Which is Best - Active or Passive, ETFs or Funds?
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 426. It's titled Active vs. Passive ETFs vs. Funds. Now, that's just a working title, so don't be alarmed if we change it when we release the episode. Today, we have a frank, engaging, and enjoyable conversation with Christoph Gleisch.

who is President and CIO of Harbor Capital Advisors. Harbor Capital has been partnering with institutional active managers to run mutual funds for over 35 years, in

including the Harbor Capital Appreciation Fund that we used when I was an investment advisor. Then that fund is supervised by Jenison Associates, one of the firms that was on my former firm's FIG Advisors Recommended List. Harbor Capital also runs a number of ETFs.

We get pitched for interviews dozens of times per week and pretty much turn every one of them down because doing interviews isn't our preferred format. In this case, I agreed to the conversation with Christoph because I had some technical questions on the underlying plumbing of ETFs and funds that I just hadn't been able to get definitive answers.

I got those in this episode, but we also touched on a wide variety of other topics, such as when and how should individual investors use active managers? What is changing with ETFs and funds? And should we be worried about an ETF flash crash? We cover many other things. I think you'll learn a ton about what's going on with ETFs and mutual funds in this episode.

Just a brief bio on Christoph as president and CIO of Harbor Capital. He oversees investment, distribution and marketing, and executive office functions at Harbor. Christoph also leads Harbor's strategic growth plan. Previously, Christoph was a managing director and global head of manager selection at JPMorgan Chase. He has a degree in physics from University of Bristol.

Let's go ahead and get on with our conversation with Christoph Gleisch. Well, Christoph, it's great to have you here. I'm a longtime supporter of Harbor Mutual Funds back in my institutional portfolio management days. We used the Harbor Capital Appreciation Fund. We actually also had some separately managed accounts with Jenison Associates, who is the

on site to their offices several times. And so you know mutual funds. And Harbor is known initially for their active mutual funds, many of which have been very, very successful over the long term. But most active mutual funds don't do that. They trail their benchmarks. And even the good ones, such as Harbor Capital Appreciation, go through long stretches of underperformance. I think I looked at that fund. I think it's lagging over the past five years, which can be

frustrating for institutional managers having worked with endowments and foundations. Their patience seemed to be on average about three and a half years of underperformance, and then they're ready to fire. Individuals in some ways can be more patient, but given how hard it is to find an active manager that outperforms, should individual investors even try to do so or just stick to index funds or ETFs?

Great. Well, thanks for having me today. It's great to be here. Looking forward to this conversation. So let me just back up a quick bit. You mentioned Harbor there as well, and you're a previous user of our funds, which is great to hear. But just for your listeners, Harbor was kind of set up to answer that question of how to pick managers, because out of the gates, I want to say picking managers is really hard. We've been at this now for about 40 years, and we have a

Our firm is about 200 people and, you know, with our role, our dedication is to go out and across the world and find managers that we believe in, that we believe can generate value for our investors over the long run. And I'm going to emphasize long run. And we do that and we find managers of different shapes and sizes and different stripes with different expertise. And we try and we spend a long time

understanding them, underwriting them and ultimately investing with them. But we also pass up on most managers that we meet with. So if we meet 100 managers, we might pick one at the end of the day that we invest in. So what I would say is, well, in investing, I think balance is key.

And anything done to the extreme generally is to the cost of the end investor. And so I think if a portfolio is all tilted towards active management, it's going to do worse than a portfolio that has a balance of index funds and a balance of active funds. And likewise, if a fund is all tilted into index funds, I think that's taking it to the extreme as well. And so I do think there are one of the challenges is there are periods and regimes that can last a long, long time.

So, for example, take where we are today in the 2020s. I believe that returns are going to be harder to come by. Certainly proving that way so far.

And that indices or index investing is probably not going to be the same experience as it has been over the last 10 years prior to this period. And so I recommend that listeners have an open mind to that. We're in a different regime, and we believe there's a role that active managers can play in a portfolio if they're thoughtfully blended with index funds. What I would say is generally...

Listeners, you've got to do your own homework when you're investing with an active fund. I think one of the traps that people fall into is they over-diversify and they pick too many managers and they end up with essentially an expensive index fund. So I would recommend that you find...

a couple of managers that resonate with you. You do your own homework on them. There's plenty of online resources now. I think the number one piece of advice I would give is if managers write quarterly, annually,

Before you invest in them, see what they've said over the last 10 years. It's a really good window into how they think. And identify with a manager who invests in a style that you can resonate with. I would just finish up on this point as well, because you mentioned the Harbour Fund underperformed the last five years. Absolutely. This is the biggest challenge with investing, I think, is the time horizon dynamic. And we actually created something called the Crystal Ball Portfolio, because that's sort of what we do.

And I wanted to run this thought experiment that was if I gave you a crystal ball of five years and said, here are the top performing managers for the next five years, build a portfolio of those managers, how would you do over the long run? And it was really interesting. And so we did this over a 30-year time period where you break it into five-year chunks and

and you deliberately pick on a go-forward basis the best managers, right? So it's clearly a hypothetical, not a practical example, not investable, but you can learn from it. And over that 30-year period, knowing the future, you outperform the S&P by about 400 basis points a year, which is decent, right? But it's not 1,000 basis points, you know, 10%. It's not 20%. It's about 4%. And...

Hang on, let me make sure. So you picked, you had a five-year window and you picked the top performing managers over the previous five years to see, or you just want to see how, oh, I see, you're looking backwards to figure out, you know, who did outperform. Exactly. So it was if we had a crystal ball. So we take a portfolio in 1990.

And we look at who are the top 20 percent of managers from 1990 to 1995. Let's hold that portfolio for that time period. Then you hit 95 and you say, OK, who are the next best performing managers from 1995 to the year 2000? Let's hold that portfolio over the next five years. So it's the most egregiously unfair portfolio because you need a crystal ball or a time machine to build it. But you can still learn a lot from going through this exercise.

And what you learn is, I mean, in a geeky way, the present value of a crystal ball. But in a more helpful way, you learn that if a manager is claiming they're going to add you like 10 percentage points a year, like call kind of BS on that because they're not. You've got to have reasonable expectations. And even if you know the future, four percentage points of outperformance is got to be kind of an upper case for what your expectations would be.

But the most interesting thing I found through this whole exercise was that that portfolio still underperformed one year in four, which when you think about it is amazing.

that even knowing the future, you're going to go through periods of underperformance. And so even knowing the future, investing can be difficult. And I thought it was a difficult enough endeavor because you don't know the future. So I just think it's a really important lesson to like ground yourself in reasonable expectations and realize that when you invest with a manager, you're going to go through a period of underperformance.

So we spend a lot of time writing down before we make any investment, like when was manager underperform, what type of environment, like we commit it to paper, to virtual paper. Right. So going back to the study then, did you happen to do sort of the opposite, take the managers that had outperformed the previous five years and then build a portfolio out of them and see how they did in the subsequent five years?

Yeah, we did. And that underperforms. And so. OK, I'm just making sure that that. Yeah. So that doesn't mean they're bad managers either. But that that's exactly what I saw as an institutional money manager, because you get there with a committee and endowment and the committee gravitates to the best performing manager. And I I tried my darndest to get them to pick the one that had underperformed.

over the previous five years. You know, they're on a recommended list, they're good, but if we could pick them after a period under performance, then often it was spectacular. But it's hard to do. Yeah, absolutely. So we looked at this in different ways. And you know on every compliance presentation it says past performance is no indicator of future returns? Right. It's said for a reason. Like, it's statistically true. And actually, if you pick...

The best performing funds over a five year period and hold those, do nothing else. You just do that systematically. That's actually the worst selection criteria for a go forward basis. If you pick the worst performing funds, it's not a great strategy in itself, but it does better than if you pick the best performing ones. So if you had to do one or the other, I would say pick the best, sorry, the worst performing ones.

But as a discipline, historical performance should be one factor of many that you look at as an investor. And I think the trap our industry falls into is it over-relias and overweights that one single factor and it drives behavior. And it actually, it's really sad because it just creates a lot of bad investor outcomes.

And Morningstar have done some great studies on this where they look at, you know, time weighted versus money weighted average. And it's unfortunately, there is always a propensity to performance chase, which does ultimately destroy value. So you as an investor, individual investor or an institutional investor, if you can be aware of that phenomenon and that effect and build in behavioral value,

barriers to kind of save yourself from yourself, all else being equal, that's a good thing to do. Makes sense. Yeah, it's hard, right? I mean, it can't just be performance. And I think that's what Harvard does well. And certainly, you know, in our research, it has to be the culture of the firm and has to be the investment process and all the intangibles that you only figure out by meeting with them and talking to them. Correct. So...

If we look at long-term trends, so looking at the 2022 investment company fact book, it looked at the periods 2012 through 2021. And index funds and ETFs, they received net cash, including reinvested dividends of over $2 trillion, whereas domestic equity actively managed mutual funds lost $2 trillion. And that seems to be the trend

In fact, I didn't know this until we looked at Harbor. I didn't realize that they had launched some ETFs. What's driving the trend toward less active, more passive vehicles? And has that or will that lead to an indexing bubble, if that is even such a thing?

So, look, I expect the trend is going to continue. This has been a trend that's been in place for a long, long time now into indexing and low-cost investing. We just touched upon a number of the factors of the trend.

challenges of picking active managers ahead of time, you know, I'll make the statement that most active managers will underperform and we should expect them to because investing is more or less a zero sum game in the secondary markets, you know, give or take share buybacks and IPOs. Right. But let's put those to the side and just say it's a closed system. And for every buyer, there's a seller and for every seller, there's a buyer.

So the way I view active managers are, it's no different from another sport where they're competing against one another. And the average manager, by definition, is going to kind of underperform net fees versus low-cost indexing funds. And then indexing funds exist because all of those different active managers are going through a process of setting valuations on underlying securities. And if they do a pretty good job of doing that, then index investing can kind of exist. So that's

That's sort of structurally how I would view this. And I would view the trend into index funds as one that's likely going to continue. Now, let me unpack that a little bit. So ETFs. ETFs historically have largely been an index phenomenon. And so if you look at most of the assets that exist in ETFs today, they exist in index products.

Now, those index products, it would be a mistake to then say that means they're passive. I have a strong belief and we have a strong belief at Harbour that index does not equal passive necessarily. There's a big difference between some more complicated rules based index strategy that's really trying to follow a fundamental approach versus something like the S&P 500.

And so within index investing, there's various degrees of sophistication. What is also happening is there was a regulatory rule change in December of 2019 called the ETF rule. That's what has been adopted, the name that's been adopted. And it's essentially allowed issuers like Harbor. You mentioned you looked up, you were surprised that we had ETFs. Well, what happened is the SEC changed the rule book significantly.

to level the playing field for issuers to issue ETFs or mutual funds and make them almost equivalent to one another. So prior to this in December 19, if an issuer like Harbor or anybody wanted to launch an actively managed portfolio in the ETF wrapper, they would need something called exemptive relief, which

which is a long and painful and drawn out and expensive process that may not even end in success and can take years. And what the SEC did in 19 is they said, right, if you want to launch an active ETF, we're not going to make you go through this anymore. We're going to level the playing field. We're going to put a rule book out there. And if you follow the rules, you can launch ETFs. So what this is now leading to is an explosion of new ETFs.

ETFs coming to the ETF market, largely coming from active managers. And so you're beginning to see an increasing market share of the shift from the mutual fund to the ETF wrapper now being taken up by active ETFs, which is an... And in looking at that, are more of those ETFs, because as we've looked at that, there's transparent ETFs,

active where they're sharing the holders or they're sharing their holdings, you know, ARK being an example. And there's non-transparent ETFs where there's sort of special authorized participants that are able to see the holdings on a whatever every 15 minutes. And we'll talk a little bit more about authorized participants in a minute. Are you seeing more of these, this new proliferation of active ETFs are more still doing non-transparent or are we still, are we seeing more transparent?

So we spent a lot of time thinking about this before we entered into the ETF market. What kind of path do we want to take? Do we want to embrace transparency or do we want to go down this semi-transparent path that exists? And when we looked at why clients prefer the ETF wrapper, I

I think it came down to cost. ETFs are cheaper for investors, which is... And if you can do the same thing that you did before, but do it cheaper from an investor perspective...

That's kind of guaranteed alpha, right? Or guaranteed return. Like it's structural, it's embedded. There was also the tax advantages of an ETF wrapper for taxable investors. There is no debate that in the US, an individual taxable investor is better off in the ETF than they are in the mutual fund wrapper. And then thirdly was transparency. I

And we decided to lean into that. So consumers of ETFs prefer to know what they own and they want transparency. And so when we thought about going into the ETF marketplace, you know, transparency was a was a client or a customer preference. And we wanted to meet that preference. So, you know, we went fully transparent. I would go as far to say that the semi-transparent wrapper is dead transparent.

I don't think it's going to exist in five years' time. It's this weird, quirky thing that kind of lives in the sidelines, and you read about them periodically in the press. But when you actually look at where the money is going, clients are voting with their wallets, and they want full transparency.

and you're seeing transparent index funds, passive or index funds, more thematic or fully active funds in an ETF are gaining traction in a fully transparent way. And in the semi-transparent, they're not. And actually what you've seen is

I won't name any firms, but some large competitors of ours that launched initially with the semi-transparent wrapper have now done a 180 and they are now launching transparent versions. And my best guess is the semi-transparent stuff is going to shut down and it won't exist. It will go the way of the mini-discs.

Do you find that, I guess it depends on the structure, but it seems like more, well, let me answer this way. So Vanguard's ETFs have always been share classes of their mutual funds. And apparently, I guess their patent is expiring on that. So other fund companies like Harbor could basically, and maybe you're considering this, doing ETF versions of some of your mutual funds.

in which case those active managers weren't sharing their portfolio every single day. I guess the question is, is Harvard going to do that? And are there still some active, like a rule-based approach that's sort of active, like structural or fundamental indexing, it's less of an issue. And a truly active manager that's trying to get in and out of holdings, et cetera, without telling the world every single day, is there not value in that still? Yeah.

To some extent, and it depends in what asset class that you're talking about. So, for example, in a liquid small cap or, you know, small cap emerging market, there will be more of a benefit to that. In a very liquid market like US, US large cap, it's less of an issue. And so there are ways, though, that a fully transparent ETF, you

With a 24-hour delay, you don't have to give out your exact basket details to the marketplace. You can use something called a custom basket, which provides some of that shielding benefit, but it's delivered through that fully transparent ETF wrapper. So that's the path that we've gone. You asked about Vanguard and the patent that they have. Yeah.

And that is interesting. And there's been another issuer that has just filed to basically do the same thing that Vanguard have done and be allowed to create a ETF as a share class. And so just for your listeners, this is quite, I guess, technical or in the weeds, but just bear with me for a second. So when we issue an ETF, it's a separate vehicle. It

It has its own pool of assets that are dedicated to that vehicle. And so underneath that ETF or inside that ETF wrapper are the actual assets that that ETF owns, right? There's a separately managed account holding those assets.

In Vanguard's path, they almost have like a pooled asset base and they have different share classes of their mutual fund and the ETF that has a claim to those assets in a way that Vanguard have been doing very successfully for a long time now.

Our understanding is that the SEC are not keen for others to follow what Vanguard have done. Oh, interesting. And that they're going to block other people that try. And look, who knows until we actually kind of see this. But at the moment, that's not something that we're going to be actively pursuing. We're going to stick with fully transparent, separate trust. We think for us and for our clients, that's a better fit. But I will say we definitely watch...

Well, obviously Vanguard are very big. We watch what they do closely and it's worked for them. But at this point in time, I don't anticipate many other, if any other issuers being given permission to follow that structure. But we'll have to see. Time will obviously tell. You asked me a question earlier about index bubbles and I didn't answer it. So I want to make sure that I do as well. Yeah, sure. Go ahead.

Behind that question is if tons of money starts going into index funds, it's going to create a bubble in those stocks that have the biggest concentration and momentum is going to drive those stocks to become even bigger and bigger and bigger.

until the whole thing kind of collapses is the index bubble. I think there's quite a bit of scaremongering done by the active management community or has been historically about that effect to try and put people off in a disingenuous way about the index bubble. By the way, I think index funds are good. They serve a really good purpose for individual investors. And I don't like the fact that active managers will use this kind of scaremongering tactic because it's just not true. And why isn't it true?

If you take large cap equity in the US, right, and just look at all active managers that do large cap equity, there's probably a thousand of them, right? There's a lot. And if you think every time a dollar leaves those managers and goes into the S&P 500, what really happens? Nothing. Because if you took a dollar and spread a dollar between a thousand active managers, what do you end up with? You end up with the index, right?

And so the fact that money shifts from active to passive, all that's shifting is a wrapper and clients are going to be reducing their fees because they're going into an index fund. So this notion that the indexing itself is going to drive bubbles I don't buy into. And then people will say, well, look at the rise of passive and the rise of concentration in these indices now.

And then they'll neglect to then say, well, actually, if you go back to the late 90s, it was the same. Or if you go back to the nifty 50, it was the same.

And we didn't have index investing then on anywhere near the scale that we did today. So when you start to pick apart the argument, I think like with more intellectual honesty, I don't think investors should worry about an index bubble being caused by index funds. But clearly, I'm not saying bubbles can form and we see them and it happens in markets all the time. And people need to do their own homework and investment due diligence. But I would be surprised if that was the reason that caused them.

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That makes sense. And it's sort of how we approach that. I mean, I guess if we think about it, if funds are leaving your typical active manager in the U.S. equity space, domestic tends to be more mid-large. And so if assets are leaving that and going into a straight size-weighted S&P 500, then that, well, it has pushed up the value of sort of those mega caps, but

But, you know, the thing that worries me is that, you know, will it ever? I think ultimately you get trends, right? And so generally speaking, at least what we have found is the active managers that have outperformed were often because they had a smaller average size. And so when they outperformed,

And I think Jenison's probably an exception here. It wasn't even so much because of good security selection. It was just because they had more of a mid-cap tilt and we went through a period of mid-cap outperforming. And I guess that goes back to the point how difficult it is to find active managers because we think we're buying security selection and oftentimes we're just buying factor exposure that may or may not be gotten more efficiently in another way.

So you hit a topic that's very near and dear to my heart. And I'll just spend one minute on this. You're 100% right. And we start, when we look at any manager, we start with the kind of hypothesis that all excess returns are due to luck and work backwards from there. And because what happens is when you actually start to sort of break apart those excess returns into their component parts, there's

There's a number of things going on. There's biases, market cap biases, regional biases, industry biases. And then you also mentioned this factor biases. Are they loading on value? Are they loading on quality? Are they loading on momentum? And then you need to measure. This is what we do a lot of here at Harbour is we measure the impact of those biases and those tilts.

And then we see what's left over. And the bit that's unexplained and left over is more indicative of skill. And so if you look at a manager's return pattern, you need to sort of break it apart and see which part is what we would call idiosyncratic and more indicative of skill and more indicative of something that is more persistent and sustainable on a go forward basis rather than paying attention.

for a manager that's just loaded on a bunch of different factor tilts that you don't need to pay active management fees for because iShares has a wonderful menu of different ETFs where you can allocate to whatever sectors, styles, tilts that you want without paying active fees. So it's a really important point. Well made.

When we look at the number of ETFs, there's 150 to 300 ETFs launched each year in the US. It looks like Harbor opened up at least seven new ETFs last year. And we run some model portfolio examples on our membership community. And in the past, a couple of those ETFs closed because they didn't attract enough assets, which was frustrating to me, it was frustrating to our members.

And so when someone looks at a new ETF, and we've had this question in our forum, it's like, I'm afraid it's going to close. So is there a level where an ETF is profitable for a company like a Harbor to where an investor doesn't have to worry so much about risk of closure? And is that level of profitability, the asset level, is that dropping? Yeah.

So firstly, I would look at the, like I said, there's a lot of ETFs that launch. There's a lot of fads that launch as well. It brings a lot of some thematic stuff that might be trying to tap into the sentiment of the day that may not exist in a few years time because sentiment has changed and moved to something else. So to kind of skew your odds of that

that not happening, find an approach or if it is a theme, it's a long-term kind of more durable theme that's likely still going to be important to investors two, three years out from now.

Then the second thing is you can look at the issuer. Do they have a track record of closing lots of funds, mutual funds or ETFs as well as an indicator? But generally speaking and giving a general answer is just that. That's my caveat. There's going to be different examples of the extreme. But an ETF level of about 80 million to 120 million is

It's probably somewhere in the sweet spot where for the issuer, it's beginning to become self-sustaining and profitable. And the chances of it closing after it reaches that level are going to be much, much lower. And so when you come to market and if you're looking at new ETFs, I would say, you know, you should be a bit more discerning and a bit more skeptical and push and probe and ask questions. You know, you should, and you should look at, you should speak to the issuer of the ETF and

You know, what are their intentions with it? Why did they launch it? You know, what's their plans to scale it? And, you know, there may be some ETF issuers there that kind of just chuck lots of stuff against the wall and see which ones stick. And then they'll shut the other ones down. And, you know, what we do is we have just an investment. We're an investment led firm and we have a very strong investment thesis every time we launch a new product. We think it's doing something differentiated. We think the manager that we've launched it with

is able to drive superior risk adjusted returns over the long run. And we stand behind those and we support those. And the other thing I would say to look out for is make sure ETF issuers are capping the expenses, because there are certain operating expenses which are charged back to the fund. You know, think administration, accountancy and audits and things like that. That

That if you're talking about a small ETF, those costs could be a disproportionately large amount of the overall cost basis. So it's incumbent on people like Harbor to come in and, you know, overwrite that and pay the money back to the fund to keep those costs manageable and competitive for individual investors that go in as well.

Yeah, that makes sense. This is probably a little in the weeds also, but what's remarkable or ingenious about ETFs was the structure to allow... They're publicly traded, but there's also a net asset value. And then there's these authorized participants that are buying part of the reference baskets that you mentioned, as well as shares or selling shares of the ETF to keep that price

in line with the net asset value. And that process has generally worked. There's been a few flash crashes where there's been a disconnect. But as we see more and more ETFs with more sophisticated strategies, an example being the Harbor Scientific Alpha high-yield ETF. So in looking at their portfolio, there's a number of unregistered 144A bonds.

And not necessarily picking on that fund, but as there's more strategies, are there enough authorized participants out there willing to trade in some of these less liquid holdings to keep the price in line with the net asset value so there's not a big premium or discount?

Yeah. So again, I'll be technical on this one because it's a technical question. Oh, that's all right. We like technical. All right. Technical is good because that's why people listen to the podcast. If I geek out too much, let me know. So just a quick correction. So it's not the authorized participants. It's actually the market makers. And I'll explain. And we hear this a lot. So let me just kind of clarify this.

So the market maker's job that trade those ETFs on a daily basis, on an intraday basis, it's their job to ensure that there is good liquidity and tight spreads. And the authorized participants that you mentioned, they are authorized to exchange ETFs.

typically at the end of the day with the ETF itself. Right. So market makers are not allowed to trade or interface with the fund. They create the secondary market. Authorized participants are able to exchange at NAV with the fund at the end of the day in

In some instances, an authorized participant can also be a market maker, but not always. So let me break that down a little bit more and talk in general terms. So for us, one of the focuses that we have is to make sure that we have a good capital markets team.

and we've built out a capital markets team here at Harbor that face off to the street and essentially build the relationships and appoint different market makers and authorized participants.

And so typically for an ETF, for a harbor ETF, we might have seven, eight, nine, 10 market makers making a market in our ETFs on a given day. But then we might have two or three authorized participants that are able at the end of the day, depending on what the trading volume's been to convert, um,

or destroy units in the ETF. So because you know that authorized participants can always trade at NAV at the end of the day with the fund, then the market makers know that if there is a deviation away from the NAV real time, they, the

depending if the deviation goes too high they can sell short or if the deviation goes too low they can buy and that they know that they can then take those etfs work with an authorized participant and effectively trade at nav with the fund and collect the difference so it's actually a really like an ingenious like system i think that ensures uh on the whole you

you know, pretty tight spreads, pretty good liquidity. But we do have to pay attention. We do watch our spreads very carefully during the day. And we will work with our market makers to make sure that the spreads are being kept effectively tight and that they are making a market in them. We report on that to our board every quarter as well. One of the things I love about, you know, mutual funds and ETFs is the board structure.

Again, I don't know if all of your listeners know this, but trustees oversee, there is a board of trustees, independent trustees that oversee mutual fund boards and ETF boards like under the 1940 Act. And so if you're invested in a 1940 Act product, be it a mutual fund or an ETF, there is a board of trustees that are overseeing to make sure that what's being done inside that ETF is done for the benefit of shareholders.

And so we, as the advisor have to report to this independent board every quarter and report our spreads on our ETFs to make sure that they are trading within a certain range and that clients are getting, uh, you know, good execution. And that's just, again, one of the good kind of regulatory benefits that exists. It's very different in my home country and that in that dynamic, and it doesn't get good regulation, doesn't get enough, enough airtime. Um,

We always seem to, you know, in this country, we seem to complain about regulation all the time. But I think that's a good piece of regulation. The other thing I'd mention as well is something that we did recently this year is we took some of our ETFs because we noticed that we wanted to get the spreads even tighter. And we listed them on the floor of the New York Stock Exchange. And so now we have someone there as a trader now on the New York Stock Exchange. Rather, it's sort of being done electronically.

There is a trader kind of in the pit making a market in our ETFs, and we've seen spreads come in even narrower. And very few issuers have done that, but we've worked closely with the New York Stock Exchange to make that happen, and we're pleased with that decision. So, you know, there are...

There are technicalities that happen in the marketplace, but there are mechanisms exist to ensure that things don't get too wide. But you do need to make sure that your ETF issuer is focused on this, has the right people to ensure you're getting the best kind of execution possible.

What I'd say is if any of your listeners are just sort of blacked out of what I've just said in the last few minutes, just thought, well, I want to know what on earth you're talking about. I just call your ETF issuer that will be on their website. There will be a help desk. There will be a number. And if you want to buy shares in one of their products, call them up and ask them how to do it. And they should be able to advise you. And if they can't find another ETF issuer. So just, just to make sure I understand this. So you're right. I didn't just,

Describe that correctly. So most market makers, so they're making a market without having necessarily buy underlying shares in the reference basket. Correct. So how often, how frequent is it then that authorized participants are trading that reference basket during the day or is the vast majority at the end of the day and just in the creating or redeeming shares? Yeah.

So what happens is this is more now, what you're asking is actually more of a market-making activity. And I'll explain what I mean. So it's...

In a mutual fund, so let's start with a mutual fund. If one of your listeners puts in an order for a mutual fund at like four o'clock at the end of the day, that order goes through and new shares get issued reflecting that buy. Let's assume it's a buy order, right? Somebody puts in an order for $25,000. New shares are issued when that order goes in and then you own units in the mutual fund, like kind of easy peasy so far.

That's the role that the authorized participants kind of play that's most close to ETFs. What market makers do. So say one of your listeners at 11 o'clock on Monday morning decide they want to buy 25,000 shares of ETF ABC. Now, ETF ABC is only allowed to issue new shares at like four o'clock at the end of the day, like a mutual fund.

And so if your listener is going to go out and buy ABC shares in this ETF at 11 o'clock on a Monday morning, they're going to place what's called like a market order. And that is going to get filled in the marketplace by a market maker.

Now, a market maker may happen to hold 25,000 shares of that ETF in their inventory. So market makers are the best example is that kind of like grocery stores, like with inventory, but their inventory rather than being, you know, tomato soup and salads and things like that, that they give to sell to customers as they come in, their inventory is a collection of securities.

from equities, different fixed income securities. And so they might sell you, they might happen to have that inventory and be like, okay, well, that perfectly offsets. In the real world, that's an oversimplification. What the market maker would actually do is they would sell you short those shares. And so your listener that buys, buys their ETF, gets the ETF shares, but

But the market maker is short those shares the moment that transaction happens. And then at the end of the day, the ETF will decide, do they want to carry that short position overnight? Do they want to carry it overnight the next night? Or do they want to close it out at the end of the day? And they can close it out at the end of the day by going to an authorized participant and saying, either here is the cash or here are the shares.

go and create me the new units of the ETF. And then it's up to the market maker how they, you know, that's market making practices every day, how they hedge out that risk. And so a market maker might say, oh, I like this, you know, I'm going to sell you $25,000 of this ETF because I've got most of the stocks that already exist inside it. But I might have to go and buy a couple of the stocks over here. And then I can, you know, click a button on my screen and I can create that basket. Again,

I'll give that to the authorized participant at the end of the day. He'll give me shares and exchange, and then I'm kind of flat. And that's the kind of what I've described happens instantaneously. It's incredibly technology oriented. It happens globally, and it happens in a way that our imaginations find, I think, quite hard to kind of comprehend in terms of like how markets like actually work. It's really quite amazing. No, it is amazing.

As market makers have become more sophisticated, as technology is there, is the risk of a flash crash to where you get a big disconnect between the price of the ETF and the NAV, is the risk of that less now than, let's say, 10 years ago?

Yes. As an investor, I worry about lots of things on a daily and nightly basis. An ETF flash crash is not one of them. It's not near the top of my list. I think the industry now is sufficiently mature and works and the plumbing works very, very well. And flash crashes are...

if not impossible to forecast. And, you know, there's been like, whether it was a crash of like 1987, which all of these years later, people are still debating about like what causes that kind of crash. You know, I think ETFs increase price discovery. And I grew up in the school of marking to market and it was just ingrained into me day one of my career. You know, I was at a different firm and they used to say that we are a mark to market firm.

And I think ETFs do a good job of helping investors market to market their positions more accurately. And I think they're a force for good. And I don't see a major risk of some kind of like vehicle specific like flash crash happening. I actually think the bigger risk is stuff that's held inside a mutual fund that may not mark the market quite as quickly as it should do. And if you get redemptions, there

There are less liquid securities. I mean, leverage loans is a good example. They trade in frequently. They take 15 to 25 days to settle. And if you get investors that get out at NAV because they exit quickly before the asset class is kind of caught up, the people left behind are the ones kind of carrying the bag. So eventually those things will get marked down and that will be reflected in the NAV.

And again, I don't want to scare people. It's just for the sake of giving you a fuller answer. If something like that were to happen in an ETF, you would get the ETF with Mark Black to market almost instantaneously. And actually, that's just more fair and equitable for all investors. That is interesting. Yeah, we've had that discussion with bank loans before and ETFs. But one final question. This is also a more technical question, but we have not been able to find the answer to this. We've searched the SEC website. We've checked.

The one person that gave us a very confident answer was a chatbot. But we didn't trust the answer, but...

Here's the question. That international funds or you own international stocks, there's dividend withholding taxes, which oftentimes that tax rate's higher than what the tax rate is for the U.S. And so there can be a disconnect. And so the mutual fund companies or ETFs, they're trying to recapture some of that tax money. What we don't know is the SEC yield that you see Morningstar publishes or the fund company publishes,

Does that show the impact of the dividend withholding taxes or is it sort of the pre-tax number? And it's relevant because members or listeners, investors are deciding to purchase a particular ETF or fund and they're looking at that dividend yield and they don't know whether that's a pre-tax or after-tax or in-between-tax dividend yield that's reflected in the SEC yield.

So I believe so for our funds, the SEC yields when we show them as net withholding tax. So it would be reflective of net withholding tax and tax credits. So it'd be more reflective of the yields that investors actually get.

I don't want to speak for the SEC yield and definition, but for Harvard funds, that is the case. Because what you have is if you had like a foreign tax rate of like 35% that's applied to a dividend, the fund only receives, you know, 35% is deducted that goes into the fund. But then there may be a tax treaty between the US and that country. And then if you like, the fund then adds back a receivable tax

So let's say the fund says it can claim because of the tax treaty, it can claim 15% back, right? So what you would see in the fund, again, this is super technical, is the dividend would pay, what would actually get paid into the fund would be 65, like net of the 35. And then you would then add back that receivable of say 20. So now the fund is as if it's been paid a dividend of 85.

And then it's up to the fund company like Harbour to then go and chase down all of those tax receivables from the foreign governments, depending on the tax treaty with that particular country. And then that's how we have an amazing tax team here that does all of that work and then chases down all of those payments for those tax credits. So, again, it's another example where it's a really technical area of the market where there's a lot of stuff that actually has to happen.

Like people are doing like real work, chasing down real invoices to sort of make this happen. But your question for our funds is it's kind of the SEC yield is the best estimate of the yield that gets paid to shareholders net of all of that work. Well, that was the answer I was hoping for. Because that's what makes the most sense to me. It's the cash flow that came.

adjusting for any receivable, but it's the fund company that goes and finds the money and works at it. Which, coincidentally, is what the AI bot said too. But not as eloquently. Laughter

Well, Christoph, thank you for joining our show today. It's been fascinating. I definitely have learned some stuff, particularly the whole market-making aspect of ETFs. And very, very, very helpful. So thank you. Well, thank you so much for having me on. That was a lot of fun, and I really enjoyed it. Thank you. We appreciate Christoph Gleisch taking the time to have this conversation on ETFs and funds.

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