[fairestvalue]

Ummm, have y'all thought about spread costs?

If you look at the spread of any of these ETF's mentioned (spread = ask px - bid px), you will notice that the spread is much smaller than if you were to sum up the spreads of each component stock.

That's possible because of a mature ecosystem of ETF market makers and arbitrageurs (like Jane Street).

If you buy all of the stocks individually, as it sounds like y'all's solution does, you will pay the spread cost for every. single. stock. The magnitude of these costs are not huge, but if we're comparing them against VOO's 17 bps/yr expense ratio, it's worth quantifying them.

I imagine eventually you can hope that market makers will be able to quote a tight spread on whatever the basket of stocks a client wants, but in the meantime, users would be bleeding money to these costs.

(Source: I work in market making and think about spreads more than I would like to admit.)

[ikourtid]

Also former HFT / market maker here (UBS, GETCO), and also the developer who wrote Wealthfront's direct indexing with tax loss harvesting 10 years ago.

I had that same skepticism before I built it. Using a Bloomberg terminal back then, my conclusion was that the weighted spread for the S&P 500 was 3.2 bps, vs. 0.6 bps for SPY.And this was > 10 years ago, so I'd think by now it would be even tigher. The ratio may have changed, but who cares? It's like saying that rice got more expensive at the supermarket - it's already so cheap that it doesn't matter.

With tax loss harvesting specifically, each order typically has a threshold, so that you only trade when the projected tax benefit is a large multiple of the transaction cost.

Also, I'm sure this is obvious to you if you work in market making, but for others reading this: the spread costs aren't additive (re: 'every. single. stock'). If you have 500 stocks, each with 2 bps round-trip spread cost, but each is at e.g. 1 / 500 = 20 bps, then the weighted spread for the entire basket is 2 * 500 * 1 / 500 = 2 bps. It's not 2 * 500 = 1000 bps. The main question then is - how much tighter are spreads for ETFs than for the average stock? And, since bigger stocks (AAPL, NVDA etc.) will have tighter spreads than smaller index constituents, the weighted average will be even lower.

Here's my blog post:

https://eng.wealthfront.com/2014/03/04/marketside-chats-4-co...

[ikourtid]

Follow-up to my (most upvoted, it seems) post.

ETF expense ratios are only the headline cost. There's also a hidden cost you never see.

An index (and, therefore, any fund that tracks it) has a methodology that results in additions/deletions/index changes being announced to the market ahead of time. Usually that's quarterly, but also sometimes annually.

For an index addition announcement, you can imagine that the price will go up beforehand, since market participants (all except the actual ETF) will buy the stock in anticipation of the extra demand of that stock being in a widely held index. [This is actually more complex, and doesn't always work in that direction, but that's beyond the scope of this comment].

Now, the ETF doesn't care about this. They get graded on how closely they track the index. So they will buy the index addition on the closing auction of the day of the index reconstitution. Sure, they'll get a worse price (on average) than if they had bought 2 weeks ago, but who cares? They don't, and their clients don't (partly because they don't know).

This effect is even more pronounced in certain indexes where this dislocation would be larger, e.g. those with more turnover, infrequent rebalances, etc.

Just drop "what is the drag on returns due to index reconstitution in the Russell 1000 index?" in ChatGPT. Admittedly that's one of the worst offenders, and this is not scientific, but ChatGPT says 0.2% to 0.3% annually. That's already more than the 0.17% average mentioned in the original posting.

[Source: I worked on the trading floor in the program trading desk of a bulge bracket bank that actively traded these index reconstitutions.]

[jjmaxwell4]

Yes we've thought about them a fair bit.

We believe that in most ETFs right now the transaction costs are largely factored into either the expense ratio or the ETF bid-ask spread, exactly due to the redemption mechanism you discussed. See section titled Spread of the Underlying Securities in an ETF Basket in the following PDF and the following quote:

"If a market maker has to obtain a portion of the ETF constituents on the secondary market to then deliver into the fund as part of the basket process, the cost of acquiring those names should be reflected in the ETFs bid/ask spread — as costs are traditionally passed through to the end customer."

https://www.ssga.com/library-content/pdfs/etf/au/spdr-au-etf...

Also we take estimated spread costs into account when running our portfolio optimization. A higher bid-ask spread as measured by past 1 month NBBO p50 spread generally gets penalized in our portfolio optimization all else being equal, although this depends slightly on what optimization setting you've chosen on Double.

[fairestvalue]

Except, in practice (not "traditionally"), the cost of a sophisticated market maker to acquire these constituents is usually much less than if you or I were to trade on the market in our brokerage account. SPY's spread is only 2 pennies wide (3 bps), for example.

[westurner]

I just found this while researching for my other comment in this thread; re: "Fund of Funds Investment Agreements",

Would Rule 12d1-4 (2020) apply to holding funds versus holding individual stocks and/or ETFs? What about the 75-5-10 rule for mutual funds?

From https://www.klgates.com/SEC-Adopts-New-Rule-12d1-4-Overhauli... :

> Rule 12d1-4 will prohibit an acquiring fund and its “advisory group” from controlling, individually or in the aggregate, an acquired fund, except for an acquiring fund: (1) in the same fund group as the acquired fund; or (2) with a sub-adviser that also acts as adviser to the acquired fund. [4] Rule 12d1-4 requires an acquiring fund to aggregate its investment in an acquired fund with the investment of the acquiring fund’s advisory group to assess control

[i-cjw]

Surprised to see so many current and ex HFT/MM folks in the comments yet no mention of the fact that you don't have to cross spread to get filled. If you're lifting the far touch 100% of the time then, sure, you're going to pay the full spread - but no-one with half a brain cell does that. Unless you really think you have intraday alpha in the name (and in this case they most certainly do not) then you'll camp out on the near side or down the book and cross much less than half the time. Add into that the liquidity rebates and life just got a whole lot cheaper.

[dlubarov]

Wouldn't fees generally be more significant if holding over a significant time period? Like VOO's 17 bps would mean ~2% over 30 years. Not sure what the weighted average spread of broad index funds looks like, but I would have thought it's far lower.

I guess rebalancing also creates an ongoing spread-based cost, but it seems like that should be far more minor, at least for broad index funds with low-single-digit turnover.

[darkerside]

There's also time value of money. Paying upfront like this means that money can't be invested (by you), and you lose out on the money plus the return.

[dlubarov]

Wouldn't that be for fixed-dollar fees? I think here all the costs we're talking about are percentages.

I.e. ignoring taxes, the amount I theoretically expect to exit with should look like

    entry_cost * (return_rate * fee_rate)^T * exit_cost

Where return_rate might look like ~1.1, fee_rate might look like 0.9983 (17 bps), and entry_cost and exit_cost might look like half_spread/price (under some assumptions...).

So I think this comes down to whether T is large enough for that exponentiation to dominate the half-spreads.

[late2part]

What value does "Ummm" provide in your response?

[igor47]

It's an incasualator. It causes the response to read as more casual/conversational, and less pedantic. But I guess you wouldn't know anything about that ;-P

[ada1981]

I’d like an answer to this question as well.

[ada1981]

Can someone honestly explain the downvotes for agreeing with a commenter that I’d like to understand how they handle the spread issue?

[munk-a]

Likely due to the guidelines[1]

> Comments should get more thoughtful and substantive, not less, as a topic gets more divisive.

your comment didn't add anything of value to the thread. Upvoting will cause the thread to float higher in the overall discussion and increase the visibility (and thus chance of a response).

Just as a note - your reply comment and even this comment itself is also against guidelines due to being a comment on the comment system and off-topic for the article - but I wanted to make sure you were familiar with the system.

1. https://news.ycombinator.com/newsguidelines.html

[ada1981]

I appreciate that.

The parent had skipped over responding and I wanted to voice that I too would be curious to know the answer.

Are you saying the best and only option is upvoting?