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So exchange traded fund, what is it? Well, it's basically a mutual fund. It's more or less structured the same way. It's structured under the same rules by the SEC. But an ETF receives certain exemptions from what makes a mutual fund a mutual fund and what makes an ETF an ETF.
Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte. And if you've ever wondered what an ETF is, how it's different from a mutual fund, and why they are so popular, today's episode is for you. Today, I'm joined by Ryan Kurland, ETF expert and head of capital markets for Alpha Architect. Ryan is one of the sharpest individuals I know, and he and his team are my go-to experts for all things ETFs.
I just want to quickly mention one thing before you dive into this conversation. It is absolutely critical that you nail down all the basics of financial planning before you start getting concerned about the complex world of ETS versus mutual funds versus individual stocks and what the absolute best solution might be for you. Make sure that you have a financial plan in place, an emergency savings fund intact, and
All of your retirement accounts are being maxed out for both you and your spouse, and you're on pace to reach your goals. If the basics aren't nailed down, your time and energy is likely better used reducing costs, increasing your earnings, and saving more money instead of trying to find the best investment solution and trying to navigate ETFs versus mutual funds and all this stuff we're talking about today.
To learn more about Ryan and his firm Alpha Architect and access all the resources mentioned in today's episode, head over to youstaywealthy.com forward slash 54. All right, well, let's not waste any time here. I'd like to kick this off with mutual funds versus ETFs. So Ryan, who do you think comes out ahead in the long run and why?
Yeah, I'll give you a quote and I'll give you a quick story too. So I read the book Anti-Fragile by Nassim Taleb. It has this quote in it. It goes, Michelangelo was asked by the Pope about the secret of his genius, particularly how he carved the Statue of David, largely considered the masterpiece of all masterpieces.
His answer was, it's simple. I just remove everything that is not David. So hold that thought. And then now I'm going to give you a little story. So I've been a rower my whole life. I love it. And for those who aren't aware, rowing is a highly technical sport. The boat's about as wide as your hips. And you need to balance that while using every muscle in your body to propel the boat forward as fast as you can.
So you're basically sprinting down a balance beam with a squat bar on your back is kind of what I would compare it to. But because of that, because of the balance needed, there's a big focus on technique in the sport. So you want to be as fit as efficient as possible in your application of power to make sure you're not wasting energy.
At my peak in rowing, I rode on the U.S. team. And when we were working on technique, my coach at the time used to say, we're going to focus on removing the bad parts of your stroke. And if we remove all the bad parts, the only parts that will be left will be the good parts.
So that's the same concept Michelangelo was explaining to the Pope. And that really encapsulates why I think ETFs are going to beat mutual funds in the long run. It's easier to focus on removing things we know are bad than trying to identify things we know are good.
So ETFs have a few advantages over mutual funds that simply remove things that are bad from the mutual fund structure. The largest advantage ETFs have, the biggest one everybody always talks about, just simply ETFs may assist in reducing your taxes. And if you're investing your money or you're managing money for others, typically, I guess you would say the goal is having the largest amount of wealth.
So then taxes are detrimental to that. So if one product helps us removing that bad thing, then all else equal, we should go with that product. Now that's the big caveat too, right? All else. I kind of kept the question broad. I said, will ETFs come out ahead in the long run? When you think about that, do you think ETFs will have the majority of assets? They'll have more assets in ETFs than mutual funds. Is that how you think about it?
Yeah, yeah, they will in the long run. When exactly will that crossing point be? I don't know. Mutual funds have pretty much been flat for the last five years or so in terms of assets under management. They've been around $17 trillion, whereas ETFs now are about $4.
$4 trillion, I believe. But the ETF market has been growing by like 50% every year, 30%, these huge jumps, whereas the mutual fund market has just been flat in terms of assets. Now, there's good arguments against why is the mutual fund market flat? Well, who's the average mutual fund owner?
Well, the wealthiest people are always the oldest generation, right? They've had a lifetime to build their assets, whereas somebody who's 30 years old hasn't had a lifetime to build their assets. So the one great argument for why mutual funder in these extreme outflows relative to ETFs is simply it's just a generational sale. If you're 80 years old, if you're 70 years old,
and you have most of the wealth in this country and you're liquidating your retirement money for income, well, you're probably selling mutual funds because that's what you've owned your whole life and you don't own ETFs because they didn't exist. So there are some good arguments, I think, for some of the outflows in mutual funds ETFs. But yeah, just to kind of give the other side there. But I think the advantage is the ETFs make them win in the long run either way. Sure. And I'd like to dive into that. And it's a nice segue into my next question, which is,
A lot of people just don't know exactly what an ETF is and they know what a mutual fund is because they've been around forever and they've been investing in them for decades. So maybe before we start talking percentages and dollars and trillions and get real deep and nerdy with this, let's just back up really quick and maybe just explain in the most simplest form what an ETF is or also called an exchange traded fund. Yeah, I love it. Get back to basics. We have a major problem sometimes in this industry of just jumping right to it.
So exchange traded fund, what is it? Well, it's basically a mutual fund. It's more or less structured the same way. It's structured under the same rules by the SEC, but an ETF receives certain exemptions from what makes a mutual fund a mutual fund and what makes an ETF an ETF. But the biggest, most noticeable difference is just simply that ETFs you can trade, they're listed on an
in exchange. So they trade similar to a stock, right? So you can buy it one minute, you know, you could buy it at 10am and you could sell it at 1001 or however often you want, but you can buy and sell them during the day. Whereas a mutual fund, you can only trade once a day at the end of the day. That's the most noticeable difference because
Because the structure in terms of how you own stocks and things like that on the back end are pretty similar, right? It's just a fund so other people can invest in it. And then you receive professional money management. And that's the advantage of investing in a fund as opposed to on your own buying stocks or whatever. And so you mentioned that ETFs trade intraday, meaning you can buy and sell ETFs all day long. You don't have to wait for the market to close like a mutual fund. Right.
You've previously mentioned that contrary to what most people might think, that intraday trading actually reduces panic selling or panic trading. So I'd love to hear you just kind of expand on that and explain how intraday trading may not contribute to panic buying or selling. Yeah, because that's one of the big arguments. Somebody who has a
proponent of mutual funds or as a mutual fund company, you're going to say, well, we use mutual funds because they help our investors stay invested. If you give people the option to trade all day, they're going to overtrade their account. And we know if you trade too much, you're going to lose money in the long run.
I agree with the second half of that statement. You shouldn't be sitting there buying a stock, an ETF, a mutual fund, anything, right? One day and then the next day waking up and being like, hey, I'm going to sell it tomorrow. But the benefit to trading is
Intra day, one of the biggest benefits in the aggregate is, and this story was passed along to me by a portfolio manager from State Street who was around on the creation of SPY, the first ever ETF in 1993.
was that crash of 1987. The market went down 20% in one day. And the SEC was trying to do an analysis of what went wrong. Why did the stock market go down 20% in one day? Well, it turns out one of the reasons was that mutual funds at the time, many, many mutual funds, you could only buy and sell once per month.
And all mutual funds, obviously, as they still are today, you could only buy and sell once per day. So when you saw the market go down 10%, you got very, very scared, right? Just behaviorally, hey, if I don't sell this today...
I might not be able to get out for another month. And a month from now, it could be down 40%. Who knows? So this is my chance to get out. And even if you were in a mutual fund that you could sell once a day, you still saw the market drop 10%. And you said, hey, if I don't get out today, it could be down another 10%, 20% tomorrow. I don't know what's going on. This is really scary and big.
behavioral humans were wired for the fight or flight. So there was added selling pressure in that crash due to people wanting to get out. Now, what's the comparison? What did we figure out? Well, there's in movie theaters, you used to have one tiny door at the front of the movie theater and there'd be 2000 people in the room or whatever it may be. And a small fire starts in the back of the movie theater.
And everybody goes or sprinting towards the exit, starts screaming, panic, dah, dah, dah. And what happens? More people die from trampling over each other to get out of that tiny exit.
exit, then people die from the actual fire itself. It's not really a big deal. Fire is easily controlled. So what do we now have? We now have rules and regulations where it's, hey, every movie theater in America now has to have giant doors at the front, well-marked exits. Here you can leave. And then what actually happens if there's a small fire in the back of the theater? Well, now people do an
orderly exit and slowly file out of the theater and everything's good. I walk out the front, somebody else walks out those giant doors in the back and it's just like everybody's laughing and it's whatever and everybody lives. So ETFs are kind of like that where just by simply giving, again, in the aggregate, you're still going to have people that panic sell, but you can't control that. But in the aggregate at the market level, it actually reduces panic. ETFs can help reduce panic
Because you just simply give people the option to sell, they won't sell in a 10% drawdown or something like that.
Yeah, really interesting. I appreciate that perspective. Again, contrary to what a lot of people think. So thanks for that. ETFs have grown tremendously in the last 10, 15, 20 years, largely in part to their structure and their benefits. So I'd love to really spend some time here. And I'd love for you to get into the weeds a little bit and share what you think the main benefits are of exchange traded funds, and why that's contributed to their rapid growth over the last 10 to 15 years. And sounds like what you think is going to be rapid growth from here on out.
Yeah. ETFs are simply a better technology than mutual funds. And it's hard to wrap your head around sometimes when you say ETFs are a technology. What does that mean? Well, I'll give you the biggest, easiest example how ETFs are simply a better technology. And then I'll get to what the benefits that lead from that are. But ETFs are a better technology in that
I started at the New York Stock Exchange and the ETF group there. I got hired by one of my clients at the time, this little ETF company called Revenue Shares. We grew that to the point that the behemoth Oppenheimer...
mutual funds, wanted to acquire revenue shares, ETFs. And so then I kind of got to see inside the machine for the first time in my career, a mutual fund company. So I'd always been in ETFs my whole career, but for a brief time period worked at Oppenheimer and saw kind of inside the mutual fund machine. And the most mind blowing thing to me, having worked in ETFs my whole career, Oppenheimer had something like 3000 employees,
1,500 of those employees, half of their employee workforce worked in what they call the record keeping department, which is just basically where they track who owns our funds, who buys and sells it. If you get your quarterly statements in the mail from your mutual fund company, that's coming from that record keeping department at the mutual fund company, right? So 1,500 people were employed at Oppenheimer for that.
The ETF world, the ETF structure, we don't have that. So right there alone, there's 1,500 people you don't have to pay. Therefore, that's a whole lot of cost savings. So the three biggest benefits of ETFs are simply that they're more transparent, they're lower cost, and they're more tax efficient. So that example I just gave you gets to the lower cost, right?
Things like that are why in general, all things equal, which they never are, but all things equal why an ETF of a similar strategy is cheaper than a mutual fund of a similar strategy is simply just structural reasons like that. Like we don't need a record keeping department. The other one is transparency. Why is transparency good? It's not always good, but most of the time it is.
So let's start, again, just throw the mutual fund world at bone. When would being not transparent be good? It would be good if you're trading micro caps, right? Because maybe it takes you, if each company is $20 million or $30 million and you're managing $50 million in a micro cap strategy, it could take you really, really long to build a position and
and buy those micro-cap stocks if you're a fund manager, right? So you don't want everybody to know what you're doing if you're buying micro-cap company XYZ on Monday.
because then you still need to buy more Tuesday and you need to buy more Wednesday and you need to buy more Thursday. Well, then maybe people are going to front run you and be like, hey, great. This huge mutual fund company is buying this micro cap stock. Let's get in front of them and let's front run that. So for strategies like that, there are advantages to not being transparent. But...
On the whole, transparency is normally good. So that's one of the other benefits. Maybe just quickly touch on while we're on transparency here, talk to us a little bit about the ETF culture and how that translates to transparency.
Every ETF issuer has to, or isn't required to, but does post their daily holdings for their fund each day. They post the holdings for the fund on their website. And that's not required by the SEC or anything. That is just simply something the ETF companies do because it's part of the culture. So the culture of transparency, that...
pervades through everything ETF companies do. So if you go to an ETF company website, if you go to alpharchitect.com, if you go to ishares.com, you go to WisdomTree, you go to Vanguard, whatever, these companies have all these free tools where you can openly analyze both their funds and other competitors and
side by side and get any information you need. Hey, here's the holdings, here's the PE ratio, here's the price to sales ratio, whatever you're interested in getting to. The ETF industry just has a culture of pushing out as much information as you can. And the biggest example of that is just simply being publishing their daily holdings, even though they're not necessarily required to publish that every day. So yeah, it's a cultural thing. And that
The cultural is really what helps it win in the long run too. Culture kind of wins no matter what business you're in, right? Somebody could give you the recipe on how to build the iPhone or whatever, right? But it's really Apple's culture of innovation and things like that that always keep them one step ahead of their competitors. So culture is really important anywhere you go, right? There's a culture of transparency.
So we're talking about the three main benefits of using exchange traded funds. You talked about lower costs, the culture of transparency, and then the big one is tax efficiency. So maybe let's dive into tax efficiency a little bit. And maybe just start with a study done by Rob Arnott that you've previously shared that concluded the average mutual fund causes...
an 80 basis point or 0.8% tax drag compared to 0% for ETFs. Maybe you can talk a little bit about that and then more about the benefits of ETFs and the tax efficiency.
That study is great. Rob Arnott, for full disclosure, mainly makes most of his money off of creating indexes for ETF companies. So Rob Arnott did a study that already looked at what was the average capital gains tax burden, mutual funds, active mutual funds versus ETFs. And the answer came to about 80 bps per year. Now, what does that mean? That means...
What each year, if you hold the fund, do you end up having to get kicked out on due to the mutual fund having to sell a stock? So if a mutual fund owns Apple, Apple goes up from $10 to $20, and then they decide to sell that stock because they want to move into Microsoft stock.
Well, what happens? Well, now they just went from 10 to 20. They have to pay a capital gains tax on selling Apple. You then get that kicked out to you in form of dividend distribution that you then have to pay taxes on. So that's no good because...
Just like from a financial planning perspective, typically, one of the first things at least, a financial advisor would tell you, hey, you're looking to do financial planning. Well, first question, are you investing in your 401k? Are you investing in an IRA? Why? Because it's better to compound your wealth tax-free than pay taxes all along the way. So the mutual fund structure...
causes issues where it's going to constantly be kicking out capital gains distributions for you that you're paying as Rob Arnott calculated about 80 bps per year on. That's a drag. Whereas the ETF structure is largely, not always, but largely able to avoid those same taxes. And that gets a little into the weeds. We can walk through it if we want.
Let me just ask you a quick question on that. And this is like purely out of my own curiosity. So on the last episode I did on target date funds, I just shared this fact that about 70% of just all mutual funds fall into that active category. And I'm wondering if Rob Arnott's conclusion there, if most of that is related to actively managed mutual funds or
And what might that look like if Rob was just looking at indexed-based mutual funds versus ETFs, like the Vanguard S&P 500 mutual fund? Would you still see that big of a tax drag when you're comparing those index-based mutual funds to ETFs? Or how do I think about that? Or do you have any data to support that? Yeah. So there was somebody else who did a study. I don't think I'm allowed to say who, but
He works for a mutual fund company. He's somebody you and I both know. And he did the same study. He basically tried to replicate Rob Arnott's study. And he came out to 38 pips was what the tax saving was. And so that's like, okay, well, this is somebody who's in a sense, in every way wants to diminish that because he gets paid by a mutual fund company. He wants to diminish Rob Arnott's study. And he came out to like 38 pips.
So Rob Arnott, who everything in his being wants to make this as big as he can, came out to 80 BIPs. So it's like, all right, so let's say it's kind of maybe in the middle then. It's actually a great thing. Two people who have very different incentives. One person works for ETFs. One person works for mutual funds. 80 BIPs, 38 BIPs, we'll call it 50 BIPs. But then somebody else you and I both know, Andrew Miller, who's a financial advisor based out of Indianapolis,
He brought up the best point of all is that who really knows what the exact calculated tax advantage is every year? Maybe it's 38 bps.
whatever. But the biggest advantage he says is that ETFs, because they're not paying out these taxes per year, and even if it's to your point, just maybe a very minor difference when you're comparing pure index-based low turnover mutual funds versus ETFs, maybe then let's say the difference is only 10 bps or something at that point. The biggest advantage then
how he looks at it from a financial planning standpoint is just simply, it gives you the optionality to pay taxes when it's the most optimal time for you to pay taxes. So if you've had a client for 10 years, or you're just an individual and you've been invested in the stock market for 10 years, take an extreme example, say you've been laid off from your job. So you now have no income. Well, you could that year then,
sell the ETFs that you've owned for 10 years and hopefully you've made money on over the last 10 years. And if it's like today over the last 10 years, you've made a lot of money. Take your tax hit that year because you're now in a low income tax bracket because you don't have an income versus when you did. And then the next year when you get a job, you're back in a higher income tax bracket. But now you've just kind of re-locked in your tax basis going forward on those ETFs.
And so the optionality that ETFs create is the argument for really the, that's the most powerful advantage from a financial planning perspective is just the optionality. Or what I might call flexibility. Flexibility. Yeah, sure.
So one thing I want to note, and then you can share anything else about tax efficiency we should know. But just to clarify for our listeners that when we're talking about tax efficiency and tax drag on the portfolio, this really only comes into play in taxable investment accounts. So if you're investing in a 401k or an IRA, the tax drag of a mutual fund is kind of
irrelevant. There are other benefits to using the ETFs, but taxes really come into play when we're investing in those taxable accounts. So I don't know if you have any other additional thoughts on that or anything else to share in this tax efficiency department. The two other important things to throw in, because it does get mixed up sometimes, is that this is at best simply a tax deferral. You do have to eventually pay the taxes, but that's the same as an IRA or 401k. It's still better to compound without paying taxes the whole time.
But there is a catch. If you're super wealthy and you got $30 million, $40 million, and you're looking to be handing down a huge amount of money to your kids when you pass away, well, guess what? If you had it in an ETF structure, you were reducing your taxes the whole time through that, something like a 401k or IRA.
you would then get the step up in cost basis. So your children or your grandchildren or whoever you pass the money down to would get a step up and they wouldn't have to pay taxes on it.
Let's be clear too. I don't know how many of our listeners have $30 million, but if there's any sum of money that you don't need for retirement, maybe it's $100,000, maybe it's $10,000, maybe it's a million dollars. You say, I don't need this sum of money to help fund my retirement. I want to invest it and pass it down to my heirs.
An ETF structure is a great tool for that because like you said, you're not paying taxes on it. You're deferring those taxes. And then when you die, that position gets inherited by your heirs and they get that step up in basis and it's a win-win for everybody. So it doesn't have to be a large amount of money. It's just more money than you actually need to fund retirement. Correct. Yeah. I just always think if I had less money, then I'm probably burning through it all. And I'm probably burning through it all for my kids if I have 30 million too. Yeah, probably. Yeah.
But it does work really well for super high income earners in a high tax bracket that want to defer and even avoid some of these capital gains issues.
So let's shift gears a little bit here. We're talking about buying and selling ETFs. You can trade intraday, which we've already talked about. But because of that, there's something that investors need to be aware of, which is the bid-ask spread. So in short, trading ETFs and trading mutual funds are two very different animals. I'm just kind of curious, from your perspective, if someone wants to buy and sell ETFs, are there some best practices that they should be aware of
certain times of the day to trade, how to place an order, anything like that if they are going to choose ETFs over mutual funds? Yeah. I think the simple answer is, and some people make it a little more complicated, but the simple answer is just use limit orders. So the biggest difference between a mutual fund and an exchange traded fund is...
The cost of trading is put back in your hands when you're trading an ETF versus a mutual fund. And that is one of the reasons why that ETFs are all things equal. The same strategy typically in an ETF is cheaper than owning a mutual fund because the
there's not somebody there that needs to trade all these ETF shares and deliver them back out at the end of the day to their customers like the mutual fund is. So you do have to be more wary when you're trading an ETF versus a mutual fund. And that would be the way to do it. You use a limit order as opposed to using a market order. Don't use a market order. And maybe the most simplest form, what is a limit order?
So a limit order you put in, say, okay, you look at the ETF, you see it's trading for $25 and you're saying, all right, I don't want to have it executed at a price higher than $25.10.
Now, that is a common misunderstanding with limit orders, I think, is that so somebody sees ETFs trading at $25, they put in a limit order for $25.10. They're like, oh, yeah, I'm going to get screwed. This is going to get executed at $25.10 and I'm going to get cost that $0.10. But that's not going to happen.
That's not true. And why is that not true? You're more likely than not going to get executed much, much tighter, no matter what you put the limit order at. If you put it at 2520, if you put it at 2550, whatever, you're still likely to get executed extremely close to whatever the net asset value is, which is if you use mutual funds you're familiar with, net asset value is just simply if we totaled up all the worth of the stocks and the fund, what's the share price worth?
So why are you likely to get executed and you don't need to be that concerned about what price you put the limit order at? Is that behind the scenes, what's happening is these market makers, these trading firms are competing to execute that order for you. So Goldman Sachs maybe has their trading desk and this all happens in the blink of an eye, but they're with their super high powered computers and they're like, okay, $25, 10 cents order just came in. Goldman's like,
Awesome. We're going to make 10 cents on this trade because the net asset value is $25. And then what happens? Well, then JP Morgan's ETF trading desk says 5 cents a share. We'll execute that no problem at 25.05 because that is a huge profit for us. We make 5 cents every share traded. And then RBC, the Bank of Canada, their trading desk comes in and is like, hey, we're going to make 10 cents on this trade.
One penny a share is a lot of profit, free profit for us. We'll do it at 2501. And then bang, it gets executed at 2501. So there's huge competition on the back end and that's what keeps the prices of ETFs tight. If there was some scenario where these trading desks could just make a dollar profit or something totally insane, it would instantly get arbitraged away because all those desks want to make that money and they're all competing against each other to feed their families and whatever.
So a limit order, why do you even use the limit order? Well, a limit order is just, it's like using a seatbelt when you get in the car. You don't expect to get in an accident, but it prevents you, if you do getting in an accident, from getting hurt. So you put the limit order on and now you know, worst case scenario, I'm not going to get executed above $25.10 on this ETF that looks like it's trading at $25.00.
You get in your car, you put the seatbelt on, hopefully you don't get as hurt, but you don't expect to get in an accident. Yeah. So moral of the story, use limit orders when trading ETFs. Don't use market orders. If you need more information on limit orders, go to Google, search around. You can learn a ton. There's a bunch of information out there. Also bid ask spreads, really get familiar with bid ask spreads. It might look like a small number, but when you divide that by the share price as a percentage, it can be really high for every share that you're trading. So just be aware of that stuff.
All right, let's move into factor investing here. So factor investing, we both know it's been around forever, but it's all the rage these days. Listeners might have heard factor investing referred to as smart beta, which is a curse word in our world. So maybe just like what is factor investing? What's a factor? And why is this important when people are investing in ETFs?
Yeah. So a factor I think is better understood if we call it a characteristic. So every stock has a characteristic and let's compare it to cars again. Insurance companies use characteristics to pay insurance fees. So
companies, if you go out and you buy a sports car, one person goes buys a sports car, one person goes and buys a minivan, the driver of the sports car is going to pay a higher insurance fee than the driver that drives a minivan. And why is that? Well, because insurance companies looked at data in the past that they have access to, right? They looked at data in the past and they've said, wow, a
Drivers of sports cars get in accidents at a much higher rate than drivers of minivans. Therefore, anybody who is a sports car driver, we're going to charge them more money to insure them. Factor investing is a similar thing. We look at characteristics of stocks in the past. For example, we say, wow, stocks that are cheaper relative to other stocks, value stocks,
in the past did better than stocks that were more expensive, gross stocks. So any in the aggregate stocks that have the characteristic or the factor of being cheap are
look like to be a better investment than stocks that have the characteristic of growth. But again, the key is in the aggregate because that doesn't mean... Some stocks are cheap and they should be cheap, right? And they're going to do even worse. And some stocks are really expensive and they're going to do really well. But it's
But in the aggregate, at the aggregate level, value stocks, in our opinion, tend to do better than growth stocks, right? And same thing. The average sports car driver may get in more accidents than a minivan. That doesn't mean every driver that drives a sports car is going to get in more accidents than every driver that drives a minivan, right? So it's just these characteristics in the aggregate is what factor investing is. And other characteristics could be
Momentum, what's gone up the most? What stocks have gone up the most? That's a characteristic of stocks. Could be low volatility, which stocks have essentially not moved around the most. That's another factor or a characteristic stocks could have.
You mentioned a few of these characteristics, momentum, value, low vol, price. Are there any factors that used to provide a premium that no longer do? Or maybe like, are there factors that are characteristics that we used to pay attention to that they're not really relevant going forward? Maybe the question is, or does that mean like there's going to be a reversion to the mean at some point? Yeah, probably the one that's in the hottest debate right now is size.
aka, and what's the size factor? Just are small companies going to outperform large companies? And for a very long time, a lot of both academics and practitioners believe that if you bought small companies over the longterm, they were likely to outperform large companies. The recent
Research shows that that factor may not provide an edge. So I would say that's probably the biggest one that's kind of like, huh, making people think maybe small companies don't provide a larger return. And it makes sense. You want to think small companies provide a higher return because...
It would make sense from a risk standpoint. They're smaller. Anything you can come up with for investing. A large company is safer. They're more robust. They can withstand recessions better, blah, blah, blah. So there's a lot of great sounding arguments, but I would say that would be the best one that's currently in pretty good debate. Is there actually a size factor? Do small companies provide outperformance over mid and large companies over the long term?
So in my mind, when I think about factor investing, you're basically taking kind of a plain vanilla broad-based index, and then you're applying these academic principles to it and tilting the portfolio towards these characteristics that have proven to add a premium to the portfolio over long periods of time. It kind of suggests that...
beating the market might be possible by tilting towards these different characteristics that you just talked about. But you and I are also in this kind of same camp that says, beating the market is really hard and almost impossible to do year over year over year. So how can both of these be true? How can we use factor investing to maybe get an edge, but also still believe that beating the market's really challenging and maybe even impossible? Yeah.
how can both be true the issue is i believe there's a problem between marketing and research and
In order to take advantage of these factors, what normally the research shows is, okay, if we invest in, again, let's just use the value factor. I think it's the easiest to understand, you know, no matter what your background is, you know, like, hey, I want to buy houses when they're cheap as opposed to when they're expensive, right? Or I want to buy stocks when they're cheap as opposed to when they're expensive. So using the value factor, okay, so the value studies look at it and they say, okay,
All right. If we own the cheapest 10% of stocks, so if we took a universe of 1,000 stocks and we invested in the cheapest 10%, so 100 stocks every year, and we rebalance that annually, how would we do? And the academic studies have shown, okay, if we did that, we invest in the cheapest 10% of stocks every year,
based off of really whatever metric, you would do well. You would outperform the market. It doesn't matter whether you're looking at it by price to book, by price to earnings, by EBIT to total enterprise multiples, which is what we use, but they all kind of outperform. And then we go, we step into the real world though, the fun world. And a lot of the fun world though...
They don't do that. They'll say, hey, this is the example we use, we pick on sometimes because they can handle it, is the Vanguard Value Fund. If you look at the Vanguard Value Fund and you go back VTV to its inception, you go back to its inception like 20 years ago, compare it to SPY, you'll see VTV, the Vanguard Value Fund, is an exact opposite.
overlay to SPY. It's giving you the same exact returns. And it's like, hey, wait a second. You told me based off of this academic evidence that value outperforms. And then I hear, here's the Vanguard value fund and it didn't outperform. And it's got this huge long history. What gives? Value doesn't work. Factor investing doesn't work. You can't beat the market.
Okay. Well, why did the Vanguard value not beat it? Well, the Vanguard value essentially has about a 50% screen on the market.
So it's investing in the cheapest 50% of stock names. But that means that it's not getting down to those super, super cheap stocks. The academic studies would show actually is where the value factor lives. It doesn't live in that middle section, right? It gets weaker. It lives in the cheapest 10%. Now,
The problem is the trade-off. Is Vanguard dumb? Why is Vanguard doing this? They're not dumb. The problem is people don't like at the fund level, at the retail level, or the institutional level, really, it doesn't matter. But they don't like being different. Being different, aka in our business, what we would call tracking error, creates a whole lot of pain. When the market is up 10% and you're up 0%,
Because you only invested in 10% of the market. Well, you're going to be getting a lot of calls from investors being like, hey, SPY is up 10%. You're at 0%. This is stupid, right? Like, I'm going to go invest in SPY now.
So that tracking error is why a lot of the fund assets that do factor investing or whatever, just simply they're what we would call closet indexing, which just means you basically buy the market and you put a little bit of sprinkling in of value stocks or on the other way, you can go the other way or growth stocks or momentum stocks or
low volatility stocks, right? So that you're only like plus or minus 1% or 2% the market. That's the reason just to avoid pain is why these companies don't take advantage of exactly what the academic studies show. Yeah. And I think for me, kind of the moral of the story is like, if you're going to use factor investing, if you're going to do something more than invest in a broad-based index and try to go after these premiums,
it sometimes takes a really long time and a lot of patience in order to reap the benefits. So you do need to understand exactly what you're investing in, how it works and mechanics. And you have to be really, really, really patient if you want to reap the reward. I want to be courteous of your time here. We're winding down. I want to know, are there any resources, tools, or websites? Our listeners love taking action on this stuff and doing their own research. So are there any resources that you might suggest they use if they want to research ETFs more, learn more about factors or
compare some different ETFs? Yeah, you can go to alphaarchitect.com. We have our website there. We typically publish about three research blog posts a week. One of our things is transparency. So we publish research on everything, not just what we do, all the factors and anything we can come up with. So you can learn a lot there.
And then there's other free resources, Portfolio Visualizer. If you really want to get geeky, you can dive into that kind of stuff. And then, yeah, most the issuers have websites. Most ETF issuers have websites with various free tools. So yeah, I would check any of that out.
Okay. And when listeners are using those tools, are there any specific characteristics, any specific data that they should be zoning in on or looking at? Or if you go and you're looking at two different ETFs and you're comparing them, like what are some things that you're looking out for?
That is person to person. That's very tough to say. Do you believe you can beat the market? If so, yes. Okay. Then maybe you want to look at value investing or momentum investing. If
If you don't believe you can beat the market, well, then you probably just want to look at cost. You want to go find the cheapest fund you can. Make sure you're not overpaying. That question, I guess, would take a whole other podcast. Sure. Yeah.
Yeah. Well, I also think your story about the Vanguard Value Fund is a great example too. Look under the hood and see what the holdings are to make sure you're not buying this value fund that really just looks like the S&P 500. If you're really going to go and buy a factor-based ETF, make sure that it looks really different from the other stuff that's out there along with the other criteria that's important to you. Yeah. Yeah. And that's why we beat up on Vanguard too, because guess what? That fund, it's only six bips. So yeah, they're giving you the market-like returns.
but they're also cheaper than SPY. SPY charges you nine bips, they charge you six bips. So nobody's being harmed there. It's not like a malicious thing. They're just giving you a little bit of a twist. So it's all good. But yeah, there are definitely other funds out there that charge a much higher fee and do the same exact things. They give you a market-like returns and charge you much more than the market. So yeah, if you're paying for something, you definitely want to
make sure you're getting something different for it because you can get the market for almost free. There are ETFs out there that are two bips, three bips. There's even a negative fee ETF out there right now. So... Oh, geez. They're paying you to invest in it. Paying you to invest in it. Yeah. So... We've spent a lot of time just beating up on mutual funds here. And I just want to give mutual funds a little bit of a chance here at the end. Are there any downsides to investing in ETFs that you can think of?
Is there any part of you that can make a case for using a mutual fund instead of an ETF? Yes. And it's what I talked about at the start. I think a good rule of thumb is ETFs have a lot of advantages over mutual funds, but there are cases where the mutual fund wrapper is better than ETFs. So a good rule of thumb, because this is the way the market is working out,
Does the investment strategy you're searching for exist in an ETF? If so, then you can probably go with the ETF and feel pretty good about it for the advantages I described. But if not, then invest in the mutual fund. And why do I say that's kind of a good rule of thumb? Because...
A lot of the strategies that don't work in an ETF don't have an ETF, but there's great options on the mutual fund side of things. So there's micro cap investing in stocks. I started this with, that's a good example. Doing more leveraged things, that's another example. I go back and forth on it, but there's definitely people that make a case that fixed income investing is better in mutual funds instead of ETFs.
I would disagree there, but there is at least an argument to make there. There's definitely certain investment strategies that are better, but I would adamantly, openly, gladly debate anybody that if you're investing in a high turnover equity strategy, aka an active investment strategy that's not micro cap, so it's small, mid or large, you should be using an ETF. Robert Leonard
Well, I appreciate that perspective. I appreciate you coming on and sharing all this information with us. You guys all at Alpha Architect do amazing work and do a lot for this industry. I sincerely appreciate all that you give. And thank you again for your time. I will put all of your contact information in the show notes, which can be found at youstaywealthy.com forward slash 54. And hope to see you soon, Ryan. Great. Thanks for having me on, Tyler.
Hey, it's me again. I just wanted to say thank you one more time for listening and remind you to please, please, please leave a quick review. If you're on an iPhone, leave a quick review on iTunes. If you're enjoying the show, I'm getting great feedback from listeners just like you. And I really want to keep the momentum going. So if you have a chance on your iPhone, leave a quick review on the Apple podcast app. And thank you so much in advance for all of your help and support.
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