How tax-efficient, low-cost ETFs could still lose their edge

ETF managers that follow index-hugging mandates might not perform as well as they expect to

How tax-efficient, low-cost ETFs could still lose their edge

A common goal for ETF managers is to minimize the tracking difference between their index and their actual returns. But when a portfolio manager has a complex mandate and adopts a low-tracking-difference strategy, that approach could wind up eroding performance.

“[I]t is entirely possible for an ETF to have low all-in costs, including trading costs, expenses, tracking difference, and tax liabilities, but still leak cash,” said Elisabeth Kashner, vice president and director of ETF Research at FactSet in a recent note. “A ‘smart’ strategy may well lose its edge when it hits the real world.”

As Kashner explained, marrying a complex mandate with a low-tracking-error-oriented strategy exposes the portfolio to leakage on the trading floor. Since basic index rules require pricing at the day’s closing value, index additions and deletions happen at the closing price. That leaves ETF portfolio managers with their hands tied: trading ahead of the day’s close means they risk deviating from the index value. On rebalancing days, the need to trade in step with the index becomes even greater.

“That’s a vulnerable position in the capital markets. Market-on-close execution invites front-running,” Kashner said. Front-running during portfolio rebalances alters the index performance by increasing the prices of additions and reducing the prices associated with deletions. As the AUM behind an index-tracking fund increases, the risk of underperformance against the fund’s back-test goes up.

Since the frequency of rebalancing isn’t the same for all ETFs — the broadest cap-weighted funds can go for years with the essentially same index constituents — the costs of rebalancing varies depending on the ETFs. Those with low turnover face the least risk, while those with high turnover have increased exposure to slippage in the capital markets.

Complex fund mandates seek market outperformance by maintaining active risks against the broad market, Kashner said. A greater pursuit of active risks need increases the amount of turnover portfolio managers have to live with, which explains why the biggest turnover funds are the “anything but market cap” crowd.

“Slippage could well be the reason that ‘smart beta’ ETFs have consistently failed to produce risk-adjusted outperformance vs. broad, cap-weighted benchmarks or ETFs that track them,” Kashner noted. “After all, if the foundations of the strategy remain sound, alpha should persist when packaged into indexes and ETFs. Yet we have seen that, most often, it does not.”