In most industries, whether it be cars, jewelry, food or beverages, some products are built for scale and mass distribution, while others are niche and serve a distinct customer segment. However, some products simply aren’t meant for mass distribution, either due to the fact the product has naturally constrained production or, in the case of some products (e.g., branded retail), mass distribution would limit the good’s appeal. Most goods and services fall within the boundaries of infinite scale and uber-niche.

The ETF industry is no different.

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Every ETF falls into one of those three categories:

  • Built for scale,
  • Niche products with limited scale, or…
  • Something in between.

Any business or ETF can scale, but it often comes at the expense of quality (perceived and/or real). ETFs experiencing rapid growth in niche products experience a difficult decision at some point in their life cycle: Do they punt on their niche products and go for scale (potential to maximize profits, but may hurt performance)? Or do they make the decision to remain niche (may not maximize profits, but may maintain performance)?(1)

In a previous post, I broke down all the ETF firms into divisions. We could do the same exercise here with individual ETFs: breaking all of them down into the three scale buckets above. However, given that there’s now approximately 2000 ETFs, this effort would be 1) a ton of work and 2) not that helpful for investors. Instead, I’m going to walk through the problems managers face so reader’s have the necessary educational toolkit to judge the scalability of any ETF that may come down the pipe — now or in the future.(2)

The 1964 Supreme court case of Jacobellis v Ohio was to determine whether something is an obscenity or not (largely relating to pornography). United States Supreme Court Justice Potter Stewart was famously quoted as saying, “I know it when I see it.” Likewise, by the end of this post, you should be able to know the scale potential of various ETF strategies when you see them.

Let’s break this down.

Why Fund Managers Run into Scale Issues — Liquidity Problems

For active or passive fund managers, either in the mutual funds and/or exchange traded fund format, there can be scalability issues.  When you’re managing $200 million, perhaps an investment strategy is able to generate outperformance.  However, once assets begin flowing into a fund, it might be becomes more and more difficult for the manager to maintain the prior outperformance for a host of reasons.

Let’s use a simple example to illustrate:

Say ABC Asset Management has a strategy that has demonstrated outperformance. The strategy involves a 10 stock portfolio and all of the stocks in the portfolio have a $100 million market-cap– a $1 billion market-cap combined. Also assume that each stock trades 5% of its market cap per day, so $50 million notional trading volume in total for the combined portfolio.

What happens if the fund reaches $500 million in assets under management? You now own 50% of the combined market-cap! Also, if you traded $50 million in the fund, you would be using up the entire average daily liquidity.

Is this strategy going to continue work?

Not likely. Trading impact pressure from the fund manager will drive the prices of the individual companies up very quickly (perhaps higher than they are actually worth). Clearly, liquidity matters, especially for smaller, more concentrated portfolio strategies.

How Asset Managers Can Increase the Scalability of Their Funds

Faced with the problem outlined above, the asset manager would have two options:

  • Close the fund to new investors before the manager reaches a liquidity problem.

This option sometimes comes into play and highlights why investors see small and mid-cap managers closed down to new investors.(3)

When speaking with financial advisors, they tell me this is one of the more subtle advantages (well designed) ETFs provide for them. Let’s use small cap managers, as it’s the most typical example.

In the small cap space, by using highly scalable ETFs, an advisor doesn’t have to consistently find new small cap managers to put new client money to work. This is a sharp contrast to the active mutual fund space where once the advisor finally finds a good small cap manager, the fund often closes down to new investors shortly after. Or, perhaps even worse, the fund moves from being a small-cap manager to a mid-cap manager to increase its liquidity and scalability. Either way, it harms the financial advisor’s ability to run a consistent portfolio for their clients.

Using ETFs, an advisor can simplify their small-cap allocation. For example, the advisor can put all of their clients’ small cap allocation in the iShares Core S&P Small Cap ETF ($IJR) and have a consistent investment portfolio across the board for all of their clients. That means less time analyzing new investment managers, and more time to do other value add work for their clients (or to go find some new ones!). Of course, this might also mean giving up on identifying any edge that comes from identifying high performance managers. Win-some, lose-some.

  • Alter the strategy to increase its scale.

There are two ways to do this for a fund. You can either increase the number of holdings within the fund, spreading the investor assets across a larger amount of individual holdings (and likely decreasing the potential returns of the fund, or “diworsify“). And/or, the manager can hold larger market-cap companies.

The Flexibility of Active Managers – A Blessing and a Curse

Active managers can change their strategies on the fly. As assets pour in, they can decide to now own 20 individual holdings (instead of the previous 10). They can choose to own five mid-cap companies and five small-cap companies (when they originally owned 10 small cap companies). Both of these solutions create more liquidity and enable a larger fund size.

But flexibility is a double-edged sword. The active manager is more adaptable, though the ability to change can lead to problems for active managers. Among many problems, it brings human emotions into play.(4) Our emotions often cause us to make poor investment decisions. Another problem with flexibility is that this can create style drift. For example, an investor might buy a value manager’s fund and check back one year later and learn that the fund is now a blend between value and growth to accommodate more capacity.

ETF Portfolio

How can a rules-based process eliminate these problems? And how can they add scalability as part of their algorithm?

Rules-based processes eliminate flexibility because once the rules are set…they are set. You can’t easily change the rules and/or deviate from what the index your ETF is meant to track and the optics look bad.

As far as building in scalability, I’d recommend reading Dave Nadig’s piece at ETF.com. It’s a great piece outlining everything that goes into managing a passive ETF. That’ll give you a base for the discussion below.

Let’s look at how to build scale into a rules-based index.

Market Cap Weighted ETFs: The ultimate in scale

Most market capitalization weighted ETFs are the ultimate scale products.  In SPY, the largest amount of your assets when you buy go into the largest, most liquid, name in the index: Apple.  The smallest amount of your money goes into the smallest, least liquid holding in the index (currently News Corporation Class B Shares). With the iShares Core S&P Mid-Cap ETF ($IJH),

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