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Tuesday, September 9, 2014

"Slippage The Hidden Costs of Managed ETF Porftolios

Among the costs of actively managed mutual funds often cited by critics such as John Bogle is the hidden cost of “market impact”. Market impact is the change in market price created when a large mutual fund decides to liquidate or initiate a position in a particular stock. Depending on the size of the trade and the particular stock the active fund manager can find that as he buys (sells) stock he pushes the price up (down) increasing the impact on the funds returns.

Portfolios made up of ETFs were thought to alleviate this problem. Trades were to be infrequent and when the trades were exercised in relatively small amounts by individual investors the impact would be small. However the growth of large “managed ETF programs” and “robo advisors” may mean that the “slippage factor” may have returned through these programs reducing the returns for investors in these programs.

Managed ETF programs have grown tremendously over recent years as brokers and investment advisors “outsource” the management of ETF portfolios to large managers. The strategies and frequency of the trading varies. But observers have already noted that the large trades can have significant impact on market prices. The impact can be further aggravated because some of these managers both manage accounts directly and issue “buy and sell alerts” which individual advisors and large brokerage firms implement on their own. Thus not only are there trades directly from the advisor entering the market but trades from other sources making the same buy/sells as well. The result when the orders hit the market is that the trades can move the market creating the same ‘slippage” as active stock manager’s experience. For the client that means an unseen cost.

An article by Matt Hougan in  focuses on the large flow created by some of these managers although it doesn’t specifically reference the slippage article. He writes that through use of the fund flow data on the website it is possible to isolate ETF activity that generates one time large trade flows and those that represent a trend in flows in and out of an asset class. He notes that often there are large flows in a particular ETF even though similar flows may not be present in other ETFs in an asset class.

He offers the example of large one day flows in three US treasury etfs, His explanation:
The fact that all those flows occurred on one day suggests that a single large investor made these decisions, as opposed to "investors" in general. In fact, we can probably even guess which investor made these bets: Good Harbor Financial.
Good Harbor is a large, well-run ETF strategist firm with $10 billion invested in quant-driven ETF strategies. It rebalances its portfolios twice a month—once on the 15th and once at the end of the month—which coincides perfectly with the timing of these flows (due to settlement delays, fund flows don't always appear the day an investor buys a fund).
What we're seeing in the flows for IEF, SHY and IEI is Good Harbor getting nervous, not the market in general. That's a worthwhile signal—Good Harbor has a great track record—but it's just one opinion. And in fact, a quick glance at this morning's preliminary flows numbers suggest big outflows in both SHY and IEI, two of the Good Harbor targets in question.

I have no idea whether Good Harbor is a well-run strategist with a good track record or not. I do know that by looking at the flows from their trades and the market behavior on those days it is clear that their trading has a market impact. It also seems quite possible that if an analyst like Mr. Hougan knows the dates of the rebalancing then so do some market participants who may try to profit from that information to the detriment of Good Harbor. The examples in his articels  are from Etfs in US Treasuries which have large numbers of assets, large daily volume, and good liquidity, yet the trades by this one manager clearly have impact on the market in those ETFs. It would only be reasonable to assume such impact would be even greater in the case of other less liquid ETFs.

 The charts of the one month flows from are below. Below each graph I have put a price/volume graph (2 months) of the same ETF. In all three cases there was an increase in the day’s trading indicator of market volatility—relative to other trading days. In fact there are other large trading range days that also occur on the 1st and 15th of the month the rebalancing dates for Good Harbor.

Here's the chart for IEF in August fund flows for August and below it price/volume for July and August

And here is the same data for SHY

And here for IEI

Good Harbor is only one of a number of large managed ETF portfolio managers. Many market participants have noted that their trades can have significant intraday market impact which may be a drag on returns. As the assets under management of these managers grows the impact is likely to increase. Furthermore there is a rapid growth in robadvisors internet based portfolio management with allocations that are rebalanced at fixed dates. As these grow there is more potential for increasing the number of large trades that create volatility and perhaps distort prices for brief periods

What are the implications for individual investors? That is the subject of my next blog on the subject.

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