From the April 2016 issue of Investment Advisor • Subscribe!

Advisors, Help Clients Get ETF Educated

Drivers know a car doesn't protect them from a crash; why do investors think an ETF protects them from a market crash?

ETFs rapid growth in popularity makes education imperative. (Illustration: Davide Bonazzi/Theispot.com) ETFs rapid growth in popularity makes education imperative. (Illustration: Davide Bonazzi/Theispot.com)

We’re constantly reminded of the need for great ETF education. Most astute advisors know the successful statistics of the growth of ETFs. Over $2 trillion in assets have flocked into exchange-traded funds in the United States alone for a product structure that is just over 20 years old. That's not just impressive growth, it's the most successful commencement of any product structure in history. Even with that success, the size of the ETF market remains roughly one-tenth of the size of the mutual fund market.

As much as ETFs are touted for their ease of use — similar to buying or selling a stock — there are similar attributes of the pooled investment approach seen with mutual funds. Key differentials, though, for ETFs are their trading control and ease of accessibility through an exchange, where they trade on a value based on other underlying securities that also trade on an exchange. Even an exchange-traded company such as Berkshire Hathaway, which also invests in many public securities, is both valued and traded differently from ETFs.

Retail investments are typically marketed as easy to access and use for an investment portfolio. The simplicity is evident if someone wanted to buy shares of a major blue chip company via a Fidelity or Schwab brokerage account, which once carried a tag line of “point, click, invest.” The same concept applies if someone wants to purchase shares of an ETF from firms such as iShares or State Street, where you may have heard a marketing slogan such as “one-click diversification.” Nevertheless, despite such simplified accessibility, it's imperative for advisors and clients to remember that you are still investing in the market, and all its associated risks stand the same.

In a way, purchasing a stock or an ETF is not all that different from buying a car. An automaker can use a slogan such as “sign then drive,” which seems rather easy. However, despite the ease of the acquisition, the vehicle is not immune from ever experiencing engine trouble or driving over a pothole that causes a flat tire. Thankfully, the general public is well-versed on the potential challenges of buying and driving a car. The ETF industry needs to reach that same level of understanding for its investors.

For any security that is exchange-traded, the risks can be broad. We have unfortunately seen acts of terrorism, as well as technological issues, close markets. The residual effects from sell-offs in international markets have caused pricing challenges on U.S. exchanges, too.

Does the impact of such events indicate that part of the system is broken, whether it be the exchanges, market making system, stocks or ETFs? The short answer is no. However, like everything else in the world, improvements can be made; most importantly, it's necessary to understand the full spectrum of risks. Unlike mutual funds, ETFs carry the risks of exchanges and market makers. Thankfully, the full transparency of ETFs helps their shareholders better understand how such risks can affect the value of their investments.

While certain deviations may be frustrating to academics and occasionally entice regulators to offer pointed criticism of ETFs as problematic, it only reinforces the need for more ETF education. The large migration of money from mutual funds to ETFs illustrates how important it is for investors to understand the ETF structure, as well as how exchanges operate and how the market making process functions. As financial professionals, you may have to manage client concerns about misleading headlines regarding ETFs. Thankfully, a significant amount of education exists from ETF sponsors as well as from organizations such as the Investment Company Institute. The ICI provides a good starting point with their website UnderstandETFs.org, a collaboration between ICI and ETF providers, including AdvisorShares. The proliferation of such resources and education will only make the ETF space that much better.

--- Read Fixed Income ETFs Added Billions in February as Equity Funds Bled on ThinkAdvisor.

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