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  • Bogleheads on Investing with Wes Gray on the tax benefits of ETFs and more: Episode 70

Bogleheads on Investing with Wes Gray on the tax benefits of ETFs and more: Episode 70

Post on: June 3, 2024 by Jon Luskin

Dr. Wes Gray is the CEO of Alpha Architect. Our topic of discussion for this podcast is exchange-traded funds (ETFs) and their unique tax benefits.

Wes is an author, portfolio manager, United States Marine, Iraq War vet, and former professor of finance at Drexel University. He earned an MBA and a Ph.D. in finance from the University of Chicago, where he studied under Nobel Prize Winner Eugene Fama.

• • •

This podcast is hosted by Rick Ferri, CFA, a long-time Boglehead and investment adviser. The Bogleheads are a group of like-minded individual investors who follow the general investment and business beliefs of John C. Bogle, founder and former CEO of the Vanguard Group. It is a conflict-free community where individual investors reach out and provide education, assistance, and relevant information to other investors of all experience levels at no cost. The organization supports a free forum at Bogleheads.org, and the wiki site is Bogleheads® wiki.

Since 2000, the Bogleheads’ have held national conferences in major cities nationwide. There are also many Local Chapters in the US and even a few Foreign Chapters that meet regularly. New Chapters are being added regularly. All Bogleheads activities are coordinated by volunteers who contribute their time and talent.

This podcast is supported by the John C. Bogle Center for Financial Literacy, a non-profit organization approved by the IRS as a 501(c)(3) public charity on February 6, 2012. Your tax deductible donation to the Bogle Center is appreciated.

Listen On


00:00:10 Rick Ferri

Welcome everyone to Bogleheads on Investing Episode #70. Today we welcome back Dr. Wes Gray. Wes is the CEO of Alpha Architect, a quantitative asset manager. He’s also the author of several books and a decorated Marine Corps officer. Today we’ll be talking about exchange traded funds and the interesting tax benefits that they have created.

Hi everyone. My name is Rick Ferri, and I am the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at boglecenter.net where you will find a treasure trove of information, including transcripts of these podcasts.

Before we begin, I have one announcement. Tickets for the 2024 Bogleheads Conference in Minneapolis, MN are now on sale at boglecenter.net. The conference begins at 1:00 PM on Friday, September 27th and runs through noon time on Sunday, September 29th. We’re going to hit the ground running with the full agenda. Lots of great speakers. I hope to see you there.

Today we welcome back Dr. Wes Gray. Wes was my podcast guest five years ago back on Episode #9. Wes was the CEO of Alpha Architect, a strategic advisor to ETF Architect, and President of Alpha Architect Global LLC. He’s also a prolific author, portfolio manager, fellow Marine Corps Officer, Iraqi War vet, and former Professor of Finance at Drexel University.

Wes received his undergraduate at the Wharton School of Business at the University of Pennsylvania and then went on to receive his MBA and PhD from the University of Chicago, where he studied under Nobel laureate Eugene Fama.

Today, we’re going to focus on exchange traded funds and some of the interesting products and services that Wes and his team have taken advantage of because of the unique ETF tax structure. With no further ado, let’s welcome back to Bogleheads on Investing, Wes Gray. Welcome back, Wes.

00:02:40 Wes Gray

Rick, appreciate you having me back.

00:02:42 Rick Ferri

Thank you for coming back. And a lot has happened in the last five years since we had you on the podcast. But for listeners who are not familiar with you, I wanted to talk a little bit about your past and how you got to where you are today. You were raised on a cattle ranch in Colorado, so I assume you’re a vegetarian.

00:03:02 Wes Gray

Yeah, I’m all vegan. No, I’m a big fan of steaks and old school stuff.

00:03:10 Rick Ferri

You went to the Wharton School at the University of Pennsylvania, where you graduated Magna Cum Laude in 2002 with a Bachelor of Science degree in economics.

And from there you took the unusual step of applying to the University of Chicago Booth School of Business to get a PhD right out of undergrad, which is unusual.

00:03:34 Wes Gray

Yeah. It’s definitely unusual. But what happened, I was basically serving as the data monkey/programmer for the Wharton Finance Department and all of them were Chicago PhD’s. And through that process, they highly recommended that I go for it because they thought they could get me in.

And they said, hey, you get paid to go to school. You should do it. And at the time, I didn’t know any better. It seemed like a good idea. So that that’s how I got pushed in that direction is I had a bunch of professors suggesting that I go that route.

00:04:06 Rick Ferri

What would you say once you got there to the University of Chicago? You were probably one of the youngest PhD students there I would assume. And how many others were there right out of undergrad?

00:04:15 Wes Gray

Yeah, I was definitely the youngest, and I don’t think there were any others that were right out of undergrad. I was 21 or 22, and most of the others were married or had a kid or had actually done something in their life. And so, it was a little bit awkward. I definitely felt like a fish out of water there with respect to experience and life knowledge.

00:04:36 Rick Ferri

And you did your first two years there, basically banging your head against the wall trying to get up to speed, if you will, 15 hours a day of study seven days a week. And then you needed a break. And was it some of the people that you spoke with, some of the fellow PhD students who had been in the military, were they talking with you about the military?

What made you decide to go into the Marine Corps?

00:04:58 Wes Gray

I had always wanted to do the service. The problem was just timing. I was going to do it after high school and my parents were like, well, you should go to college.

And I was like, alright, great. Then I got into college, so I started doing that. And then after college I was thinking, OK, now I should go to the Marines. But then I got into the PhD program. And so, it’s just a matter of, I either have to do this now or it’s never going to happen.

And just by serendipity, at the time in my program I’m guessing at least half the people in that program were former military officers, either from Nordic countries or Israel or China even.

And when I mentioned this, like, hey, I might take a sabbatical. They’re actually like, oh yeah, of course you should do that. That because I’m the only American in the program. I think in my group. So that they’re like, well, of course you should do the service and serve your country. That’s totally logical. And so unfortunately depending on your perspective, probably my mom’s, I had a reinforcing situation within the PhD class at the time.

00:06:03 Rick Ferri

And you went in the Marine Corps, became an officer, and you ended up out in Japan, correct?

00:06:09 Wes Gray

Yes, I got my sabbatical approved and extended for four years as opposed to one. And another lucky thing there is my PhD director was, actually her husband was, a former Navy chief. So, she was very amenable to the idea. I had a lot of stars aligned. And then Fama, I had to get him to sign off. You know, Professor Fama.

And he’s also kind of a pro-America, pro-freedom guy. So, I said everything lined up to allow me to do this weird, funky move. And then you’re right. I got in. I spent like a year and a half in pipeline training. Then started off in Japan.

00:06:45 Rick Ferri

And then you were tasked to become retrained and go over to Iraq, where you would be embedded with the Iraqi soldiers. And during that period of time, you taught yourself Arabic?

00:07:01 Wes Gray

Yes, just like I am with Spanish now, I’m not going to claim fluency, but I’m going to claim functional. And I was the Intel officer. So, my job on the team was to be the person that could communicate.

And then as you probably recognize, if you live with only Iraqis that don’t speak English and you get tired of doing hand motions, it behooves you to just put it in a serious investment to learn the language. I actually went on a few missions where I was the “terp”.

The “terps” had to go help the other guys. I was like, you know what? I got it. So, we go do combat patrols and you know everything. And I was I was the “terp”.

00:07:39 Rick Ferri

“Terp” is interpreter, of course.

00:07:41 Wes Gray

Oh, sorry. Yeah, interpreter. Yeah, that’s jargon.

00:07:44 Rick Ferri

I was stationed in Japan for about 6 months and while I was there, I picked up all the Japanese.

And I try to teach myself how to read and understand the language. I was only there for six months, but almost became somewhat functional. I was able to understand enough to get around. So then after that you wrote your first book, “Embedded”, which was about your experience in Iraq.

00:08:02 Wes Gray

Oh yeah. I was very gung-ho. Let’s go after Iraq. I was drinking the Kool-Aid. I had to write a book.

00:08:16 Rick Ferri

After Iraq, you came back and went back into the PhD program, received your PhD and again under Gene Fama. He was your dissertation advisor, and you ended up doing your dissertation on active management because you were going to be the next Warren Buffett, right?

00:08:35 Wes Gray

Yeah, that was the plan. Yeah. Easier said than done. As many people, especially Bogleheads, come to realize.

00:08:42 Rick Ferri

The point on this is you’re a smart guy. And there’s a lot of other smart guys, smart women all over the place. Everywhere there are brilliant people. It’s difficult to beat the market, isn’t it?

00:08:56 Wes Gray

Yes. You have got to focus on what you can control, which is taxes and fees and the process. But as you know, to beat the market at least in the short-term sense because everyone wants to try to beat the quarter numbers, that’s impossible.

And usually, you’re going to overpay in fees and taxes to get there. So, I don’t think you disagree. But I do believe that there are ways to beat the market in a long-term sense, but it’s not a free lunch. You’re going to have to do weird things. It’s going to have to be painful. You’re going to have to take more risk. Et cetera.

And you have still got to worry about keeping the fees down and keeping the taxes down. Otherwise, it’s all for naught.

00:09:34 Rick Ferri

And speaking of risk, I want to talk about that for a minute. Because you left the University of Chicago when you were going to become an academic. In fact, you got hired by Drexel University. Both you and your wife Katie were hired by Drexel University.

And you got a research assistant named Jack Vogel who was working on his PhD. And his dissertation was about is value investing a behavioral phenomenon or a risk phenomenon? And I’ll let you explain what that means.

00:10:08 Wes Gray

Yeah. So, basically, as you know, there are these huge debates. Which in some sense are worthless from an investment standpoint. But academics like to debate whether the reason value beats “the market” is that because of additional risk like fundamental risk? Or is it because of mispricing? People throw the baby out with the bath water. This company is a loser. It’s no good.

And that’s just because of behavioral issues or is it because it is fundamentally riskier? Again, no one will ever settle this debate. Let’s just be clear on that. And I’m of the opinion that it’s probably a mix of both. But I think Jack’s paper and a lot of the other papers related this more and more I think it’s hard to argue that behavioral issues and mispricing is not at least one component, or at least more than half of the component of the of what drives factors like momentum and value in particular.

00:11:04 Rick Ferri

There’s been a lot of papers written about this, but since those papers have been published, there’s even faster computers and more PhD’s and more mathematicians that are in the industry.

00:11:13 Wes Gray


00:11:14 Rick Ferri

My guest last program was Larry Swedroe. He wrote a book called, “The Incredible Shrinking Alpha” where he makes the case that it’s even harder now than it was 20 years ago to beat the market.

I think it’s even getting harder now to call it behavioral, given the fact that 90% of trading in the marketplace is institutional.

00:11:35 Wes Gray

I actually think it might be the opposite, weirdly enough. Because the issues with behavior usually have to do with short termism and corporate boards and weird governance structures where for example, if you go to the “smart money,” they’re always going to have a three-year mandate to beat the market. And if you don’t beat the market, you present that to the board who has CYA issues and you’re going to get fired.

So, if your benchmark is “beat the market over three-year periods,” well, that’s actually very constraining because as you know most factor phenomena, they work on 10-year cycles or 15-year cycles or 25-year cycles. So, the more information people have, the more ability they can check on how you’re doing every second and the more data the more transparency. I think it actually forces the behavior to be worse, because now people unfortunately have more information to grasp on more and the frictional cost of transacting is basically free. And so, if you have more information, you have more data, you have lower frictional cost to action, it’s kind of what Jack Bogle, the “B” version, the really famous one used to say, the problem is the ability to trade.

Like why did he hate ETFs? Because you can trade intraday, not because they’re fundamentally bad, but the fact that I’m allowing you to potentially do something stupid makes you worse at investing. And I think all the world is set up now is to make people terrible at investing. And you see that like Robinhood. There are so many DIYers, and I don’t think professionals are any better. If anything, they’re worse because we deal firsthand with professional investors. Many times, they’re influenced by their constituencies, which aren’t professional investors. They’re some dude on a board who is a lawyer who doesn’t know anything about finance.

And intuitively to them, wait, this person with 20 PhD’s underperformed the last three years? Fire him and go hire this other person that has a better pitch deck. And so, I think the world is just set up where long-term behavioral mispricing issues that are tied to tracking error and just the pain of sticking with something, if anything, I think those premiums might be going up over time, not down.

00:13:56 Rick Ferri

Oh, interesting perspective. So, you and Jack started Alpha Architect in 2010 and you began implementing quantitative strategies. By this time, you weren’t trying to pick stocks, you realized you were not Warren Buffett.

So, the first clients you picked up were separately managed accounts, some large investors, but then you started launching exchange traded funds. Now let me ask there, why did you decide to go with exchange traded funds rather than mutual funds?

00:14:18 Wes Gray

Yeah, so we in some sense, were very lucky. And I just knew a lot about finance back then. I’m not rich. I didn’t really know that much about taxes or fees. It just wasn’t in my psyche, but the seed investor that we worked with was a multi billionaire, and they spent 30 years paying more fees than anybody to all the hedge funds. They used to be the biggest hedge fund seeder in the world and after 2008 they lived through that experience of, wait a second, we pay “2 and 20” and you guys are also down 30% and you won’t even give us our money back. Your taxes are terrible. So, they had kind of a Kumbaya moment at that stage where they’re like, this is not the way. We need to get efficient, transparent control, all the good stuff that Bogleheads love.

And so, I was heavily influenced by that and what we learned about the ETF structure. And to be frank, it’s basically a massive tax deferral structure in plain sight. We’re doing active strategies, 1 + 1 = 3, and it made a lot of sense for us to move in that direction.

00:15:30 Rick Ferri

We’re going to get into the tax advantages of ETF’s here in a minute, which you’ve really excelled in. You wound up launching some ETF’s and most of them were factor ETFs. Value, momentum.

You started to get a name and people started to give you money to invest. And so, you started going down that path and learning also how to run an ETF.

00:15:54 Wes Gray

Yes, we at the time, whether it’s good or bad, we’re Marines. And then Pat was also my teams from Marines. As you know, it’s all about do more with less and just find a way. So, stupidly we decided to build all the ETF infrastructure from the ground up out of my house, which I would not recommend. We did the path of let’s build out the infrastructure and implement our own strategies. And yeah, we did that ever since the very beginning.

So, trading compliance reporting. A funny story is we actually, before we even raised, we raised a little capital after we got smart. But one of my other partners and I were like, oh, how hard would it be to start an ETF? These prospectus things and these exemptive reliefs, they sure look like they just xeroxed them and change the names.

So, before we got smart, we actually submitted without any lawyers, our own exemptive relief and our own registration statement. And literally the SEC lady called us up. She’s like, did you guys submit this yourselves without a lawyer? We’re like, yeah. She’s like, well, technically, you could do that. But that’s not how this works. You guys need to hire a lawyer. We’re like, oh, really?

And then we went back to the drawing board. So, we were total bootstrap way back in the day and then you know over time we’ve gotten smarter. We try to do everything ourselves, even get rid of the lawyers. Lesson learned as that’s impossible. And now, I’ve got more lawyers than I know what to do with. But at the time I was trying to avoid the lawyer situation.

00:17:27 Rick Ferri

Yeah, I remember those days. I remember the first time I went to your office. Maybe it was 2012, but whenever it was, when you had first moved into your basement of your house.

Basically, we’re creating this company. It was really a cozy setting. But you built out this infrastructure for ETFs from the ground up and you said, hey, let’s invite other people who want to launch an ETF or maybe should launch an ETF because they believe in a particular strategy. Let’s invite them to come in and use our platform. So that then created another business line for you.

00:18:02 Wes Gray

Yeah. So, you’re providing way too much value to our brain power. We actually fought that idea tooth and nail for many years because we’re like, we don’t want to deal with other people’s problems. We just want to focus. We’re quant PhD geeks. We do factor investing and yeah, we know how to do all the infrastructure and we do it cheaper than everybody. But we don’t want to deal with this.

And then we got blessed. Because this lady, Perth Tolle, who had known for many years, she had talked to everybody, and she just did not want to work with anyone else. And she kept, you know, basically beating our door down and slamming us on the face like you guys should do this. You guys should do this.

And then finally, kicking and screaming, we said, alright, whatever, let’s try it. So, I don’t even want to portray that this was like some grand genius idea. This was all serendipity and luck and we started with Perth. And then from there we kept getting like one or two people that learned that we were going to do this, still kicking and screaming, you know, we were just doing this very, very selectively and it just over time because we kept getting people call us and say, hey, how do we give you money?

We thought, well, if people want to keep giving us money to do this, we must be on to something. And then and then we quickly started hiring, professionalizing, and then created what is now what they call ETF Architect, which is just A-Z ETF operations for the marketplace.

But the history of that was not genius. It was we stumbled into this what is now basically a gold mine type business.

00:19:41 Rick Ferri

Well, I know Perth told me personally, I remember when the ETF was launched, she’s very persistent. Her ETF is the Freedom 100, which is basically an emerging market fund that leaves out restrictive regimes.

00:19:57 Wes Gray

Yeah, it exactly. It’s all about freedom. So economic freedom, personal freedom, which obviously you and I, I just love the idea, just from a Marines perspective that maybe investing, you could argue different ways. Effectively that’s what it’s doing. And she’s to your point she has amazing persistence. So, it’s her and she has 800 million dollar of assets.

Her out there telling the story of, hey, you should deploy freedom concepts in emerging markets because freer societies for your economies generally grow faster and have property rights, which is kind of important. And of course, if you avoid Russia and China over the past three or four years her thesis was 100% correct. So, she’s done very well for herself.

00:20:46 Rick Ferri

Yeah, but I remember, I recall it was really slow at the beginning and we had some conversations, Perth and I, about what if this doesn’t work? And I’m so happy that it actually worked out for her and that she has almost a billion under management.

That’s great news. OK. Now, here’s where the real story, in my view, the reason why I really wanted you back today besides to talk to you, because you’re an overall nice guy and very smart. By the way, do you ever get tired of being called very smart?

00:21:17 Wes Gray

No, it gets counteracted with my kids and my wife telling me I’m an idiot every day. So, I need to balance it out a little bit. I’m still way in a deficit. It’s all good.

00:21:29 Rick Ferri

Very good. You went to I’ll call it an extreme, and I’m glad you did on ETFs. So, you figured out that, wow, there is an awful lot of benefit to the ETF structure from a tax standpoint. So, walk me through the history of how you began to realize this and what it has become.

00:21:56 Wes Gray

Yes, so going way back, most of our initial clients, well, all of our initial clients were real estate investors. And what do real estate investors do and how do they get so rich? Well, they never pay taxes. They do 1031 exchanges, take properties, roll them into new properties and they keep punting the can down the road. And if you do that for 20-30 years you obviously have a massive tax liability in the end, but you’re able to compound on pre-tax dollars.

And so, all my experience was hanging around folks that were incredibly wealthy. And always emphasize tax minimization is how you get rich. So that was just buried in my brain. And then of course, way back 10-15 years ago while I was at some rich, rich people thing with one of our big clients. And this lady started telling me about the ETF structure and she walked through custom rebalancing, seeing how it all works.

Wait a second. So, what you’re saying is if I put my money in an ETF, I never have to distribute capital gains effectively? She’s like, yeah, you rebalance your custom baskets. I was like, well, that seems like a huge deal. So that’s where it started. And then rolling forward, as you know, but before the ETF, the new ETF rule, it was unclear.

Index funds had this advantage. Some firms like Vanguard and iShares had it on active funds. It was unclear who could use what they call custom create/redemption, which has basically allowed us to swap out securities and not have to pay taxes.

So, let’s just step back and just walk through a very oversimplified example of a one stock fund in either an ETF or a mutual fund. And let’s just say again, this is way oversimplified, it’s not exactly correct, but just for the audiences’ purposes, let’s say this fund owns Microsoft.

Buy it at $1 and it goes to $100 and we’re like, you know what, we don’t like Microsoft anymore. We want to go buy Exxon. So, what happens? Well, in a mutual fund, we sell Microsoft, and we’re going to also get a $99 capital gain. And then we take the $100 of cash and go buy Exxon. Great. In an SMA or a separately managed account, same thing. If you DIY in your brokerage account, same thing. If you do it in a hedge fund, an LP, same thing.

00:24:21 Rick Ferri

All of those concepts that we just talked about, the mutual fund, the separately managed account, and hedge funds, they all have to realize a capital gain in the account and investors have to pay taxes on that.

00:24:33 Wes Gray

Yes, exactly. Whenever you have a realization event, obviously that is a taxable distribution. And so now you’re going to have to pay taxes at the end of that year on that gain or what have you.

Now, the ETF also, if you did that exact transaction and you sold Microsoft to cash, it’s just like a mutual fund. We would also have a huge capital gain distribution out to the shareholders. However, ETF’s have a unique ability to transact in-kind. They don’t have to transact in cash settled transactions. What we can do, and again, just to oversimplify it, is basically we want to get rid of Microsoft. Great. Let’s put that in a custom basket, deliver out the security.

We’re not going to sell the security, we’re going to exchange basically the Microsoft security and then use what they call an authorized participant to deliver in cash or in this case, Exxon, a security, and those are non-taxable transactions because they’re done in-kind.

00:25:38 Rick Ferri

Why would that be non-taxable, Wes? I don’t have the Microsoft anymore. I’ve given it to this third party, so it’s not in my account anymore. But why is that not taxable?

00:25:50 Wes Gray

So, the reason it’s not taxable is ETF mutual funds are taxed as RICs, regulated investment companies. Section 852 of the code, 852B6 is one line in the RIC Statute that specifically says that in-kind transactions are non-taxable. So, the reason they’re non-taxable is because that’s the law and the only way you would change it is you’d have to change the law which has to go through the legislative process.

00:26:21 Rick Ferri

And by the way, President Biden just put forth his new proposals for increasing taxes and changing this law was not in it, correct?

00:26:29 Wes Gray

Yes, and I’ll give you the reason why I think that’s actually fair. Certain things in the tax code, as we all know, only benefit rich people, clearly. Like “2 and 20” private equity carried interest. These kind of things. Obviously who owns these things? Billionaires. The insurance schemes that are out there especially like PPLI, PPBA, it’s all billionaires. Great.

We should probably close those down. The ETF obviously benefits billionaires, but it also benefits millionaires and smaller investors. But more importantly, it’s good public policy because it eliminates tax externality problems, whereas in a mutual fund, if a mutual fund has been around for 20 years and has zero basis securities and someone comes in with the big redeem. If I happen to buy that fund this year and they get a big redeem and they have to sell down securities to incur a huge tax liability, me as a new shareholder will get stuck with someone else’s tax bill.

00:27:30 Rick Ferri

Yeah, it’s always a problem.

00:27:31 Wes Gray

Yeah, that’s just not fair and it’s a bad structure where the ETF externalizes all taxes to the end user. You want to be a day trader? Great. You can pay short-term capital gains every time you buy and sell the ETF. You want to be a long-term investor that holds for 20 years? Great. You get compound deferral for being disciplined and having long horizon. But then no one else in the fund can affect the other person’s tax problem, which is how it should be from a public policy perspective.

00:28:02 Rick Ferri

So, you send out this Microsoft to the authorized participant. Basically, this third party. And they turn around and they give you the equal amount of Exxon. So now you have Exxon stock.

00:28:14 Wes Gray

Yes, and this is again oversimplified, it doesn’t work like this exactly, but pretty much it works like this. When you receive the securities in-kind, they have mark-to-market basis at the price you received it at. So, in this case, we received an Exxon and it’s at $100.

The basis on Exxon is $100. So, what the ETF has done is it has tax efficiently rebalanced from Microsoft to Exxon, and it hasn’t dodged tax. It has deferred tax because remember that NAV of the ETF was $1, it went to $100. So, if you sell the ETF, you’re going to pay your tax and eventually you will pay the tax. It’s just you get to compound tax deferred until you sell the actual ETF structure itself.

00:28:56 Rick Ferri

Well, let me ask some question about losses. I mean, not every stock you buy goes up. So, if you have a loss in a mutual fund, they could sell it at a loss and they can offset some gains. In an ETF, do you sell losses and exchange out gains?

00:29:11 Wes Gray

We do, not because you really have to but it just builds efficiency in the funds. So, for example, if I can always get rid of gains through redemptions, that’s obviously a good idea for shareholders. But if I have a natural loser that I want to get rid of, why wouldn’t I sell that to bank a bunch of tax loss that we call it tax loss insurance?

So then maybe I don’t have to do a custom in the future. Or let’s say a company announces hey, we’re doing a cash offer on this stock you own and it’s going to happen tomorrow. I want to have a little bit of insurance there. So, I don’t have to quickly do a custom rebalance and gives the trading team flexibility and optionality.

And then also just because I don’t know if other people do this, just what we do, but I’m just always concerned about the government and the long game because they’ve already proposed eliminating 852B6 before.

So, we just try to accumulate and bank as many losses as humanly possible. So OK, you guys eliminate the law. Great. I’m still 10 years compounding tax free because I’ve been accumulating losses for the last 10 years.

00:30:15 Rick Ferri

Do those losses expire at some point?

00:30:18 Wes Gray

No, you can’t distribute them in a RIC, but you can carry them over forever.

00:30:24 Rick Ferri

So now we’re going to go to a product that you created, probably the product that has the most amount of assets in it and you’ve only created it about a year and a half ago. It’s called the Alpha Architect one-to-three-month box ETF. The symbol is BOXX which is like a money market fund.

But it uses this ETF structure to defer taxes. By the way, on the Bogleheads Forum, this has 50,000 views and pages and pages of comments. It’s probably one of the biggest discussed items on the Bogleheads Forum in the last year and a half.

So, first of all, tell us what it is and how you use these trades to create a tax-efficient money market fund. One thing that’s, before you answer, I need to say this. I’m going to be making a lot of comments about taxes, but Wes, you’re not going to be commenting about taxes specifically related to this fund, and perhaps you could start by explaining why.

00:31:33 Wes Gray

Yeah. One of our core beliefs is transparency. However, when it comes to BOXX, I always tell people it’s like Fight Club. The first rule of BOXX Club is we cannot talk about taxes. And the reason for that is to protect shareholders. So, I will tell you about box spreads and I’ll tell you about the ability, if you don’t have distributions in a RIC, obviously you have a capability to compound.

However, there’s this rule. It’s called Section 1258, which talks about discussing the taxation of certain transactions. And so, we just basically do not want to talk about tax in general on this thing because it’s in the best interest of shareholders.

But that said, the box is basically something that’s been around for a long time. It’s essentially a way to extract funding rates out of the option markets. What I mean by that is whenever you buy or sell options, they’re implicitly leveraged positions. Obviously, a call option is very different than just buying VOO.

00:32:38 Rick Ferri

And VOO is the Vanguard S&P 500.

00:32:42 Wes Gray

So, what happens is if you just buy VOO versus buy a call option, obviously the call option you can effectively get the upside benefit of a stock, but you only have to post a little bit of capital and there’s, long story short, there’s embedded leverage in the option.

And so, what a box spread does functionally is you do two option positions that create what they call a synthetic long position. So, if you buy a call and you sell a put at the same strike, it effectively replicates the payoff profile of a stock. It’s just math. And then that’s one leg of a box spread. The second leg of a box spread is to create a synthetic short position in the stock.

And what are you going to do there? You’re going to buy a put and sell a call on the same strike. And intuitively, if one creates a synthetic long position and a synthetic short position, you will have effectively eliminated market risk, right? Because if you’re long and short the same asset you don’t have risk. And in the context of the option markets, if a position is fully hedged like this would be, what is it going to deliver?

Well, the box spread is going to deliver the payoff and the difference of the strike prices. So, if I create the synthetic long position with say, a strike price of $100 and I create the synthetic short position at a strike price of $200, that option box will deliver $100 guaranteed in say 3 months from now.

So anytime in the marketplace, if we all know for market efficiency, where you have an opportunity to get $100 payoff guarantee three months from now, it’s obviously not going to be selling for $10 or $20. It’s probably going to be selling for $99 or $99.50, and it’s going to be arbitraged very closely to effectively Fed funds rates.

00:34:43 Rick Ferri

Basically, you’re teasing out, say, a T-bill rate.

00:34:47 Wes Gray

Yes, exactly.

00:34:49 Rick Ferri

I remember that when I was in the brokerage industry, I never did a box spread. But they used to talk about it all the time in The Morning Call. They were talking about the cost of doing a box spread on any particular day. It was very routine.

00:34:54 Wes Gray


00:35:00 Rick Ferri

The transaction is not new. This transaction has been around for decades. Like you said, it’s widely known. Tease out the T-bill rate from doing these box spreads on options, but you have taken this concept and you put it in an ETF.

00:35:15 Wes Gray

Exactly. So, we basically took what is effectively an institutional money manager trading funding trade and thought, why don’t we put this in the ETF? Generally, box spreads have a premium over equivalent duration bills, so this funding spread, it’s a limit of arbitrage problem. Typically, what you’re going to get is like Fed funds plus say 25 to 50 basis points.

00:35:38 Rick Ferri

And that 30 to 40 basis points means 0.3 to 0.4%. So, if the Fed funds rate was 5%, then your borrowing cost would be 5.3% or 5.4%. I know we threw out a lot of jargon here, but the bottom line with the box spread is you’re going to get if you’re a buyer of a box spread, probably a little bit more than the three-month T-bill rate.

00:36:03 Wes Gray

Yeah, exactly.

00:36:04 Rick Ferri

And now, you’re going to charge a fee for putting it in an ETF. And I think your fee is 0.2%. So, the net result is an expectation of the T-bill return to an investor.

00:36:18 Wes Gray

Yeah, we’ve beaten it a little bit, which is our goal.

00:36:21 Rick Ferri

So, you can do in-kind creation and redemption just like you can in an ETF with stocks and bonds, only doing it with options. Now if it’s a stock, and you send it out in a basket to be exchanged for another stock, you don’t have capital gain.

And that’s the way it is with options as well. So, I know you can’t comment on this, but I will. That creates almost like a money market fund that doesn’t pay out interest or capital gains but just grows in value. And then me as an investor decides when I’m going to pay my capital gain by selling shares in the ETF. This is really interesting to me and should be especially interesting to people who have had a realized capital loss in their portfolio.

You can only write off $3,000 against your ordinary income every year, and unless you have capital gains and this creates a very steady stream of potential capital gains. And I know you can’t comment on any of that, but that’s just me as an advisor thinking now how would I use this product.

00:37:24 Wes Gray

I don’t want to comment on any of the characterizations of the taxation, but the one thing I can comment on, and when I say that our objective is to achieve is we are attempting to not distribute anything to the extent that we’re able in that particular fund, that that’s something we want to do is we don’t want to impose people with any sort of distributions of any kind of characterization.

00:37:49 Rick Ferri

Before jumping off this topic, I will state the other side of the coin that is that there is an opposing view on how the gains in BOXX should be taxed. Many of the posts on Bogleheads are about this very topic. Some notable academics believe that it should be taxed as ordinary income and not capital gain. So, my advice is to consult your tax advisor.

OK, let’s move on to the next topic. Direct indexing. One of my favorite things to talk about with you. This has become a popular separately managed account sold by advisors, asset management companies, brokerage firms, and I emphasize the word sold.

Direct indexing is: you hire an asset management company to go out and buy hundreds and hundreds and hundreds of individual stocks and then manage that portfolio to an index.

But if there’s a loss in any particular stock, they would sell one stock or two stocks, take the loss, and then you could use those losses to offset gains that you may have if you sold stock that had a gain or a business that had a gain or real estate that had a gain. And this is one of the uses for a separately managed account.

Or direct indexing. Another one would be you have a big position in a particular company and you want to build around it. Another one would be you have an ESG mandate, so you want to eliminate various stocks. There are other reasons.

But this reason, the one that I’m talking about, is a way to generate capital losses that can be used to offset a capital gain that either you took this year or you know you’re going to take. So, you’re going to build up these losses and then take the capital gain next year. Now, did I say anything wrong about direct indexing, by the way?

00:39:43 Wes Gray

No, you covered it.

00:39:45 Rick Ferri

OK, good. Thanks.

Well anyway I have an issue with this and that is, well, what do you do with this thing? Let’s say you have a big capital gain. In other words, you sell your business in January, and you take the money and you put it into direct indexing. And you try to create as many losses as you can during that one tax year so that you can use the losses that you generate in direct indexing to offset the gain that you have in the sale of your business or the gain that you have in the sale of this big block of maybe one stock.

But the next year it’s done. I mean, you’re not going to sell your business the second year. The taxable event is this year. So next year what? What are you left with? You’re left with a whole bunch of stocks, hundreds and hundreds and hundreds of stocks.

And what do you do with them now? The advisors and the brokers and the asset managers, they don’t want you to get out of all of these stocks because they collect fees every single year on these, on the management of this account. But you don’t need all those capital losses anymore and you certainly don’t want to carry hundreds and hundreds and hundreds of stocks.

For the rest of your life, my issue with the directing indexing has always been there had to be an exit strategy from that. Now the exit strategy could be well, you take the stocks that went up and you give them to charity and all the rest of the stuff. You just sell and liquidate. So that was one way of getting out of direct indexing and not having to pay evergreen fees and not have to pay who knows how much to CPAs to figure out what you owe in taxes every year.

But you came up with a different way. Can you talk about that?

00:41:12 Wes Gray

Yes. So going back to the tax code – which is super exciting, I’m sure, for Bogleheads – we’re going to talk about this other tax code called Section 351. It is a section of the code that says that you can seed or basically transfer assets into a C-Corporation and not incur a tax hit via that transaction. And within 351, there’s a specific regulation tied to funding RICs, which as we discussed earlier, is what ETFs and mutual funds are taxed as from an IRS standpoint.

And so, a 351 allows you to, it says hey you have this, let’s say you have this direct indexing portfolio. You basically now have an overpriced index fund with no tax loss harvesting opportunities and a lot of complication. We can transfer all that in to seed an ETF. And then once we get all this stuff back into the ETF structure, we can be tax deferral forever. Clean it up. Fees are tax deductible again. It just went back to the Vanguard model. So, it’s a way to solve the complexity.

00:42:22 Rick Ferri

So just so I understand, I can have this portfolio of hundreds of stocks. And I could take it and I could turn it into your company. And what I’ll get in return is one ETF. And I’m not the only one who’s turning in stock, I mean there might be 50 people who are doing this. So, you’re collecting all of these portfolios out there and then maybe private investors who have portfolios of a lot of stock that they want to create an ETF.

So, everybody turns all their stock into Alpha Architect, and you then issue from all of that one ETF that for me has the cost basis of what the aggregate portfolio that I turned in has. Now I don’t have a I have to pay CPA. I don’t know how much money a year to figure out what my taxes are. I don’t have hundreds and hundreds and hundreds of stocks anymore. I have one. But what index does that track? I’m curious, when you create these.

00:43:22 Wes Gray

Well, you’ve got to get everyone to agree on either the index or the strategy, but doing exactly what you say, mechanically, you get 100 of your buddies. Hey, we have all got $10 million of low basis, direct indexing. Great. We’re going to do a syndicated 351 and then you we can all agree, let’s do VTI or you could pick whatever you guys would want to do.

00:43:46 Rick Ferri

VTI is the Vanguard Total Stock Market ETF. So, you’re going to mimic that.

00:43:50 Wes Gray

Yes. Or it can be anything, but let’s just keep that for simplicity. Great. Let’s say everyone’s at Schwab tonight. What we’ll do is we’ll take everyone’s account and we will transition (free of payment) all the securities over to our ETF custodian. Every single individual contributing, what’s going to happen is at the tax lot level, the basis in the individual securities you have will get remapped into ETF shares that you will receive in your account. Tomorrow when you wake up.

00:44:21 Rick Ferri

No kidding, really. It’s that fast?

00:44:21 Wes Gray

Yeah. I mean, of course we’re in the back end. There’s a lot of work going on here, but it happens overnight where you go to bed with say 500 random securities. And when you wake up tomorrow, you’re going to have the Rick Ferri ETF in your account or whatever the name of this ETF is, and then all the tax lots and the mapping and all this stuff is going to be, it’s never perfect. There’s always like $5 or $10 of leakage on one of the shares. But who cares if we’re talking millions of dollars here.

And you basically have not changed tax status, but now you’ve simplified everything into one ticker. And that just keeps the deferral game going forever.

00:45:05 Rick Ferri

Wow, that’s just incredible. I’m so happy to hear that you’ve done something like that. And by the way, this ETF now is traded, correct? I mean, you could buy it and sell it, and I can buy and sell somebody else’s ETF, right?

00:45:12 Wes Gray

Yeah, exactly. It’s just an ETF like any other ETF in the world. 351 is strictly just the seeding mechanism. But once that thing cuts the tape, hey, we’re open for business. It’s just like VTI, VOO or any other ETF that you would buy or sell.

00:45:31 Rick Ferri

How many of these have you done already, and how many do you do a year?

00:45:33 Wes Gray

We have done, we’re up to eleven of these tax-free transactions. Not just with SMA’s but with partnership interest transfer, mutual fund interest transfer. And this only came about four or five years ago because until the active ETF rule came out where they allowed all ETFs to be unified with respect to using customs.

00:45:55 Rick Ferri

Active ETFs, meaning you don’t need an index anymore.

00:45:58 Wes Gray

Exactly. And now we can use the tax efficiency as long as you have good policies, procedures for anything. And that’s really critical for 351 because let’s say you have 100 accounts and they all have a little bit different direct indexing program in this example we’re using. The problem is those aren’t all the same index.

And index funds have very, very strict rules with respect to what the fund can actually do. And so, the problem is if we dump in a bunch of these syndicated accounts and day one, it’s out of compliance with what the index is, we got other problems now with the SEC. So active, even though you may run an index fund internally like, hey, we’re basically following the VTI, whatever index that thing’s doing, but we’re not registered as an index fund. We’re registered as an active fund.

00:46:47 Rick Ferri

I see. Is that how you solved that issue?

00:46:50 Wes Gray

Yes, because now you have flexibility at the margin, even though mechanically you’re an index fund from an investment perspective. Legally, you’re not an index fund, so there’s a little bit more looseness on your ability to kind of manage and massage to your investment objective. And that was critical to be able to facilitate these deals.

00:47:08 Rick Ferri

What is the basis point cost that you charge because you have to manage this now going forward?

00:47:15 Wes Gray

So, from the infrastructure side, it’s all about scale. So, the all-in operating cost to do a plain vanilla U.S. equity fund at a billion dollars, the all-in cost of productions probably 9 basis points, 9 1/2 basis points. And then if you get bigger than that, the marginal cost of production is usually around 4 basis points, 4 1/2 basis points. So, the bigger the deal, the lower the operating cost.

And so, if you had a group of Bogleheads are just like, hey, we want to do a not-for-profit version of this and we just want to pay the cost of production, I’m sure you could probably set something up like that. But you can get these things pretty cheap if you have scale, which is the same way that Vanguard keeps things low cost because if you have scale.

00:48:02 Rick Ferri

So why don’t companies like Vanguard, BlackRock, why don’t they do that?

00:48:05 Wes Gray

It’s actually very complicated to facilitate and I’m sure they could eventually figure it out. But if your main asset is marketing distribution, and you’re out there like pumping these different ETFs and doing this and that. I just don’t know if their businesses are designed for efficiency to do bespoke custom ETF launches. We launch ETFs in our sleep. I’m sure if you try to do this at Vanguard, it takes five years of 50 committees to figure out how to get out of our own way to launch an ETF.

So sometimes one of the benefits of being small, nimble, entrepreneurial is we just get stuff done. Whereas if you’ve got boards upon boards of bureaucracy upon bureaucracy doing things like this, which are very entrepreneurial, very innovative, they’ll eventually get there, because even Vanguard I think does direct indexing now. But it’s just, they’re usually always, you know, five years behind people like us who are out there like innovating, getting new ideas out there.

00:49:03 Rick Ferri

Well, that’s fantastic. I mean, I’m happy. I’ve always been against direct indexing because there wasn’t any exit strategy. That was never any good exit strategy. But you have created one. So, that’s fantastic. I have one more question for you. It’s another tax question but it’s a lifestyle question as well. So, you now live in Puerto Rico and the federal income tax rates in Puerto Rico are rather unique for business owners. Can you describe that?

00:49:29 Wes Gray

Yes, it used to be called Act 2022. Now it’s called Act 60. And there’s two components of the Puerto Rico Act 60, there’s the Export Services Act, which is what you’re referring to and what that does is it says to the extent that you’re delivering services out of Puerto Rico, that income earned and that entity is going to be taxed at a corporate rate of 4%.

And the dividends distributed, because these are set up as C-Corps, so they have double tax, dividends distributed to bona fide Puerto Rico residents or zero. So effectively you pay 4% tax. There’s also frictional cost and you have to hire yourself as an employee. So, it’s not as good as it seems, but if you have any scale it’s a game changer. If you have $1,000,000 in export services income and you structure it down in Puerto Rico and your bona fide resident and you do the services here.

It’s a lot better paying 4% than 50% or whatever the heck, you know they’re charging nowadays.

00:50:31 Rick Ferri

Well, the top rate for federal income tax is 37%, but if you’re living in a state like California, you could be paying more than 50% total. Let me ask a question. If I lived in New York and I decided to not pay New York State income taxes, so I want to become a resident of Florida. I have to actually move down to Florida. I have to get voting in Florida. I have to get a license in Florida. I have to get a place to live in Florida. And then I don’t have to pay in New York State income tax.

But I have to stay in Florida, I think it’s like more than half the year or no, I don’t have to stay in Florida, but I can’t be in New York for, you know, a certain period of time do they have.

00:51:06 Wes Gray

The same kind of rules for you, same exact rules. And it falls on the same IRS guidelines on that. You have got to be a bona fide Puerto Rican resident, which means the same deal. You have got to live here. You have got to go to school here. You have got to vote here. You have to, actually, no kidding, this is your real place of home and activity. Remember, capital gains are sourced where your bona fide resident is.

So, there is a thing down here we can also pay 0% capital gain. It’s called the Individual Investor Act and you only have to be here six months in a day and be a bona fide resident. However, income and services are sourced where the service is performed. So, if I live here in Puerto Rico for six months and a day, doing my service, but then I go back to New York and hang out there for five months, New York can say, hey, that service income is sourced to the US and sourced to my state.

And so, yes, you’re PR bona fide resident. But I don’t care. So, then what would happen there is you’d have to do six months and a day of your income is PR sourced and then the remainder wherever you are perform those services would be sourced to that jurisdiction. So, it behooves you if you’re doing what I’m doing. I spend 90% plus of my days down here and the only time I go to the states I’m on vacation or whatever. But I don’t do any services in the states because I don’t want to have to attribute income up there, so it’s a little more complicated on that.

00:52:33 Rick Ferri

Let’s say I owned a very big position in a particular stock and then my basis was $0 and I moved to Puerto Rico, established residency, voting license, rented a house, and I lived there for six months and one day. I could sell that block of stock and not have any federal capital gains tax?

00:53:01 Wes Gray

No. So what they do is when you move down under the Individual Investor Act under Act 60, what they’ll do is they mark to market that position and so all gains after that are 0. But that prior carryover basis remains. However, if you live in Puerto Rico for 10 years, all that basis gets attributed to your PR residency, and then you can do that and you pay I think 5% Puerto Rican tax. But you can’t live here for six months a day, sell it and avoid the whole billion-dollar tax. Unfortunately, they have rules around that. But there’s a lot of techniques and tools that one can look at to help manage situations like that. But it’s not as easy as you mentioned. But it is very, very favorable.

00:53:45 Rick Ferri

How long have you been in Puerto Rico now, how many years?

00:53:50 Wes Gray

I’ve been here just over three years now.

00:53:52 Rick Ferri

So, in seven years you could sell your company for $500 million and basically not have to pay any capital gain.

00:53:58 Wes Gray

Exactly. So, I’m in a very good tax position obviously down in Puerto Rico.

00:54:05 Rick Ferri

I didn’t mean to put you on the spot, but I was just curious because when you told me you were moving to Puerto Rico, I said, what?

00:54:08 Wes Gray

Yeah, it’s not for everybody. But for service members, it’s very compelling because by nature you’re used to deployments and uprooting yourself. Because that’s usually the problem. Most people that do the math and they’re like, oh my God, I’m going to get paid tons of money to go live in a beautiful tropical island. Why don’t we do this?

But the problem is status quo bias is a very powerful thing. You have got to have someone who’s got a little bit of adventure spirit in them because Puerto Rico is not Plano, TX where everything is bubble wrapped and perfect. It’s not. I think it’s great. I personally love it for me, but it’s just, you know, it’s …

00:54:49 Rick Ferri

Not it’s not Miami Beach.

00:54:50 Wes Gray

It’s not Miami Beach. But I actually personally like that and I like the people here a lot personally, but it is not for everybody. Just want to highlight that.

00:54:59 Rick Ferri

You have three children, three young children. How is the school system down there?

00:55:02 Wes Gray

My kids do not speak fluent Spanish. That automatically puts you into the private school network, which I remember in Philly, it’s like $40,000 a year just to send your kid to private school. Here it’s expensive, but it’s like $10,000 per kid, but it’s much more reasonable. And they have English speaking schools and where I live in this place called Palmas Del Mar, the school is literally a quarter mile from my house up the road here and it kind of placates to the Palmas and like the local community here.

00:55:33 Rick Ferri

Well, Wes, it’s been great having you on Bogleheads on Investing. It’s always interesting to talk with you and all the interesting things you’re doing, not only with Alpha Architect but personally as well. So, my best to your wife and kids and thank you so much for being my guest again.

00:55:50 Wes Gray

You got it, Rick. Appreciate the time.

00:55:53 Rick Ferri

This concludes this episode of Bogleheads on Investing. Join us each month as we interview a new guest on a new topic. In the meantime, visit boglecenter.net, bogleheads.org, the Bogleheads Wiki, Bogleheads Twitter, the Bogleheads YouTube channel, Bogleheads Facebook, Bogleheads Reddit, join one of your local Bogleheads chapters and get others to join. Thanks for listening.

About the author 

Jon Luskin

Board member of the John C. Bogle Center for Financial Literacy


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