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Portfolio > ETFs

The ETF Advisors

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In the last few years, exchange-traded funds have bloomed and flourished as the white-hot darlings of Wall Street.

Indeed, trendy ETFs — much advertised and widely hyped in the consumer press — are even surfacing in cocktail-party chat. Yet oddly, most investors would be hard pressed to explain just what an exchange-traded fund is. All the more surprising, many financial advisors haven’t even bothered to learn ETF basics, let alone how to integrate these versatile vehicles into client portfolios.

Since their debut 13 years ago, ETFs — funds that can be traded like individual stocks — have shown explosive growth, with assets today reaching about $350 billion. Plus, new ETFs are scrambling to the market at a non-stop clip. Totaling some 250, they include sizzling gold ETFs and those tied to countries like Canada, Brazil and Australia.

ETFs’ main advantages are by now familiar: liquidity, tax efficiency, lower expenses than mutual funds — and they’re clearly ideal for diversification.

To be sure, with their outstanding financial-planning and monetary benefits, exchange-traded funds make life easier both for advisors and retail clients — affluent as well as middle-class investors — and institutional accounts, too.

Research recently talked with three ETF-savvy industry pros, who offered a wealth of insight into how these dynamic new-age products can best be put to work.


Mitchell SlaterPartner, The Slater-Trainor Team

Smith Barney, Florham Park, New Jersey

Mitchell Slater has one gentleman client who phones him the first of every month: “Where in the world are we going now?” he asks the financial advisor eagerly.

What he means: Where are we going now to invest in international ETFs? Because with Slater’s model portfolio, each month usually brings a strategic change. “[Last August], for instance, we took out Austria and South Korea, and added France and Italy. Clients absolutely love that,” says the senior vice president-wealth management. His mostly fee-based team of four manages about $150 million in high-net-worth client assets, a sizable $40 million of that in ETFs.

Slater is a long-time ETF fan: He started out with HOLDRs, SPDRs and BLDRs nearly as soon as they debuted. At the time, he was with Merrill Lynch. “I had strong demand from clients who wanted to look at ETFs. I approached Merrill a number of times for an asset-allocation model portfolio, but they basically had no research analysts in that arena. So,” says Slater, “I had to look outside. Smith Barney was the only firm that had research, and I was able to use their domestic and international portfolios.”

Smith Barney’s ETF platform is in fact a major reason Slater moved his practice there from Merrill a year ago last January.

ETFs “absolutely make managing assets easier,” says the FA, 45. “With an ETF asset-allocation model, you can look at valuations a little more and understand that, unlike individual securities — with high betas and a lot more risk — the sectors fit into what’s happening in the economy domestically and globally.”

Slater especially likes the model portfolios’ recommended weighting breakdown vs. the S&P 500. “In health care, for example, our weighting is 20 percent; the S&P’s is 12.2 percent. Merck has gone from 25 to 42. An ETF was a great way to take advantage of that without owning just Merck. The same thing goes for being overweighted in the energy sector the last couple of years, or being underweighted in consumer staples.”

Capturing assets in ETFs that clients’ previous advisors had put in mutual funds has brought a sharp increase in Slater’s business. “A lot of brokers still have clients in ‘B’ shares. ETFs are a much better tool,” he says. “They’re lower in cost and are more tax efficient. I’d be happy any day to put the top 10 mutual funds out there vs. ETFs. It would be a pretty good battle!”

But, warns the advisor, ETFs “aren’t a panacea. You can’t just go out and pick the 10 highest trading ETFs every day and just expect that they’re going to make money. You’ve got to be [at least] somewhat active with them. Trends change, and you must be on top of them. For instance, if the Fed is done raising interest rates, you want to own financials.”

According to Slater, diversification is key. In many ways, “you run the same risks with index ETFs as owning the S&P. You want to buy an entire market or sector, an industry, a country, or a region — and get the kind of liquidity that ETFs have.”

As for performance, Slater’s international portfolios have been “significantly beating” the S&P, he says; and his domestic model has had higher numbers as well, up just under 20 percent as opposed to the S&P’s 15 percent.

Further, Slater lauds ETFs as a terrific prospecting and referral tool. “Because of their tax efficiency, they typically make more sense than mutual funds for retirement accounts. That’s why I get a lot of referrals from accountants: They really love ETFs,” he says.

Slater’s advice to fellow advisors: “Be cautious about new ETFs coming to market. Some are closed-end funds hiding as ETFs; they’re not really tracking indexes or sectors.

Stick with the ones that have been time-tested. Investing folks’ money in things you don’t understand yourself is not a good idea.”


John P. O’Leary

Westfield Profit Formula Group

Wachovia Securities, Mountainside, New Jersey

Weekends find John P. O’Leary basketball-coaching his three kids and poking around antique stops with wife Karen. So much for chilling out. At work, the financial advisor is a driven man. What drives O’Leary is a passion to help his high-net-worth retail clients — especially new ones — increase their returns while lowering their risk.

In the first quarter of this year, O’Leary, 45, moved into ETFs. The product has lifted clients’ investment performance and, he says, boosted his business “enormously.”

“They’re something different to talk about to clients. ETFs can be explained in such a way that they really understand what this product can do to help them achieve goals and provide instant diversification. It’s a compelling story,” says the Wachovia managing director, who, with a partner, runs a six-member fee-based team. They manage $300 million-plus in assets, the bulk in managed accounts.

O’Leary has embraced Wachovia’s ETF Advantage Portfolio program, which uses an actively managed separate account approach to strive for a combination of strategic as well as tactical asset allocation.

“It’s a win-win for the clients,” says the FA, noting that ETFs boast lower expenses. “They’ve helped our assets grow in a big way. We probably add seven figures-plus in [ETFs] every month.”

O’Leary puts together ETF programs weighted in a variety of areas and divided by sectors. But if he sees momentum in a certain area, he’ll shift into that one and out of another.

“That’s something I really like about ETFs, too: They offer a dual approach. We have that asset allocation, but also tactical maneuvering inside the portfolio to move into areas that have more momentum. It offers an excellent complement to other strategies we use. If,” says O’Leary, “we feel there’s more momentum in a given sector or asset class — health care, oil services and so on — we’ll move in and out of an underperforming sector,”

This is in contrast to simply putting various amounts into large-cap, mid-cap, fixed-income and others, in which case, he says, “you could be waiting quarterly or even annually to rebalance the account.”

ETFs provide a more efficient way to buy, O’Leary points out. Every client with whom he’s broached the subject of ETFs has reacted positively. He then takes them through a sample portfolio and explains that ETFs are “a better way: You can participate in multiple companies rather than buying, for instance, only one financial company.”

After determining risk tolerance, O’Leary matches clients up with suitable ETFs, including SPDRs, iShares, Vanguard ETFs and StreetTRACKS.

“ETFs are great because they give clients active management and access to a host of things they ordinarily wouldn’t get. They’re continually monitored in terms of risk, performance, asset class and sector. But a lot of it has to do with how they actually fit.”

O’Leary stresses that asset allocation must be spot-on. “You need to set up the portfolio according to how much money you should have in fixed-income, growth — different asset classes and sectors.”

The advisor has observed, though, that despite ETFs’ numerous benefits, many advisors haven’t yet adopted them. “When transferring new assets, I don’t see a lot of clients with these holdings. ETFs have their place in everyone’s portfolio — but not as the only piece. What you have access to with ETFs is tremendous. But if they’re not managed correctly, it could be a disaster.”


John W. Wing

President, Quantitative Advantage

Minnetonka, Minnesota

After building asset-allocation models using mostly mutual funds for 13 years — first as a Merrill Lynch financial advisor, then going independent with Raymond James — a frustrated John W. Wing embarked on a quest. He was out to find a different, better way to invest.

“You’d fill in all the style boxes and major sectors with funds but find that your winners offset your losers and vice versa. It was hard to get performance,” says the ex-wirehouse branch manager.

Then he met Thomas G. Fox, formerly with Shearson Lehman and Dain Bosworth. Fox had developed a math- and computer-based quantitative system for tracking trends and making selections. “My lights went on,” says Wing, 41. Thus was launched Quantitative Advantage, to help financial advisors manage client portfolios. A year later, in 2001, Wing, QA president, and Fox, chief investment officer, started using ETFs. Today the funds are unquestionably the firm’s product of choice.

“We bridge the gap between passive and active because we actually manage passive investments,” notes Wing. “More and more advisors have realized they’re better with relationship management and financial planning than with portfolio management. They want to outsource that day-to-day research and trading.” QA provides an ETF wrap program to broker-dealers, wirehouses, independents and RIAs.

Right away, QA saw big advantages in implementing its quantitative Adaptive Risk Management System (ARMS) with ETFs instead of mutual funds. “ETFs aren’t encumbered with mutual funds’ restrictions, and they have more transparency and liquidity,” says Wing. “They’re hands-down one of the best products for getting quick and clean access to markets.”

QA manages about $190 million in ETFs, or about 70 percent of the firm’s total managed assets. Between 2003 and 2005, asset growth, driven by ETF investments, soared. “Consistency is our goal. Our method is non-emotion-based and very disciplined. The idea,” says Wing, “is to hit singles and doubles.”

QA uses seven different model portfolios, from conservative to aggressive growth. Its flagship Global Equity Portfolio is a meld of style, sector and international strategies. Though ARMS applies a tactical style allocation process, “we do not market-time in and out of equities. We use the system to [decide] which style or sector or international region, or combination of those, to be in,” says Wing.

Every 30 days an update function determines whether to stay or go elsewhere. “We sell out of those areas that are weakening,” says Wing, “and add those that are coming into favor.”

For instance, after being in utilities for most of 2005, QA dropped the sector early this year, then in July, brought it in again. In the same month, “we started filtering large-value back in. That’s been out of favor since 2000,” says Wing. “For two years, lots of people have been talking about value coming back. But our system didn’t indicate to do anything until June or July.”

Wing notes that QA is “on the cusp” of a solution to employ ETFs in 401(k) plans. This involves setting up collective trust funds. “The underlying investments will be the ETF portfolio, just as in managing a personal IRA.”

QA is cool to actively managed ETFs. “They open up a whole new door of risk: portfolio manager risk — managers making poor decisions. The beauty of an ETF,” says Wing, “is that it’s passive. You know exactly what you’re going to get each time you buy it.”

Still, he emphasizes, with ETFs, “you always come back to the selection issue: There are more than 200 of them now. People want someone to be making decisions about where to be when. They’ve seen that buy-and-hold strategies at some point falter. They don’t want to ride Cisco down to a few bucks again.”


Advisor Guidance Needed

How well do ETFs perform? It all depends…

John W. Wing, president, Quantitative Advantage: “It depends on which ones you own. Over the trailing 12 months, for instance, some iShares ETFs have had unbelievable stellar returns, but some have been completely shellacked. It depends what style, sector, international region or country they’re in. All these different segments zig and zag in different directions at different times. So performance varies widely.”

Mitchell Slater, senior vice president-wealth management, Smith Barney: “It depends on when you invest. If a client invested in August 2002, the numbers are obviously fantastic because they were at the bottom of the market.”

John O’Leary, managing director, Wachovia Securities: “You have to have the right asset allocation — how much you should put in fixed-income, in growth, in different asset classes, different sectors. You can’t say that just by buying ETFs [per se], they’ll outperform or underperform.”


Jane Wollman Rusoff is a contributing editor and founder of Family Star Productions.


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