day will come when ETF investors actually get paid to invest. What’s not to like about something for nothing, right?
Well, it depends on one’s definition of nothing. If an ETF provider can economize investing through scale or a business model that is simply less expensive to operate, then it’s hard to quarrel with whatever savings get passed along to investors. But it pays to read the fine print, for nothing might actually be something that’s been waived or obscured away. For example, an ETF might rely on “securities lending” to defray operating costs. If you’re unfamiliar, securities lending is the practice of lending portfolio securities to a borrower, such as a short-seller, and then reinvesting the cash collateral. Securities lenders can use this net reinvestment income to blunt costs, lowering a fund’s expense ratio in the process.
Managed prudently, securities lending is a laudable way to reduce fund operating costs. But the operative term is prudently, as securities lending is not riskless—lenders court counterparty risk (e.g., the securities borrower could default) as well as reinvestment risk (e.g., the lender could reinvest collateral in securities that lose value). Many lenders learned these lessons the hard way during the financial crisis, when their counterparties went under or their collateral reinvestments tanked.
But memories run short, and the price battle being waged in ETFs is especially fierce. In this climate, some ETF providers lack the economies of scale or operational efficiencies to compete on cost alone, and they could lean more heavily on securities lending to close the gap. The starker the cost disadvantage, the stronger the temptation will be to stretch by, say, lending portfolio securities more indiscriminately, seeking less collateral coverage, or plowing that collateral into lower-rated or longer-dated securities.
ETFs have been hailed as one of the signal investing innovations of the past few decades, and rightly so. They’ve made it simpler and cheaper to build portfolios than ever before while placing tools and techniques that were formerly the province of institutions within reach for advisors and retail investors.
But to hear some proponents tell it, ETFs haven’t just made investing easier—they’ve helped to liquefy areas like the over-the-counter bond market that have stubbornly resisted modernization. Where an investor might formerly have struggled to transact in certain types of bonds such as high yield, they now have a ready means of doing so—bond ETFs, which act as a more-transparent mechanism for price discovery.
Is that liquidity free, though? The short answer is—maybe. It’s true that fixed-income ETFs in areas prone to illiquidity, such as corporate bonds, have continued to trade and price even amid market tumult. This has provided a valuable outlet to traders leery about getting hung-up in individual bond positions that they couldn’t exit at a fair price, or questioning their ability to adroitly enter a fast-moving over-the-counter market.
The catch, though, is that the more you need this liquidity, the likelier it is you’ll have to pay something for it. Indeed, popular high-yield ETFs have tended to trade at widening discounts to NAV amid heavy selling pressure, at slight premiums to NAV under normal conditions, and at widening premiums when demand spikes. All things being equal, an investor demanding liquidity is likely to buy in at a modest premium to NAV and sell at a discount. The more-frenzied the desire for liquidity, the steeper the cost is likely to run. To illustrate, the exhibit on the next page plots the rolling five-day returns of the S&P 500 Index against changes in iShares iBoxx $ High Yield Corporate Bond ETF’s HYG percentage premium or discount to NAV. (In other words, we took the ETF’s percentage premium or discount to NAV on day 5 of each rolling period and subtracted it from its premium or discount on day 1 of that period; an expanding premium or narrowing discount is expressed as a positive while a narrowing premium or expanding discount appears as a negative.) As the chart shows, the stronger the S&P’s performance over a five-day period, the likelier it was that the ETF’s premium to NAV expanded (or its discount narrowed); conversely, the weaker its performance, the likelier that the ETF’s discount to NAV widened (or its premium narrowed).
What’s that got to do with liquidity? Let’s suppose that investors would be likelier to rebalance from stocks to bonds after a strong run for equities, and do the opposite when stocks tank. What the chart implies is that investors would have to pay a bit more to rebalance into, and out of, high-yield bonds using the ETF. That is, at the time they’re rebalancing into the ETF, it’s likelier to be trading at a widening premium to NAV; and when they’re rebalancing out of the ETF, it’s likelier to be trading at a widening discount. When investors are buying higher or selling lower in this manner, they are paying a tax of sorts. One could argue that it is the cost of liquidity in these instances.
It’s not just ETFs that seem to dangle the prospect of free liquidity. The same can be said of practically any other product that trades daily, including traditional mutual funds. In these cases, investors pay for the privilege of being able to trade on a given day, if in oblique ways. For example, funds can suffer a “drag” from cash-equivalents that managers might keep on hand to fund redemptions. Even less obvious are the compromises that managers might make in the name of liquidity, such as glomming onto widely traded securities (which are easy to transact) and forgoing the chance to invest in less-liquid, but potentially more-lucrative fare.
This last point bears some explanation. Academics have devoted an entire body of research to studying the role that liquidity plays in security returns, finding that markets tend to discount less-liquid securities. Put another way, investors in these less-liquid securities can capture an extra liquidity premium. As one would expect, the opposite holds for more-liquid securities, which trade at premiums that dampen their expected future returns. All of which brings us full circle to daily-liquidity products like mutual funds. Fund managers generally can’t load up on thinly traded securities, even if they’re grievously mispriced, because they’re hard to trade. As a practical matter, they must invest primarily in more-liquid securities, a practice that research suggests comes at a price.
Whether it’s nontraded public REITs, closed-end funds, or other more-exotic instruments, the pitch tends to be a variation of a recurring theme: You can wring out a few extra percentage points in yield without taking any skin off your back. Some of these products are pushed because fear sells (e.g., “you won’t outlive your savings!”) and often very handsomely at that (e.g., plump payouts). But extra yield isn’t free, especially today. If you want it, you’re going to have to pay up.
Given this, vehicles like these should be seen for what they often are—a mirage. True, you can crank out extra income from something like a closed-end municipal-bond fund. But to do so you’re almost certainly going to have to assume more risk, be it from greater illiquidity, opacity, or leverage.
Some of these risks are easy to grasp. For example, it doesn’t take a rocket scientist to figure out that the market price of a closed-end bond fund is going to be more prone to permanent capital loss than a comparable open-end fund. Why? The fund won’t suffer redemptions, so the manager can pad investors’ assets with borrowed money and trowel through the bond market’s less-liquid, or more-risky, realms for higher-yielding issues. But leveraged investing is a doubleedged sword, especially when you’re using that borrowed money to invest in flakier securities. (See also: the financial crisis.)
Other risks, though, aren’t as immediately apparent. For example, nontraded REITs appear to share a number of traits in common with their publicly traded siblings. Like public REITs, they must distribute at least 90% of their taxable income to shareholders and are subject to the SEC’s full reporting regime. But because they don’t trade on an exchange, it can be difficult to reliably ascertain the market value of a nontraded REIT’s shares, meaning investors are putting faith in the REIT’s manager to not only invest their capital prudently, but value those investments faithfully.
Nonpublic REITs also usually come with strings attached—shareholders are often subject to redemption limits of various kinds, which further impinge on liquidity. (Nonpublic REITs are less liquid than public REITs by definition, because there’s no secondary market in the shares.) Put that together with potentially high fees, as well as the risk that a nonpublic REIT manager will use new capital to finance your distributions, and you’ve got a doozy of an investment. Extra income? Maybe. Free? No chance.