One of the bright spots in U.S. markets over the past few years has been ETFs, whose assets have grown at almost 30% a year since 2005 and now total well over $1 trillion. In its most basic form, an ETF is an open-end fund (typically tracking an index) that trades on an exchange. It has a unique creation and redemption process for primary transactions and provides daily transparency of holdings. Introduced in the U.S. 18 years ago, ETFs have been steadily gaining traction among investors and advisors, so that, according to Morningstar, they generate up to 40% of exchange trading volume.
According to the Rydex|SGI AdvisorBenchmaking survey conducted this spring, the popularity of ETFs is being driven by a variety of factors. Among the key benefits is affordability, as ETFs provide relatively cost-effective market exposure compared with actively managed mutual funds or even index mutual funds. Morningstar reports the 10-largest ETFs in the country charge an average fee of 0.26%, compared with 1.5% charged by the average actively managed mutual fund.
Lower fees was the most commonly cited reason for using ETFs, named by 47% of advisors surveyed, followed by ETFs’ ability to provide exposure to specific benchmarks, cited by 44% of advisors. About a third of advisors said they favored ETFs either for their trading or transparency advantages.
The features of ETFs are attractive, but what do they do for clients’ portfolios? According to the survey, advisors implement ETFs in their clients’ portfolios for a variety of reasons, led by the goal of gaining “core” exposure, which was cited by 26% of survey participants. Other reasons included sector plays (named by 14%), alternative exposure (11%) and as a portfolio “satellite,” that is, a complement to a core holding (10%). The survey confirms that ETFs provide advisors and investors with attractive options for expressing their views, which has helped generate strong, consistent growth for these vehicles.
More indicative of future prospects of ETFs, perhaps, is the survey’s finding that more than half of advisors plan to increase use of ETFs in the next three years. This is in-line with some industry projections that U.S. ETF assets will double, to $2 trillion, in the next five years.
Given the rapid increase in assets and popularity of ETFs, advisors are surprisingly modest in ranking their ETF knowledge. Only about 50% of advisors rated themselves as “expert” or “above average” in their knowledge about basic ETF issues, such as liquidity, investment methodology and trading. In the more technical categories—like ETF structures or calculating the intraday indicative value (IIV)—the percentage of advisors who rank themselves as expert or above average drops to below 35%. The data suggest that advisors could benefit from more information and education on ETFs in order to maximize the utility of these popular and powerful investing vehicles.
ETFs are here to stay, and could figure even more prominently in investors’ portfolios in the years ahead as they seek flexible, cost-effective ways to gain exposure to the full scope of investment strategies. Following are ways advisors can respond to current client needs for information and guidance on ETFs, and prepare themselves for expected growth.
- Know the basics of ETF trading and pricing. Advisors should be conversant about such critical concepts as liquidity—as reflected in secondary market trading volume as well as the ETF’s underlying securities. Advisors also need to know about the role of authorized participants, whose ability to create or redeem ETF shares as market conditions warrant provides a unique safety valve ensuring that ETF market prices will closely reflect the value of their underlying holdings. Advisors may want to understand the calculation of an ETF’s indicative intraday value, or IIV, which provides a clear picture of how well ETF quotes reflect the current market value of underlying securities.
- Don’t settle for average ETF knowledge. Between a third and about half of advisors rate themselves as average in all categories of general ETF knowledge, according to the AdvisorBenchmaking survey. This knowledge gap certainly provides an incentive for providers to deliver more and deeper educational content on key ETF issues and for advisors to fill such gaps so they are expertly equipped to implement ETFs on behalf of their clients. The survey indicated that various Morningstar ETF websites are the most popular sources of information, but most major ETF providers offer clear and comprehensive information on all aspects of ETFs, from industry overviews to how they are created and how they trade.
- Keep up with ETF market trends. ETFs often hold stocks, bonds or commodities that track an index. But increasingly they are designed around less-common investments, including precious metals, currency, infrastructure or thematic holdings like homeland security or social media. ETFs also are leaders in alternative weighting or selection strategies, including equal weighting or pure style factors. Take time to assess the different types of ETFs and how they might fit with specific client needs. Also, stay up to date on industry issues, such as regulatory oversight of ETFs that track an underlying product by buying derivatives rather than actual assets proportionally to an index.
ETFs are well regarded for many reasons, perhaps chief among them that they are efficient trading vehicles with low fees. They enable individual investors to use institutional quality tools, in addition to offering the potential for diversification, even with a limited level of assets, and access to restricted markets. ETFs may not be suitable as the only investment vehicle for client portfolios, but worthy of consideration in helping investors gain or hedge exposures and serving as a foundation for a range of portfolio and trading strategies.