Why Advisors (and Family Offices) Should Consider Creating their Own ETFs
We believe that the primary benefits of the ETF wrapper (tax efficiency, easy access, and transparency) should be available to a broader set of professional investors and not just the Wall Street behemoths. Our firm mission is aligned with this vision as we seek to lower the barriers of entry to the ETF market. The good news is that we have been working hard to lower the cost of establishing and operating ETFs, thus making the ETF wrapper more accessible to a broader audience of potential users. This piece highlights how non-traditional ETF sponsors, such as registered investment advisors (“RIAs”), family offices, and boutique asset managers, can leverage the ETF wrapper to potentially benefit their clients.
Of course, the biggest challenge non-traditional ETF sponsors face is transitioning their asset base (e.g., managed accounts, LP, or mutual fund) into the ETF structure in a tax-efficient manner. To solve this problem, we have specialized in facilitating tax-free conversions from SMAs, LPs, and mutual funds into ETFs (often referred to as “351 transactions”). You can dig into the weeds of how this works via this post. But here is the bottom line: low-basis assets can be transitioned into the ETF wrapper, tax-free.
I’m an RIA or Family Office. Why Should I Consider Creating or Converting into an ETF?
Let us be clear upfront. Starting an ETF will never be cheap and/or easy (explained below). And in most situations, the complexity and costs will not be realistic for many advisors. However, that does not mean investors should never consider unique solutions to problems. In the end, good advisors — from advisors managing bespoke stock strategies via separately managed accounts (“SMAs”) to financial-planning-focused advisors with simple investments — should have one overarching goal: to help their clients win. Conveniently, the ETF allows one to potentially deliver low-cost, transparent, and tax-efficient investment advice, often leading to better client outcomes.
Here are a set of solutions the ETF can solve for asset owners:
Common problem: Advisor fees are not tax-deductible
The current tax code does not allow the deductibility of financial advisory fees, which means that a 1% fee is a pre-tax expense to the client. E.g., $10,000 is paid on $1mm SMA is $10,000 out the door. (see Kitces piece).
ETF solution: Fees are tax-deductible
Management fees in an ETF can be netted against dividends, interest, and income, implicitly making them tax-deductible. The deduction’s value will range depending on the situation, but at a minimum, the after-tax fee for HNW clients will likely be 25%-30%+ cheaper than an SMA equivalent. E.g., $10,000 might only be $7,000 on an after-tax basis, or a 30% cheaper after-tax fee than the SMA equivalent after-tax fee., $10,000 (1-t) on a $1mm, where t = the blended tax rate on the dividends, interest, and income received in the ETF wrapper.
Common problem: Operational complexity
Some advisors recommend holding several Vanguard funds that rebalance maybe once a decade. Not a lot of complexity in this situation. But for many other advisors, managing client portfolios is an ever-growing complexity. There are software solutions (often expensive) that can minimize these problems, but the devil is always in the details.
ETF solution: Simplify SMA operations
Operational complexity tied to ticker management and rebalancing is outsourced to the ETF operator. The RIA needs to buy/sell a ticker symbol to access its investment approach versus managing buys/sells across many ETFs and/or stock tickers.
ETF operators also liberate resources previously consumed by back-office paperwork. While launching an ETF is expensive, so is managing payroll for traders, client relationship specialists, etc.
Common problem: Tax optimization is challenging
Related to the above, managing taxes across multiple accounts with varying basis situations is exceedingly complex. RIAs have leaned on outsourcing this problem to direct/custom indexing software solutions. Still, many advisors quickly realize that the benefits of direct-indexing programs are short-lived when the tax shields evaporate (or aren’t useful), and the client is stuck with an expensive, highly complex index fund with no flexibility. Yuck.
ETF solution: Leverage the ETF structure to minimize taxable distributions
ETFs have been referred to as a great “tax swindle.” While we think this language is inflammatory, we agree that ETFs have unique tax advantages that benefit the broad investing public. In short, ETFs can achieve substantial deferral benefits, even in the face of substantial turnover in the underlying strategy.
Common problem: Brand building and business development
Building a brand is challenging since advisors are ubiquitous in the landscape, and differentiation is challenging.
ETF solution: Enter the broader marketplace and become part of the conversation
Launching an ETF is akin to having a public IPO. The financial ETF media and ecosystem (e.g., Morningstar, FactSet, and Bloomberg) will integrate you into their daily flow, and you will more easily establish awareness for your brand and credibility.
Common problem: Competitive threats
Vanguard (Schwab and Fidelity are other examples) is not shy about threatening to take out advisors and lower the cost of advice to the marketplace via PAS (Listen to Tim Buckley). Advisors should take note of this threat. Especially those advisors who buy a handful of index-based ETFs and then charge the client 1% for their investment advice and planning services. Advisors must provide a unique value proposition and lower their cost structure to survive the next decade.
ETF solution: Vertical integration
Advisors can create an ETF, which allows them to vertically integrate into the asset management aspect of the business and compete with monopolistic competitors.
Sounds Great…But what are the Downsides of Launching an ETF?
At the outset, we stated that while we are trying to lower barriers to entry on the ETF wrapper, we can’t make it super cheap/easy (at least not for the foreseeable future). The reality is that launching an ETF will probably always be an expensive operation because of the complex web of rules and regulations.
Below we discuss some downsides of launching an ETF (with a particular emphasis on launching an ETF via a 351 tax-free conversion):
ETF startup and ongoing costs:
The most obvious challenge is costs. The typical costs are $50k startup, $175k-$225k+ ongoing fixed costs, and variable costs as you scale the ETF’s assets. Here is a post with more details.
One should only consider an tax-free conversion if you have at least $25mm in hand, and it is preferable to have $50mm or more.
Tax-free conversion complexity:
To convert low-basis securities into an ETF, you can expect additional upfront costs, extensive client communication/education efforts, and compliance with Treasury and SEC hurdles.
Compliance and billing complexity:
When an advisor creates an ETF, they create an affiliated fund conflict of interest. The advisor will need to update their disclosures and implement systems to manage and document that, despite their potential conflict of interest, their decision to use affiliated funds is in the best interest of their clients.
We often recommend that advisors seek to keep their clients “net neutral” on direct costs. For example, if an advisor charged 1% on an SMA, but now that SMA owns an ETF that costs .50%, the advisor would drop the SMA charge to .50%. This would ensure that the client is only paying 1% in fees, but also gaining access to the ETF’s benefits. One can arrange situations where the overall fees to the client are higher. Still, the burden is on the advisor to show that the higher costs are outweighed by higher potential benefits and is, therefore, in the best interest of the client. Of course, all of this requires flexible systems and updates to the billing system.
Culture change management:
We often identify situations where the status quo is incredibly powerful and “shaking things up” will be frowned upon by executive teams who are more concerned with maintaining their current lifestyle and less concerned with the business’s future and/or their client’s outcomes. Adding an ETF can often be a bridge too far for static organizations.
We believe transparency benefits the ETF structure, but sometimes advisors are concerned that too much transparency may conceal a weak value proposition, expose their intellectual property, or lead to poor investor behavior. There is merit to these arguments.
Advisors often note that managed accounts are “sticky” and it is difficult for clients to leave once they have established an SMA. In contrast, an ETF, which is too simple/easy, may lead to clients leaving. On the one hand, this could be true; on the other hand, if an advisor has a weak value proposition, the client will eventually leave that advisor anyway. In addition, because the ETF structure rarely distributes capital gains, taxable investors will be reluctant to sell a low-basis ETF position. This tax-adverse reaction may increase client stickiness and improve client behavior (i.e., force clients to be long-term investors).
The ETF wrapper is not a panacea, but the tax efficiency, easy access, and transparency are powerful benefits to bring to a client. This can be a competitive advantage for an RIA firm facing competition from larger firms. We envision a future where accessing the ETF wrapper is cheaper and more user-friendly for financial professionals. We are on the frontier of building creative solutions to help investors improve their after-tax, after-fee investment outcomes.
Background on our ETF white-label business
Our mission is to lower the barriers of entry into the ETF marketplace. And we are trying to solve the biggest pain points tied to ETF operations: costs, brain damage, and opacity. Our offering seeks to deliver on three key objectives: 1) affordability, 2) turnkey operations, 3) 100% transparency. In addition, we have specialized in tax-free conversions with a specific emphasis on transitioning low-basis assets from managed accounts, limited partnerships, and mutual funds into the ETF structure. You can learn more at our website at https://etfarchitect.com/. Or please get in touch with us if you’d like to learn more.