Ease of use, lower expense ratios and transparency are among the many reasons that financial advisors have become big advocates and users of exchange-traded funds, according to an online survey conducted recently by ThinkAdvisor.com. The advisor poll focused on advisors’ usage, strategies and other trends related to ETFs, which are estimated to have some $3 trillion in assets under management worldwide.
Overall, 90% of survey respondents say they use index (or passive) ETFs in client portfolios, 54% employ active ETFs, and 50% rely on smart beta ETFs. The survey finds that nearly two-thirds of advisors, or 63%, offer ETFs in all client portfolios, while more than half, or 57%, use them specifically for cost effectiveness in smaller portfolios or when investment fees are a major factor for clients. Also, three-quarters, or 75%, of respondents say they use non-cap-weighted ETFs now, and most of these advisors plan to use more of these products over the next year or two.
Ninety percent of advisors (or more) rank low expense ratios, trading ease/liquidity, transparency and diversification as their top reasons for using ETFs. Low tracking error and garnering alpha are seen as important, too, with 74% of advisors or more stating that these factors influence their use of the product.
Comparing ETFs to mutual funds, Alan Myers, president and senior portfolio manager of Aerie Capital Management in Baltimore, says, “For me, the best attribute is ease of trading during the day.” Myers uses options, and the ability to write calls on ETFs is “highly beneficial.”
Another attribute he appreciates about ETFs is that they “are easy to understand relative to an actively managed mutual fund,” the advisor says. “It is one thing to say that a value-oriented mutual fund uses low price/book value as a starting point, but can you trust that they really do that? An ETF, because it has to follow the rules of an index, must use a low price/book ratio if that is where the index starts.”
Other advisors echo Myers’ thinking when it comes to the ease of intraday trading and transparency. “ETF transparency is good because it is tied to an index; it's a defined process, even with equal-weighted, low-volatility or factor-based approaches,” says John Diak, principal of Oatley & Diak LLC in Parker, Colorado, near Denver. “For a mutual fund shop, you’re entrusting individuals and a track record [with client assets], and a philosophy might change,” Diak explains.
In addition, low cost matters. “In my practice, ETFs offer a means to reduce the overall investment cost to a client,” says Rob Shedd, a financial advisor with Addison Avenue Investment of Fort Collins, Colorado. “My goal is to always place clients in the best available investment at the lowest cost to them, and by incorporating select ETFs into strategies, I can accomplish this.”
Don Roy, branch manager of New England Wealth Advisors in Merrimack, New Hampshire, agrees: “With costs being such an issue with clients, ETFs provide an alternative to assist in cost reduction while still creating a portfolio that is effectively diversified.”
Broad-based U.S. equity index ETFs are the most popular products used by advisors today, with 81% of advisors polled saying they employ them. Equity-sector indexes are used by 68% of respondents. ETFs tracking broad fixed income indexes are employed by 64% of advisors polled, while broad-based international index ETFs are relied upon by 57%. Other product categories used by advisors include leveraged/inverse ETFs (17%), currency ETFs (15%) and ESG/impact investing products (13%).
Non-cap-weighted ETF strategies have gained traction, the most popular being equal weighted (46%), low volatility (44%) and fundamental (42%). Plus, 49% of advisors say they will use these non-cap-weighted products more in the next year or two.
Mack Courter, principal of Courter Financial LLC in Bellefonte, Pennsylvania, mainly uses cap-weighted “plain vanilla” ETFs for the core holdings of a portfolio, and then adds sector, equal-weighted or fundamental ETFs as “opportunity” holdings, he says. “I choose the ETFs based on many factors, starting with the asset class I want exposure to, then moving on to the methodology used by the ETFs to get the best fit, and then finally I look at liquidity and expenses,” he explains.
Diak says his group's approach is somewhat different: “As we transition from mutual funds and individual stocks to [becoming] an ETF-focused shop, we’re really focused [on] broad-based index funds to create the core for client portfolios,” and have begun to add factor-investing, smart beta and low-volatility ETFs to create dividend and value-based holdings.
Mark Butterworth, president of Butterworth Financial in Tulsa, Oklahoma, has a similar approach. “We’ll have the equivalent of large-cap, mid-sized and small companies in the mixture, and if it's a taxable account or a non-retirement [account], we use ETFs because of tax efficiencies as well as the transparency of what is owned.” The advisor explains that, depending on market conditions, he has gravitated to value-added and alpha-based ETFs but doesn't employ leveraged products.
Butterworth also points out that his firm aims to be proactive. “We don't set it and forget it. Part of the rationale of using ETFs is from a tax-efficiency standpoint. ETFs can have a capital gain, but most of the time it is handled internally. Mutual funds can have those [kinds of] hiccups at year-end,” he explains.
John Cooper, a private-client advisor with Greenwood Capital in Greenwood, South Carolina, mainly uses international and corporate-bond ETFs. “The reason is some clients need diversification in small accounts under $500,000. Also, our firm does all in-house research, except for international and emerging markets,” he says, adding that the proliferation of ETFs has helped him customize smaller portfolios.
Although a growing number of managers are using non-cap-weighted funds, Nathan Raabe, a partner of CBF Wealth Management in Norfolk, Nebraska, says his practice mainly uses index-weighted ETFs for equities and fixed income exposure “because we take our tilts using DFA's equity funds.” The advisor plans to keep using more ETFs in certain asset classes due to cost, “unless mutual funds can do it cheaper and more efficiently.”
For larger portfolios, Myers and his team turn to ETFs as a “strategic addition, either providing fixed income exposure or additional exposure to small- or mid-cap stocks, for example.” The advisor says his approach does “tilt” toward value-oriented ETFs, and, if possible, equal-weighted ETFs. He also will use generic fixed income index ETFs.
Ron Hauf, an advisor with the Securities Service Network Advisory in Whitefish, Montana, who only has a small portion of his clients’ portfolios in ETFs, has a somewhat different view of the product: “If there's an asset that doesn't need active management, I might employ an ETF. But quite frankly, with the compression [of fees] in this industry, active management is as competitive as passive ETFs. Nine times out of 10, I’ll take active management with low expense ratios over passive management.”
The survey found that more than 80% of advisors favor ETF manufacturers with good performance/track records, low expense ratios, good reputations and sector availability. Likewise, 85% of those surveyed prefer certain platforms due to their low trading costs, reputations and wide choice of ETF providers. (Vanguard proved most popular among advisors in both categories.)
Yet many advisors interviewed are “fund agnostic,” such as Patrick Sier, president of Advisory Services of New England in Barrington, Rhode Island. He primarily uses one large discount broker's platform but has access to others.
“It's the clients who bear a transaction cost, so to the extent they are looking at one ETF over another, if they want to avoid the cost, I can steer them toward an ETF with no transaction costs,” Sier explains. “But that's such a [small] part of the puzzle. All things being equal, I go to the one with the lower transaction cost.”
Other advisors share this opinion. Charles Scott, president of Pelleton Capital Management in Scottsdale, Arizona, states, “If I want to be in the tech space, [and one firm has a good ETF], then I’ll go and buy it. I don't care who creates the ETF or platform.” Most advisors say that if a more expensive product is performing better, even allowing for costs, they will opt for it as the best match for their clients.
Two-thirds of advisors surveyed indicate that their clients are unfamiliar with ETFs, and more than half of respondents admit they themselves do not fully understand ETF structures and have at least some difficulty evaluating similar offerings. About 35% of advisors polled have concerns about liquidity mismatches, and 34% believe there is not enough objective research available on ETFs. Over a quarter prefer index mutual funds, while 22% worry about regulatory uncertainty in the ETF space.
Many wealth managers interviewed say clients, when they do ask about ETFs, just want to know what the acronym represents. Once advisors explain the products to them, the investors let them take the reins in creating and managing the portfolios. As one manager states, “It never fails to amaze me how many clients have no interest in wading into the weeds.”
Discussions with clients, according to Butterworth, are “tied to tax efficiency, transparency and the clarity of ETFs, and knowing what you own.” Since his group works with managed or actively traded ETFs, “We walk through an explanation of what we think is value-added for the clients’ circumstances. We explain to them that ETFs are like individual stocks (traded throughout day) versus a mutual fund that is priced at end of the day,” he says.
Properly evaluating ETFs “can be quite a challenge,” Myers says. He usually starts with a “relatively” neutral source, such as Morningstar, and reviews its commentary and information. Next, he checks performance over two- to 10-year periods and determines which are most consistent.
Once he has narrowed down his search, Myers checks the ETF provider websites for additional details. “I am primarily looking for information on how the index is constructed, how often it is rebalanced, what the turnover is for the index, performance information, and the length of time for that performance history,” the advisor explains.
Many advisors see the continuous rollout of new ETFs and illiquidity as possible stumbling blocks in the future. “We’ve seen a proliferation of ETFs that have since consolidated or have shut down because they don't have sufficient assets,” says Butterworth.
“We are getting to a point that we are slicing and dicing the market into far too many sectors, and this has the potential of watered-down results,” explains Myers. “In other words, a successful strategy could lead to a bubble that would lead to the demise of the strategy.”
Shedd adds that using ETFs for index investing has become today's “fad.” “It's not hard to pick winners right now, and those strategies are working for most investors. The test always comes when we have a downturn, a 5% plus or minus pullback. That's when the active managers earn their pay, weeding out the losers and hanging onto the winners,” he states.
Hauf agrees. “People don't understand passive management and the risk involved with it,” he says. “They understand cost, but wait until all hell breaks loose, and it will.”
Courter, too, is concerned with the ETF illiquidity and volatility during a flash crash. Like other advisors, though, he still views ETFs as “the best investment vehicle there is.”