How ETFs Changed The Advisory Business

January 17, 2019

[This article appears in our February issue of ETF Report.]


Financial advisors who managed client money before 1993 had a few public options available to them: mostly mutual funds, individual stocks and individual bonds.

They left asset allocation in the hands of actively managed mutual funds, but that vehicle’s structure meant they didn’t know what they were holding real-time. Then along came the SPDR S&P 500 ETF Trust (SPY), which would radically change how advisors accessed the market, the cost they’d pay for that access, transparency, the tax efficiency and a host of other improvements over mutual funds. Fast-forward to 2019: ETFs are a $5 trillion global business.

Elisabeth Kashner, CFA, director of ETF research at FactSet, says the interest in passive investing and the efficiencies of ETFs over mutual funds have helped with their popularity.

“It’s a phenomenon I call ‘keeping your money.’ ETFs are truly a better mousetrap in terms of tightness of index tracking, tax efficiency, cost management and fairness,” she said, referring to the creation/redemption process in ETFs.

Transparency's Value
Sue Thompson, executive vice president and head of SPDR Americas Distribution at State Street Global Advisors, says ETFs’ transparency was key to advisors embracing the product. Accounting scandals with Enron and WorldCom made investors question what was in their mutual funds, she said.

“At the time [in 2002], I was working at Vanguard, and I would be talking to people, and they would say, ‘What’s my exposure?’ she said. “And we couldn’t actually [tell] with them because all you would have and all you could share was the latest quarterly holding. So advisors to some degree were flying blind. And that was tough.”

Several factors sped advisors’ ETF adoption—the internet gave people greater access to the market; stronger computing power allowed new types of risk modeling; and the dot-com bust and the 2008 credit crisis made advisors change their asset allocation models.

Matt Schiffman, principal at Broadridge Financial Solutions, called ETFs a “mostly good” disruptive force for the industry, noting a key benefit was allowing advisors to take control of the asset allocation model, which was otherwise left to mutual funds.



“They needed to be able to supplement what they’d done in the past with active mutual funds, and now take fuller control of that asset allocation,” he said. “They were able to use ETFs to slot into pieces of those portfolios and be able to offer their clients the kind of immediate liquidity and lower expenses and transparency they felt clients were looking for.”

Bob Phillips, managing principal of Spectrum Management Group, who has been a financial advisor since 1995, says he used to use mutual funds for asset allocation, but started switching to ETFs about 12 years ago for the tax efficiency, as the biggest detriment to having mutual funds held in taxable accounts was trying to avoid phantom income. Then there were the frustrations of mutual funds’ opaqueness during volatile markets of the early 2000s.

“In those bumpy markets, you had managers that you thought you understood what they owned and what their game plan was. And then they would tend to blow up in bad environments and you’d find out after the fact what caused that. With ETFs, you know what you own day by day, so you know what risk you’re taking,” he said, noting ETFs make up 50% of his business.

Exposure & Ease
Jay Batcha, founder and chief investment officer of Optimal Capital, who has been in the advisory business since 1985 and started using ETFs in the late 1990s, says at first he’d use an index-based ETF like SPY for quick stock exposure and then buy the individual stocks he wanted to own. He’d also use them (and still does) for tax-related trades, taking a tax loss on a security, but swapping into an ETF to maintain the position while waiting for the 30-day wash sale rule to pass.

Now, he says, as ETFs have become more sophisticated, he uses them for exposure to themes and factors in a low-cost, liquid way, and lets the ETF issuers do the deep research dive into the individual stocks.

“You don’t have to be an expert in biotech stocks to buy a biotech index if you like the space in general; you can take convenient exposure there,” he noted.

About half of his portfolios are in ETFs, spread between equity, fixed income and commodities.

Schiffman said passive ETFs still leave investors subject to the same beta volatility of the underlying index, so many advisors are using passive ETFs as core investments and using actively managed ETFs funds or open-end mutual funds to change the characteristics of a client’s overall portfolio.

“The beauty of these products is that it’s a kaleidoscope in terms of how you want to use them, where they go in the mix, how you want to change the risk/reward nature of the overall portfolio,” he said. “They’re an excellent vehicle to be able to do that.”

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