Episode #347: Radio Show – Wes Gray & Patrick Cleary, Alpha Architect– All Things ETFs
Guests: Wes Gray is the founder and CEO of Alpha Architect, a quantitative asset management firm.
Patrick Cleary is currently the chief operations officer and chief compliance officer of Alpha Architect.
Date Recorded: 8/17/2021 | Run-Time: 1:24:26
Summary: Episode 347 has a radio show format with Alpha Architect’s Wes Gray and Patrick Cleary. We cover a variety of ETF-related topics, including:
– Current state of the ETF space
– The ins-and-outs of launching an ETF
– Mutual fund conversions, active funds and index funds
– Crypto ETF predictions!
If you enjoy this episode, be sure to check out episode 258 with Wes Gray on how to launch an ETF.
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Links from the Episode:
- 0:40 – Sponsor: The Idea Farm
- 1:10 – Intro
- 2:02 – Welcome to our guests, Wes Gray and Patrick Cleary
- 3:29 – March for the Fallen
- 7:03 – Alpha Architect’s White Label business
- 9:36 – Thoughts on the ETF space today
- 11:06 – The process to launch an ETF
- 21:21 – Key considerations for launching an ETF
- 25:28 – Fund conversions, whether or not they do them, and what will the Netflix moment will be for ETFs
- 31:16 – How you can work with Wes and Patrick to launch an ETF
- 34:57 – Whether or not there’s a possibility for an exchange fund in an ETF structure
- 36:42 – The use case for advisors and family offices to adopt in-house ETF products
- 41:12 – Advisor obligations and their relationship to the fund as a sponsor
- 44:16 – Defining an index fund, the difference between passive and active, and government regulation
- 50:07 – The nature of promoting funds on social media and questionable marketing strategies
- 57:38 – Whether or not the SEC will ever equalize tax treatments for ETFs and Mutual Funds
- 59:37 – The naming rule
- 1:05:31 – Thoughts on the crypto space and possible funds
- 1:09:25 – The role of the lead market maker
- 1:13:21 – Ideas that they believe have a lot of potential
- 1:17:28 – Why culture matters so much when partnering to build your ETF
- 1:21:00 – Learn more about Gray and Patrick; alphaarchitect.com; www.etfarchitect.com; Email firstname.lastname@example.org
Transcript of Episode 347:
Meb: Welcome to The Meb Faber Show, where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.
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Intro: What’s up, everybody? Today we’re back with a radio show, topic is, “The Landscape Of The ETF Space.” I thought we’d invite some friends to share what they’re seeing. This topic is up your alley, feel free to go back and listen to Episode 258, which was a deep dive on launching an ETF with our guest. In today’s episode, we start with a high-level view of this space and why as one of our guests says we’re in the hockey-stick phase of growth. We review how to launch a fund, the cost of doing so, what types of ideas work great or not so great within the ETF structure? Then we discussed the recent mutual fund to ETF conversion flood, active funds, index funds, and of course, we couldn’t finish the episode without getting some predictions on when the first Bitcoin ETF will launch. Please enjoy today’s episode with Alpha Architect’s Wes Gray and Patrick Cleary.
Meb: Wes, Pat, welcome to the show.
Wes: Thanks for having us, Meb.
Patrick: Thanks for having us, Meb.
Meb: Listeners, we have Wes Gray, who should be familiar to everyone. He is a multiple-time alumni. You’ve been on two, three times, Wes?
Wes: I think so. This might be third, maybe fourth, who knows?
Meb: People aren’t getting sick of you, yet. Pat is a “Meb Faber” show virgin and it’s good to have you both on today because we’re going to go as deep as we can, as deep as possible on ETFs for all the questions we get a gazillion times that will be really interesting as well. But first, before we get started, where are you guys? World headquarters? Pennsylvania, Puerto Rico, Antarctica?
Wes: I am in global headquarters of Alpha Architect in Palmas del Mar, Puerto Rico. Pat?
Pat: I’m in the Puerto Rico of the North known as Philadelphia.
Meb: Well, you just came back from Crested Butte which I’ll be in Colorado in a little bit. Wes, how’s your surf game? You started checking out Rincon and the bioluminescent phase of the East shore?
Wes: I haven’t. For some reason, I came to Puerto Rico now I work two times as much. I just stare out the window here. I don’t know what happened, man. Too many people want to launch ETFs, I guess. But one of these days I will be surfing, fishing, and golfing.
Meb: I’ll come down for a due diligence trip, we’ll organize that.
Wes: There we go.
Meb: Hopefully, for the fall time. Before we get started, we are bumping up against your annual March For The Fallen. Why don’t you give the listeners who haven’t been a brief overview? I’ve been, it’s awesome, experience all around. You guys used to do it in the springtime, right?
Wes: Yeah. So, this year, we’re going on September 25th. It’ll be the first live event in a couple years because of COVID, obviously, last year. Yeah, I got the barracks locked down, I got the Chow ready to roll. And the 28 miles of fun and entertainment is still there waiting for us to go out and march for the fallen. So, you’re going to be there right, Meb?
Meb: Let me add. First of all, it’s not 28 miles because Wes makes everyone walk an extra mile to dinner afterwards on Saturday. So, it’s technically 29 miles. And then if you’re smart like Meb, you end up finding an Uber back from the pub, so you don’t have to make it 30. But it’s an awesome time, really wonderful experience with a ton of great people. I have a potential conflict, I, for the longest time on the top of my bucket list to go see music, is Pearl Jam, who I’ve never seen and I keep getting sidetracked because when they were playing, I’ve been set up to see them a few times and some sort of intervening force always comes and stops it from happening. So, pandemic for the last year, before that, on and on. Anyway, they’re playing that weekend in San Diego, but they just announced a second weekend of shows. So, of course, as you know me, I obviously don’t even have a ticket yet. So, to the extent, I can get a ticket, we’ll see if we can wrangle it together. But I love it, fun time. Although, the dude that I slept next to was the biggest snorer I’ve ever heard in my life. Oh my God, what was his name?
Wes: It wasn’t Philbrick, right?
Meb: No, it wasn’t Philbrick. I mean, there are a lot of fun memories. I mean, we have those guys brought a full like coffee bar of French press and espresso and 5:00 in the morning, or whatever it was.
Wes: What I should highlight, like, obviously, it’s 28 miles, but the intent is everyone has their own personal summit, and it’s all about March For The Fallen and represent for Gold Star Family. So, we always joke it’s strenuous, but to the extent, people want to do a lighter version, they don’t want to sleep in the barracks. There is a hotel that’s cheap and local. I don’t want to scare too many people off either, but I should point that out.
Meb: What was your burpee promise this year? I think I saw it come across Twitter.
Wes: I’m going to try to do it, but I’m just going to try to do 50 burpees every mile, just to mix it up a little bit and represent because I’ve been training.
Meb: I’m trying to do the math on that. That’s a lot of burpees.
Wes: There’s a lot. It’s 1,400 burpees … So, I got to get some gloves practice.
Meb: The highlight of my trip was, I remember being in the airport on the way out with Cory and I had found, whatever airport sort of local rural airport it was, had a massage chair in the airport, and I sat in the massage chair for probably two hours, like just totally not giving anyone else that came up. I just have like, there was like a pool table stack of quarters that I just sat there. It was so sore.
Wes: I think Perth did that. She came out a few years ago, and they used to have a massage parlor at the end there. I think she said she finished and she just sat there with the masseuse lady for like, same thing, like three hours, she just wouldn’t move. Eventually, they’re like, “Ma’am, we need to open this up for other people.”
Meb: All right. So, let’s talk about ETFs, guys, we got a lot to get into. Most of the listeners will be familiar with what y’all do. The business for the longest time has been very research-driven, you guys put out a ton of content, you have a pretty awesome module on the website that has a lot of advisor-related tools that are pretty awesome. You guys manage your own funds, and now you have an extremely fast-growing white label business. Give us a little more in-depth overview of what you guys are up to, the folks you have working on this? And then we’ll dive deep into the industry.
Wes: Yeah. I’ll give the quick nickel tour. Essentially, what happened is we realized that trying to sell concentrated factor funds that bounce around the market require a 20-year horizon, super educated investors is pretty difficult, and it’s a niche segment. But it turns out everyone and their sister wants to launch an ETF. And we just happen to be in a situation where we kind of built a low-cost infrastructure to do this, and what used to be a cost center to us, we’ve now turned into a business. And I brought Pat on here, well, you brought him on, technically, but I brought him for backup because I always come on his podcast to talk about at the high level, but he’s the one that actually knows what he’s talking about. So, Pat is basically the CEO of what we call ETF Architect. And I’m hoping he can help shed some light on a lot of the nuance of the weeds of the ETF and what people ask us all the time, so we don’t have to keep addressing the same question a hundred times.
Meb: So, Alpha Architect, traditional money management business, you do boutique investing for institutions as well? So, you have your own ETFs, you guys have research and analytics, and then ETF Architect, that’s actually a great name for the white label business. How many funds do you guys have so far, give us a quick overview?
Wes: So, right now we got around 15, and I think it’s $1.1 billion or $1.2 billion, but in the pipeline, like under registration or in the flow-through end of year here, depends on how fast the white labellers operate, but we’re probably going to have like anywhere from 20 to 25. And I’m guessing by $1.5billion to $2 billion price. So, it’s getting there.
Meb: That’s awesome. So, just enough background on you guys, and we’ll kind of paintbrush a little bit more about you guys, as we talk about a lot of the topics today, but most of them are sort of evergreen topics about the ETF industry, in general, as well as specific to today. Pat, Wes, what’s the ETF landscape look like today? I tweet a lot about this, of course, where my thesis for a long time has been co-opting the Marc Andreessen phrase, “ETFs are essentially eating the world of the asset management industry and it seems to be accelerating.” Give us a little overview, what’s going on with ETFs?
Patrick: I think we’re definitely in that hockey stick moment with ETFs. Personally, when we launched the ETF Architect platform where we get dribs and drabs of leads interested folks on ETFs. Now, we’re getting several leads a day, people calling in the office every week. And we’re also seeing that on the registration site. So, typically, when you register an ETF, you know, you got the 75-day period. And right at that midpoint, 35, 40 days, SEC gives you a call, and they want to work with you on your prospects you’re trying to launch. Now, we’re getting called back by the SEC on like day 50, or day 55, or day 60, and they’re swamped. And so my heart goes out to our friends on K Street where I think the size of the SEC has not grown, but the demand for pushing new products to market has grown exponentially. And you’ve seen that with DFA converting their mutual funds to ETFs and others. I think the sea change is here, and it’s definitely accelerating.
Meb: All right. So, we’ve been doing this since 2013 on our own, we’ve been sub advising even before that, and so you guys have kind of been here also through the maturation of the industry, ETFs go back to the 90s. Technically, even earlier in Canada, I think, didn’t Canada have their first ETF?
Meb: But why don’t you walk us through, what’s the process to launch an ETF? So, okay, I’m Joe Smith, I have the best idea ever for an ETF, no one’s ever thought about it before, I have an amazing ticker. I call you guys up. What’s that look like?
Patrick: Sure. So, I think to start, you have to take that idea, and you have to test it against whether or not it’s suitable for an ETF in and of itself. So, there’s a lot of factors at play, where you sit down with a good lawyer, whether it’s with us or someone else, you have to sit down with a good securities lawyer that has connections to the SEC, where they… Meb, what are you looking to achieve? What is your funds objective? How are you trading this thing? And we basically take that raw material idea and kind of mold it into, okay, does this work, or if it doesn’t work, we try and save you a lot of money and say this is not a good idea. I can send you anyway.
But you do that. And then once we get that concept in the fighting shape, you file your initial prospectus with the SEC, that starts a 75-day clock. And then, like I said earlier, about the midpoint, you’re going to get a call from an examiner, and all examiners are different. They’re all trying to do the right thing, but some have been with the SEC for three decades, others that have started a year ago. And you’re going to get comments and questions on that prospectus. If your idea is something really simple, like the S&P 500, if you’re just replicating that, well, that’s going to sail through approval. We just did a different fund that was a crypto mining industry ETF, that’s going to be much more complex and get a lot more comments.
And the SEC basically uses that as an opportunity for two things. One, it’s primarily quality control. They want to make sure there are no mistakes, that retail investors aren’t harmed, your disclosures are clear. But the more interesting part is, is they’re also going to use this to kind of shape the priorities of the SEC director and the SEC staff. So, I don’t know if you saw a couple months ago, SEC comes out and really kind of hammers ESG. And they say, “Hey, just because you slap ESG and I’m an ETF, does not mean it’s an ETF. And we’re coming for you.” And so you see that guidance that comes out in public statements from SEC Chair Gensler or others. That gets translated into the fund approval process.
So, we noticed a significant increase in scrutiny on ESG funds after the ESG kind of guidance is released. Same thing with index providers, the prior SEC Chair spoke at a conference about how index providers were really something they wanted to focus on because it’s kind of a loophole. We’ll get into that. But it’s kind of a loophole for registration, onboarding registration. And why don’t you know it, the index funds we started working on after that speech was scrutinized much more carefully. So, that’s kind of the process. Basically, you launch with the SEC, they review it, they ask questions, you answer them, your prospectus is approved. And then, in parallel, what we’re doing is we’re presenting the concept to the board of trustees because you have to present to an independent board.
So, while we’re telling the SEC this is how the idea works, this is what retail investors are going to see, we’re on the back end telling the board, here’s the compliance, here’s the operations, here’s how we’re going to safeguard investors and the trust from XYZ risks. And then there’s a third pillar where a lot of people have a great idea, but they don’t know how to be an advisor. And you have to swallow the compliance flow if you’re going to be in this business. And so there’s this third educational tract. And if you’re an advisor, that’s registered with the SEC, that might be really quick, or if you’re a newbie, and you’ve got great concept, great distribution, but you’ve never been in this industry, there’s a whole undergraduate degree you’re going to earn with us in 6 weeks, 10 weeks on being an SEC-registered investment advisor.
So, those are kind of like the three pillars of work that you have to focus on. And then we haven’t even touched on you have the marketing. So, that’s the economic growth of ETF. Who’s your target market? How are we going to focus on distribution? How are you going to be a thought leader in this industry? How are you going to compete against iShares and Vanguards that are juggernauts in this industry? So, it’s kind of a drink from the fire hose moment, for sure.
Meb: We talk about this as sort of like the Leprechaun, everyone I talk to sees the pot of gold at the end of the rainbow as far as ETF ideas, everyone’s got a great idea. And we often talk to people over the years and say… It’s almost like writing a book, everyone who comes to me and says, “Should I write a book?” If they think about being an author. And my answer usually is like, “Absolutely, not. You should definitely not write a book.” It’s a miserable experience. You guy’s books are bigger than mine. It’s the same thing I would say with ETFs, I’d say don’t write one or don’t do one unless you like have to, you like, very spend a lot of time thinking about it because everyone sees the romance of writing a book and the rewards of launching an ETF, whatever they fit in your category, monetary or publicity, all these other things, but the actual effort required a substantial.
And so we used to always say, look, there are a couple of different categories you can fit into. One is, and which is the best ways, is you have some sort of seed capital, or you are taking some existing assets and cannibalizing them. So, if you have a hedge fund, or separate account, or DFA is tens of billions of dollars in mutual funds, and that’s the best way, the easiest way. The second best is you have a massive pent-up demand or audience or it’s a product that doesn’t exist. So, obviously, the first Bitcoin ETF will probably get a lot of assets, even if it has no seed. And then lastly, which is still viable, and totally cool is, are you willing to just subsidize it and say, “Look, I’m going to let this marinate for five years, and I have the marketing plan and path and assets to cover it. And I realize it’s going to be a slog, but this is my plan.” Is that seem like reasonable categories or buckets? Do you guys put people into other ones? Are you as harsh as I am on your advice?
Wes: I mean, I can talk a little bit to that and how our process for talking to prospects on the ETF Architect business is. So, originally, we just post up a blog and said, “Contact us.” And then we quickly realize 99.99% of people have no clue what it takes to get it done. And now when you go on our blog, we have a contact us and there’s like 10 or 15 questions that really kind of say, “Hey, do you have the money? Do you have the wherewithal? Do you have the desire and the passion to do this because this is not something you just stumble on?” And so, yeah, we are, I would say, in agreement, you got to be ready for the varsity team if you’re going to enter the ETF space, for sure.
Meb: What’s the biggest gate do you think when most people contact you that they’re surprised about? Is it cost? Is it time? Is it… they come to you like a young child just naive and happy, and then you just ruin their dreams. Like, what is the main one that, like, really, people are surprised about?
Patrick: One that really surprises me, and it’s funny because most of the prospects we get are a younger demographer, mid-30s or 40s. A lot of people still think that if you launch a product, and you get on CNBC, or you do a press release with Nicey, that a dump truck of money is going to show up and just dump a pile of cash on your ETFs. And I try and tell people, I say, you know, people do not buy funds like they used to back in the ’80s and the ’90s. And advisors, if you buy financial advisors a pizza, and you give a presentation on your mutual fund, they’re probably not going to buy your mutual funds, they just going to eat your pizza. That’s what’s most surprising to me. And I use this example a lot with prospects. I say, when you watch a golf tournament, like if you watch like The Open or something, and you see Phil Mickelson with an iShares thing on his visor, do you log into your trading account and buy iShares products? Somebody said, “No, of course not.” I’m like, “Well, why do you think that’s going to happen with your ETF with a millionth of the budget that iShares has?” So, that, to me is the biggest stumbling block. I think people think that if they can just launch. Launching the ETFs is the easy part, the hard part is you know, Meb is deep in the street for three to four years selling that thing, share by share.
Meb: Yep. Wes, what’s yours?
Wes: I’ll kind of echo on that comment because when you’re talking about ETF innovators or ETF innovation where you haven’t started a fund yet, they’re like, “Oh, well, it’s easy. We’ll just go hire some people and pam the distributor.” And I’m like, “Listen, man, that’s called wholesaling.” If a wholesaler could take a fund from zero to $50 million, they wouldn’t be called a wholesaler, they would be called the CEO or the equity owner of the ETF firm. You have to sell your passion and your idea, and then you could go hire people to spread the word, but it just doesn’t work like that. And so it’s just, again, that zero to $50 million it has to be the passion it has to be the thought leader that is willing to drive that fund to success initially. No one it’s going to just fall out of bed by herself.
Meb: Look, it’s just like writing a book. If you’re J.K. Rowling or if you’re Patterson or Stephen King, you have already demonstrated, and you have your audience. And it’s different than if you’re a startup author. Now, it doesn’t mean you can’t do it, Rowling, famously got turned down like 40 times by publishers, and now she’s one of the richest person in England, I think or up there. And it’s the same thing with launching ETFs. We see a ton of independent successes, but also is it easier if you’re BlackRock and you already have the name recognition and all the pipes into place? Of course, and the thousands of wholesalers out there. So, it doesn’t mean it’s not doable, it just means you need to think of.
And we’d like to say, I say, look, you need to write like a, it doesn’t have to be 10 pages, it could be one page, but just be honest with yourself, here are the 10 things timeline that I am going to do to get this fund to $100 million. And the actual strategy of the fund is usually like the least important of all those because performance, you can be lucky enough, great performance, and sometimes you can be unlucky and just be in a bad environment for two, three, five years. So, trying to put an honest hat on and not be delusional about that I think is important.
Let’s walk through, again, before we get into this a lot of the topics that we didn’t cover last time, a little bit about some of the key considerations when launching a fund. So, what are the costs? Someone comes to you, ETF Architect, I got a large-cap, Dogs of the Dow focused on technology fund, it’s going to own 30 stocks. How quick can I get this out? I’m going to write a check tonight. How much does it cost? What are all the sort of like things I need to consider on your launch schedule?
Wes: Just a quick answer on that, Meb, is obviously, we’re going to risk price it, like if you got tons of assets in place, and you got a lot of operating capital, you’re goanna, obviously, get the leanest pricing. If you’re someone that woke up out of bed, maybe a little different. But in general, for like a plain vanilla, your startup cost could range, like whatever, 50k, 60k and then your ongoing soup to nuts for something that’s under 100 mil is probably going to be 225 to 250 all in. And then there’s obviously a huge variability there on whether you’re super low risk, you’re super complex, and everything in between.
Meb: How many years of sort of operating capital do you tell people and say, like, “Look, let’s say they have a great idea, maybe it’s a new fund, maybe it’s one that they’re willing to subsidize? Because if it’s $100 million, you can forget all this because it’s already cash flow positive, it’s irrelevant. How much of a runway do you tell people how to do? Like, look, you need to be able to cover these expenses for three years, for five years. How do you kind of frame that?
Patrick: I tell folks, you should go into this with three years operating capital to subsidize, but more importantly, a clear path to get to $50 million. So, your 10 steps to write a book example, same thing in ETFs, you have to have three, at a minimum two. We wouldn’t really take and bring all of us in too, but just as important is what’s your battle plan to get this thing to semi profitability. That’s kind of one of our key screening criteria.
Meb: I mean, the main part about that, too, that listeners is, if the fund is somewhat of an orphan, meaning it’s small, it has so many headwinds against it. It’s not going to get approved on platforms, like the wirehouse’s advisors, rightly or wrongly, will assume that it’s illiquid, because it only trades 500 shares a day, on and on and on, you’re going to make the market makers grumpy about that they’re having to deal with it, etc. So, the path to $20 million to $50 million, I think is a great waypoint that you need to get there as quickly as possible, otherwise, it’s painful. What should people think about, in terms of just the launch schedule when it comes to what they need to be thinking about, or they are unaware about when it comes to compliance, operations, trading, LMM, all the things that just go into getting a fund out with you guys over the course of a few months?
Patrick: So, one thing I try and tell folks is you’re hiring us to deal with most of that stuff, so the compliance will teach you, the operations will run, obviously, you will have control over all that, but we’ll make the sausage for you, right? What I try and do is I try and say, you really need to focus on how do you de-risk this thing. And I hate to keep getting distribution, but we can take care of all the back office, we can take care of the trading, we can take care of the LMM relationships, but for most folks who say, “Look, we’re going to be here, we’re in this for the long haul.” So, if you want to launch a private fund and convert it, that’s a great way to launch an ETF.
Meb, as you said, if you’re in the, I’ve got a great idea and I can subsidize this thing, but why not take two years and manage SMEs and convert, or why not launch a private fund and convert it in a year? Those are all options. And I think we’re a fiduciary, and if you’re an advisor, you’re also a fiduciary. And at the end of the day, we have to do this with a modicum of belief that you’re not going to harm shareholders by shutting this fund down in three months. And so that’s what I try and do. I spend a lot of my time decoupling the 120-day launch timeline and kind of expanding that to, “Okay, this is actually, maybe this is a one to two-year journey. And the launching the ETF is an added state that’s kind of farther out so where you can de-risk it. That’s the one thing I really push folks on when we talk.
Meb: We’ve kind of scratched our head about this for a long time because we’ve done both. We’ve converted separate accounts, meaning, we said it’s clearly better, not always, but in this, for us, it was to manage an ETF rather than hundreds or thousands of separate accounts for a lot of reasons, both on the advisor and the shareholder side. So, you have economies of scale, and the main one being the tax benefits of the ETF. And I’m surprised that more haven’t done this, but you’re starting to see more and more in the news of advisors saying, “Look, we have this strategy, instead of me doing this on this insane block trading through TD or Fidelity, why not just launch an ETF? I have the upside of potentially getting other investors who may be interested in the strategy as well. The clients have tax been…on and on and on. We’ve also done it with hedge funds. So, private funds, we just picked up and dumped into an ETF structure for the same reason. Talk to us a little bit about fund conversions, do you guys do this? They seem to be accelerating at a very rapid clip, we’ve always asked what is going to be the Netflix blockbuster moment for ETFs. And I’ve been waiting and waiting over years, I’ve had my various guesses, but all of a sudden, it’s conversions, which has surprised me, would not have guessed that five years ago, but everyone seems to be doing it. Walk us through, what are they? What are the rules? Do you all do them, all that good stuff?
Patrick: So, a fund conversion is basically… I’ll explain what it is, but I have to back up to what it isn’t. So if you were running managed accounts, and you tell people to buy an ETF that is basically replicating your strategy, you’re going to have people sell those positions down, realize a tax ITIN most likely, unless it’s in an IRA or something, and then buy the ETF. That is like conversion-like, you know, your clients are willingly accepting the tax ITIN to invest in a more tax-efficient vehicle. So, that’s like the brain-dead version. The more sophisticated conversion methods you’re talking about. Yes, we do them. Yes, they’re becoming more popular, and here’s how you do them.
So, you basically take your strategy or your pool of assets, and you go to the SEC with what’s called a plan of reorganization, and you tell the SEC, “Hey, we’re going to launch this thing, and oh, by the way, we’re going to take these assets, and we’re going to convert them into an ETF.” So, what’s the test that the SEC looks at? There’s a very specific no-action letter that basically lays out the criteria to reorganize existing funds into an ETF. And the reason why I see so many mutual funds convert is mutual funds are… because you know, Meb, they’re already part of the 40 Act, the 1940 Registered Investment Company Act. So, they’ve already by default been following all these rules and these guidelines that the SEC inspects to see if it can convert into an ETF.
So, you go to the SEC with a plan of reorganization, you typically hire the best securities firm you can, because you don’t want to mess this up. And you’re going to have this plan of reorganization, you’re going to show the SEC, hey, based on these requirements, and I’m just going to rattle off a couple is the investment manager changing? No. It was Meb before, it’s Meb in the future. Are the funds managed in accordance with the 40 Act? So, if you’re running a portfolio with three stocks, if you’re picking three or four stocks, that’s too concentrated, that violates a 25% rule, that violates this other thing called the 50% rule, that doesn’t qualify as an ETF. But if you’re picking say, if you’ve been running a long, lonely equity strategy with 50 names, and you’ve been running it by yourself, it’s get certified, it’s been Meb, the PM has been doing it the whole time, you probably check all the boxes there.
And then you present this plan of reorganization, and then it kind of dovetails into that process I was talking about earlier, which is effectively you do a different filing, but it has a prospectus, it has an SAI. It gets a little more scrutiny from the SEC. And then if they agree, if they concur with your plan of reorganization, you then effectively on a particular day, you effectively direct your new custodian to absorb all those assets. And there’s a bunch of plumbing in the background that makes that happen. But the short answer is they basically convert those assets on a particular evening. And then the next day, your fund IPOs, and rather than IPO with the zero in it, and then let retail investors buy-in, you’re basically launching a fund with $75,486,082.15 or whatever, and that’s your chunk of capital.
I think the main tail risk for reorganizations is, and this is a mistake I see people do a lot is they want to cheap on the plan of reorg. And when you go to a law firm and say, “Hey, I want the cheapest plan of reorganization I can get.” You ask 100 lawyers until you get the answer you want, you know, find a law firm that will do a plan of reorg for five grand. Do not do a plan of reorg for five grand. These are, I’d say $50,000, $60,000, $75,000 tickets, and they’re important. And they’re important because the SEC, a lot of times they’ll approve your plan of reorganization, and then they’re going to audit it, like 60 days after you launch. And if you mess it up, if it’s wrong, and there are problems 60 days later, it’s always all for nought.
We converted a hedge fund into an ETF in December and did the plan of reorg, had a top law firm that was already identified by the sponsor, worked with our counsel. We got it all done. And then, sure enough, the SEC called us 45 days later and said, “Hey, we have some follow on questions, we wanted to ask why you wrote it this way, and not this other way.” And so those are things that you just have to be prepared for. So, I think folks that are thinking about reorganization, get a good securities lawyer to just run that test. Because for two hours of legal time, you could probably get that test and save you a lot of heartburn. And then don’t go cheap on legal advice on a reorg. We certainly work with folks we trust, we get cost down, but would not recommend the bargain basement.
Meb: If someone wants to work with you guys, can they just say, hey, put us in touch with your legal? Do you guys willing to do that? Or they need like an independent totally different legal?
Patrick: Great question. We definitely arrange that. So, a lot of times what happens is, the folks who think about a reorg they’re already attached to particular firms that they like working with, but yeah, we can actually save money if you don’t have your heart set on the world’s most expensive securities firm in New York, which can happen sometimes. Yeah, we definitely do that. And there’s economies because you have your trust counsel, which that’s the one where they’re kind of like working with the board to convince them that this is legit, and it’s okay, and it’s not going to harm shareholders, then you have to plan a reorg firm. If that can be the same person, you get a ton of synergies there, because the person writing the plan is the one pitching the plan to the board. So, if you can make that one person instead of two, that’s a lot of legal signals right there.
Meb: Yeah. We use Morgan Lewis for our trust, and then Shartsis Friese for our actual company legal. Listeners, if you ever want an intro, hit me up. And if you guys want to add yours to the show notes, we can certainly add them as well. I feel bad asking because then you’ll just get dozens of unsolicited emails for legal counsel, but they’ll probably love that, it’s free advertisement. So, it’s up to you guys. Plus, it’s in the prospectus anyway, usually, right?
Patrick: Yeah. We work with a guy, Mike Pellegrino. He’s the best. I love him. He has been writing prospectuses and working with the SEC for three decades, and that’s just his passion. That’s what he loves doing. And he’s an independent, so he doesn’t pay the overhead that the big firms pay, so.
Meb: Do you guys have an internal cookbook, because I remember going through this the first time and oh, my God, my head was swimming. It was just like, this is the most complicated, unclear, expensive process. And then once you’ve been through it, like you guys have 2, 4, 6, 8, 10, 12 times, it’s like old hat. Like, easy it’s not the right word, but it’s like a process you’ve been through so many times. It’s just routine, I guess would be the right word to say it.
Patrick: Yeah. Like, we did a proxy with a fund, to your point, Meb, it was brutal. But there’s a process here, there’s a cookbook now. And what I like about this industry is this cookbook was written in the ’90s, where everybody just paid lawyers and paid third parties and margins were much fatter, so no one looked at it. So, you have the way, “Things are supposed to be done.” And then you say, “Well, I know that doesn’t take that much time. I know this can be done with a computer, I know this part I can do myself, and you can get a proxy process that’s supposed to cost a quarter-million dollars, you can get that down to 80. That’s what I like about my job is you can find these things that there’s just so much fat on them. And with a little bit of wringing the towel, you can get it down to a more affordable.
Meb: The proxy is like the most antiquated. I mean, there’s a lot of antiquated still on Wall Street, the proxy is the most nonsensical. And when we did it, my hack was, because you guys are kind of brothers from another mother with being value-conscious, aka cheap bastards. And when we had to do proxy, and I was looking at some of these checks, we were going to have to write, I was like, “Oh, no, no, no, no, no, no, no, we got to find out a different solution.” And we had found an automated call center that would call all of our shareholders for like, 1/20 the cost and I just recorded a message. I was like, “Hey, this is Meb. You’re a shareholder in one of our funds.” And just recorded it and it was infinitely more effective than whatever process they had, which cost a gazillion dollars. But listeners, if you got a start-up that’s disrupting any of this hit me up because it’s, what a nightmare.
Someone’s going to email or tweet back to this blockchain to solve this somehow, but I’m not sure how. Okay. So, we talked about conversion, I think we talked about this last time maybe, and I don’t know anyone that solved it yet. But what’s it called where you have appreciated stock, you toss it into an exchange fund? There are a lot of rules and tax regulations around that. Everyone asked me kind of two questions about ETF over and over is like, are we ever going to be able to figure out a way to do an exchange fund with ETFs? You guys have been able to cookbook anything up there or is that just sort of a pipe dream?
Wes: So, in the end, we get calls all the time now, where it’s like, some billionaire who’s like, “Hey, I want to put my family office in an ETF.” And I’m like, “It doesn’t work like that.” Nor would we want to do that because the worst thing for our industry would be like a “Wall Street Journal” headline, billionaire uses ETF structure to dodge a ton of taxes for himself. So, even though that doesn’t make any sense, nor will we ever want to do that, we get that question all the time. Now, that said, as long as you do what Pat said, and you follow the guidelines on like, what the 40 Act requires, and more importantly, what the IRS requires. And you’re following the intent of the rules with respect to taxes. There are ways for syndicates of maybe really rich people that have highly appreciated stock that come together to potentially do these ideas. But they have to legitimately have the intent of being in the ETF business. It’s like, nothing can be 100%, we’re doing this for tax. It has to be like, “Hey, we’re doing this because we want to launch a legitimate business in the ETF space and try to deliver a cool investment solution for folks. And hey, if it happens to be also really tax-efficient along the way, that’s just a side benefit. So, it’s really content.
Meb: So, there’s two parts to this. So, the first part, which is the exchange funds, listeners go Google it, I don’t want to get into it here. But essentially, you can contribute highly appreciated stock into a fund. There’s a bunch of rules, you have to hold it like 5 or 10 years or something, but you basically get a diversified portfolio in return. And there’s sort of this potential if you could figure out a way to do it in an ETF structure that you could avoid, or delays.
Wes: Yeah. There’s a rule explicitly against that. It’s called the diversification rule. And the IRS doesn’t want you going from non-diversified to diversified. And to Pat’s point, the 40 Act specifies what those rules are, like, you can’t have a single security audit over 25% of the book, the sum of your 5% plus positions can’t be greater than 50%, etc. So, you can go from diversified under that regime to diversified. But if you were to go from like, “Hey, I’ve got my DoorDash stock, and I want to go seed an ETF, that’s never going to slide, as far as I know, I’m not a tax attorney, but…
Meb: So, that’s one thing, it’s sort of a dream that probably will never happen, and probably for good reasons, as you mentioned. However, you did touch on something that I’m surprised you haven’t seen more of, which is we talked about advisors and the use case for advisors launching funds for their current clients they’re doing asset management for, and that’s an obvious use case. And I’m surprised you haven’t seen a hundred of those already, and I think you will. Second is you mentioned the family office, and I’m actually surprised you haven’t seen more family offices because family offices are notoriously tax-aware that run taxable active strategies, which is often most that we talked to in-house, why they wouldn’t wrap it into an ETF and actually launch it as a product. Do you guys see that as something that there’s no real interest in? Or do you see it as people considering it? Or why wouldn’t they do it?
Patrick: So, I’ve had several conversations with family offices that explore this. And I had the same reaction you did, Meb, which was just like, okay, these family offices are perfect, large tax proposal capital, tax-efficient wrapper, this is a no brainer. And what we’ve found digging into this is an ETF cannot, and again, Meb, you know all this, but an ETF can’t have a control person. So, if a controlling person has 75% or 80% of the assets that blows up the IRS rules on ETFs, you can’t be a regulated investment company or an ETF. Now, with a family office, the analysis comes down to, what does the org chart look like in this family office? There are five trusts and a senior trust, and the senior trust is the mom and dad. And then they say, “Oh, well, I’m not a control person because all these trusts of my kids are going to invest as well.” The IRS is most likely going to look at that as you can influence the allocation of that capital, therefore, you are one entity in the eyes of the IRS. So, I find a lot of family offices come to the ETF conversation with an org chart and they say, “Look how diverse we are. We’ve got this trust and that trust and this thing and this foundation, blah, blah, blah, blah, blah.” But at the end of the day, who’s pulling the strings? Daddy is. And because daddy’s pulling the strings, it’s one person.
Meb: How much can the aggregate family own?
Patrick: I believe it’s 80%. That’s where you run into hard and fast rules, but there are lower thresholds as well. So, if you want 25% or more of an ETF, you have to disclose that in the SAI. You have to put in a bunch of disclosures. And as soon as you tell a high net-worth person, “Are you okay with your trust name or whatever being listed in public?” They’re like, “No, thanks. We’re not interested.” Right? So, yeah. Twenty-five per cent is disclosure, and then 80% is just the hard and fast limit, but people run once they hear 25%. In fact, 5%, ideally, was where you get listed in an affiliate of the fund, so.
Wes: And, Meb, a business idea that we keep talking to people is if you could somehow herd the cats, you get four family offices, all with $100 million, and they all can somehow agree to the general ethos of investment philosophy. It’s got diversified ownership. Like, all of this is technically plausible. It just hasn’t happened yet because herding the cats is hard. But, hey, whenever someone figures that out, they should call us up, and we’ll help to get it done.
Meb: So, most of the people that come to you for sort of the ETF Architect white-label, what is their actual obligations? So, say, I’m an advisor, I’m in LA, I got $100 million. I want to cannibalize into my Alpha juice strategy that buys what was it? Dogs of the Dow tech names. Am I technically a sub-advisor? Is the SEC going to be hammering me every day? What’s my relationship? What are my obligations? What do I do? Or do I just have to rebalance once a year and sip pina coladas?
Patrick: Sure. Great question. And there are different models out there, Meb, so there’s no one size fits all. So, I’ll give you the spectrum of options depending on what you’re looking for. So, some folks, they don’t want to register, they are comfortable not pumping their security, not marketing it, and they run a passive quantitative rules-based strategy. That’s an index provider, we can get into that. That’s basically you run your index, you only market your index, those are your obligations. So, that’s one. Then you have white label platforms where they provide the board of trustees, so it’s a Rent-A-Wreck, they provide the board of trustees, and then you the fund sponsor, are an advisor on that platform.
So, you’re actually going to board meetings and presenting your compliance program, you’re reporting to the trustees in your activity, you’re doing the trading and execution, or you’re hiring a sub-advisor to do the trading and execution on your behalf. But that’s a much more, I’d say heavy-lift option that some people like. Our approach is a little different. We basically say most people that want to launch ETFs do not want to rebalance ETFs, they do not want to vote proxies, or they want to tell us how to vote proxies. They do not want to be involved in the day-to-day back-office crap that we deal with on a day-to-day basis.
In that model, we stay as the advisor to the trust, so we’re the ones reporting to the trust, preparing the board books, and doing all that stuff. The fund sponsor is what’s called a non-discretionary sub-advisor. And so what that means is, the sponsor is sipping pina coladas and sending us a spreadsheet, and we take care of everything else, and then we help them craft, like a custom compliance program. And that compliance program basically has a lot of parts removed from it, like best execution, how do you select a broker for your trades? That’s not my problem. That’s the advisor’s problem, ETF Architect. How do you vote proxies? Please refer to Alpha Architect or ETF Architect’s proxy voting process, because that’s not my problem.
So, it just depends on like, there’s two dimensions you kind of have to consider when you look at launching an ETF, what’s my active versus passive lens, and then how much control versus convenience do I want? If I’m a control freak, and I want to really be in the thick of it, hey, be an advisor and report to the board. If you want to just run your idea, which I think 75% to 85% of advisors just want to run the idea, go the non-discretionary sub-advisor route and just focus on selling. It just liberates your mind to focus on, again, what we’ve been saying is the most important, which is distribution.
Meb: Being an advisor is a ginormous pain in the ass. So, listeners, I don’t know why anyone would ever want to do that. But who knows? You hit on something that I think is important that is muddied and cloudy and has changed over the years and morphed and has actual real implications that I think most don’t understand, which is what the hell is an index fund? What does active versus passive mean? And how does that translate into what are the obligations and roles of that decision?
Patrick: So, let’s just talk about government regulations, in general. We are governed by the 1940 Act, but that just kind of underscores how lethargic regulations can catch up to reality. You think about how’s Congress regulating crypto? How is Congress regulating these things? And it just underscores how there’s such a disconnect between what the markets do in practice and what the original law was designed for?
Meb: And to be clear, what we’re talking about is not some acronym, 1940. That’s the year, 1940, which is almost 100 years ago.
Patrick: Yeah. So, the rule that I have to be smart on and follow was written when my grandfather was too young to join the Marine Corps, it’s basically, the law. So, an index provider in the past, these were broad-based market indices that follow very generic market exposure that everybody knows, the S&P 500. So, Standard and Poor’s forms an index company, and they create these indices, and then they license them to fund managers like us. And we basically say, “Okay. We’re going to charge S&P 500 ETF 15 BPS, and we’re going to pay the licensing fee of 5, we’re going to net 10. That’s how index providers are supposed to work.
Now, the SEC saw this and they said, “Great. These entities, this S&P group over here, this Dow Jones group, this NASDAQ group, they’re providing financial services, they’re providing financial advice, we want to regulate them.” And what happened was S&P and NASDAQ, and Meb, to your point, nobody likes being an advisor. So, these guys gave the SEC a big push legally and said, “No, we do not have to register. We’re not marketing securities.” This went all the way up to the Supreme Court. And the Supreme Court ruled against the SEC, and they said, “Publishing an index is freedom of speech, anybody can publish an index, it’s not financial advice, SEC, you do not have jurisdiction to regulate index providers.” From the 1980s perspective, that made sense.
But what happens is when the Supreme Court says, “If you do this, you don’t have to register,” a lot of people start jumping over the fence and trying to be index providers and not register. And so what you’re seeing is, initially, you would have these fund sponsors basically create an index, and make sure it was rules-based enough to where they were just talking about the index, and they would never have to register as an advisor. It’s lower cost, you’re not under SEC jurisdiction. It’s great.
So, that was a pass. But the SEC is on to this, and the SEC hates this. And I’ve just seen in our eight years in this industry, the level of questioning, you know, rigor and public statements against index providers just gets amplified every year. So, we’re seeing two things. First, we’re seeing strategies that aren’t really indexes trying to get played off as indices. And then we’re seeing the SEC as much tougher questions about the index composition itself. So, where does that bring us today? If you want to be an index provider and avoid registration, you better make damn sure that your index is 100% quant and can be 100% replicated by a third party. And the simple test to assess your strategy with this is, if you say anything in your index methodology about you arbitrarily pick names, or you go through CEO press statement, press releases, anything that smells qualitative, that smell stock picking to stop right there and go register because the SEC is going to make it be an active fund.
So, that’s what we’re seeing right now is because the SEC can’t go over the Supreme Court, they can’t overrule the justices on the bench, what they’re doing is they’re applying pressure where they can and the pressure is basically on us to basically prove to the SEC that these are, in fact, bonafide quantitative indices and that there is no need for this index provider to register. So, another test is if you’re going to be an index provider, and the only way you make money is the scaling of your ETF that you’re sponsoring, that’s probably not a good set of facts. If you’re an index provider, and you’re licensing your names over here to Meb, to run an SME and you’re licensing your index to West, to run an ETF and maybe you’re licensing your data elsewhere for a newsletter, whatever, the more you look, act, and smell like an index provider, you’re safe. But if you’re just a one-man band, and the only client is yourself with a fund you’re sponsoring, that’s where it gets pretty tough.
Meb: So, there used to be an advantage to being an index ETF, which was a tax benefit, which went away a year or two ago or three years ago, I don’t even remember at this point. So, they’re now on sort of more equal ground, do you guide people in one way or the other? Or do you say, “Look, just be an active fund and don’t deal with it?” Or do you say, “No, life’s easier for an index fund?” Or is it totally case-dependent? And then like, what percentage of your kind of white label do they end up on one side or the other?
Patrick: I would say we steer people to active for the reasons I just laid out. How you been an index provider unless you want to build an index business, you’re just taking a shortcut that you make up for later on. Because the key thing about an index provider is you can’t directly promote the security. And when we talk about getting from zero to $50 million, and nobody cares about your fund, but you, who the hell is going to promote the security? It’s got to be you. And if you’re saying, “Well, I can’t promote the security now.” It makes it really tough. We’ve also found that the index providers we worked with in the past, really struggle with figuring out a concrete distribution plan without being able to talk about the ETF.
Meb: There’s been a weird sort of state of affairs that I imagine as you talk about SEC is probably going to get increasingly magnifying glass, microscope on, which is the ability to talk about an index all over social media, all over TV, all over everything. And also backtested returns of the index, which prospectus marketing material, everything, but then not the actual ETF. It seems like the weirdest loophole, and it seems wrong. Is that the right word? Like, I’m not trying to offend all my index fund providers, but it seems a dislocation. Are they getting increasingly interested in that? Or is that part of this whole story that you’re weaving?
Patrick: Yeah. I think it’s definitely something they’re looking at. I mean, the three words that should scare any index provider are facts and circumstances. And that is the test that the SEC is going to use to determine if you are promoting a security without registration. So, if the facts and circumstances, so let’s say your backtest example. If you have that backtest prominently displayed, and you can very easily access the ETF website that promotes the security that you have an economic interest in, those facts and circumstances are not in your favor. So, as an index provider, things you should think about are if I have a proprietary index that is also being used in ETF, what are the compliance firewalls and protocols I’m proactively putting in place to not be perceived as marketing a security?
And this is where, I think people with the right mentality that a good offence is a good defense, you do not have to have a compliance program as an index provider. Guess what? If you’re on our trust, you do. You need to because you need to have firewalls in place to make sure that you’re not going to be marketing the security. You need to have your website set up where the backtest isn’t directly promoting your ETF. There needs to be robust firewalls and disclaimers and accredited investor warnings and things like that. So, yeah. It’s definitely something that the SEC is looking more closely at, and the industry, folks like us are trying, we have to demonstrate best efforts to comply with the securities laws. And you can’t just sit on your hands and say, “Well, index providers are exempt so we’re not going to do anything.” I think that’s a very risky approach to run your fund.
Meb: I mean, I think so much of what we do in our world also comes down to intention, and how much of it is like, you’re clearly trying to be deceptive, or is it like an honest effort? We reported a couple funds to SEC. And look, I love the SEC, like you mentioned, I think they’re overwhelmed and understaffed. I think their job is probably one of the hardest jobs on the planet, but to where we saw, on one case, a firm marketing a, “Real track record” for like 20 years or something that they converted to a public fund, and it raised a billion dollars. And you guys know, if you spend enough time with data and markets, like what’s possible, and what’s not, and with a 99% probability can eliminate something as impossible. And if it was possible, it would be a $50 billion fund, not something that’s $20 million. It just doesn’t check the smell test and still see a fair amount of those that actually make it to the light of day. So, it’s good to see that they’re interested in that. So, how does Portnoy get away with this? He came on the scene in what seemed to me like a pretty questionable marketing strategy where he was and still is, I don’t know, I haven’t followed it, really talking up the BUZZ ETF. What’s the story with that? Is that been squashed? Is he still doing that? I haven’t really followed along.
Patrick: That is a slow-motion train wreck. Mr. Portnoy, I appreciate you adding pain and misery to everybody in our industry, but I think that BUZZ ETF’s YouTube ad, you should definitely check it out. Talk about using a loophole to promote a security. That gets the gold. So, what happened there? So, first off, how is somebody…definitely check out the YouTube video, but how is somebody allowed to basically pump the performance of a backtest while marketing a security? Well, they were very smart, very well trained lawyers advise on this ad. And if you watch the ad and listen to the audio, the word ETF is not said by Dave Portnoy, the word ETF is dubbed in by a third party. So, the first thing he did was when Dave Portnoy is talking about the BUZZ Index, they named it the same as the ETF, which I would argue is a very high risk, and I don’t recommend you to do. But then they dubbed in the word ETF for index and had somebody else say it. So, Mr. Portnoy technically was not saying ETF, which is absurd, like that is just the most ridiculous abuse of the rule I’ve ever heard.
So, that’s how he did it. Whether or not you think it’s right or not, it certainly got the attention of regulators and that was basically followed up with FINRA saying, “We are now going to do a sweep of all social media influencers, they should have just crossed it out and said Dave Portnoy, and people like him that are doing these types of things.” So, it’s one of those things that like regulatory regimes are like a barge, it’s going to take them a while to turn and kind of go in a different direction. But that is starting to happen.
Meb: Right. I mean, it seems so absurd, even if he’s not talking about the ETF that somehow this person can promote the index that has the exact same name as the ETF. But you can promote the ETF, like, that is a loophole that seems like it is months or quarters away from no longer existing. I always say the SEC eventually gets things right on these decisions. The ETF rule is a great example. Sometimes it takes a Portnoy to shine the light on and say, “Oh, wait. This is clearly not in the best interest of investors to be able to do this.”
Wes: One thing I wanted to mention, Meb, just so Pat can explain it. Like, we all know this, but it’ll be unclear what we’re talking about is that difference between just a pure index provider that doesn’t want to get regulated by anybody. And then like a sub-advisor, but you can also do a hybrid approach, where you can run an index and also be registered as an SEC advisor. Maybe Pat can talk to why someone might want to go that route. Because it’s not like an index is all bad, per se. Some people, there’s benefits to it.
Patrick: And we advise that all the time, we said, look, people love rules-based quantitative processes, a lot of investors like that. So, you can do that, and you can register and you can either stay passive and just say, “Come hell or high water, this is our cookbook, this is what we do.” Or you can be active, but have a quantitative rules-based methodology in your prospectus. And the benefit there is, if things really hit the fan, you can, as an active manager pivot. So, you have an index, and then the COVID crisis happens if you want to go to all cash, or if you want to allocate to equities, where you think the market’s at the bottom, that active gives you a little bit of flexibility, whereas the index, you really have to just follow those rules. But to Wes’s point, you can be a regulated index provider, no problem, and it also gives you more avenues.
So, if you’re an index provider, now you can actually talk about the security if you’re regulated, you can solicit institutions directly, you can also run different distribution channels for your index. Meb, I’m sure you’ve had this happen a lot where you may be talking about your funds or one of your ideas. And someone says, “Hey, I’m not interested in the fund, but I’m interested in… can you manage some of my money? Or can you manage an account for me?” If you’re registered, you can do that. You can take advantage of that opportunity. So, definitely, still on just swallow the pain pill. There are people to help you, you just register. That sucks, but it’s better than the alternative,
Meb: I think a topic of discussion that, again, people in their head, I think they think index, they think low cost and low taxes and active high-cost, high tax. That’s totally been destroyed as a general category, I think it’s still true at the mutual fund world. But a big potential problem if you are an Index Provider, which is why we are active and do the indexes in-house as sort of actively managed index, is, and this depends on the index, you don’t have to but if you clearly disclose the index methodology, to the point where you get big and it can get front-run, it becomes a very real problem for the fund because it could be a big cost. And in some categories, it’s only a few basis points, but in some it’s percentage points. While we’re on the topic, the SEC, my guess is the status quo will continue, which is mutual fund companies can just convert into ETFs. Do you think the SEC will ever say, “You know what? It’s odd that this one structure has big tax advantages and this other doesn’t? Maybe we’ll just equalize the two and say mutual funds get the same tax treatment as ETFs? Or what’s your happy hour guest here?
Patrick: I think it’s just going to stay the course. And the reason why is the taxation piece is a treasury issue, the Treasury issue is settled statute at this point. The 1940 Act is governed. The mutual funds and ETFs, again, are brother and sister. They’re the same structure with a few nuances. So, I don’t think there’s impetus to change that legislation from the Treasury side, which is where you need to see the tax reform come in. And then on a political landscape, as more and more ETFs get adopted by mainstream investors, by mom-and-pop investors and not just big high net worth folks, woe to the senator that tries to attack that. I think every year that the ETFs just grow, it’s just going to become more and more entrenched and have more and more lobbying power. I think to your point, Meb, I think it’s just going to be, the floodgates are open, and it’s just going to start sweeping in.
Meb: Do we talk about the naming rule, what’s the naming rule?
Patrick: So, this is something that’s really interesting, and I think it applies to both advisors and retail investors. So, this is something we, I don’t want to say wrestle with the SEC, but we work with them a lot on because it’s another wrinkle in regulatory issues that people don’t know about. So, if you launch an ETF and you call it The Meb Faber Is Awesome ETF, you can do whatever you want, you can invest in Japanese micro-cap, you can do Indonesian bonds, you can do domestic… whatever. The name of the ETF is wholly unrelated to what you’re doing. But most people want to give a clue to the investor what they’re buying. So, if you want to launch a cannabis ETF for already serving ETF, the naming rule states that if you have a name that the SEC deems to be indicative of what you hold, you need to invest 80% of your assets in those things that are referenced in the name. So, if you call it the Patrick Cleary Semiconductor ETF, I need to invest 80% of my ETF’s assets in companies that are deemed to be majority involved in semiconductors. So, that sounds reasonable, right? If you launch an Italian ETF it should be an Italian security… Where things get tricky is where if you are an advisor, and you’re like, “Hey, I want to invest in companies that are going to benefit from the adoption of solar power.” So, I’m not going to invest in solar companies, because that’s going to be a bunch of crappy micro caps, but I want to invest in the big companies that have a lot of flat roofs or companies that are smelting aluminum that can use solar, whatever.
So, you want to buy big REITs and big energy companies, whatever. Now, you have a problem, because if you want to call it the Solar Adoption ETF, the SEC is going to say, “Okay. You need 80% of your assets invested in solar companies,” and you’re going to respond to them and say, “I don’t want to invest in solar companies. No, no, no, I want to invest in the businesses that are most likely going to benefit from adoption of solar and are going to do really well.” That’s where the naming role is now really challenging because we’re seeing a lot of managers with great ideas that want to front-run kind of these new technologies, and we get the pop from how our economy is evolving. But this naming rule basically says, “Well, if you say solar in the name, or you say cannabis in the name or hydrogen in the name, you have to invest in the actual constituents, not the benefactors of the technology. And that’s the biggest challenge we’re seeing right now.
And how do you mitigate that? It kind of seems silly, but it’s what we do is you have to basically juxtapose another industry that you think is going to fit that naming world. So, if you’re going to like launch a hydrogen ETF, you’re going to call it the Hydrogen & Energy ETF. And why would you call it the Hydrogen & Energy ETF? Well, you’re going to say, “Well, I’m going to invest in hydrogen companies, but I really want to invest in the energy producers that are going to adopt hydrogen, and they’re going to become much more valuable.”
We’re kind of playing this like shuffle game with the SEC on names. I mean, we launched to fund that the SEC basically came back and said, “No, we don’t think this fund is clean energy, it needs to be Cleaner Energy.” And we had a two-hour debate with the SEC on, well, what determines clean energy? I literally asked this question, I said, “Well, what if the solar panels of this Cleaner Energy company were made in China using coal-fired electricity?” They’re like, “Well, it’s solar still, so it’s clean energy.” And I was like, “Oh, God.” Again not to knock the SEC, but we basically asked them, we said, “You know, this seems ridiculous, where we’re looking to regulators to define what is cleaner energy, or what is solar, whatever.” And I said, “Look, this is a crappy rule, but we need to apply. It’s better to apply a crappy rule, universally, as opposed to try and help out investment companies.” Because what happens when we help out investment companies, Vanguard and iShares are going to get helped out more than the little guys on Main Street.” And so they’ve kind of taken the position. Yes, this is a tough role, but we don’t want to start making exceptions because the well-funded, well-heeled, well-connected will be able to get better treatment than the little guys. So, we’re just going to treat everybody poorly.
Meb: A fun Inside Baseball stat as we once had a fund, it doesn’t exist anymore, partially because of this reason. But the strategy, we published a white paper on this, and I love this because no funds do this, global bond markets weighed by GDPs. So, you end up, if you’re investing in the world’s largest asset class, which is foreign X U.S. bonds, government bonds, you end up with a bunch of bonds at zero and negative percent. Why in the world would anyone want that? And so we launched a, essentially a carry strategy on this topic. And it basically took all the countries in the world, the sovereigns, and invested in the top third by yield, so a high yield global bond strategy, and we had named the fund The Sovereign High Yield Bond ETF, very accurate description.
And the SEC came back to us and said, “You got to change the name”. And we said, “Well, why?” And they said, “This is not a junk bond fund.” I said, “I know. Correct.” They say, “Well, investors high yield means you’re investing in junk bonds or it implies.” I said, “No, it doesn’t. Junk bonds implies that you’re investing in junk bonds. You can have high yield without them being junk, they can be highly rated.” And they said you can’t do that. It’s misleading. And so we got down to the point like where you’re talking about the Meb Is Awesome name. I was like, “How about we name it The Sovereign High Yield Bond Fund That Is Not Junk-rated ETF.” And our counsel said, “Meb, you don’t want to pick a fight, do you? These are our friends.” And I said, “Okay.” And we changed the name.
And unfortunately, I think it actually had the opposite effect, where people… it was just called The Sovereign Bond strategy ETF or whatever. And I don’t think anyone… I think they understood less, like, they didn’t understand what they were investing in. So, anyway, I understand the frustrations because there are a lot of crazy names out there, and they have a hard challenge, but sometimes it’s frustrating on our end, too. We can’t let you guys end this without talking about crypto. You guys got nine Bitcoin filings like the other 400 that are in the queue, I mean, what’s your wager on what’s going to happen there?
Patrick: So, I absolutely love the ping pong battle going on between Senator Warren and Chairman Gensler on the SEC. So, Senator Warren sends a letter to the SEC and makes a big deal about it, saying, “You better protect investors. I’m nervous, I’m making a big sting about this because I’m fighting on behalf of shareholders.” And puts Gensler on the spot. I think Gensler gives a velvet knife back to Senator Warren and says, “I agree with you. And if you can only pass the laws that would give me the authority to do all these wonderful things you’re asking about, I will gladly help you. If you have any questions, please contact my office.”
So, I think if you look at the Gensler-Warren narrative, and also look at the crypto regulatory attempts in the most recent legislative battle to get the infrastructure pass, I think it’s very indicative that I don’t think this is going to be an SEC issue. I think that some Senate Finance Committee is going to have to write some horrendous Dodd-Frank type piece of legislation that’s going to have all sorts of things wrong with it, but at least it’s going to be a starting point of legislation where Congress, not the SEC, starts to get its hands wrapped around the crypto piece. People are looking at Gensler saying, “All right. What’s the SEC going to do? Are they going to launch a futures product?” He said futures in passing, or I saw on his legal notepad futures. So, it’s going to be a futures thing.
I think the bigger issue is that Congress is going to have to figure this out. And until then, we’re just going to see a lot of derivative-type products than others, but I think it will happen. There’s two things that will drive bipartisan success on this issue is one, the United States wants to remain the preeminent location of capital for both domestic and foreign investors. So, I think that’s something that both parties can get behind. And two, if there’s a way taxable revenue can be derived from it. It’s a lot easier to tax crypto owners than hardworking people of the middle class. And so I think there’s plenty of incentive for this to happen, but I’m not optimistic that we’re going to see something in 2022 with direct holding Bitcoin or crypto.
Meb: I’ve had three comments on this that I take a little bit of pride in. I mean, as listeners know, I’m consistently wrong all the time. So, this isn’t me taking a victory lap. However, I did say in 2013 that I said I don’t think a Bitcoin ETF is coming to market. Anyone who wants to take this wager we’ll bet a sushi dinner or bet dinner over it. I like sushi. No one would take the bet and I’ve tried to re-up it every year since and there’s never been one, so I’m eight years in. Second, I mentioned before he did it, but I said I’m surprised no one who is a huge crypto bull hasn’t just loaded up their corporate balance sheet with Bitcoin defacto becoming a Bitcoin security, and now you’ve seen Michael Saylor do it. And then lastly, you saw that Bitcoin mutual fund come to market first. I don’t think that it’s really garnered any assets, though, which is a little surprising to me. But I would be surprised if the way that it came to market was not through a conversion to try to get ahead of the actual approval. You think the future is and/or fund-to-fund related models the one that makes it or what do you think’s the right structure that comes out?
Patrick: I think futures are the way to go. I mean, you have… So, you talk to the market makers, and market makers said, “Look, I just need a publicly disseminated price to make a market, which you have. And futures allows for derivatives of products that are tough to purchase directly. So, I think that is a viable path. So, my money would be… my sushi dinner, Meb, would be on the futures launch. But I’m going to say, Meb, I’m going to take you up on it. I think there’s going to be a futures ETF in 2023.
Meb: Oh, God. 2023? You just skipped over 2022?
Wes: He’s a good poker player, Meb.
Meb: My goodness.
Patrick: I deal with regulators every day, Meb, I know it’s going to just take longer than they think.
Meb: We’ve kind of glossed over this a couple times, I wanted to touch on it briefly. What role is the Lead Market Maker play? I feel like there’s some consistent topics that we educate investors on. One is obviously, if you’re a big advisor, how on-screen liquidity doesn’t translate to actual liquidity? Just call your desk, you can place orders $50million, $100million, $500 million if you want. It’s usually not a problem. That’s a big one that we’re consistently talking about. And listeners, I don’t want to get into it. But if you want to talk about it, hit up the Alpha Architect crew or us, and we’re happy to educate you. But how is the role of the LMM changed over the years? How do you guys think about them? Is it their warm, happy relationship? What’s the general takeaways on that topic?
Patrick: Sure. I’d say the LMM is the most underappreciated, overlooked aspect of the ETF value chain. And I think anybody launching an ETF, any shop that you partner with to launch an ETF, I’ll tell you with ETF Architect, we are religious with working closely with LMMs. I know, Meb, you guys are as well. LMMs are the most important part of the value chain. And the reason why is when you launch a product, yes, you have the regulatory piece, but you also need effectively the sponsor in the marketplace that’s going to make markets in your ETF when nobody else wants to. That’s what an LMM’s job is. An LMM is basically putting their hands in the air and says, “When the Dogs of the Dow Meb Faber fund launches with $2 million in it and there’s three shares traded today, we’re going to be there making markets and maintaining reasonably tight spreads.” They’re critical.
LMMs… So, the big Wall Street banks hate being LMM. They want to be able to sit on the sidelines, get in when it’s opportunistic, stay on the bench when it’s not. So, nobody likes being an LMM, but that’s their role. Now, in the past, people would fight to be an LMM. Why? Because ETFs were few and far between and the funds that were launching were these large Vanguard type juggernauts that you were relatively confident that when Vanguard launched a domestic equity ETF, it was going to have several billion in it in day one, and there’s going to be ample opportunity to make money. Fast forward to 2021. Now, you’re seeing all of these bespoke boutique ETFs come out. And you really have to convince an LMM, that there’s going to be a viable business plan there for them to participate.
So, for us, how we address that risk, and I think others do as well is, I know it sounds simple, but you have to get on the phone, is to call these people, and you have to listen to what their concerns are and what they need to maintain a viable market for retail investors. I know it sounds revolutionary, but like so many people just I got my fund launch, you have the SEC improvement and you focus on marketing, who’s my LMM? I don’t care, that’s not my problem anymore, and they don’t pay attention. That is not wise. So, what we do is we try to understand, okay, here’s the basket composition. Here’s what we’re planning to hold, how can we maintain tight spreads, what’s the best way to kind of make sure that retail investors are getting a fair shake, and they’re also getting active participation by you? So, that’s kind of how we view LMM relationships.
And you got to just… I mean, I know it sounds stupid, but, you guys are just like, talk to people and understand what their pain points are. And, for example, if you’re holding international securities and domestic securities and you’re holding South Korean stock. So South Korea is a nightmare to trade in, they don’t allow exchanging of securities, you have to deal in all cash. There’s just all these problems. So, if you call out the LMM and say, “Hey, instead of holding Samsung that’s trading in South Korea on the KOSPI, why don’t we hold the Samsung ADR in the United States?” That’s going to be great for them, they’re going to be more willing to participate, they’re going to be more active, the spreads are going to tighten. So, that’s just an example where, where are the trade-offs you can make in your portfolio that help amplify market participation, that really aren’t that big of the deal, in terms of a hit to your investors or your strategy? So, that’s how we think about LMMs.
Meb: Let’s take off the CEO, COO, PM hat for a minute, and let’s just circle around with a coffee or beer. As we look out the next 1, 3, 5,10 years, what kind of opportunities do you guys see? I mean, you see a lot of pitches, you see a lot of ideas out there. There’s tens of thousands of funds, the success rate of your average publicly-traded fund is half of them go away over the course of a decade. So, listeners, I know everyone thinks their idea is the one that’s going to succeed, but the reality is roughly half don’t. What do you guys see that you say either on your list of, man, I wish someone should do this, or I think this area is underserved or ideas you say, “Look, this is a topic that has a lot of potential.” Anything come to mind?
Patrick: I’m actually really excited about the ETF industry. I’m more excited about the ETF industry than I’ve been in a long time and here’s why. I feel like the costs are coming down. You have all these avenues for free distribution, social media, YouTube, podcasts, whatever. For me, the key indicator of success in this industry is, do you just have the grit and the determination to make it happen? And if you’d asked me that question 10 years ago, I would have told you, you need to be connected to a big shop with a wirehouse. Wirehouses are dying. I think all the parts of Wall Street that we don’t like are dying on the vine. And yes, it’s super competitive. Yes, it’s super hard. This is not an easy industry. But guess what? I think it’s incredibly…it’s becoming more and more of a fair industry, where a little shop like us can be on a first-name basis with the SEC, can take their feedback, can work with them, can bring products to market, can bring for what we’re doing relatively low cost.
So, I think, for me, guys, like you, Meb, like guys that can build an audience and then put in the time and write the books and build a presence, whether you’re an advisor, or you’re just a personality on the internet, or whatever, I’m actually bullish. It actually gives me faith that in 30 years from now, it’s not just going to be this duopoly with iShares and Vanguard, there’s actually going to be a third group of differentiated, cool products sponsored by people that are busting their butts to deliver value to the retail investor through education or content or whatever. So, I’m excited.
Wes: Yeah. I’ll just echo what Pat was saying. I just think in the end, the ETF is a better client experience, I can type the ticker in Schwab and be a proud owner, I get the tax benefit, the low cost. And so it’s really just a question of how do we get the other legacy structures into the ETF? Well, how do we get the RAs to play ball? How do we get SMEs in there? How do we get mutual funds in there? How do we get hedge funds in there? And is it appropriate for everything? Of course, not. But to the extent that it’s better for your client outcomes, you should lean in that direction. And then it’s on people in our industry, like ETF Architect and others, we got to figure out how to lower the cost and broaden access so more people can come into the ETF tent, and presumably, deliver better outcomes to their clients. And I think that’s why we’re so pumped, we’re like, we could actually do this. We could open this tent and allow a lot more people to play who can be successful. We just got to get on our horse and figure out how to rip the cost out and make it more efficient, coach people, make it turnkey, and all these other things that competition leads to, essentially.
Meb: Yeah. There’s entire areas, I mean, again, this is coming from a relatively small issue or compared to the gazillions the top five have, but you see a lot of the incumbents launch so many of these just calcified ideas that there’s 500 products that do the same thing. Like, we really need another Large Cap Growth Fund. But there are entire areas and categories that have never existed and a lot of creativity, I think it’s still a pretty blue ocean opportunity. And you see the tailwinds of just the ICI reports every year of ETFs versus mutual funds. And the gap is going to be even more of like an alligator jaw than it has with these conversions as well. So, bright times ahead. We’d had a bunch of Twitter questions. Is there anything we didn’t cover today that you guys think is important to touch on? We’ve been going pretty wide and deep. Anything that we missed out on?
Patrick: I would say there’s one thing that I underestimated when I got started in this. And Meb, you were actually kind of instrumental in my appreciation of this. I’ll tell why in a second. So, I think culture matters. You’re in unchartered waters with distribution with this. And I told this to all prospects, I said, “I don’t care who you go with. You need to go with somebody. You need to launch an ETF with good people and high integrity people that when there’s ambiguity that wasn’t covered by your contract, you know there’s a party on the other side, that’s there for you in a win-win.” And for the listeners out here, when I was getting smart on this industry, Wes would tell me, “Hey, go reach out to Meb.” And I asked Meb this question. And I’m thinking to myself, “Why would Meb share that. He’s a competitor.” And Meb was the friendliest. Like, “Hey, man, like, here’s how we do it. Here’s how we think about it.” And that just kind of culture of like openness and transparency and helping others win, I think is crucial. So, Meb, you were personally kind of instrumental for taking my like, jerk MBA protective shield down.
Meb: Well, listeners, you got to take what he says with a grain of salt because ETF Architect agreed before the podcast for every new advisor that signs up they send me a case of beer, so I have to disclose that ahead of time. But you know, it’s funny, like I tweeted about this, and I think there’s, like, if you look at the Venn diagrams, and I was kind of being a little frustrated with a lot of the startup scene, where I was talking about some of these Fintechs and I said, it seems like every FinTech that’s “Democratizing investing,” or whatever, is basically just Vanguard but with a wrapper of much higher fees. And I said that sort of casually and I don’t like being a negative critic. But as you look at the ETF industry, in general, versus the old school mutual fund industry, and look, the mutual fund industry is just a wrapper. I mean, there’s plenty of mutual funds that are just fine.
But if you had to make broad generalizations, one of the biggest problems in the mutual fund industry, besides the fact that the average fund cost is like 1.25%. So, dollar-weighted, it’s lower, but the average fund. There are so much legacy conflicts of interest. This involves the platforms. This involves commission, 10b-1 fees, front end loads, back end loads, the supermarkets on Schwab, on and on and on. And so the reason these funds have to be so expensive is because you couldn’t exist otherwise. And along came this new store that’s an ETF, that’s just blasted those to smithereens. Now, again, there are exceptions, Vanguard’s mutual funds, notoriously are one of the good guys. But I think this legacy architecture is slowly crumbling, will the dam eventually burst to these conversions? Maybe, I think so. But that fosters a sense of optimism in my mind as there’s really never been a better time to be an investor. Sermon over. Wes, you got anything else before we sign off?
Wes: No. I think you nailed it, Meb. It’s never been a better time to be an investor and I actually do genuinely believe that the ETF industry is leading the cultural revolution in financial services. It’s just a fact trying to help client outcomes and help people.
Meb: Well, and so when you guys, we talk a lot about this publicly, I’ve been mourning for years. The biggest problem with the ETF industry, there’s no way to invest in the ETF industry. There’s only one publicly traded company, which is WisdomTree. But to launch a fund that invests in early-stage ETF issuers, I think is a fantastic idea. So, maybe convince you guys to do that one of these days. People want to find out more, they want to sign up, they got a billion-dollar fund idea with all sorts of seed investment and pent-up demand. Who do they contact? Where do they go? What’s the best place to submit?
Wes: etfarcthitect.com or alphaarchitect.com or email@example.com. Those all work, easy.
Meb: He just through all the emails inbounds to you, Pat, sorry. You’ll get a handful. You guys, it was a blast today. Thanks so much for joining. Fingers crossed, see you, eyes at the March For The Fallen, otherwise, thanks so much for sitting in today.
Patrick: Thanks, Meb.
Wes: Yeah. Appreciate it, Meb.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us feedback at firstname.lastname@example.org. We love to read the reviews, please review us on iTunes and subscribe the show anywhere good podcasts are found. Thanks for listening friends and good investing.