Exchange-traded funds have been around for nearly 30 years, and their popularity soared after the 2008 financial crisis.
With longevity on ETFs’ side, financial advisors say their clients are aware of these investment vehicles, but being aware doesn’t mean they understand the differences between ETFs and mutual funds.
Even fewer clients are likely to request that advisors specifically use ETFs in their portfolios. However, advisors say there’s little client resistance to using ETFs.
Most Clients Have Heard Of ETFs
Financial advisors say most of their clients have heard of ETFs, so when advisors talk about using them in portfolios, clients aren’t surprised.
“In general, people know what ETFs are at this point,” said Hagen Pruemm, president of SIS Financial Group. “And they’re pretty comfortable with them, just like they used to be comfortable with mutual funds.”
Tyson Romanick, assistant vice president and portfolio manager at Baker Boyer Bank, says that he’s never had any clients refuse to use them, even if they don’t understand how they work.
“I don’t think I’ve ever had anybody say, ‘No, I don’t want to be in these.’ When we’ve said we have an investment idea [in an ETF wrapper], nobody’s ever [said], ‘No, I’d rather have a mutual fund,’” he added.
Education Remains Necessary
Clients may be aware of ETFs, but there’s still a lot of educational work needed to explain the differences between ETFs and mutual funds.
Adam Pawloski, certified financial planner at Telemus, says for a number of his clients, ETFs are mostly “a buzzword,” something they mention but really don’t understand with regard to their role in the portfolio. He notes that with three of his most recent clients, he’s had to explain in-depth the differences between an ETF and a mutual fund.
“One didn’t even know what the acronym ‘ETF’ meant,” he said. “That’s fine with me—it’s my job to educate them.”
Daniel Milan, managing partner at Cornerstone Financial Services, says he’s had a few clients or prospects who know enough about ETFs to ask him to use these in their portfolios because they’ve done some of their own research—but that’s rare, a sentiment shared by the other advisors.
“We actually have a marketing piece we use to show the differences between ETFs and mutual funds,” Milan explained. “And we frame it that mutual funds are more or less like an archaic way to invest, and ETFs are more client-friendly.”
Pawloski finds his clients are looking for more information than he believes clients did in the past: “I feel like the old-school advisor just said, ‘I’m your manager, and I’m taking care of it; you don’t have to worry about it.’ The New Age investor wants to know a little bit more and have some transparency about what’s going on.”
A number of advisors’ clients are generally older, some nearing retirement. The older clients have most of their wealth in retirement accounts, although a number also have taxable accounts. Most clients’ investing experience is with mutual funds, especially if their money grew in a 401(k), where there are few ETFs available.
Advisors say they’ll lay out the pros and cons of mutual funds and ETFs, often first highlighting the tax efficiency of ETFs, although that’s less of a selling point for clients who hold the bulk of their money in tax-sheltered accounts.
Tax Efficiency & Flexibility
SIS Financial’s Pruemm says that once he’s satisfied that a prospect will be a good fit, his firm starts ETF education early on. Tax efficiency becomes a bigger interest for clients if they have a portfolio of mutual funds in a taxable account, noting that ETFs can avoid much of the capital-gains tax issues that mutual funds can’t sidestep. He also points out another important ETF trait: flexibility.
“Flexibility is what we’re after,” he said, noting that underlying assets in mutual funds fluctuate, and these funds offer little clarity about outstanding shares.
“With a mutual fund, you can’t sell until the market closes,” Pruemm added. “With an ETF, you can trade intraday, and you can reallocate and reinvest it right away.”
Cornerstone’s Milan sometimes finds that clients mix up the types of investment vehicle they have, even if they were investing for themselves: “Sometimes people say, ‘I have this index mutual fund,’ and it’s really an index ETF.”
He notes that index products are the source of one of the biggest misunderstandings by his clients about investing.
“There’s definitely still an education gap about the differences between mutual funds and ETFs,” Milan explained. “A lot of it comes where they might include an index into some definition of mutual fund or ETF, but not understand there can be an index mutual fund or an index ETF.”
Milan says he uses model portfolios with his clients, so ETFs’ efficiency is vital, particularly when it comes to bid/ask spreads, pointing out the volatility seen in the quick market drop during mid-July. Do-it-yourself investors are most likely to be burned by not understanding bid/ask spread ratios when they trade.
He adds that retail investors who sell during sharp drops are “getting fleeced by the ETF managers because of the spreads ... . That’s the biggest risk for a retail trader or investor, because they typically don’t understand or don’t know about that. And we point out to our clients that it can be a con, but it can be a pro if you know to look for that.”
No Hesitancy To Use
Advisors say clients don’t show any reservation about including ETFs in portfolios, especially after advisors educate them on their utility.
Milan says that he might get pushback when it comes to using certain fund families. Clients might say they want him to use Vanguard or Fidelity funds because they’re familiar with those names. He explains that while those issuers have good funds, there’s no reason to be captive to a particular issuer, since that organization might not necessarily have the best offerings for a certain sector.
He points out his firm uses a mix of ETFs from First Trust, Schwab, Vanguard and BlackRock for its core and satellite positions.
Baker Boyer’s Romanick points out his bank’s portfolio managers are beginning to ramp up ETF usage in client portfolios, especially for tactical positions.
Although his firm has only a small number of clients who express specific interest in ETFs, Romanick says advisors try to avoid steering them to one fund type or another, since both have their place depending on client needs. Most of the clients who request ETFs generally have some understanding of the vehicles.
“For clients who want a more sophisticated strategy, that’s where it comes up more,” he said.
That includes if a client is interested in very tactical active management, such as momentum funds, where ETFs are more tax efficient than mutual funds.
Telemus’ Pawloski notes that being able to talk about tax efficiency of ETFs and why his firm uses these vehicles in certain instances versus mutual funds or individual stocks lends him greater credibility beyond just explaining that ETFs can save money because fees are cheaper.
“When we talk about saving money on taxes, that’s when they realize, ‘OK, this person isn’t just a regular advisor who just invests my money ... there’s actual financial planning going on,” he said.