While Benjamin Tobias lately has been busy shifting client money out of mutual funds and into exchange traded funds, fellow advisor Susie Johnston, CFP, has been doing just the opposite with the client portfolios she manages -- proof that for advisors, there's no set playbook for addressing volatility.
Although their approaches with exchange traded funds differ, Tobias, Johnston and many advisors like them are continuing to use ETFs as a vital part of their playbooks. Some, like Tobias, owner of Tobias Financial Advisors in Plantation, Fla., are leaning on ETFs more since the market downturn. These days, he says he favors them over mutual funds because they can be traded more transparently and more readily on an intraday basis than mutual funds can, important considerations when markets are prone to bounce around considerably within a given trading day.
Having the ability to place a limit order on an ETF transaction is also valuable, Tobias notes, "Because of the volatility we saw on some days, with 5-, 6-, 7-, even 8- or 9-percent swings, you could have gotten killed using mutual funds. Maybe what was a purchase situation early in the day would turn into a sale situation later the same day. With ETFs, at least you know what you're getting [with pricing at transaction time]. There's no guesswork."
Others like Johnston, an advisor with Cherry Hills Investment Advisors in Greenwood Village, Colo., have de-emphasized ETFs, at least for the near-term. Volatility is the very reason she has been using an actively managed tool such as mutual funds instead of a largely autopilot tool such as ETFs.
"Right now, we feel like it's better to have mutual fund managers making decisions based on what they think is happening in the market," Johnston explains. "[Active management] might help avoid some of the landmines."
Nevertheless, Johnston says she expects to reverse field and move some client dollars from mutual funds back into ETFs once market volatility subsides, chiefly to capitalize on the tax advantage ETFs tend to hold over mutual funds. "We like ETFs, especially in taxable accounts, because they are generally more tax-efficient" than mutual funds are in that setting.
Why ETFs now?
ETFs can be more tax-efficient than mutual funds because they are structured to accommodate in-kind trading, so investor redemptions typically don't represent taxable events, nor do they result in year-end capital gains. In-kind redemption means that, unlike a mutual fund, an ETF nets low gains and high losses. As with shares of common stock, ETF shareholders typically realize taxable consequences only when shares are sold. Those attributes generally translate into deferred capital gains for shareholders, a major selling point, particularly in the current market environment, asserts Bruce Bond, president and CEO of Invesco PowerShares, a leading ETF provider:
"At a time when the financial markets and many funds have lost significant value, the last thing investors want is to pay taxes on those same investments."
Bond's colleague, Invesco PowerShares Senior Vice President of Portfolio Strategies Ed McRedmond, proudly notes that Invesco PowerShares has never made a capital gain distribution from any of its equity - and fixed-income-based ETF portfolios since their launch in 2003.
ETFs also offer complete transparency in terms of holdings and weightings, something many investors appreciate with Wall Street collapses and the Madoff scandal still fresh on their minds, says McRedmond. "Every day you know what your exposures are - do I have an exposure to an AIG or a Citigroup? You can just go to the ETF provider's Web site and find out."
Tax-loss management was one area where Tobias and many other advisors got great mileage out of ETFs in 2008. Indeed, Tobias cites tax-loss harvesting as the chief reason for moving client funds into ETFs last year. Such a maneuver essentially entails liquidating an equity position with which a tax loss is associated in order to realize that loss, then investing in an ETF with a sector profile similar to that of the liquidated equity instrument, so the investor retains exposure to that sector. After 31 days, the investor can roll back into the same equity instrument, avoiding wash-sale rules in the process.
While she hasn't been using ETFs as broadly as she did prior to the market collapse, Johnston continues to recommend them to clients as a lower-cost, lower-risk way to gain exposure to a specific niche or segment. "An individual stock is going to be a risky play, particularly in a niche like green energy," she explains. "An ETF can give you exposure to that entire sector, and you get that exposure at a really low cost."
Which ETFs now?
ETFs can deliver compelling benefits to investors, but as with any investment tool, advisors should be discriminating in how they use them, cautions Tobias. During especially volatile periods, he says, it's particularly important to be discerning and selective with ETFs, no easy task given the ever-expanding array of funds hitting the market. That entails a back-to-basics approach.
"I want to be able to see and feel and know everything about an ETF I'm using," Tobias says. "I'm sticking with [ETFs linked to] the more traditional, basic indexes because I think if you start in with the more exotic ETFs that use a lot of derivatives, the level of trust just is not very high. Besides, through all this mess, I think people who stuck with the tried-and-true types of [investment] vehicles ended up ahead of the game."
In that vein, both Tobias and Johnston say that lately they have been using more Treasury ETFs, including funds linked to TIPS (treasury inflation protected securities) and one- to three-year Treasury bonds. "It's a pure vehicle for hedging inflation in a portfolio," explains Johnston.
Both advisors say they are also eying the potential upside of ETFs tied to international markets because "I think some countries are going to come out of this [recession] earlier than we are" in the United States, reasons Johnston.
Whether to gain exposure to international markets, to hedge inflation risk or to accomplish some other objective within a client portfolio, advisors such as Tobias have emerged from a tumultuous year thinking ETFs in situations where they previously might have thought mutual funds. "Because of things like transparency and trading flexibility," says Tobias, "I can see the day when ETFs dominate like mutual funds do today. Those factors certainly have had a big impact on my thinking. You get to the point where you see active management not doing as well as the [ETF] indexes and you say to yourself, 'Who's fooling who?'"
More financial professionals appear to be coming around to that viewpoint, according to McRedmond. "There's a real evolution occurring, where more and more advisors are building entire asset allocation portfolios out of ETFs."