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The Great Landscape of ETF Opportunities

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I’ve never been shy in this column about discussing the burgeoning innovation and benefits emerging from within the ETF space.

The design structure of the ETF allows more advantageous investment features: full transparency, intraday liquidity, and enhanced operational and tax efficiency. The ability of the investment structure to go beyond tracking only traditional indexes, but also to the creation of custom, strategic indexes and the influx of top-tier portfolio managers — both passive and active — exemplifies the ongoing industry buzz over these products.

Among many industry pundits and financial writers, a recurring notion exists that since active managers cannot regularly outperform benchmarks, the best approach to investing in ETFs is to seek the cheapest funds with the most trading volume in order to avoid investing in illiquid funds with wide bid/ask spreads. Such experts also tend to quantify an ETF or mutual fund’s success according to its assets under management. While that certainly represents a measure of success for a product sponsor, shouldn’t performance ultimately serve as the true measure of success for an investor?

On a recent conference call for investment advisors, Chris Hempstead, who oversees trading at leading ETF market maker KCG mentioned that 90% of ETF volume comes from 300 products. However, to say that the other 1,600 ETFs currently trading lack liquidity could not be further from the truth. He suggested that if an advisor has spread or volume concerns, then the first action should be to call the capital markets team at the ETF provider. While doing so may cost a few extra minutes, it could also save a considerable number of basis points. That’s a piece of wisdom that opens up a world of previously unconsidered opportunities that was closed if you hewed to the aforementioned punditry. As reinforced in these pages previously, ETF trading volume does not equal liquidity.

The ETF space resembles a magnetic field of innovation coming from various directions. Yes, plenty of low-cost passive ETFs from some of the most established and reputable firms exist in the marketplace. However, the pouring in of ideas that shape the ETF landscape often originates at smaller firms. Entrepreneurial shops imprinted their own innovative contributions before being acquired by larger providers — firms such as EGShares (Columbia), IndexIQ (New York Life-MainStay) and RevenueShares (Oppenheimer).

Ideas have emerged such as hedging the currency risk out of country-specific equity exposure or investing in the growing threat of hacking and cybersecurity. A younger firm like Elkhorn may not be as recognizable as Invesco PowerShares, but you may discover intriguing ETF strategies when looking closer. The expertise of South Korea’s largest investment firm and its 40-plus year history is now accessible in an actively managed ETF. In fact, the first three firms in the actively managed ETF space, which includes AdvisorShares, were startups. Today, BlackRock iShares believes in the concept of currency hedging with its own offerings, and even Vanguard has announced that it intends to launch transparent actively managed ETFs.

Investments should be approached the same way. Start with performance when researching new ETFs. Consider smaller ETFs that appear on your list; while those funds may not typify the entire portfolio allocation, such due diligence illustrates the full-scale innovation available in the fully transparent ETF space and shows clients how their hard-earned investment dollars are being put to work.

Advisors represent the foundation of the industry and take well-measured risks to provide a value-add for clients. Fully understanding ETFs in the proper context can provide an edge to your practice and help ensure that the innovation driving a more investor-friendly environment continues in the right direction.

— Read Has Fiduciary Rule Sparked Price War Among ETF Providers? on ThinkAdvisor.