Keep ETFs simple

I met a broker from Rochester at breakfast on the second day of an ETF conference in Albany, New York. I was a speaker on the first day and a moderator on the second, and was curious about the audience’s knowledge level and how the message was getting through.

“Do you use ETFs in your practice?” I asked.

He admitted he had purchased some SPDRs (Standard & Poor’s Depositary Receipts, SPY) for his largest client.

“I went to a meeting with her auditor and all he said was ‘I see that your broker bought an ETF for your portfolio; he must be doing a good job for you!’” he said. “I’m here to find out what I bought and why they’re so good!”

There’s a halo effect over ETF use that transcends their undeniably beneficial use in portfolios. But we, in the industry, should not rest on our laurels.

The directness that has accompanied the electronic revolution and social media can bite, so making ETFs just another offering on the investment product buffet could be dangerous. Take, for example, the Ally Bank commercials that show conventional bankers as insensitive to clients, who are portrayed as kids. Fine print, exclusionary offers, undisclosed information, run-arounds, and the now ubiquitous “egg-management fee” are offered as proofs of the big-bank practices that “even kids know” aren’t fair.

It could be argued that banks deserve this treatment. But then again, mutual funds could be painted with the same brush and with them, the entire investment profession. In Canada, the major banks, through branches and wholly owned brokerage firms, account for two-thirds of all mutual fund sales. And yes, mutual fund fees seem inexplicably large in relationship to what they deliver, particularly when compared with ETF fees.

But mutual funds still provide retail investors with professional management and diversification while sharing expenses. That their structure is outdated is not entirely their fault: lack of transparency in an era of full disclosure, once-a-day pricing in a 24-hour-a-day global market, bundled fees when everything is being unbundled (except cellphone and cable TV packages, strangely enough); the traditional mutual fund format struggles to keep up.

And the same fate may await practitioners if they treat ETFs as just a bunch of mutual funds and stuff them into client portfolios like last year’s hot performer. ETFs should be used to provide the kinds of solutions, continuous client value and vehicles for managing risk for which they are so well suited, with costs justified and construction communicated simply and effectively.

There are lots of ETFs, and more and more appear each week. While there are many ways to sort them, keeping things simple has great appeal, because it’s easier to explain to clients. Loulia Tretiakova, Director of Quantitative Strategies at PUR Investing, classifies the ETF universe into two basic categories: those that are passive and those with embedded strategies.

“Passive ETFs follow a simple index or an unleveraged commodity. They are characterized by low fees. Those with embedded strategies are everything else. ETFs with embedded strategies often have higher fees. Leveraged and inverse ETFs and those that follow a manipulated index like revenue or fundamentally weighted, are examples. Actively managed ETFs are the most obvious examples of an embedded strategy.”

Explaining to clients that a low-cost core of passive ETFs is an effective way to capture beta or exposure to market returns will help. You could build a core of actively managed mutual funds or ETFs with embedded strategies that try to outperform your benchmark, but it’s difficult to identify successful ones in advance, extremely difficult to pick them consistently year after year, and you risk the inefficiency from fund overlap (see the September Advisor’s Edge Report article “How Many?”). You do, however, know their cost in advance. Go with what you know: It’s logical and clients understand it.

With your passive core established, consider the manageable characteristics of ETFs (or other assets) that make the most impact on portfolios. Cost and diversification are the most important, followed by liquidity, tax efficiency and tracking error.

And what about returns? They can’t be predicted in advance, but by capturing the market return inexpensively with a core of passive products, you can select other “satellite” assets around the core that position the portfolio to perform.

Diversified exposure to areas you feel will do well – such as small capitalization stocks, emerging markets or commodities – can be added as individual securities, passive ETFs, mutual funds or ETFs with embedded strategies.

If the satellite investments chronically underperform the core, you’ll know and so will your clients. But what to do about it will be clear. In coming issues, we’ll examine the considerations for satellite assets more closely.

Keeping portfolio construction and classification of ETFs simple will help clients understand what you are doing, help dispel the mystery of the egg-management fee and will ultimately distinguish ETFs as a signature part of the portfolio menu.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.