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.