From the January 2007 issue of Research Magazine • Subscribe!

XTF Takes Aim at Investors

Mike Woods, CEO of New York-based XTF Advisors, wants his fledgling firm to become as integral to the retail exchange-traded industry as the ETFs themselves. He's in the midst of building an empire that encompasses ETF-oriented investor services ranging from ma naged ETF portfolios to a full-blown ETF rating service. Even mutual funds of ETFs are on the near term horizon.

He recently took time to visit with Research to share his thoughts on why the clutter of new ETFs bodes well for business by increasing the need for good advice.

Research: Building and managing portfolios is something a lot of financial advisors pride themselves on. How does XTF overcome the perception that it's competing with advisors with its ETF portfolios?

Woods: We're assisting financial advisors to take the portfolios to the next generation of asset management, which is the tactical or dynamic allocation changes of the portfolio above and beyond the strategic side. We start with the strategic and then go to tactical. Our portfolios are a quantitative/tactical model based upon econometric signals -- both past and leading indicators, as well as relative value. We also look at risk metrics (from both a domestic and global viewpoint) and market conviction and momentum. The quantitative side is not what financial advisors typically look at. Instead, advisors tend to be focused on the strategic aspects of portfolios based upon the proper allocation for the risk tolerance of their individual clients. We want to help financial advisors to free up their time to focus on raising more assets.

How does the ballooning number of ETFs play into this?

The proliferation of ETFs is creating a need not just for advice, but for education. Not every ETF is structured the same way, even in the same asset classes. There are numerous differences in terms of fees, pricing, how funds are managed, how funds are manufactured, how they manage cash, the bid/ask spread and beyond. Each of these factors can help to determine which is the best ETF to buy.

One of the big debates in the ETF industry is about what constitutes the best method for assembling an index. Is it traditional market cap-weighted indexes, equal weight or fundamental indexing?

We differentiate ETFs according to their different investment objectives. While we're looking at the fundamental and equal-weighted indexes, right now we use primarily capitalization-weighted indices for our core portfolios. In some of the country-specific ETFs and models we've assembled, we're currently looking at equal-weighted indexes.

The elevated fees and lack of trading volume for fundamentally-weighted ETFs makes them prohibitive at this particular point. However, we do believe it's a very interesting development and we think as these products are allowed to mature, they may become a more suitable option for some of our investment portfolios in the future.

Target maturity portfolios have been a huge success in the mutual fund world. What does XTF offer in this regard? And why would target-maturity ETF portfolios be better than what's currently available?

We now have six target date portfolios as an SMA structure from 2005 to 2030, with five-year increments between each. With each year that gets closer to age 65, equity exposure is reduced while fixed income increases. Also, tactically, during the year, we dynamically change the portfolio per our tactical models where we adjust the asset classes. This is a contrast to other tactical models, which are strategic. For example, at the beginning of the year, they assume a fixed percentage of an individual's portfolio should be allocated to equities and when an age change happens a new percentage allocation is recommended. We're taking this a step further because the benefits of ETFs allow us to dial into the asset classes without any variance or style drift.

One of the big problems with active managers on a tactical basis is security selection risk or negative alpha. How can you quantify what the manager is going to do right or wrong? Active managers never talk about negative alpha but it's a real risk. ETFs have eliminated both style and security selection risk.

One of the ingredients missing with ETFs has been a consistent flow of retirement assets coming from 401(k) plans and the like. These flows are dominated by mutual funds; what's XTF's view of the landscape here?

I don't think mutual funds will stop dominating the 401(k) business. The driver is the operational processing side, and mutual funds have simplified the reporting and compliance aspects that govern 401(k) plans. Nevertheless, we still see incredible potential in the 401(k) space. In December, we filed our target maturity portfolios, our tactical models and also some specialty funds as mutual funds. We plan to bring these products to market by April 2007. I'm convinced that in 2007, the retirement world is going to be ready to embrace properly priced ETF portfolios. Again, we believe the solution to getting ETFs into the 401(k) marketplace is a low-priced fund-of-funds ETF solution.

XTF has been beta-testing a rating system. How will your ETF rating solution differ from those offered by the other rating services?

Our initial beta version is focused on the structural integrity of ETFs. This looks at specific characteristics such as bid/ask spreads, fees, correlations, tax efficiency of the ETF versus similar funds in the same asset class and so forth. All of this makes up the statistical data that investors need to know about and understand. We feel this will go a long way toward helping investors to be educated on the ETF structural side. Beyond that, during the first quarter 2007 we're going to launch a second beta version, which will focus on the investment metrics of ETFs. The service will highlight the performance of ETFs relative to their corresponding benchmark.

Our rating service will use a point system from zero to 10, with 10 being the best. The final rating of an ETF will be composed of two key factors: a fund's structural integrity and its investment metrics. This will be a very different perspective than what's currently available. For example, Morningstar rates ETFs compared to their open-end mutual funds service. Our approach will be more comprehensive.

Let's say a financial advisor wanted to use XTF portfolios for his or her clients. How would that work and how much would it cost?

Our ETF portfolios are currently available on multiple platforms such as Fidelity, Schwab and Pershing, so they can be obtained directly from these sources or through brokerages that clear through them. Brokers can utilize our portfolios through any one of these channels in a separately managed account (SMA) format. The cost of the portfolios is 50 basis points for our advisory fee, and then the underlying ETF portfolios are an additional 18 basis points, which is very competitive. By contrast, most of our competitors are between 25 to 35 basis points with just the cost of the underlying ETFs, not including their advisory fees. We are very sensitive to cost.

As I mentioned earlier, XTF is planning mutual funds that will follow our ETF models and we hope to have them ready by April of 2007. From a competitive perspective, Seligman, Rydex and Federated each offer ETF funds of funds, but the total expense ratios can range anywhere from 1.20 percent to 2 percent, which we think is quite high. Our goal is to bring a mutual fund solution of ETFs that's well under 1 percent.

Ron DeLegge is the editor of www.etfguide.com.

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