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November 01, 2008 at 04:00 AM
Advisor Mike Patton of Integrity Wealth Management in Baton Rouge, Louisiana, thinks highly of exchange traded funds in building client portfolios since they are relatively low-cost, tax-efficient ways to capture the entire market or slices of the market–a cheap, tax-sensitive, liquid alternative to index mutual funds. Advisor Gene Balliett of Balliett Financial Services in Winter Haven, Florida, likes ETFs for different reasons. He believes that certain ETFs can help him in his continuous quest for absolute return vehicles, including inverse ETFs that capture double the beta of major market indexes–one of the only ways in the current market atmosphere to produce alpha in a market where everything, including most fixed-income investments, is in the red. These two advisors represent the two ends of the spectrum when it comes to advisor use of ETFs in client portfolios, and both are appropriate approaches, according to product manufacturers, money managers, consultants, and other advisors interviewed on the subject.
Sue Thompson, who runs the RIA channel of Barclays Global’s U.S. iShares business, says it’s been “an amazing journey to see the variety of ways that advisors use ETFs in their portfolios.” She cites the core/satellite approach to portfolio building as an example. Normally, she says “we think of that as indexing the core and doing active management in the satellites. But many clients take the opposite approach. Their core is a group of stocks on which they’ve done fundamental analysis, and their satellite is the ETFs. They may not have expertise in emerging markets, for example, so they decide to index that. It’s almost a reverse core/satellite.”
Like those Thompson cites, more and more advisors are incorporating ETFs into client portfolios, helping to increase the pace at which money is being invested into ETFs since their introduction almost 16 years ago (the SPDR was introduced January 29, 1993). Even this year, when the assets in United States-listed ETFs fell 6.6% through the end of the third quarter, they held up much better than the value of, say, the MSCI U.S. index, which fell 20.52%, according to Barclays Global Investors, the largest manager of ETFs in the U.S.
In 2008 alone, another 103 ETFs were launched in the U.S., bringing the total up to 681 holding $542 billion in assets, including the first actively traded equity ETFs, which must disclose their portfolio holdings (see chart on following page displaying the growth of ETFs over the years). Moreover, there are an additional 486 ETFs planned for launch in the U.S., Barclays reports, though some of those may be postponed indefinitely due to the current market freefall.
In fact, the growth of ETFs, and the flexibility that they offer in constructing portfolios, is leading some experts to suggest that ETFs might challenge mutual funds’ hegemony in the near future.
A Threat to Mutual Funds?
Cerulli Associates’ Director Cindy Zarker wrote starkly in an August 2008 report, Product Development in an Evolving Portfolio Construction Environment, that “ETFs are a potential threat to mutual funds,” reporting that advisors are using ETFs in both “core and satellite allocations, as well as in the active and passive slices of investors’ portfolios.” Zarker notes that advisors who are strategic asset allocators are “likely more interested in ETFs for their lower fees and long-term investment themes,” while advisors who employ a tactical asset allocation approach may use ETFs “because they offer continuous liquidity and access to commodities and other markets where they want to make a concentrated bet.”
While Balliett argues that “ETFs will drive a lot of mutual funds out of business,” the vehicles have a long way to go to challenge mutual funds over all, of course.
As of the end of August 2008, the most recent month for which we had data as of press time, there was $11.578 trillion resting, uncomfortably these days, in 8,081 U.S. mutual funds, according to the Investment Company Institute. The woes of September and early October would have put a big dent in that amount, particularly in the money market funds, which had $3.520 trillion in 800 funds as of August, and which had seen $343 billion in net new inflows for the year-to-date through August. But as is the case with advisors who use a range of alternative investments to capture alpha and diversify client portfolios, advisors who are heavy users of ETFs are often among the leaders of the profession.
Plain Vanilla and Tutti Frutti
Natalie Lera, vice president for product management at Schwab Institutional, acknowledges that ETFs are a “large part of how our advisors round out portfolios, and they’re growing.”
She recalls that a few categories of ETFs have been tried where people said at the end of the day, ‘You know, this is not a great application for an ETF,’” citing in particular the attempt earlier in 2008 that “tried to track the price of oil, and they didn’t do too well. Do I think we’ll have more ETFs that track oil? Yes. Will they do so in the same way? Probably not.”
“ETFs have become a more popular tool,” says Ed Lopez, director of ETF strategies for Rydex Investments. “As mutual fund providers, we know ETF usage has outpaced individual stock usage in 2008.” Research conducted by Rydex AdvisorBenchmarking among RIAs found that almost three-quarters of advisors now use ETFs in building client portfolios, and that 37% of advisors surveyed by Rydex AdvisorBenchmarking chose ETFs “as the number one investment vehicle that has helped them increase business since 2001.” (Disclosure: Rydex AdvisorBenchmarking and Investment Advisor have a content sharing relationship under which Rydex provides research data monthly for the IA “Practice Edge” electronic newsletter.)
What accounts for the attraction of ETFs? Lopez ticks off the standard ones: cost, ease of use, access to specific market segments, and diversification, noting the popularity this year among advisors of Rydex’s eight CurrencyShares ETFs and commodity ETFs. Sector ETFs, Lopex says, allows advisors to be more “flexible and dynamic with client portfolios.” Speaking on October 6, Lopez said Rydex was seeing good inflows lately to consumer staples ETFs, and outflows from oil funds. He noted that energy ETFs had posted 30% positive gains by mid-year 2008, but that the trend then reversed.
Another growing use of ETFs among advisors is to hedge client portfolios, which is why Lopez has seen more interest in leveraged and inverse products–a specialty of Rydex and ProFunds–particularly in inverse financials ETFs. He’s also seen good flows to the bond ETFs during the recent market turmoil. It’s been a big focus of Rydex to educate advisors, says Lopez, mentioning in particular a Rydex publication called ETF Essentials. Balliett is one of those advisors who doesn’t need convincing. He uses Rydex because of their “long list of mutual funds and ETFs that are no-load, many are inverse, and with no transaction fees.” It gives him a “way to diversify within a sector,” being able to buy 12 stocks in a sector, for instance, and only pay one commission rather than 12. He notes that it’s “easier to pick a sector that will bloom, rather than the one leader in that sector.” Moreover, amid the current market strife, the inverse funds in particular provide “opportunities to soften the down side,” Balliett says (he also recommends www.ETFConnect.com for advisors looking for more education on exchange traded funds).
Regarding the active/passive debate, Porter says he “can’t even imagine managing a portfolio in these kinds of markets without using active management. I can’t stand the thought of being a passenger. The ETFs are very conducive to active management: the executions are instantaneous, and many of them are to four places.” He’s quick to admit there are “a lot of caveats you have to put on them–especially the thinly traded ones, and the inverse ones, and warns that “you don’t use market orders.” But he says ETFs are a great way to do “style and market cap rotation during an economic cycle while doing a sector rotation; it’s a great place to get alpha.”