Episode #522: Wes Gray & Robert Elwood on How to Convert a Separately Managed Account (SMA) to an ETF

Guests: Wes Gray is the founder, CEO and Co-CIO of Alpha Architect. Robert Elwood is the co-founder of Practus, LLP, a business law firm that focuses primarily on investment funds.

Recorded: 1/18/2024  |  Run-Time: 47:02 

Summary: Wes and Bob just helped complete a separately managed account to ETF conversion of $770 million, so we had to get them on the show to walk through the process! They walk through the process of doing an SMA to ETF conversion via Section 351 from start to finish. They share some of the more nuances involved in the process and answer some common questions they hear over time.

While the most popular ETF story so far this year is the Bitcoin ETF, this is arguably a bigger long-term story and a trend to watch in the next few years.

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Transcript:

Welcome Message:

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Disclaimer:

Meb Faber is the Co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit CambriaInvestments.com.

Meb:

What is up everybody? We have a truly fantastic and wonky show today. Our many time returning friend of the podcast Alpha Architects, Wes Gray, is joined by Bob Elwood, a business lawyer with a focus on investment funds. Wes and Bob just complete a separately managed account to ETF conversion of almost a billion dollars across thousands of accounts. So we had to get them on the show to walk us through how this all went down. They detailed the process of doing this SMA to ETF conversion via section 351 from start to finish. They share some of the more nuances involved in the process and answer some common questions they hear over time, like, why isn’t everyone doing this? While the most popular ETF story of this year so far is the Bitcoin ETF race, this is arguably a bigger long-term story and a trend to watch in the next few years. Stick around to the end. We get into some interesting ideas and implications for the future. Please enjoy this episode with Wes Gray, Bob Elwood. Wes, Bob, welcome to the show.

Wes:

How we doing, Meb? Glad to be back.

Meb:

So, Wes, you’ve been on probably more than anyone. Bob, you’re a newbie. You’re a Meb Faber show first. I figured we would start, get a little update from Wes, what’s going on in the world and then we want to get into this topic that I was pestering you guys about that I’m really excited to talk about. What’s going on at Alpha Architect ETF Architect Headquarters, Wes? You guys seem to have ton of stuff going on. Give us an update.

Wes:

Funny enough, literally right now, January 18th, we are launching the biggest 351 conversion that I know of on record into the marketplace. Today’s been an interesting day, same old stuff. Last time we talked about box, which we thought was a good idea and it almost has a billion dollars in it and we haven’t even marketed it really, and with the help of Bob and his team, this conversion business is just crazy. Just a matter of triaging the demand to figure out who’s serious and who’s not and bring them to market and let them join our fun ETF game that we all know and love.

Meb:

Let’s go ahead and cannonball right in because I pinged you guys. Bob, you can get us into this and I’d love to hear a little bit of your background and how you joined this Motley crew. What’s a 351, by the way? Let’s start there.

Bob:

So a section 351 transfer, you can do this with a private fund. You can do it with a group of separately managed accounts. You can do it with a lot of different inflows of assets, but the idea is, and I’m not going to use a lot of technical terms here, it’s a capital contribution to a newly formed corporation, which in this instance is an ETF. So to take an example, let’s say the three of us decided that we wanted to create our own ETF and let’s say that Wes had a portfolio that was heavy on tech stocks. Let’s say I had a portfolio that was heavy on old world economy stocks, oil and gas stocks, for example, and let’s say, Meb, you had mid-cap stocks that you thought were particularly suited to growth. We could combine our assets and what Wes would do is to cause all of his assets to be transferred in kind to the ETF. Same for you, same for me. And so for a moment in time, the ETF owns all of Wes’ portfolio, all of your portfolio, and all of my portfolio. Now you’d say, who cares?

We could do this in a private fund. We could do this in a lot of different ways. We can do all this inflow on a tax-free basis if we satisfy some requirements, which I’ll tell you about in a minute. But the really cool thing is obviously we’ve got a little bit of a shaggy dog of a ETF here because we’ve got tech stocks, old world economy stocks, and mid-cap stocks. And let’s say the manager says, wow, we’ve got this mix of different assets. I’d like to start rebalancing it or diversifying it in a way that makes a little bit more sense and maybe has a view toward maybe once out of a strategy that says, I’d like to find 25 names that will outperform the market going forward. If this were an ordinary mutual fund, if this were a private fund or if this was an SMA, the only way to do that is to basically do market sales. You could sell some of my old world economy shares, which might be underperforming in the future, but you’ve got a taxable gain or loss there and that obviously is a drag on performance.

What ETFs can do, and this is really cool, is they can do an in kind redemption. I’ll use my portfolio as the least attractive portfolio you could take out through the form of a party that’s called an authorized participant, makes an investment in the ETF, let’s pretend it’s just $10 million or $1 million, whatever it might be, and then does a redemption request. And instead of redeeming them out by paying them the million dollars in cash, what we do is send them in kind 1 million dollars of my portfolio of old world economy shares. And you would think what’s the difference? The difference is that there’s no tax at the fund level if we do this in kind redemption. So what we’ve managed to do is take out perhaps some of the losers in our portfolio and then we could do the flip side of that. We could say, hey, Wes’ portfolio, which is hot with tech stocks, let’s do an in kind transfer from the authorized participant that’s heavy on tech stocks. So what we’ve managed to do is diversify the portfolio in a way that we like without incurring any meaningful tax.

So we’ve got a lot of nice advantages here and we can continue to do that going forward. Each one of us has to satisfy two tests. One is that combined we own 80% of the ETF. That’s almost always going to be easy. In our example, we should own a hundred percent of the ETF, but we could have whatever the transfer or group is, it could be the three of us. In the deal that Wes is talking about, we have 5,000 transferors so it can get gargantuan, but the transferor group as a whole needs to own more than 80%. That’s usually easy to satisfy the part that’s hard to satisfy, and we do this person by person, transferor by transferor, the top position has to be less than 25% of, let’s say, Wes’ portfolio. And Wes’ top five positions need to be less than 50% of his portfolio.

And we do this transferor by transferor. So just the fact that you have a portfolio that is uncorrelated with his, that doesn’t count. We’re just going to look at your portfolio, my portfolio, and Wes’ portfolio and I’ll give you a little bit of a war story with respect to the deal that’s closing today. A decent number of the transferors were heavy on some big name tech stocks and as you may know, there was a big run-up in value in tech talks yesterday and I got calls from one of Wes’ and my colleagues yesterday saying in effect, holy (beep), we’re suddenly over 25%, what are we going to do? And we came up with a variety of strategies to do that, but let’s say for example, one of the customers was at 24.7% Apple two days ago, all of a sudden they were at 25.7% Apple. And what we did was essentially draw back some of the Apple shares to make sure that we satisfied the 25% test and the 50% test.

Meb:

So for the listeners, this reminds me a little bit of the exchange funds of yore where the Morgan Stanleys of the world would do on a private basis something somewhat similar, charge absolutely astronomical fees, lock you up, there were certain requirements, lock you up for like seven years. Is it a roughly similar structure except in this case you end up with an exchange traded very tax efficient vehicle?

Bob:

The reason that the Morgan Stanleys of the world charged so much was that they had to essentially match a lot of different transferors to end up with an ultimate combined portfolio that made sense. Let’s say for example that Wes had worked at Facebook and had 90% of his net worth in Facebook shares and let’s say, Meb, that you had worked at Google and 90% of your value was there. That’s great. Everybody likes Facebook and Google, but maybe what we want to do is create a diversified portfolio of 25 different tech stocks. That means you’ve got to find 45 different transferors who are all willing to put in their shares and then end up with a nice thing and of course managing all those different transferors. And of course Wes might have $10 million of Facebook shares. You might have a million dollars of Google shares and you don’t end up having the parody that you’d like. And so it takes work and I don’t begrudge Morgan Stanley the money they charge because it’s a hard business to manage all those sort of moving pieces.

Plus there’s a big lockup because of a special rule that applies to partnerships but doesn’t apply to ETFs. In contrast, what we do, and Wes is especially good at this, is he finds typically private funds that have a strategy or investment in advisors that have a particular strategy and let’s just take the investment advisor because this is the deal that we’re closing today. They have a strategy that is very much value-based, but they have a group of, in this instance, 5,000 customers who more or less all have portfolios that are vaguely speaking the same. So then we combine them all together, we end up with a portfolio that is at least close to the ideal portfolio and we don’t have to worry about some of the things that exchange funds have to worry about.

The other really cool thing is that in contrast to an exchange fund, which then has lockup periods and has constraints on how it rebalances its portfolio, we don’t have any lockup periods and we don’t have any real constraints about rebalancing the portfolio. So going back to the example I had before, if Wes has a portfolio that’s heavy on Facebook and you have a portfolio that’s heavy on Google, we can very soon after closing harmonize it in a way that is consistent with the vision of the investment manager as to, for example, how heavy he or she wants to be on Facebook versus Google versus anything else in the portfolio. So we’ve got a lot more freedom and latitude in contrast to the exchange funds.

Meb:

I had a tweet about a year and a half ago, I said, is it me or does this totally obliterate the entire high fee exchange industry? Every investment advisor in my mind who has a similar situation, particularly with appreciated securities and taxable, why wouldn’t they all do this? And maybe they are. Wes, give us a little insight on the ones you’ve done so far.

Wes:

It’s like any good ideas that go against the status quo. You need true innovators and people that embrace value creation. So this group that we’re talking about here, the other big issue that advisors usually have is like, but right now my clients have these 20 little shiny rocks in their portfolio. We could talk about them and I add value and you’re like, it’d be way better for the client to have it in one ETF to get capital compound deferred and the fees are tax deductible, blah, blah, blah. And so what you really need is a true fiduciary. A lot of advisors hold themselves out as fiduciaries but they’re beholden to their own, let’s just say, need to keep the client in the seat. So once you identify a counterparty that actually cares generally as a true fiduciary to their clients and they’re like, yes, I’m going to have to educate my clients, but this is just better for them, let’s do it, then it’s perfect.

So this group literally did that hard work where they did something that is complicated and it’s going to make them look weird ’cause they have one ticker in the account but they went to every single one of their clients and explained this is better for you in the end and it’s going to be weird. Let’s do this. And they put in the effort and now after the fact, it’s going to be obvious. And so I think it just takes someone who’s a leader at scale to present this and say, hey, it’s okay to actually be a fiduciary and do the right thing for your clients if you just educate them and explain. And I think now you’re going to start seeing more bowling pins fall down as people are like, oh crap, those guys did it. Now we got to do it.

Meb:

So to date, have you guys done more fund to ETF conversions or is it more separate account to ETF conversions?

Bob:

Roughly a third have been mutual fund into ETF, private funds into ETFs, and separate accounts into ETFs and uptake and forth family offices into ETFs. I’ll share a quick little story about a family office. It was a family office that had a really clever idea around 1980. They decided a company called Berkshire Hathaway and a guy named Warren Buffett were really good at this so long before he was as famous as he is now, they went down, and this was a family office that had wealth at the top generation, but the younger generations were school teachers, firemen, ordinary people. You ended up, thanks to Berkshire Hathaway, appreciating like crazy, turning a lot of these sort of ordinary middle class people into millionaires, multimillionaires and so forth, but they had a portfolio that was heavy on Berkshire Hathaway and had the problem that how could we diversify if for example Warren Buffet passes away and Berkshire Hathaway isn’t the cash cow that it has been.

We took that family office’s portfolio and took a lot of analysis of those 25% and 50% tests that we did and we turned it into an ETF and now everybody’s pretty happy. And now if you don’t mind me continuing and I’m going to channel my inner Stephen A. Smith and take a really hot take here. You mentioned that maybe this obliterates the exchange fund business. I’m actually going to go a step further and say that this makes more sense than just about any other existing structure. I think that because of this ability to do diversification effectively, it’s better than an ordinary mutual fund because ordinary mutual funds can do this, but the logistics are a killer. Private funds can’t do these in kind redemptions, generally speaking. SMAs can’t do it. Family offices can’t do it. And it’s funny, Wes and I brainstorm all the time about how we can proselytize this, but I’m thinking about writing an article that might be why aren’t you in an ETF? Because everything else has a disadvantage and an ETF doesn’t have a corresponding disadvantage.

Meb:

There was a couple of things I was thinking about as you’re talking. Family offices tend to be pretty independent and forward thinking. The ones they’re concerned about their portfolio and that’s about it. They’re not really managing for the most part other people’s money and all the various interests involved in that. I’m not surprised you’re seeing a lot of those. I’m not surprised you’re seeing a lot of mutual fund ones. On the separate account, RIA side, as you guys do more and more, it becomes that country club mentality where someone sees a big name to it and they’re like, oh, they’ve blessed it, maybe I need to look into this.

You guys mentioned the one thing that a bunch are nervous about is, hey, I launched this. I roll up 5,000 of my clients into it now they just have an ETF. What am I here for? They can sell it and maybe assets are going to go down and assets come out. On the flip side, there’s the opposite scenario where, hey, I launched this ETF, oh, now it’s in the marketplace. People may like the idea and assets may come in. So I feel like that’s exposed to an entire audience that may not know about the strategy and it may go from a hundred million or billion to a billion or 10 billion so that there’s both sides to that.

Wes:

That’s always a conversation. What about the stickiness of the assets? And I say, you ever heard of this thing called Vanguard and iShares? Get used to having a value prop and playing in a competitive game ’cause if you don’t have a value prop, the money’s leaving anyways. And so what does that mean? Okay. You launch this ETF. They’re now in an ETF. Yes. It’s technically less sticky than an SMA because you could just sell it in your Schwab account, but in particular if you do a 351 and you bring in low basis, it’s not like you’re going to want to sell the ETF because you have to pay the taxes.

So you already have the tax basis issue that keeps it real sticky. And then the other thing is this is a good thing. Now you’ve separated, hey, there’s an investment thing I deliver and then there’s the tax, the planning, the CFP business I deliver. We can now transparently, as a client identify what I pay for what service and that might suck, but if you’re in the business of being competitive, being transparent, and getting with the program of the 21st century in asset management, you have to do this anyways. You don’t have to but you’ll just die because there’s other people that will. So I just say, hey, long game, this is just required and have a value prop.

Meb:

And also if you think about it, if you’re an RIA and we used to do this where you have a separate account business with various strategies and dozens or hundreds or thousands of clients and you got to do block trades and it’s just an absolute nightmare. People are calling and asking about things. So not only does that, it simplifies your life to focus on the value add things you should be doing in the first place, which is whether it’s insurance or trusts or behavioral coaching and handholding or concierge offerings, whatever, the wealth management taxes, obviously this is a part of it.

I would love to hear from both of you guys. You’ve done a bunch of these already. Feel free to talk about any conversations, pros and cons of things that people ask you, that come up, how much does this cost? Why shouldn’t I do this? Who is this? I’m sure there’s a hundred million dollar, billion dollar RIAs is listening to this saying this sounds actually awesome. I’ve never heard of this before. I’m interested. Who is it not right for? And talk just about some of the considerations of having done this a bunch to where maybe you have some war stories too about ones that may not work.

Wes:

I’ll give you a few off. The top specific with respect to family offices and private folks is you’re in our fun business of being regulated to no end. You’re going to create a registered fund with the SEC, which means you just signed up for the biggest compliance regulatory burden that the world could ever invent, which means everything’s transparent. Everything in your life is now monitored and there’s third parties everywhere and some people are just not up for signing up for that party, especially family offices ’cause this is now bringing everything into the light and that’s just sometimes even the tax benefit’s not worth the brain damage. That’s a big one for private people.

Meb:

And also if you have a garbage strategy, all of a sudden it’s out there. Even if it’s not a garbage strategy, if you have a strategy, one of the things about separate accounts is you don’t have to publish gifts performance. You can just be like, here’s your account. People don’t even know if the exact returns per year. Now you can go to Morningstar and be like, wait a minute, we were only up 10% and the S&P was up 15.

Wes:

SMAs are like private equity mini. They can hide performance in what you’re doing. Where the ETF is you cannot hide because every second of the day someone is telling you what they think your stuff is worth. You’ve definitely got to manage around behavior, but the good news again is taxes enforce good behavior. You probably deal with a bunch of real estate people all the time. They hate taxes more than they like making money, I found and I’m like how did this guy get so rich? The guy hate taxes.

So all they do is even though they may not like this real estate, they may not like this or that they hate paying the taxes worse than making a bad behavioral decision. So sometimes just the fact that I got to pay taxes is going to be like I’m not going to transact or do anything, which actually weirdly enforces good behavior because you just own the ETF forever to let it compound tax deferred even though you want to sell this thing and buy this thing because you’re usually an idiot when you’re watching CNBC. So it corrects itself via the tax wrapper. It forces good behavior at least for those who are in a taxable situation.

Bob:

I’ll come at this from a slightly different perspective and I’ll use the deal we’re closing today as a case study, and this is going to sound a little bit like hyperbole, but I probably got a phone call a day for about four months with the client asking a specific question about a specific investor’s situation. And there were, over four months, 120 different questions. Some of them had to do with esoteric one-off things like there was a customer who had Indian securities that were only traded on the Indian Stock Exchange. And it turns out in that case there’s not an easy solution around that. We just pulled them out of the portfolio. There were other situations such as a complicated situation in which person one was the beneficiary of a trust set up by his father, also had a joint marital account, also had a personal account, and then applying these 25 and 50% tests turns out to be, well, are those three different accounts or are they one account? And how do you deal with the fact that at least one of them, the spouse has an interest in the account?

So we handled that. We’ve dealt with just about every sort of weird asset and or weird investor situation that’s come along. And in addition to the one that we’re talking about today, all told, I’m counting just myself, I’m not just ETF Architect plus other clients. We’ve done about 55 or 60 of these. I don’t want to be arrogant and say we’ve seen everything that could possibly go wrong, but we’ve seen enough that we have a way of figuring out if there’s a bump in the road, how do we deal with it? And how do we avoid any sort of unexpected thing? Because ultimately this is a business about trust and you got to make sure that the ultimate client who is really the investor, not the RIA or not the private fund manager, that the investor has faith in the RIA or the private fund manager who has faith in Wes, who has faith in me that everything is going to go smoothly, no hiccups. And in particular Wes’ team has people that sweat the details like crazy. That conscientiousness really makes a big difference.

Meb:

I imagine there’s people, I’m just thinking in my head, Ken Fisher, $250 billion RIA because the ones that are particularly investment focused, it seems like a perfect structure. The ones that are a little more bespoke family planning, particularly on the smaller side, maybe not as much, but I’m going to give you guys a lead. You ready? There’s this guy in Omaha. He’s got, what is it, a 200 billion plus portfolio. The big problem is it’s pretty concentrated. So one stock is the majority of the portfolio and that’s Apple. Theoretically, could Warren Buffet transition his portfolio to an ETF? Now he’s not, to my knowledge, registered investment advisor. It’s a corporation but is it at least theoretically possible?

Bob:

I love the question and I’m going to jump on it. A corporation as a transferor, particularly a so-called C corporation, presents a bunch of tax issues and distilled to its essence it’s almost always going to be a no. Because a corporate transferor presents the obvious problem. You don’t want to achieve this get out of jail free card in a situation where ultimately, even though Berkshire Hathaway is managed in a way that is very tax efficient given its overarching structure, you can’t very easily do it with a corporation as they transfer or due to some technical tax reasons.

Meb:

But I didn’t hear it’s a no. So if anyone could figure it out, it’d be Uncle Warren. Well, I said it’d be his best trade ever. This idea of potential tax savings is monumental. Do you guys have some research we could point to on how dramatic and important this is versus just continuing to chug along in a separate account or mutual fund or family office, et cetera?

Bob:

So I wrote an article for Wes’ blog maybe six months or so ago. It’s not particularly long, six or seven pages or so. Wes could probably supply the [inaudible 00:24:49] a little bit more smoothly than I could. But it goes through that and with all of us, we want to do it like what you see is what you get. There’s requirements. There are technical things that you have to master, but the end result is in most cases this is a really good thing.

Wes:

It’s really hard to quantify as you know, Meb, because it’s so contingent on how long you hold it, how often you trade, all these other things. I guess the best piece of research to point to is Robert Arnott and his team at research affiliates have that article comparing on average across all active funds, what’s the average net present value annually of the benefit of just the tax wrapper? And I think it’s in the 70, 80 bips a year type thing. You don’t have to do a lot of math, but if you compound at 70, 80 bips in addition to the benchmark over 20, 30 years, that’s the difference between millionaires and billionaires. And then there’s also the tax deductibility of the fee within a 40 Act structure. So most of the time when you pay an advisory fee, unless you got crazy structuring, which some rich people do, it’s non-deductible. So if you charge me 1%, I got to pay that with after tax money.

That sucks. Whereas an ETF, if I’m doing the same thing, the ETF only has to distribute the net dividends and income. So instead of paying out 2% income because I’m charging 1% fee, I only have to distribute 1% income. I’ve implicitly made the fee tax deductible, depends on the mix of whatever you’re distributing. That could be a 20, 30% savings just on the fee without even doing anything. And again, maybe that’s 20, 30 bips, but 10 bips there, 20 bips there start to add up, especially in a compounding sense. But again, going on the other extreme, if you come to us and say, hey, I’m running an S&P 500 Fund that never trades or changes stocks ever, the marginal benefit of the ETF tax mechanisms are basically worth zero because you’re not trading or transacting. You’re buying, holding forever anyways. So obviously a passive index is not that big, but if you’re doing any level of turnover, active management, the benefits start to get crazy. You get a compound on the money you didn’t send to the government and then you only pay it 20, 30 years from now.

Meb:

So is this equities only or could it theoretically also involve ETFs, fixed income?

Bob:

The asset has to be a security. So we couldn’t, for example, do this with dirt law, real property interest. We can’t do this with collectibles or other things like that. But as long as it’s security, I did one that was primarily debt instruments and we’ve done a couple that have involved, for example, esoteric things like South American equities and other kind of strategies like that. So there’s a pretty wide range of strategies that make sense as long as there’s things that you can imagine are someplace covered in, I’ll call it, like the Morningstar universe, that there would be a bond fund. There’s trillion bond funds out there. There aren’t that many collectible funds or other kind of things like that. One cool thing that we did recently, and Wes you may have a better handle on whether this is fully closed or just about to close, we were one of the first to launch a Bitcoin fund and I think that closed a week or so ago, but it’s got the chance to sort of do an asset class that hadn’t been done before.

Meb:

Can you explain that it’s a Bitcoin fund that owns what securities or is it owned actual spot Bitcoin or futures or what?

Bob:

I’m going to try to keep this simple ’cause I don’t want to get too deeply into the weeds. What we typically do is the ETF creates a Cayman subsidiary that represents 25% of the total portfolio and then the Cayman subsidiary can in fact own actual Bitcoin or Bitcoin futures or Bitcoin derivatives and things. But typically you put an awful lot of Bitcoin itself into the subsidiary. But because the subsidiary is treated as a corporation, it’s then treated when the ETF owns it as owning a corporation, of this case, a foreign corporation. So you get direct exposure through the Cayman subsidiary.

Then with respect to the other 75% of the portfolio, generally what you do is use the mix of cash and derivatives to mimic the exposure of Bitcoin or it can be other cyber currencies. There’s a chance to do things. In that instance, we did not do a section 351 transfer. I think that will eventually come, but the logistics of handling custodians, taking things from somebody’s wallet and holding Bitcoin into the fund and keeping everything straight and keeping things like holding periods and tax basis correct, if we have a podcast like this a year from now, two years from now, I wouldn’t be surprised if we’re one of the first to do that. And I think it is doable, but it is a challenge that’s a little bit more than an ordinary challenge.

Wes:

I got an idea, a live idea that I’m sure listeners on here would be very interested. There’s this thing called Grayscale Bitcoin trust that charges 10 x more than the other funds, but they got you stuck because of tax liability. So how the heck do we 351 and what’s the limitations of dumping all that and a 351…

Meb:

Go from an ATF to an ETF?

Wes:

Yeah. But with one tenth the fee, there’s probably a limitation. Right? So you could contribute 2499 in Grayscale trust plus a diversified portfolio of other stuff. But I know there’s a lot of people that are in that predicament. They got billions upon billions of dollars stuck in Grayscale Bitcoin trust and they’re like, I would love to buy the iShares one for 20 bips, but I’m stuck because I don’t want to pay the taxes to get out of the damned thing.

Bob:

So let’s just tease the episode six months from now when we figure that one out and we close it.

Wes:

Got it. But it’s open invite to anyone out there who’s got this problem, reach out, let’s try to solve it. There’s probably a solution.

Meb:

There’s a potential upside in current events for you guys because you guys got all sorts of different partners on the ETF side, I see names people will recognize like ARC and other names like Bridgeway who is a podcast alum, a really awesome shop, but also I see Strive. You guys potentially could have had the president of the country as the owner of one of your ETF partners. Are you glad he dropped out of the race?

Wes:

Yeah. As I discussed, Vivek is an amazing character regardless of your politics. I vouch for the guy personally. The problem in a personal selfish interest as we were discussing is he was the best salesman of all time for Strive funds. But obviously once you get the conflict of interest, you have to get separated from your business. That’s great if he wants to go fix the country. That’s obviously more important than helping us grow a better ETF company. So I’m conflicted here to be frank. I don’t want him to lose, but if he loses and comes back and runs Strive and goes on Fox News every night, I’m a fan.

Bob:

You and your viewers probably know him mostly through TV and other sort of public persona things and I don’t know him inside and out, but I have had the opportunity to meet him in person and he really is full of charisma. He’s got ideas flowing. If you had the chance to spend three hours at dinner with him, not talking about politics, not talking about economics, talking about British literature or the greatest comic book of all time, you name it, he’d have an interesting take on it and it’d just be fun to hang out with him.

Meb:

So you guys got a lot of pretty interesting esoteric funds. Are there any in particular that come to mind that you think are interesting, not case studies, but you want to talk about or talk about the process or stories from converting them that might’ve either been interesting or painful? As people marinate on this episode and think about moving some stuff to the structure, is there any stories that come to mind? How many do you guys have? I’m scrolling on its ETFArchitect.com. There must be 50 at this point.

Wes:

I think we’re 49 officially right now, but he’s saying it’s every week we launch our fund it seems. So Bob’s going to have way more interesting stories because obviously on our platform, because the whole function here is how do we Vanguard-ize this stuff? We need people to fit in a box, not do anything crazy, and be focused on something. So all the deals we’ve done are generally, it’s the same situation. Hey, I got low basis and a bunch of equities. I’d like to get rid of this stuff someday. Can we somehow move it into an ETF, get in the business of the ETF, and move on in life? So they’re all not boring, but it’s not general US equity portfolios are not that exciting. I’m sure Bob has way more exciting stories of conversions.

Meb:

Let me interject one question real quick. How often do you guys have these conversations? And the inquiry is maybe the RIA or investment advisor reaching out, but how often is it where they’re like, I have this client. He listened to Meb’s show or he heard this from you guys to where he said, look, I have this highly appreciated portfolio. If I sell, I’m going to get murdered. Why don’t you think about converting? The show gets a fair amount of individual listeners that I imagine after this drops, are going to pick up their phone, email their advisor, and be like, hey, this could save me millions and millions of dollars. Can you please convert my account to an ETF? Does that happen or is it mainly at this point too we are an esoteric?

Wes:

Let me give you the hit list because we do a lot of screening because people get ideas and they don’t actually listen to the podcast as much as they probably should. So there’s three no-go criteria. There’s a bunch more. But the big one, I get the call, hey, I heard you guys can deal with single stock issues. I got a bunch of Tesla, can I turn an S&P 500? No. Can’t do that.

Meb:

Could they theoretically, by the way, I was going to ask you this question earlier. Let’s say your account is 70% Tesla and then 50 other stocks. Could you only convert the amount to where Tesla is 25% in the other stocks?

Wes:

Yeah.

Meb:

I mean that’s still better than nothing.

Wes:

It can solve part of your problem, but most people are hoping for a pipe dream. They’re like, God, I just want to get rid of my a hundred mil Tesla stock. I don’t really have any other wealth, my IRA with 50 grand or something. So you can’t do that. The other thing is, oh, I don’t want to deal with all this regulation and I don’t want to be transparent. I’m like, no, that ain’t going to work either. And then the third thing is, oh man, I’m really good at stock pick and I’ve been running this prop trading strategy and I’m like, dude, it’s an ETF. It’s not a prop trading instrument.

Meb:

Meaning they’re super active.

Wes:

They want to do 10 trades intraday. And I’m like, you understand that in order to facilitate customer rebalances, I need a 24 hour trade cycle, bro. And so no day trading. Yes, you got to get regulated. Yes, you got to be compliant. And, no, I can’t diversify your single stock position in Tesla. But outside of that, which is 90% of inquiries, of like how do you give me a magic secret sauce without doing anything, we’re open for business. Go for it, Bob.

Bob:

Well, I have fourth criteria, which more or less answers a question that you had had, Meb, a moment ago. You also need a certain size and ETF is not economically viable unless you’ve got X number of millions, and Wes would probably have a better idea about what that is. But obviously if somebody comes to you with, oh, I’ve got this idea and it’ll be 5 million AUM, just have to say, it’s not going to be economically viable for you. But I will double back to a question you were starting to ask, Meb. Could an individual investor do this? And could we end up having an ETF that is owned by, let’s just say, one or two people? And I did one, and it required a fairly substantial amount of wealth for obvious reasons. But I did one which was essentially a family.

It was primarily the patriarch of the family, and then there were two other members of the family and combined, they had round numbers, $50 million of personal wealth that was in fact diversified and they created an ETF simply to take advantage of that tax advantage diversification strategy that I talked about at the very beginning. But it was three people and they decided they really had no interest in marketing this. They didn’t want to grow this to other people. They actually wanted to try to keep this on the down low as much as they could. I said, obviously the SEC is going to be aware of you. People can Google you. They can find out about you. Given that you’re on a platform, you may have buy orders coming in, but they wanted to do it on the down low. But again, if you have an individual investor or perhaps a group of individual investors that can get to the magic number that gets us to an economically viable size for the fund, you can definitely do almost, I’ll call it, bespoke ETF, for just your family. And it works pretty well that way.

Wes:

Just to add a little bit to that, and Bob failed to mention this, but in all those situations, we always convince them that there’s also a business case here. Why wouldn’t you do the basics? There’s obviously a tax motivation here, but there’s clearly a business case. And so you definitely want to at least consider that and put some minimal efforts in there because if anyone buys your ETF, because anyone with a Schwab account can click the button, you make free money. Right? Because they’re going to pay your management fee. And the marginal cost production is pretty low. So in every single deal we’ve done in every single deal that Bob’s done, in the end, even at the family office, more individual ETF, they get convinced of the business case to do it as well. And everyone’s like, oh yeah, at least we’ll have a fact sheet. We’ll have a website. We don’t have to have wholesalers. This makes sense to least hold ourselves out there a little bit because who knows what’ll show up.

Bob:

There’s another nice thing that has developed, which is that I have not had anybody, again, like I said, I think I’ve done about 55 of these. No one has had any meaningful regrets. And actually quite the opposite. A lot of the clients who have done this are proselytizing on our behalf. I get calls, I got one actually literally about an hour before this podcast began saying, so-and-so told me about what you did on an ETF. We’d like to do exactly the same thing. And as a law firm, we do a little bit of marketing, but we don’t do a lot of marketing.

We certainly don’t move marketing like we are the grand poobah of Section 351. But the word of mouth becomes so powerful because all 55 of these managers who have done it are out there saying, I would do it again. And if he’s talking to a colleague, they’re calling us or they’re calling Wes and they’re raring to go. So it’s been a lot of satisfied customers, and again, it’s a testament to Wes and his team. They sweat the details. They make sure everything takes place effectively at a logistics level.

Meb:

Where are you guys in total assets now?

Wes:

So as of today, it’s going to be around 7 billion. And then Alpha Architect obviously has its own asset base, but just on the ETF Architect is seven bil. And honestly, I would not be surprised if it’s potentially double that by the end of the year.

Meb:

I had a tweet, here it is. Four or five years ago, I said, mark my words, I think these guys will be a 10 billion shop in the next five to 10 years. And you guys were probably like, I don’t even know, a hundred million at that point. January 31st, 2019, so exactly five years ago.

Wes:

We were probably five, 600 mil.

Meb:

2019?

Wes:

We had a run before value totally blew up. Actually, we actually hit a billion in 2017. I thought I was going to be rich and then the value just (beep) the bed, and then I went back to being broke.

Meb:

Don’t jinx it. So I said within five, 10 years. So, you’re just a couple billi away at this point.

Wes:

We’ll get there. Give me the end of this year.

Meb:

Another idea that I was thinking of, Tony Robbins has a new book coming out and not to sideways this conversation because the topic is the holy grail of investing.

Wes:

Private equity? Yeah. I was like, oh God.

Meb:

Yeah. I was going to make you guess what the holy grail was, but it turns out its private equity, which God bless you, Tony. I think you do a lot of good for the world, but if this doesn’t mark the top of private equity, I don’t know what will. But anyway, he put out his first book on money, which was 2014, and he was promoting this portfolio. It was kind of risk [inaudible 00:40:55], totally reasonable ETF portfolio. But the way that he recommended it was that you go through an advisor for 75 basis point fee.

And I said, why wouldn’t you just do an ETF and charge, he doesn’t need the money, 10 basis points and then you could donate all your fees to Feeding America, which is one of the big charity he supports. And you give people a low cost, tax efficient way better than in a separate account. And he’d responded to me, he said, I gave you the Dalio portfolio in the books. You could do it for yourself, if you want to. Work with a fiduciary, if you want more options. And I was like, no, you missed the point. The ETF structure is more tax efficient than both, much cheaper than the advisor. So here we are almost, I guess, that is a decade later. You should ring up Tony.

Wes:

Dude, you literally wrote the best book of all time with Eric. The Ivy Portfolio outlined this pitch, I don’t even know, 15 years ago, but you spelled this out in a book 15 years ago. I don’t know why people don’t read the book and just say, let’s do this.

Meb:

Gentlemen, it was a blessing. Where do we find more information? What’s the best place to go? All right. If you’re an advisor, individual, and you want to contact Bob and Wes about starting a fund or you’re just curious about buying their funds, what’s the best places?

Wes:

So ETF Architect for shovel selling and Bob’s great tax advice. And then if you want to talk about geeky factor stuff AlphaArchitect.com.

Meb:

Do you have an email or is there a place that goes?

Wes:

Unfortunately, I’ll give it to you, but I get a million spam emails a day, Wes@YouKnowWhat.com. Please avoid spamming me more than I already to get spammed, if you can afford it.

Meb:

Be thoughtful, listeners. Bob and Wes, thanks so much for joining us today.

Bob:

Thank you so much. Bye, everybody.

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 feedback@theMebFaberShow.com. 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.

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