Matt Kaplan: Stocks are going to be part of a well-balanced, all-weather style portfolio. We need them in there to participate during the good times, and you got to take some risk in equities, so we know that. But there are a number of different ways to get exposure. Are we going out and buying 5000 individual companies, doing the position sizing, rebalancing daily basis? The other option is ETFs, but that comes with the acquired fund fees. How did you think about all this when you're putting together the strategy?
Eric Crittenden: Well, let me talk about that for a minute. I could have gotten around that and shown no acquired fund fees, if I just used futures for equity exposure, which would have been super easy on me, right? Because I'm already trading futures, they are already set up, we've got the custody and brokerage relationships and the accounting all set up for those same futures contracts, so why didn't I do that? Well, because I'm an investor in the fund, and I want my equity returns to be tax efficient.
The problem with equity futures is they're marked to market at the end of every year, meaning they create a taxable event because you can't just buy and hold, they're not ETFs. With an ETF, you can just buy and hold it. As long as you don't sell it, you don't generate taxes, the only taxes you have to pay are on the qualified dividends that come in.
For taxable money, ETFs are tremendously more effective at compounding wealth over time than futures contracts because of that tax reality. Now, if it's not taxable money, you don't care, but half the money out there is taxable. Using the ETFs doesn't hurt the qualified money at all, except in the sense that there's just the very, very small acquired fund fee of about four basis points.
Now the other option, let's say, well, don't use a futures contract, just go out and buy the common stocks, and that would be another way to get around the acquired fund fees. That's a true statement, however, because BlackRock and Schwab and Vanguard, and State Street are so big and so powerful, they're able to transact in the common stocks, especially for the foreign stocks in a way that's far more cost-effective than we would be able to if we wanted to. In other words, it's more expensive to you, the fund shareholder, if we go out and try to direct index and replicate those ETFs.
We're paying four basis points, but what we're getting in return from these guys is worth a lot more than four basis points, because they negotiate the tax treaties to make sure those dividends are coming through the right way. They're very aggressive with that. They have the ability to do very large block trades and they're probably negotiating very aggressively on commission rates, handling the slippage with algorithms and whatnot.
Then the other thing to keep in mind was that they have the ability to lend the shares out of the common stocks they own and collect short interest credit. Then most of those guys rebate all or 80 plus percent of that short interest credit back to the shareholders of the fund, which is why when you look at the performance of some of these ETFs, even though they're charging a management fee, they outperform their benchmarks.
The only way that's possible is if the benchmarks are calculated incorrectly, which is not the case, or they're lending out the shares and collecting short interest from short-sellers and crediting that to the fund. Effectively, what's happening is they're paying you to own their ETFs. Yes, you're paying a management fee of four basis points, but you're probably collecting eight to 12 basis points in short interest credit.
Matt: Eric, is that consistent across all of the ETF providers?
Eric: It's consistent, the concept is consistent. It's hard to get hard and fast numbers. I know Vanguard claims that 100% of the short interest credit is dumped into the fund. I've heard that BlackRock, it's like 80%. I've heard that Schwab and State Street are competitive with Blackrock but no firm numbers. Then when I've looked at their track records and compared them to their benchmarks, I was a little surprised that they were all pretty competitive with Vanguard relative to the benchmark so that suggests to me that the algebra is saying they must all be putting most of that back into the fund.
Eric: It's a good deal.