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Portfolio > ETFs

A Bull Market in ETFs: Practice Edge, April 2009

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As the markets continue to gyrate wildly, advisors are increasingly turning to exchange traded funds (ETFs) for their flexibility, transparency, and lower expense ratios. In fact, nearly all advisors (83%) who took part in the Rydex AdvisorBenchmarking November survey believe that ETFs will be a primary investment vehicle for them in 2009. While ETF assets fell 12.9% to $495 billion from $568.7 billion from January 2008 to January 2009, the number of ETFs on the market climbed 16% during the same period–with the greatest growth coming from global/international offerings (According to the Investment Company Institute, there are now 226 ETFs in this category vs. 160 a year ago-a 41% increase). Some industry pundits even see ETFs encroaching on mutual fund territory. In fact, an April 2009 Lipper report notes “Sales of new ETFs appear to be replacing sales of new mutual funds over the past several years. ETF launches now exceed 30% of all new (fund) products.”

How to Choose?

With the number of ETFs on the market standing at more than 700, selecting the right ETF for a client portfolio is more daunting than ever before. Advisors use a number of factors in selecting ETFs, with investment objective/index exposure ranking as the most important criteria, according to 59% of the advisors surveyed. The second and third most important decision-making criteria are fees (46%) and benchmark tracking accuracy (35%). It’s interesting to note that more than a third of advisors (38%) do not find Morningstar rankings (or rankings from other research providers) important as a decision criteria for investing in ETFs. Advisors also see provider name as a “nonimportant” or “neutral” criteria in selecting an ETF (38%) (See Chart 1 below).

When advisors research different ETF choices, more than half (55%) use the Morningstar ETF center, 40% use the Yahoo! Finance ETF center and about one third (34%) use ETF provider sites. Exchange Web sites (25%)–such as the NYSE and Nasdaq, The Wall Street Journal ETF screener (24%), and Barron’s (18%), also ranked highly.

Most of the advisors (55%) surveyed review the ETF universe and their clients’ ETF holdings monthly (see Chart 2 below).

The ETN-ETF Differences

In recent years, the next generation of ETFs has entered the scene-exchange traded notes (ETNs). First created in 2006 by Barclays, the number of ETNs has grown to 87 in February 2009 from 39 in February 2008 (Source: National Stock Exchange). ETNs are now also issued by Morgan Stanley, Credit Suisse, UBS, and Goldman Sachs. ETNs are similar to ETFs in that they trade on an exchange like a stock and can be shorted and track an index, but the similarities end there. The primary differences between the two are:

1. More exotic exposure. ETNs often provide exposure to more exotic investment choices–such as commodities and futures–than more traditional ETFs.

2. Product structure and credit risk. ETNs and ETFs have different structures. ETNs are structured products created as a senior debt note by an issuing bank, meaning that the ETN is dependent on the credit of the underlying bank. In contrast, ETFs represent ownership in the actual underlying product and are not subject to such credit risk.

3. Tracking. ETNs do offer a distinct advantage over their ETF counterparts–they track their product/index exactly (minus fees) while ETFs are subject to tracking error.

4. Taxes. ETFs must pass on yearly capital gains and income distributions, which are taxable events for the holder. ETNs do not make these distributions, so the investor can defer taxation until the ETN matures or is sold. However, because not all ETNs are subject to the same tax treatments, it’s essential that the accountants who work on your client accounts be well versed in the differences.

Accountants aren’t the only ones that may lack a thorough understanding of the differences between ETFs and ETNs. According to our research, only 8% of advisors rated themselves as “very knowledgeable” on the differences between ETNs and ETFs while 74% of advisors said that they are “knowledgeable” or “somewhat knowledgeable” on the differences.

Advisors seem most confident in their knowledge levels on the differences in tax consequences between the two products, with almost all of them (76%) believing that they are at least somewhat knowledgeable on this character difference.

Advisors are less confident in their knowledge of credit-risk differences, exposure to difficult markets, and tracking-error differences (see Chart 3 below).

With the increased popularity in exchange traded funds and projections for the ETF market to reach the $1 trillion mark in assets (Reuters, February 2009) in the next two years from its year-end 2008 global assets of $725 billion (according to Strategic Insight), having a solid understanding of the differences in these products and ensuring that your clients have fundamental knowledge is crucial.

This may also mean an opportunity for advisors to help get their clients better educated on ETFs. According to a survey by Cambridge, Massachusetts-based Cogent Research of 4,000 investors, 49% of so-called self-directed ETF owners (or individuals who invest for themselves–without the help of an advisor) show more awareness and commitment to exchange traded funds than their advisor-directed peers.

With increasing interest in ETFs and ETNs, advisors who gain an in-depth knowledge of the differences between the products will be well poised to better help clients in today’s widely fluctuating market–and to continue building their business.

Attention, Advisors: Click here to take the 2009 AdvisorBenchmarking survey and benchmark your practice against your peers. The first 100 survey participants will receive the book: Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E. Woods. All other survey participants will receive a $5.00 Starbucks gift card.

Rydex AdvisorBenchmarking is a research and analysis center focused on the registered investment advisor (RIA) marketplace. Its semi-annual survey of 213 RIA firms was conducted online in November 2008. The service is aimed at helping advisors grow and enhance their firms by comparing how their businesses fare against other advisors. Advisors also learn best practices of the most successful advisors in the business.

Maya Ivanova is a market research manager with Rydex She can be reached at [email protected].

AdvisorBenchmarking is an affiliate of Rydex Investments. The analysis on Rydex is based on the number of completed surveys and reflects only information from those surveys. This information is intended to be general in nature, and these overviews are no substitute for professional, legal or consulting advice. This information should not be construed as advice from Rydex Investments or any of its affiliates.


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