'Poor execution strategies' cost ETFs $1.7bn in rebalancing costs

James Baxter-Derrington
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'Poor execution strategies' cost ETFs $1.7bn in rebalancing costs

Predictable rebalancing strategies that can be front run by informed traders are costing ETFs $1.7bn, an issue that can be tempered with "not-so-complex execution strategies".

According to academic research by Sida Li, ‘sunshine ETFs', those which make no attempt to hide either when or what they trade, pay 67 basis points in execution costs, compared with those that mask either the trading dates or targets, which pay 33-37bps per trade.

For a $2m retirement account that accrues over the course of 30 years, these inefficiencies would cost the individual $29,000 at the point of retirement.

The research analysed US ETFs tracking US equity indices and found that a majority of these (56%) fall under the sunshine banner, which allows traders to take advantage of the trades which are "large, abrupt, not driven by information advantages and fully predictable".

These sunshine funds follow mechanical strategies, revealing the tickers and trading dates well in advance, and always complete their trades at 4pm on the index reconstitution date.

If they were to camouflage when they trade by spreading the window for rebalancing and only reporting monthly holdings, as per ‘opaque ETFs', these funds could achieve savings of 34bps per trade, which would translate to outperformance of 7.3bps per year.

Another option is to mask precisely what is being traded, a tactic many funds utilise through tracking in-house indices, such as the Schwab 1000, as opposed to publicly available indices, such as the S&P 500.

This method would enable funds to save 30bps per trade, which translates to a 9.6bps annual rebalance cost saving.

Despite this, the majority of managers may not adjust their strategies and will continue operating sunshine funds as this method produces the slimmest tracking errors.

Li said: "ETF managers might be concerned that a high rate of tracking errors could falsely signal poor management skills, therefore negatively affecting fund flows.

"ETF managers might therefore be inclined to follow index changes mechanically at any cost."

Li added that the lack of performance related management fees may prevent managers from utilising these strategies, especially when considering a passive ETF manager oversees 6.98 funds on average.

"Even not-so-complex execution strategies, e.g., simply camouflaging either the timing or the underlying stock of a trade, can lead to considerable execution-cost savings for passive investors," Li said.