Investing in Texas Exceptionalism

In June 2023 I featured a real estate investor who had made the bull case for Texas that it enjoyed unusual tailwinds as a diversified economy with low costs and a business-friendly government. 

Ten years ago Hearst Newspapers columnist Erica Grieder wrote a whole book with this thesis Big, Hot, Cheap, and Right: What America Can Learn From The Strange Genius of Texas

If you agree with this perspective, you now have a way to express this bet with your own money through a single exchange-traded fund, or ETF. 

The central thesis of the new ETF (ticker TXS) launched in July 2023 by sponsor Texas Capital Bank, is that “companies headquartered in Texas enjoy certain economic, regulatory, taxation, workforce and other benefits relative to companies headquartered in other states,” according to the prospectus.

Ed Rosenberg, Managing Director for ETFs and funds management at Texas Capital Bank put it to me this way: ““The Texas economy is growing faster than the rest of the country. You have a lot of companies moving here, for obvious business reasons. It’s cheaper, and it has a better tax situation. There is a lot of young talent. A lot of people want to live in the state. Texas has more Fortune 500 companies headquartered here than any other state.”

You can imagine this kind of message appeals to state leadership. In fact Governor Abbott has been doing yeoman’s work to tout this new ETF, and even celebrated it by ringing the closing bell at the New York Stock Exchange on September 29th, along with executives from Texas Capital Bank. 

How should we evaluate this fund on its merits?

In order of priority, in evaluating a potential investment mutual fund or ETF, I would look at effective diversification within its theme, fund cost, tax-sensitivity and lastly, a track record of returns. 

Diversification

The managers of TXS have paid outside data firm Syntax to create a unique index with two layers to it. The first layer is built on data from the US Bureau of Economic Analysis, which measures the GDP of Texas to figure out which industries contribute to the economy, in what proportions.

Syntax then seeks to match the industry weightings of the fund to the relative influence of different sectors on the Texas economy. The managers identified eleven separate industries that make up the Texas economy.  Energy is the largest component, but is still less than 25 percent of the index. Meanwhile consumer discretionary, industrials, and information technology make up 14.5, 12.7, and 11.5 percent of the Texas economy respectively, and therefore make up that much of the index on which TXS is built. From there, the index qualifies companies within each sector, and weights them according to market capitalization, which just means their size. 

As of September 29th, the top ten largest holdings comprised 35 percent of the fund, including well-known Texas-based companies such as Tesla, Exxon, Charles Schwab and Waste Management. So there is some significant concentration with giant companies headquartered in Texas. 

Further criteria for inclusion: Companies have to be headquartered in Texas, and meet liquidity and publicly-traded size characteristics. No penny stocks here, or closely held companies with a tiny “float,” of shares that barely trade. Overall the ETF owns more than 200 companies in eleven separate GDP-weighted industries, so certainly passes the diversification test. 

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Digging into the TXS details versus benchmark

Something that the fund by definition does not offer is geographic diversification, but rather the opposite, geographic concentration. An investor would need to achieve geographic diversification with some other vehicle.

Style

One thing we can say about TXS, relative to the mid-cap index against which it is judged, is that the Texas companies in the index overall skew more toward a “value” orientation rather than a “growth” orientation. This is reflected in the dividend yield (higher than the index), in the price/earnings ratio (lower than the index) and the fact that energy rather than technology is the largest industry within the fund. That doesn’t predict returns in the future, but it is a set of characteristics that would help an investor or investment advisor figure out how TXS could interact with other investments within a larger portfolio.

Costs

TXS charges a 0.49% management fee. Management fees for mutual funds and ETFs have come down dramatically over the past two decades. If a standard mutual fund would have cost around 1 percent in fees in 1993 or 2003, the competition from low-cost index funds has made a 1 percent mutual fund or ETF an outlier today. Many passive ETFs charge 0.03 percent or 0.1 percent these days, one-thirtieth or one-tenth of what might have been standard two decades ago. To choose a higher cost ETF in 2023 is to make the implied bet that the higher-cost fund will consistently outperform its benchmark, every year. That rarely happens, so it’s rarely worth doing. TXS at one-half of one percent is somewhat expensive for an ETF. You’d expect it to earn half of one percent higher than comparable funds every year to justify the costs.

I’d grade TXS with a solid B in terms of cost. It’s not 1 percent pricey, but there are many cheaper ETFs in the marketplace.

Tax 

Tax sensitivity matters only for funds held outside of a tax-deferred retirement account. A “tax-sensitive” fund refers to the idea that high-turnover funds may generate capital gains tax liability throughout the year that a low-turnover fund does not. In general, tax sensitivity would favor passively-managed investments over actively-managed investments, and a long-term buy-and-hold approach instead of a short-term tactical approach. 

TXS describes itself as passively managed, so should end up fine on a tax sensitivity measurement. The portfolio manager also has discretion to manage securities to minimize taxes, according to Rosenberg.

Expected Returns 

TXS first became available in July 2023, so past performance measurement in October 2023 is meaningless. I mention this mostly to make the point that short-term returns should be a pretty low priority when picking this, or any other, fund. 

A rookie mistake in purchasing ETFs and mutual funds is to choose the best performing recent fund over the past 1 or 3, or even 5 years. Not only is that time horizon too short to give meaningful information, but that approach puts the investor at risk of buying hot funds, just as the market or investment fashion takes a turn in a different direction.  

Any outperformance of the fund versus its benchmark may be attributed to the initial thesis of the fund over the longest period of time. Or, it could be attributable to other factors that will be mostly understood in retrospect. In any case, judging returns of a fund in a time period less than 10 years is to risk conflating noise and signal. 

We might have some useful data 10 years from now to judge whether the “Texas Thesis” of 2023 was a good one or not. But we definitely don’t have enough data now to make that judgment. So investing in TXS can only be based on a hunch and a gamble. I’m not knocking gambles. Lots of investing is done this way. I just think it’s useful to acknowledge that we’re doing that.

I do not personally own TXS in my portfolio, at least for now. (Your daily reminder: super-low cost, super-diversified equity index funds all the way, baby!). For similar life-philosophy and personality reasons I also don’t drive a King Ranch Ford F-150. For investors who don’t mind paying a little extra and who believe in the exceptionalism of Texas, Texas Capital Bank has invented a clever way to put your money where your cowboy boots are.

A version of this post ran in the San Antonio Express-News and Houston Chronicle.

Please see related post:

Book Review: Big Hot Cheap and Right, by Erica Grieder

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ETFs vs. Mutual Funds

etf_v_mutual_fundMutual funds and exchange traded funds (ETFs) do pretty much the same thing, which is allow an investor, with a single purchase, to own a diverse pool of assets – usually stocks or bonds, but also sometimes commodities, currencies, futures, bank loans or other financial exotics.

Since they mostly do the same thing, the most interesting question is usually not “mutual fund vs. ETF?” but rather a question about “asset allocation” – that is, what things you actually own within an ETF or mutual fund.

Asset Allocation

I wrote a few months ago what I consider to be the final word on the asset allocation question. To repeat:

“You should invest via dollar-cost averaging in no-load, low-cost, diversified, 100 percent equity index mutual funds, and never sell. Ninety-five percent of you should do that, 95 percent of the time, with 95 percent of your investible assets.”

What about ETFs?

You probably noticed I said ‘mutual funds,’ not ETFs. Well, 95% of the time you could substitute ETF for mutual fund and get the same result.

The rest of this column is about the 5% of the time when it makes a difference. The factors that make up that 5% include timing, minimum investment amounts, costs, liquidity, and availability of assets.

Timing

I like to call ETFs “mutual funds with ADHD” because you can trade them at any time of the day that markets are open, including multiple times a day if you like. This contrasts with mutual funds, which you can only buy or sell based on the end-of-day price, after the 4pm market close.

This feature of ETFs is not an advantage from my perspective. Since the right holding period for investing in stock markets is somewhere between 5 years and forever, the ability to trade in the middle of any day, for an individual, should be wholly irrelevant.

Minimum Investment

Some mutual funds and some mutual fund companies require a minimum investment such as $10,000, or $5,000, or $2,500. Or, different prices apply for different minimum investments. ETFs, by contrast, often can be purchased for as little as $100.

mutual_fund_v_etf

As a result, for newbie investors with their first $500 or $1000, ETFs can be the first step needed to get ‘in the market.’ Which is nice.

Costs

ETFs and mutual funds come in both high cost and low cost varieties.[1] For myself, I almost always seek out the low cost flavor, which tend to be in ‘passive’ or ‘index’ funds, rather than ‘active’ or ‘managed’ funds.

Vanguard – the giant brokerage and mutual fund company – reports that among ‘active’ strategies the average ETF is cheaper than the average mutual fund. Among ‘passive’ strategies, however, the average mutual fund is cheaper than the average ETF.[2]

The key to understanding your costs, of course, is to go beyond the ‘average,’ and to actually figure out the specific cost of any mutual fund or ETF you’re thinking of buying. Depending on the size of your portfolio and the time you have to invest, minimizing management fees will save you tens to hundreds of thousands of dollars over your lifetime.

So, it’s worth taking those five extra minutes and figuring out the fees, for a return on your time spent of, like, infinity.

Finally, depending on your brokerage company, purchasing some funds and ETF may incur ‘loads’ when you buy, and transactions costs when you buy and sell. Naturally, avoid if possible.

Liquidity

ETFs appear at first to offer better liquidity than mutual funds, because of the moment-to-moment prices for trading ETFs, rather than the once-a-day price of mutual funds. That kind of liquidity advantage, however, should be irrelevant, since your investment holding period ought to be measured in years, not hours or minutes.

In another sense, however, ETFs may in certain cases be less liquid than mutual funds. As you move on the spectrum from plain vanilla to more exotic ETFs, it’s possible that the illiquidity of the underlying assets raises the cost of transacting in ETFs.

During this past August’s market turmoil, for example, traders reported that certain ETFs in relatively illiquid assets such as bank loans or corporate bonds mispriced during the trading day.

As an individual investor, you should assume the ‘mispricing’ will not be in your favor in these situations. Market makers will raise the cost for investors of getting in and out of these illiquid ETFs through a larger wider gap between the price you can buy or sell the ETF, known as the ‘bid-ask spread.’

Availability of assets

Some brokerage or mutual fund companies where you do your investing may have a better inventory of products in ETFs versus mutual funds – or vice versa – making it necessary to buy one rather than the other. Because most of the time mutual funds and ETFs in the same assets do the same things, normally you can substitute one for the other without worry.

As always, the choice of ‘asset allocation’ – what underlying things you’re buying – matters more than the packaging, whether wrapped in an ETF or a mutual fund.

 

[1] To give you a benchmark for high or low costs, some active mutual funds and ETFs charge 1.5% fees or more, while some passive mutual funds and ETFs charge 0.15% fees or less. That’s an order of magnitude of ten times the cost between the low and high cost varieties.

 

[2] The average index ETF charges a 0.29% management fee, while the average index mutual fund charges a 0.14% fee. So index mutual funds are cheaper, on average, than index ETFs. The average actively managed ETF charged a 0.62% fee, while the average actively managed mutual fund charges 0.80%. So actively managed ETFs are cheaper than actively managed mutual funds, on average. Source: Vanguard webinar on ETFs v. mutual funds.

 

A version of this appeared in the San Antonio Express News

 

 

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Interview: Author Lars Kroijer (Part I) – on Global Diversification

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In the first section of this interview with author Lars Kroijer we talk about his idea, from the book Investing Demystified, that we should all seek portfolio exposure to the broadest segment of global equities – essentially all 95 stock markets in the world.  In the second part of this interview we talk about the opposite – namely the dangers of concentrating all of your investment portfolio within, say, your home country.

 

Michael:          I’m talking to Lars Kroijer, [/Kroy’-er/] the author of Investing Demystified which I’ve reviewed on the Bankers Anonymous site. First things first, I read your book and I agree with a ton of it, the theory. And then I thought about my own portfolio, and I thought I’m two-thirds the way towards what you’re saying. By that I mean I invest in index-only Russell 2000 index funds. Talking about my retirement portfolio. I halfway embraced what I think is – in shorthand – an efficient market hypothesis. But I’m not entirely there, so tell me about why I’m doing it wrong.

Lars:                It’s an interesting place to start because you are doing it less wrong than most people in the world would be. You being an American investing in a very broad US index, you are already invested in a very large portion of the world-equity portfolio. What I would normally tell people is you need to invest cheaply and extremely broadly in equity indices for your equity exposure.

Now what does that mean? That means all equities traded in the world.  I think there are 95 public equity markets in the world today, and you should be invested in all those in proportion to their values. You’re only invested in one, the US one, but that’s the biggest one by a very large margin. So failing to invest abroad is less of a sin than it is for someone who is based in Denmark, where I’m from, that represents only 1 or 2% of the world-equity markets. Where I’d tell you you’re going wrong is you should diversify beyond the US, and you’re not doing that.

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Only ~1 % of global equities in Danish stock market

Michael:          So I’m a complete hypocrite on this front. I worked in emerging markets so I professionally, on Wall Street, worked in non-US markets. Whenever I speak to friends, I say, “If you’re completely exposed to the US, you’re doing it wrong.” And nobody who grew up in any other country but the US would probably ever dare to be so bold as to only invest in their own country. It’s an irony.

Lars:                It’s interesting you say that, if I could just interrupt you there; you look at institutional investors in the UK or in Denmark, really any country in the world, and a lot of them will have exposure to just their own domestic stock markets, for lots of terrible reasons.

I’m saying that is generally a mistake, but in your case, it’s less of a mistake than if you lived in Denmark. If you lived in Denmark you would only have exposure to 1% of the world equities, where in the US it’s more like 35-40%. When I tell people to go buy the world-equity portfolio, you already have 35-40% as opposed to in Denmark you’d have 1-2% of that, so that is a big difference.

Michael:          Getting extremely practical, how many different positions in either ETFs or mutual funds do I actually need to buy if I’m going to get some kind of efficient frontier of global equity exposure?

Lars:                You can do just one.

Michael:          There’s a single ETF?

Lars:                The reason I’ve refrained from endorsing just one specific security is because I’m hoping that world-equity markets is a race to the bottom in terms of fees product. Right now, that might be called MSCI All Country World. Personally I don’t care what the index is called because what we’re after is the broadest, cheapest exposure. If someone comes up with a cheaper, better index, that’s even better. If an index-tracking product is cheaper and better, that’s even better. But you can buy the MSCI All Country World in one ETF, iShares will do that, DB Trackers will do that, Lyxor will do that. Vanguard does a version of it.

Michael:          I was going to ask: I use Vanguard because of their brand name, and low cost, passive mutual fund investing.

Lars:                They’re very good.

Michael:          They have this global, total world-equity exposure. Are there another half-dozen US fund companies who also –

Lars:                Yeah all the large ETF providers will have it.

ETF

This idea that you have your house, your education, your pension, all your assets come together and really are correlated to the same thing, which is typically your local economy. So one example I have in my book is imagine you’re a London-based real estate agent and you have your own flat. And you have a pension with the real estate agents, and then on top of that you own a couple of real estate related stocks in the UK.

Now, you are really long in London real estate market and that’s crazy to do that in your investment portfolio when you’re already so long in the rest of your investment life. This is yet another reason you’ve really got to stay diversified in your investment portfolio. Even sometimes your future inheritance is going to be in the same stuff: your parents’ house, your spouse’s job, dependent on the same local economy, your future job prospects dependent on the same local economy. Don’t have your investments in that same area.

This argument actually works better outside the UK because you can apply it to ‑‑ instead of London real estate I say Denmark. So very easily don’t have your equity investments in Denmark because you’re already long in Denmark. I think that’s a hugely important part of why these kind of diversified products really make a lot of sense for a lot of people. And why I think it’s a great shame that people tend to have their equity investments and investments generally so close to where their other assets are. They really all can go badly wrong at once, and that’s exactly what you should avoid.

Michael:          We know from the 2008 crisis that all risk assets correlate almost to one. In extreme downturn – everything that is a risk asset goes down all at the same time. That was a very scary reminder of that. There is nothing that is at all risky that doesn’t drop in value in a crisis.

Lars:                You’ve got to diversify. Then you could also look at if you’re a Greek investor, your real estate, your future pensions, your house, your job, all that would go belly up at the same time. Meanwhile, the rest of the world was fine. Imagine you had Greek government bonds as your low-risk asset. If you’d also had the Greek equity market as your equity exposure, you really would’ve been toast. Don’t do that. You’re not getting additional expected returns to reward you for that.

I think that’s an area that’s very important that people don’t talk enough about. That frustrates me. Again, people don’t want to listen to it because there’s little money in telling someone to buy the world-equity index. No one is interested in that.

Michael:          As an emerging-markets guy, it’s clear to me that anybody with any kind of net worth in any of these countries which has experienced typically a currency devaluation or nationalization or national political crisis, anybody generationally who grew up in that who has any net worth, always has a significant portion of their assets in Europe or the US or hard currencies. But in the US we don’t have an experience of having our credit – of course it’s been downgraded in the US but it’s not been junk status.

Our currency has never devalued wildly or unexpectedly. People are quite complacent about the idea of our exceptionalism. I’ve often said ‑‑ you said you wrote this book in a sense for your mom. I’ve often had conversations with my mom along these lines of do you know that most US investors have never considered that their house, job, currency exposure, government credit exposure is all US based? With almost no diversification. And we’ve gotten away with it up to this point, but it doesn’t mean we will in the future. It’s imprudent but as you say, people continue to do it because it’s either complicated, seems hard, boring, or not enough people are telling them to look elsewhere.

Lars:                No one is really incentivized for you to do that. No one makes money. The CFAs or financial planners don’t make money from this. What we’re talking about is not a good thing for the financial-planning industry either.

Michael:          It’s a much lower fee situation.

Lars:                Much lower fees, and paid by the hour kind of stuff.

Michael:          For the typical ‑‑ my orientation is the US investor ‑‑ the typical US investor, it will sound like madness when you say exposure to every equity market such that two-thirds of your money will be exposed to non-US will sound very aggressive to the US market. It doesn’t sound aggressive to me. It sounds like an obvious, logical outcome of the efficient-market hypothesis, just get the broadest exposure. But it will sound aggressive. You mean you’re going to put 65% of your net worth in non-US?

Lars:                You’re going to own Indonesian stocks? Where’s Indonesia?

Michael:          It sounds very aggressive. It sounds less aggressive to anybody who doesn’t live in the US, because they’re used to that.

Lars:                That’s right, I couldn’t agree more. This book actually shouldn’t but it’s going to be an easier pitch outside the US because you’re already likely to have exposure to non-domestic securities or at least you’re going to be accepting of the possibility that you should.

Michael:          In currencies and government exposure, and all of that.

Lars:                That’s why all the best FX (foreign exchange)  traders are all Argentine. They grew up ‑‑ my college and business school roommate is from Bolivia. He said the one time in his life his mom ever hit him was when he was a kid and he’d gotten some US dollars. He had to run down to the bank and exchange them. Or he had some bolivar or whatever it’s called. He ran down and exchanged the US dollars. He came across a [soccer] pitch and a bunch of guys were playing football,  so he played football for two hours and then he went to exchange it. The amount of money that had cost in the currency…

Michael:          Poor kid.

Lars:                You learn about inflation real quick.

Michael:          Tough lessons about inflation.

Please see related post, a book review of Investing Demystified, by Lars Kroijer.

 

Please also see related podcast post, Interview Part II – Do you have an ‘edge’ when it comes to investing?  We doubt it!  Also, a description of  Kroijer’s previous book Money Mavericks: Confessions of a Hedge Fund Manager

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