From the December 2010 issue of Investment Advisor • Subscribe!

Will ETF Flaws Diminish Their Appeal?

The honeymoon period for ETFs is fading

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Are exchange-traded funds (ETFs) beginning to show their warts? ETFs are still receiving lots of fanfare despite the fact that ETFs, not mutual funds, felt the biggest brunt of the “flash crash” on May 6. The Wall Street Journal reported after the flash crash—in which the Dow fell 1,000 points in a matter of minutes—that 68% of the trades that were cancelled involved ETFs.

While the most recent data from the Investment Company Institute (ICI) shows that money continues to pour into ETFs—combined assets of the nation’s ETFs jumped 10% to $882.75 billion in September 2010—assets in ETFs are still dwarfed by assets held in mutual funds, which ICI says increased in September by $486.2 billion to a little more than $11 trillion.

There’s no doubt that “ETFs currently have a halo effect around them that traditional open-end mutual funds have lost,” Don Phillips, president of fund research at Morningstar, told me in a recent interview. While it’s true that mutual funds “have a lot more baggage right now than ETFs,” the “bad things associated with ETF investing, to date, are not really sticking,” Phillips adds. “It will be interesting to see how long this honeymoon period lasts for ETFs.”

[Read about how investors don't fully understand ETFs.]

I spoke with Phillips and other ETF experts like Jim Lowell, editor of Fidelity Investor, and Daniel Wiener, editor of The Independent Adviser for Vanguard Investors, to get a sense of where the ETF market stands now and where it’s headed. I also got feedback from advisors themselves on how—and why—they’re using ETFs.

Saturation Point for ETFs
Lowell, who’s also a partner and chief investment strategist with Adviser Investments, a private money management firm advising more than $1 billion based in Newton, Mass., says that the “belief system” created over the last three to five years that ETFs are the best investment vehicle because their asset growth was so spectacular is beginning to break down. The reason: the performance of active managers over the last 18 months. “ETFs and active managers behaved almost identically in the 2008 to March 2009 [economic] meltdown,” Lowell says, “but then active managers just surged coming out of the trough, the way you would expect them to do, whereas ETFs just gave benchmark returns, which were also good, but they weren’t 70%-plus returns.”

The momentum behind ETFs is “certainly not as robust as it was, even a year ago,” Lowell says, adding that ETFs may have hit a saturation point inside the advisor marketplace, at least for the time being. Approximately 10% of Adviser Investments’ assets are in ETFs, Lowell points out, and he says it’s hard to make the case for adding “demonstrably more.”

Wiener, Lowell’s colleague and chairman of Adviser Investments, adds that the bulk of their clients are still using actively managed mutual funds “because we buy managers—we look for the best managers out there.” He adds: “It is true that the average active manager underperforms the index, but it is not true that a portfolio focused on really excellent managers underperforms the market—in fact, it outperforms.”

Who Hasn’t Discovered ETFs?
Where will the next wave of ETF investors come from? Lowell points to the individual investors who have “absolutely not come back into this marketplace.” When the $5 trillion that these investors hold does come back, he says, they will choose actively managed mutual funds and ETFs, not index funds. “I find it increasingly hard to believe that any advisor out there is going to use index funds again; it doesn’t mean they will sell what they have for tax-related reasons, but why would you bother?”

While there are “ugly incidents” involving ETFs, the benefits of ETFs are clear: tax efficiency, lower costs, access to specific market sectors and intraday trading. But Phillips of Morningstar notes that most advisors are “getting behind the ETF banner because it has positive connotations with their clients,” not because they can trade them during the day. Advisors are moving to ETFs, Phillips says, “for strategic long-term purposes.”

Most advisors using ETFs are not against active management, he adds, but like ETFs for their “halo effect” and the cost benefits to ETFs, “which leaves more room for the advisor’s fee.” A portfolio of ETFs does not include the distribution costs that are involved in a portfolio of mutual funds. Advisors “can tell the client that you’re saving so much money by using ETFs instead of traditional funds,” Phillips says.

Advisors are also using ETFs adds Wiener of Adviser Investments, “because their clients are sick and tired of [advisors] trying to buy individual stocks and getting slammed.”

David Mendels of Creative Financial Concepts in New York is one such advisor who says intraday trading is not “attractive” to him, and he admits to being “a bit baffled by the attraction so many find in ETFs over mutual funds.” He admits that some ETFs feature even lower costs than index funds, and that might make them appropriate if the transaction costs are not too high, but argues that “other [ETFs] are surprisingly expensive with costs that look like those found in many managed funds.”

There are definitely drawbacks to ETFs, says David Zuckerman of Zuckerman Capital Management in Los Angeles. One of the biggest problems: ETFs can deviate from net asset value, whereas open end mutual funds do not. A great example was the flash crash, he notes, when the iShares Russell 2000 value index ETF (IWN) traded “around $66 per share and then plunged to only 11 cents in an instant.” Some investors holding IWN, he continues, that were using stop-loss orders may have been forced to sell their positions for far less than the actual value of the holdings. Investors in open-ended mutual funds that track the same index “did not have to deal with such adverse conditions.”

Wiener agrees that the flash crash did expose ETFs’ warts, but says the “real warts show up in how advisors are using ETFs around the flash crash.” To Zuckerman’s point, Wiener says, those advisors that are using ETFs and stop losses, “that’s where they’re going to get in trouble.” But if an advisor is using ETFs to simply build long-term, diversified portfolios, he doesn’t think the flash crash necessarily “completely changes the equation.”

Some of the “narrowly focused” ETFs have the potential for “throwing advisors for a loop” as well, Wiener says. For instance, emerging markets ETFs have seen a lot of money flow into them, but historically, he says, “we know the emerging markets can be very volatile.” It’s only a matter of time before a “volatile move” in that market occurs, and “the billions of dollars that have flowed into those ETFs gets whacked.”

More ETF “Black Eyes”
The “black eyes” that have shown up in the asset management profession in the last few years have been “closely intertwined” with ETFs, says Morningstar’s Phillips. One is the leveraged and inverse-leveraged ETFs that because of their daily compounding, “didn’t perform at all the way people expected them to.” They did so poorly, in fact, that Congress questioned whether they should be banned. Second are commodity-based ETFs that have also delivered poor performance.

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