U.S. independent advisors opting for ETFs

Advisors south of the border are increasingly using exchange traded funds (ETFs) in their clients’ portfolios instead of traditional equity-based mutual funds, according to a survey of independent advisors, commissioned by U.S. brokerage Schwab Institutional.

Conducted biannually by Koski Research, the Independent Advisor Outlook Study is a survey of more than 1,000 independent U.S. financial advisors during the month of July.

This year the study found that ETFs are the investment vehicle of choice. The majority of respondents, 78%, who manage more than $235 billion in client assets, say that they use ETFs in their clients’ portfolios. In addition, 32% say they intend to increase their holdings, and only 19% say they will decrease them.

ETFs, which are designed to mimic the performance of an equity index, such as the S&P 500 or S&P/TSX Composite index, are a less expensive way for investors to get exposure to an equity market than most traditional mutual funds that invest in the same market. It’s a pure beta strategy, meaning its proportional performance is 1:1 with its benchmark. It is designed to neither outperform nor lag the market.

An actively managed mutual fund is designed to achieve alpha, or risk-adjusted returns above its industry benchmark. Investing in a mutual fund designed to outperform the market may seem like a no-brainer, but it’s a rare mutual fund that consistently outperforms its benchmark.

For example, according to Standard & Poor’s, the S&P 500 index has outperformed 72.2% of U.S. large-cap funds over the past five years. It may come as little surprise that advisors are opting to go with investment vehicles that have a better track record than the majority of retail mutual funds.

The study shows that it’s not just retail funds that are being overlooked. Very few advisors have any inclination to increase alternative investment holdings over the next six months. Only 32% of respondents invest in private equity and only 31% invest in hedge funds. Sixty-five per cent will not increase their clients’ private equity holdings, and 66% said they will shun hedge funds over the next months.

Canada is a potentially more fertile breeding ground for active management ambivalence. Standard & Poor’s has found that over the past five years, only 10% of active funds that invest in the large-cap Canadian equity market were able to beat their benchmark, the S&P/TSX Composite index.

Passive management has its downside, says Steven Belchetz, president and chief investment officer of T. E. Investment Counsel, the investment arm of T. E. Wealth. He says that successful active management requires the advisor to demonstrate his or her value to clients.

“I am aware of other outfits that do use ETFs extensively,” Belchetz says. “We’re strong proponents of active management.”

T.E. is a fee-only advisory firm, so Belchetz says its advisors and investment managers are being paid for their expertise. Being able to effectively manage the assets of its clients is a testament to the skill of T.E.’s advisors.

Belchetz says his high-net-worth client base expects exceptional performance for the amount of money they pay their advisors. They’re not going to accept an advisor who crafts a portfolio with ETFs, or even average mutual funds for that matter.

“Our clients’ [accounts] are generally large enough that we don’t tend to use retail mutual funds,” he says. “They either access equities directly through active managers or, in the case of smaller clients, we use our own multi-manager pooled funds, where we select the managers and use those.”

For advisors who may not have a HNW client base, Belchetz says ETFs can make sense in some circumstances.

“It’s certainly a lot less costly to use ETFs than to use active management,” he says. “It’s a function of the resources that advisors may have. It’s easier for them to recommend an ETF than to have a whole managed research department to find good active managers. It may be a business decision to that effect.”

The Schwab study also highlights that in the seven months since the last study was conducted, U.S. advisors have basically held steady on the geographic asset allocation of their clients’ portfolios. However, the number of U.S. advisors who have a bullish view of Canadian equity has almost doubled. Twenty percent of respondents in July, versus 12% in January, expect the Canadian market to be one of the top three performers among developed markets.

U.S. advisors have the highest hopes for Japan, Hong Kong and Singapore among developed markets. But overall, China is the spot where U.S. advisors anticipate the greatest growth, with 40% of respondents expecting it to lead the world in growth over the next six months.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(08/30/07)

Mark Noble