Welcome, everyone, to Bogle Heads on Investing, episode number 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 Ferry, and I am the host of Bogle Heads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a non-profit 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 Bogle Heads Conference in Minneapolis, Minnesota, are now on sale at boglecenter.net. The conference begins at 1 p.m. on Friday, September 27th, and runs through noontime 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 number nine. Wes is 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, 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. Rick, appreciate you having me back. Thank you for coming back. 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? Yeah, I'm all vegan. No, I'm a big fan of steaks and old school stuff. And you went to the Wharton School at the University of Pennsylvania, where you graduated magna cum laude in 2002 with a bachelor's of science degree in economics.

And from there, you took the University of Chicago Booth School of Business to get a PhD right out of undergrad, which is unusual. Yeah, so it's definitely unusual. But what happened, I was basically serving as the data monkey slash programmer for the Wharton Finance Department. And all of them were Chicago PhDs.

And through that process, they highly recommend 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's kind of how I got pushed in that direction is I had a bunch of professors suggesting that I go that route.

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? 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. 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.

Yep. 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? So I had always wanted to do the service.

The problem was just timing. Originally, I was going to do it after high school. And my parents were like, well, you should go to college. And I was like, all right, great. And then I got into college, so I started doing that. And then after college, I was thinking, okay, now I should go to the Marines.

But then I got into the PhD program. And so it's just a matter of like, I either got 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 are former military officers, either from like, you know, Nordic countries or Israel or China even.

And when I mentioned this, like, hey, I might take a sabbatical, you know, they're actually like, oh, yeah, of course you should do that. That makes, because I'm the only American in the entire program, I think, in my group. So they're like, well, of course you should do the service and serve your country.

Like, 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. And you went in the Marine Corps, became an officer, and you ended up in Japan, correct? Yes. I got my sabbatical approved for 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 amiable to the idea. So 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 just had everything lined up to allow me to do this weird funky move. And then you're right, I got in, you know, spent like a year and a half kind of pipeline training, then started off in Japan. And then you were tasked to become retrained and go over to Iraq, where you would be embedded with the Iraqi soldiers.

Yep. And during that period of time, you taught yourself Arabic. Yes. Just like I am with Spanish now, I'm not going to claim fluency, but I'm going to claim functional. And, you know, I was the intel officer, so my job on the team was to kind of 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 kind of behooves you to just put in a serious investment to learn the language. I actually went on a few missions where I was actually the Terp.

So I, like, the Terps had to go, like, help the other guys. I was like, you know what, I got it. You know, so we go do combat patrols and, you know, everything. I was the Terp. Terp is interpreter, of course. Oh, sorry. Yeah, interpreter. Yeah, that's jargon. I was stationed in Japan for about six months.

And while I was there, I picked up all the Japanese books and tried to teach myself how to read and understand the language. I was only there for six months, but it almost became somewhat functional. You know, I was able to understand enough to, you know, get around. Oh, yeah.

So then, after that, you wrote your first book, Embedded, which was about your experience in Iraq. You know, I was very gung-ho, you know, let's go after Iraq. I was drinking the Kool-Aid. I had to write a book. After Iraq, you came back and went back into the Ph.D.

program, received your Ph.D. And again, under Gene Farmer, 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? Yeah, that was the plan. Yeah, easier said than done, as many people, especially bogleheads, come to realize.

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, Ph.D.s, brilliant people. It's difficult to beat the market, isn't it? Yes. Yeah, you've 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 a short-term sense, because everyone wants to try to beat the quarter numbers, that's impossible. And usually you're going to overpay it in fees and taxes to get there. You know, 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've still got to worry about keeping the fees down and keeping the taxes down. Otherwise, it's all for naught.

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 phenomena or a risk phenomena? And what I'm, well, I'll let you explain what that means. Yeah. So basically, as you know, there's these huge debates, which in some sense are worthless from an investment standpoint. But academics like to debate whether the reason value beats, quote, unquote, the market.

Is that because of additional risk, like fundamental risk? Or is it because mispricing? People throw the baby out the bathwater. This company's a loser. It's no good. And that's just because of behavioral issues. Or is it because it's just 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 to 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 a component of what drives factors like momentum and value in particular.

Now, there's been a lot of papers written about this. But since those papers have been published, there's even faster computers and more PhDs and more mathematicians that are in the industry. Yep. My guest's last program was Larry Suedro. He wrote a book called The Incredible Shrinking Alpha. Yep. Where he makes the case that it's even harder now than it was 20 years ago to beat the market.

Do you think it's even getting harder now to call it behavioral, given the fact that 90% of trading in the marketplace is institutional? I actually think it might be the opposite, weirdly enough, right? Because the issues with behaviors usually has to do with short-termism and corporate boards and weird governance structures where, for example, if you go to like the quote-unquote 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. Or 25-year cycles, exactly. 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 behavioral to be worse. Because now people, unfortunately, have more information to grasp on, 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. It's 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's 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 and doesn't have anything about finance. And intuitively to them, wait, this person with 20 PhDs 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.

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. Yes, that's definitely not the case. So the first clients you picked up were separately managed accounts, some large investors.

Yes. 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? 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 had 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 like, wait a second, we paid $2.20, 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, right? We need to get efficient, transparent, control, all the good stuff that Bogleheads love. And so I was heavily influenced by that. And when we learned about the ETF structure, and to be frank, it's basically a massive tax deferral structure in plain sight, and we're doing active strategies.

One plus one equal three, and it made a lot of sense for us to move in that direction. Well, we're going to get into the tax advantages of ETFs here in a minute, which you've really excelled in. You ended up launching some ETFs, 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. Yes, we, at the time, whether it was good or bad, you know, we were like Marines. And then Pat was also my team's for a Marine.

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 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 prospective things and these exemptive reliefs, they sure look like they just Xeroxed them and changed 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 without, like, 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? You know, and then we went back to the drawing board. So, we were total bootstrapped way back in the day. And then, you know, over time, we've gotten smarter. But, so, we tried to do everything ourselves, even get rid of the lawyers.

But, lesson learned is that's impossible. And now, I got more lawyers I know what to do with. But, at the time, I was trying to avoid the lawyer situation. Yeah, I remember those days. I remember the first time I went to your office. I don't know, maybe it was 2012 or whenever it was, when you had first moved into your basement of your house, basically.

And 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. 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 were like, you know, we don't want to deal with other people's problems. Like, 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 Toll, who I'd 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 like slamming us on the face like, you guys should do this. You guys should do this. And then finally, you know, kicking and screaming, we said, all right, 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 then just over time, because we kept getting people call us and say, hey, how do we give you money? We thought, well, you know, if people, you know, want to keep giving us money to do this, we must be on to something.

And then we quickly like started hiring, professionalizing, and then created what is now what they call ETF Architect, which is just, you know, A to 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 goldmine type business.

Well, I know Perth told 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. Yeah, exactly. It's all about freedom. So economic freedom, personal freedom, which obviously you and I, like, I just love the idea.

Just from a marine perspective, not maybe investing, you could argue different ways. So yeah, effectively, that's what it's doing. And she's, to your point, she has amazing persistence. So it's her, and she has an $800 million of assets, her, out there telling the story of like, hey, you should deploy freedom concepts in emerging markets, because freer societies, freer economies generally grow faster and, you know, 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, you know, she's done very well for herself. Yeah, but I remember, I recall it was really slow at the beginning. And we had some conversations, Perth and I, about, you know, 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. Yeah. Okay, so 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, you ever get tired of being called very smart? No, don't, it gets counteracted with my kids and my wife, telling them I'm an idiot every day. So, you know, I need to balance it out a little bit. I'm still way in deficit. It's all good. 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.

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, right? And so, all of 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 now, like 10, 15 years ago, I was at some 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, how it all works.

And I'm like, so 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 know, you rebalance, you custom baskets. I was like, well, that seems like a huge deal. So, that's where it kind of started.

And then, rolling forward, as you know, like before the ETF, the new ETF rule, it was unclear. Like, index funds had this advantage. Some firms like Vanguard and iShares had it on active funds. It was unclear, like, who could use what they call custom crate redemption, which has basically allowed us, you know, swap out securities and not have to pay taxes.

So, let's just step back and just walk through, like, 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 audience's purposes, let's say this fund owns Microsoft.

Buy it at a dollar, 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 broker account, same thing. If you do it in a hedge fund, an LP, same thing. All of those concepts that we just talked about, the mutual fund, the separately managed account, hedge funds, they all have to realize the capital gain in the account, and investors have to pay taxes on that.

Yes, exactly. Whenever you have a realization event, you know, obviously that is 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, ETFs have a unique ability to transact in kind. They don't have to transact in cash-settled transactions. What we can do, and again, to just 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-time.

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? So the reason it's not taxable is ETFs and mutual funds are taxed as RICs, regulated investment companies. And it's 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 processes. And by the way, President Biden just put forth his new proposals for increasing taxes and changing this law was not in it, correct?

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 in 20, private equity, carried interest, like these kind of things. Like, obviously, who owns these things? Billionaires. The insurance schemes that are out there, especially like PPLI, PPVA, 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, as you know, in a mutual fund, if a mutual fund's been around for 20 years and it has zero basis securities and someone comes in with a big redeem, if I happen to buy that fund this year and they get a big redeem and they have to sell down securities and incur a huge tax liability, me as a new shareholder will get stuck with someone else's tax bill.

Yeah, it's always a problem. Yeah, that's just not fair and it's a bad structure. Where the ETF, it 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, 30 years?

Great. You get compound deferral for being disciplined and having a long horizon. But 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. 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. Yes. And this, 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 receive them at. So in this case, we received an Exxon, and let's say it was $100.

The basis on Exxon is $100. So what the ETF has done is it's tax-efficiently rebounds from Microsoft to Exxon, and it hasn't dodged tax. It has deferred tax. Because remember, the 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 a compound tax deferred until you sell the actual ETF structure itself. Well, I got some question about losses. I mean, not every stock you buy go 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? We do, not because you really have to, but it just builds efficiency in the fund. 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?

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 like, 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 rebounds.

It gives the trading team flexibility and optionality. And then also, just because I don't know if other people do this, this is what we do. But I'm just always concerned about the government and the long game, because they've already proposed eliminating it 52B6 before. So we just try to accumulate and bank as many losses as humanly possible.

So, okay, 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. Do those losses expire at some point? No. You can't distribute them in a RIC, but you can carry them over forever. So now we're going to go to a product that you created, probably a product that has the most amount of assets in it, and you only created it about a year and a half ago.

It's called the Alpha Architect 1-3 Month Box ETF. The symbol is B-O-X-X, 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, is this fund, B-O-X-X.

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, Wes, 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. One of our core beliefs is transparency. However, when it comes to box, I always tell people it's like Fight Club. The first rule of box 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 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, right? Like obviously a call option is very different than just buying VOO. And VOO is the Vanguard S&P 500. Yes. So what happens is like if you just buy VOO versus buy a call option, obviously the call option, you can effectively get the upside benefit of a stock.

We only have to post a little bit of capital. And there's, long story short, there's embedded leverage and 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 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, three months from now.

So anytime in the marketplace, if we all know from market efficiency, where you have an opportunity to get a $100 payoff guaranteed 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 $99.5. And it's going to be arbitraged very closely to effectively Fed funds rates.

Basically, you're teasing out, say, a T-bill rate. Yes, exactly. 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. Yeah. In the morning call, they would talk about the cost of doing a box spread on any particular day.

It was a very routine transaction. Yeah. So that's not new. This transaction has been around for decades, like you said. It's widely known to 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. Exactly.

So we basically took what is effectively an institutional money management trading funding trade and thought, why don't we put this in the ETF? One, 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 bips.

And that 30 to 40 bips means 0.3 to 0.4 percent. Yeah. So if the Fed funds rates was five, then your borrowing costs would be 5.3, 5.4. Exactly. I know you throw 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.

Now you're going to charge a fee for putting it in an ETF, and I think your fee is 0.2 percent. So the net result is an expectation of a T-bill return to an investor. Yeah, we've beaten it a little bit, which is our goal. 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, which is really interesting to me. It 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 unless you have capital gains, and this creates a very steady stream of potential capital gains.

Now, 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? I don't want to comment on any of the characterizations of the taxation, but the one thing I can comment on, and what I can say that our objective is to achieve is we are attempting to not distribute anything to the extent they were able in that particular fund.

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. 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. Okay, 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, you know, eliminate various stocks.

Those 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? No, you covered it. Okay, good. Thanks. Well, anyway, I have an issue with this, and that is that, 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 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 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.

And my issue with direct 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 it.

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?

Yes. So going back to the tax code, which is super exciting, I'm sure, for Vogel Heads, we're going to talk about this other tax code called Section 351. 351 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 from an IRS standpoint. And so what 351 allows you to do is 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 or tax deductible again.

It just went back to the Vanguard model. So it's a way to solve the complexity. So just so they 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.

Yes. 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 there may be private investors who have portfolios of a lot of stock that they want to create an ETF on.

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. Yes. Now I don't 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. Well, you've got to get everyone to agree on either the index or the strategy. But doing exactly what you say, like mechanically, you get 100 of your buddies.

Hey, we all got $10 million of like low basis direct indexing. Great. We're going to do a syndicated 351. And then we can all agree, let's do whatever. VTI. Or you could pick whatever you guys would want to do. VTI is the Vanguard Total Stock Market ETF. So you're going to mimic that.

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 that at the tax lot level, the basis and the individual securities you have will get remapped into ETF shares that you will receive in your account tomorrow when you wake up.

No kidding. Really? It's that fast? 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 Ferry ETF in your account or, you know, whatever the name of the ETF is, and then all the tax slots and the mapping and all this stuff is going to be, you know, it's never perfect.

There's always like five or 10 bucks a leakage on like 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, you know, forever.

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. I can buy and sell somebody else's ETF, right? 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, like, hey, we're open for business. It's just like VTI or VOO or any other ETF that you would buy or sell. How many of these have you done already? And how many do you do a year?

So we have done, I think we're up to 11 of these tax-free transactions, not just with SMAs, but with like partnership interest transferred, mutual fund interest transferred. And this only came about 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.

Active ETFs, meaning you don't need an index anymore. Exactly. And now we can use the tax efficiency as long as you have good policies, procedures for anything, right? 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 has to actually do. And so the problem is, you know, 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. I see. Is that because that's how you solve that issue? 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, like, your ability to kind of manage and massage to your investment objective. And that was critical to be able to facilitate these deals. What is the basis point cost that you charge? Because you have to manage this now going forward.

So from the infrastructure side, it's all about scale, right? So the all-in operating costs to do like a, let's call it like a plain vanilla, like U.S. equity fund. At a billion dollars, the all-in cost of production is probably nine bips, nine and a half bips. And then if you get bigger than that, the marginal cost production is usually like, you know, around four bips, four and a half bips.

So the bigger the deal, the lower the operating cost, right? And so if you had a, if a group of bogle heads 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 know, you can get these things pretty cheap if you have scale, which is the same way that Vanguard keeps things low cost. Cause if you have scale. So why don't companies like Vanguard, BlackRock, why don't they do this? You know, it's actually very complicated to facilitate and I'm sure they could eventually figure it out.

If your main asset is like 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, you know, to figure out how to get out of our own way to launch an ETF.

So, 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 like very entrepreneurial, very innovative, they'll eventually get there. Cause 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, get new ideas out there.

Well, that's fantastic. I mean, I'm, I'm happy. And 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 that's fantastic. I have one more question for you. Sure. 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 is rather unique for business owners. Can you describe that? Yes. It used to be called act 2022. Now it's called act 60. And there's two components of the Puerto Rico access 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 in 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 bonafide Puerto Rico residents are zero.

So effectively you pay 4% tax. You know, there's also frictional costs and you've got to hire yourself as an employee. So it's not as good as it seems, but it's, you know, if you have any scale, it's like a game changer. If you have a million dollars in or export services income and you structure it down in Puerto Rico and you're a bonafide 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.

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 New York state income tax.

But I have to stay in Florida, I think it's like more than half the year, or I don't have to stay in Florida, but I can't be in New York for a certain period of time. Do they have the same kind of rules for you? Same exact rules, and it falls on the same IRS guidelines on that.

You've got to be a bonafide Puerto Rican resident, which means the same deal. You've got to live here. You've got to go to school here. You've 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 bonafide resident is.

So there is a thing down here where you can also pay 0% capital gains called the Individual Investor Act, and you only have to be here six months in a day and be a bonafide resident. However, income and services are sourced where the service is performed, right? So if I live here in Puerto Rico for six months in 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 U.S.

and it's sourced to my state. And so, yes, you're a PR bonafide resident, but I don't care. So then what would happen there is you'd have to do six months in 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 like what I'm doing, like 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. Let's say I owned a very big position in a particular stock, and my basis was zero. And I moved to Puerto Rico, established residency, voting, license, rented a house. And I lived there for six months in one day. I could sell that block of stock and not have any federal capital gains tax?

No. No. Okay. I misunderstood. 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 zero, 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, like, help manage situations like that.

But it's not as easy as you mentioned. But it is very, very favorable. How long have you been in Puerto Rico now? How many years? I've been here just over three years now. So in seven years, you could sell your company for $500 million and basically not have to pay any capital gain?

Exactly. So I'm in a very good tax position, you know, obviously, down in Puerto Rico. 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? Yeah, yeah, no, it's not for everybody.

But for service members, it's very compelling because by nature, like, you're used to deployments and, like, uprooting yourself. Sure. Because that's usually the problem. Like, most people, they 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, like, status quo bias is a very powerful thing. You've got to have someone who's got a little bit of adventure spirit in them because Puerto Rico is not Plano, Texas, where everything's 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 not – It's not Miami Beach. 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. I just want to highlight that. You have three children, three young children.

So how is the school system down there? My kids do not speak fluent Spanish. That automatically puts you into, like, the private school network, which, you know, I remember in Philly, it's like 40 Gs a year just to send your kid to private school. Here, it's expensive. It's like 10K a 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, like, a quarter mile from my house up the road here, and it kind of placates to the, you know, Palmas and, like, the local community here. Well, Wes, it's been great having you at Bogle Heads on Investing.

It's always interesting to talk with you and all the interesting things you're doing, not only with Alpha Architect, but, you know, personally as well. So my best to your wife and kids, and thank you so much for being my guest again. You got it, Rick. Appreciate the time. This concludes this episode of Bogle Heads on Investing.

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