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Portfolio > ETFs

Is the ETF Market Saturated?

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The U.S. ETF market has experienced tremendous asset growth over the past two decades. But have ETF providers run out of good ideas? Has the market become saturated?

To find out, Research sat down with Herb Blank, the head of business development at S-Network Global Indexes.

Over the last 30 years Herb has been involved in quantitative risk management, portfolio research, and index and ETF development. He was involved in the development stages of iShares, the SPDR Gold Trust (GLD), CountryBaskets and Dow Jones Global Indices. S-Network Global Indexes publishes over 200 indexes, which provide the foundations for ETFs and other financial products with approximately $3 billion in asset under management.

What do you think about the CBOE S&P 500 BuyWrite Index (BXM) as a strategy for generating high income?

I think it is an excellent strategy that tends to halve the volatility of one’s investment by providing income by “writing” (selling) in-the-money index calls while holding the index. What is very interesting is that in the five most recent overlapping 10-year periods (2004–2013; 2003–2012; etc.), the strategy has also provided equivalent or superior returns to the S&P 500 index with half as much volatility. The underpinnings of the strategy are equally sound with empirical data demonstrating consistently that implied volatility of index options is higher that realized volatility so selling such volatility makes sense. From my perspective it is unfortunate that the only two ETPs out there are PBP, an Invesco PowerShares ETF, and BWV, a Barclays iShares ETNs that both charge 0.75% for providing the operational structure and “expertise” to sell the calls on the index. Since setting up options capability in a mutual fund is simply not that expensive and the strategy requires no expertise, I believe a provider that would offer the strategy at 0.40% or lower would still find much room for profit and attract many assets including mine.

If you had to build a portfolio from scratch, what are some of the ETF you would use as ingredients?

As it happens, a friend contacted me two weeks ago who needed to roll over her 401K by the following Friday into an IRA. Her mother wanted her to do it with her financial advisor who works with a national wealth management firm with which I am quite familiar. I basically told her that their popularity stemmed mostly from the fact that they lost less money for their investors than their peers in 2008 resulting from their perennial conservative approach but generally, paying the advisor 2% in addition to the high fees on the funds they utilize was an expensive and grossly sub-optimal approach. I told her to roll it over to a Fidelity or Schwab account with a discount brokerage window and to buy a full allocation of ETFs. In her case (she is in her 40s, married and middle class, I recommended 60% in VT (total global equity exposure for 12 basis points), 10% in LAG (SPDR intermediate bonds), 10% in TIP (iShares U.S. Treasury inflation protected bonds), 8% in WIP (SPDRs global inflation protected bonds), 5% in IAU (iShares gold, better structure than GLD in my opinion), 5% in IXC (iShares S&P global energy) and 2% in BSV (Vanguard short-term fixed income).

However, this is just one example. Different objectives, goals, guidelines and desired active participation in one’s own portfolio might lead to different allocations. The bond allocation being so heavy in inflation protection has to do with the relatively low upside versus potential downside on nominal bonds in the current environment. From that sense it is tactical within a 60-30-10 strategic framework if you will. If and when long-term rates rise back above 6% and the risk-free rate becomes more of a long-term historic norm of 3%, then I would shift the fixed-income allocation to something more conventional. The current low-interest environment discounts credit risk and places too much demand on marginal yield.

Do you think alternative beta ETFs deserve a place inside a person’s investment portfolio?

Selectively and tactically, I am not against deploying a low volatility equity ETF as part of a core equity allocation, especially for investors willing to give up some expected upside participation for less expected downside participation. That, to me, is a reasonable core substitute for older investors who still want equity participation but wish to have a bit less downside exposure if possible. Although some low-vol proponents insist that there is no give-up in expected return for low-vol based on empirical results during certain measured time frames, more recent results demonstrate my contention that everything is time-period-dependent and because something has worked more often than not even over a 50-year time frame doesn’t mean it will work that way during the next 50 years. And the more market investment dollars that tend to buy into the same strategy to exploit such historical market inefficiencies, the less likely that this strategy will prevail in the same way in the following period. That said for less-aggressive time frames and portfolios that need to limit downside risk, low-vol is a prudent large-cap alternative.

Beyond low-vol, I have some issue with the term “alternative beta” and even more with the term “smart beta.” Most of these are active quantitative strategy ETFs; many of which are rules-based upon a methodology that has worked in some prior periods. As a lifelong quant, I don’t have a problem with this unless the ETF provider elevates the TER [total expense ratio] to more than three times what can be paid for simple cap-weighted beta exposure to the same equity category. RAFI, for example, to me is not “smart beta,” just an alternative weighting scheme based upon historical outperformance in some measured periods.

There are other strategies such as that used in ALPS US Sector Dividend Dogs (SDOG), Guggenheim Spin-Off ETF (CSD) and the First Trust Value Line Dividend ETF (FVD). As with RAFI, all three of these are based on academic literature demonstrating above-average risk-adjusted returns in historical periods. Unlike the RAFI products, all have had excess return above SPY greater than their per-annum fees. And all use strategies that have some mathematical or theoretical justification along with the empirical results. So, I have no significant objection to an investor replacing all or part of her/his core allocation to U.S. equities with FVD or SDOG.

CSD is probably more of a mid-cap replacement, so if you had VTI, you would swap out of it with large cap, midcap and small cap ETFs in cap proportion, then replace half or all of your midcap allocation with CSD. So, I do not object to market-savvy investors substituting a well-constructed strategy index ETF (I refuse to use the inaccurate term “smart beta”) if the TER is below 0.5%. Most investors, however, are better served by the set-it-and-forget-it philosophy.

While ETFs are renowned for having very low annual capital gains distributions are all ETFs tax-efficient?

Let’s start with the fact that there are ETPs that are not ETFs. Many of them use a grantor trust legal structure, which taxes investors as if they own the underlying. Others are levered exchange-traded notes that have tax ramifications. So, the first thing to check is whether the so-called ETF is actually an exchange-traded fund. I urge all not to be lazy. If you consider buying or selling an ETP, download its fact sheet and preferably, its prospectus. Find out first whether it is an actual mutual fund governed by the securities act of 1940 (with exemptions on the way shares are purchased and redeemed), which is what an ETF is. If it is not, do not expect tax efficiency, although some of the unlevered ETNs may provide that.

Even if it is indeed an “honest” ETF, it all depends upon the underlying securities and how the fund is managed. ETFs that hold futures are unlikely to be tax efficient and are generally viewed as very short-term trading vehicles for tactical investors such as hedge funds. ETFs with more than 100% annual portfolio turnover may have difficulties remaining tax efficient. The ETF’s prospectus and statement of additional information have the information an investor needs to make the determination of whether an ETF should be able to avoid capital-gains distributions. If you stick to core equity holdings, even including the larger sector funds and alternative weighting schemes—especially those offered by the major ETF providers—you should have little worry of significant distributions, but it always pays to take the 10 minutes you need to verify this.

Have active ETFs been over-hyped?

Active fixed-income ETFs are being used now and some have been above average investments thus far. Advisor Shares offers a series of actively managed equity ETFs that fully disclose their holdings. Active ETFs are not trading vehicles. So, the low volumes most of the Advisor Shares have should not deter anyone from placing a LIMIT order if they like the manager and philosophy and are willing to pay the fee. In my opinion, this is a more sound investment than paying a higher fee to a mutual fund company for an opaque fund with no way to sell shares before the end of the day or know what the approximate NAV is. To the extent that despite the best efforts of people such as ourselves to educate, the majority of investors still feel more comfortable having their investments made and maintained by an active manager even though they pay higher fees, then a fully disclosed active ETF has many structural advantages for the investor. Also, fully disclosed managed ETFs can have their transactions handled through the tax-efficient ETF contribution and redemption mechanisms. These existing funds, some of which have beaten their benchmarks since offered, are if anything under-hyped for those who still believe in active management.

What has been grossly over-hyped is the supposed “need” for active managers to take advantage of the ETF distribution mechanism while still wishing to keep the majority of their holdings secret. When asked why they need to keep their holdings secret, they cite two reasons. They need time to work their trades. And, others may copy what they do. Both reasons are bogus. If they work their trades over time to avoid market impact, they generally fail at doing so and are late in obtaining parts of positions that are running away from them. And sales made in this manner are fully taxable.

If they use the creation and redemption mechanisms to receive the securities they now want and redeem out those they wish to sell, they do not create capital gains and they have their new positions all at once without creating new market impact. As for others copying what they do and buying securities after the fund buys them and [selling] securities after the fund sells them, this is a terrific thing for the fund’s investors. So, I believe the need and market appetite for actively managed opaque ETFs is grossly over-hyped. Then again, opaque mutual fund management is over-hyped and over-subscribed in my opinion. The best thing I can say about putting these products in ETF form is that investors need not deal with any purchase or redemption fees beyond the costs of buying or selling the shares.

ETFs have been villainized for tempting people to engage in self-destructive behavior like excessive trading. Do these viewpoints have merit?

I do not believe that the majority of investors of ETFs who buy them for investing retirement savings trade in or out [of] them excessively. They have also been demonized for their supposed potential for causing runs on a country’s stock market. That has no merit whatsoever. In cases such as Mexico when the investors have caused a run on the market, ETFs tend to serve as a dampening mechanism mitigating the rapidity of the market’s decline. This is because the equity ETF does not go into the cash market to redeem its shares. And when an investor wished to redeem the ETF’s shares, that investor receives securities which put liquidity back into the market. There are other technical reasons that also can be used to bolster this point.

Are there any things you see happening in the ETF marketplace that worry you?

I am a bit distressed at the vehicles being introduced in ETF wrappers to satisfy the market’s appetite for high yield products regardless of the merits of the investment in the underlying securities. BIZD, the Van Eck BDC ETF with a 9.17% total expense ratio, is one that makes me shiver. That said, the product is offered in good faith in response to demand and fully discloses its risks and cost structure. I just worry that people do not read the fund’s disclosure documents before investing.


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