I’ve participated in dozens of ETF panels. I enjoy them and have made some very good friends in the process, and I’ve also spoken with many advisors interested in ETFs along the way.
Some think shrewdly about how ETFs can improve the service they provide their clients. Others get ETFs at some level, but their thought processes lead them to miss out on some key advantages.
My goal is to move this second group toward a better success rate with ETFs. Specifically, there are three segments of the investing public looking at ETFs in the wrong way. I call them the plumbers, the purists and the constrictors.
The plumbers spend too much time worrying about how ETFs work and not enough time on how ETFs benefit investors. I attended a panel in Miami recently with an audience of financial advisors relatively new to ETFs. They asked question after question about improving ETF trading. They wanted to know the best times to trade and how to get the best prices; they wanted to understand the creation/redemption process in detail.
All good topics, but these are not the reasons ETFs are exciting.
Halfway through, I decided to reverse roles and ask the advisors a question. “How many of you do your own plumbing?” A few hands rose. “I’ve installed three toilets,” I said. “Or, to be more precise, I’ve installed the same toilet three times.” (Sad, but true.) “Your questions are about the plumbing of ETFs,” I told them, “rather than the value that makes them such an important step forward.”
ETFs lower costs, expand available asset classes, support risk management and improve tax management of portfolios. Overlooking those advantages misses the reason all that plumbing is worth the hassle.
Vanguard founder John Bogle exemplifies the purist approach to ETFs. His concern is the ETF sullies the index fund concept he has championed for many years. In a recent Financial Analysts Journal article, Bogle decries the high turnover of ETFs, the smart-beta revolution and leveraged ETFs.
Yet these applications are only natural. ETFs offer the improved liquidity of futures markets, but with a wider set of choices. Actively trading mutual funds affects existing shareholders through trading costs and tax consequences. It is no surprise active traders have moved from the narrower choices in the futures market and the repercussions of actively trading mutual funds.
The purists hold the index in the highest esteem. How high? Bogle ties index funds to a passage in the Psalms referencing the Messiah. That’s high! ETFs are a great innovation that can be used in a lot of different ways. They aren’t perfect.
The constrictors are stuck in the world of deciding whether to replace a mutual fund with an ETF. By doing so, they constrict the ways ETFs could help their clients. They miss the opportunities to use ETFs to improve portfolio design by looking beyond mutual fund replacement.
Financial advisors should look at ETF strategists as possible replacements for one or a group of positions in their portfolios. Many international mutual funds focus on a bottom-up, stock-selection approach. Some advisors will combine actively managed funds with broader international ETFs, like the iShares MSCI ACWI ex U.S. ETF (ACWX | A-95). ETFs provide ETF strategists the tools to provide a complementary, top-down allocation focused on individual countries and regions.
Advisors can also create different risk profiles by using ETFs and ETF strategists. ETFs are the preferred vehicle for investors looking to adjust portfolio risk level higher or lower. While using ETFs or an ETF strategist to tactically adjust risk won’t put a smile on Mr. Bogle’s face, it might put one on your client’s by offering a portfolio that matches their risk tolerance and helps them reach their goals.
The Coming Wave
The next wave of innovation in the ETF marketplace will rely on advisors and strategists finding new ways to combine ETFs into solutions that help clients reach their goals.
The lower costs of ETFs helped investors keep more of their gains; the democratization of narrower asset classes and smart-beta strategies gave investors better choices; the next step will require advisors and strategists to use ETFs to improve portfolio design.
Focusing on more than the plumbing, seeing the potential of ETFs as more than complements to index mutual funds, and being open to a portfolio of ETFs replacing one or two holdings are essential to riding the next wave.
At the time of this writing, CLD held ACWX for its clients. CLS Investments is an Omaha, Nebraska-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Chief Strategist Scott Kubie at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.