Do ETFs Turn Beta Into Alpha?

January 11, 2011

A funny thing is happening in wire houses: Advisors are starting to really use ETFs.

I spent a few years in the brokerage business at Smith Barney and, being a journalist, I just can’t help keeping in touch with people in that part of the financial advisory business.

Back then, I felt pretty lonely in my belief that the ETF was the security of the future. I always thought: “What’s not to like?” I figured then, and believe even more now, that investors need a good, cheap, tax-efficient way to get returns that are on average better than actively managed mutual funds. I can’t think of a better way to build a great portfolio for the long term than with ETFs.

But it was as if brokers in that world were holding the ETF at arm’s length.

I’m not talking only about old-timers and stock jocks who were just on this side of being put out to pasture. We all know the type: those that will let slip a dismissive reference or two to “E-F-Ts,” and the dangers of newfangled contraptions. I also heard plenty of rookies and advisors who had hit their stride talking down ETFs, too. They either extolled the supposed superiority of active management or just showed a complete lack of curiosity.

Or perhaps it was all as simple as the fact that most ETFs don’t have 12b(1) fees, or that ETFs had none of the charges and break points associated with mutual funds, some of which end up in the wire house advisors’ pockets.

To be fair, there were some advisors who saw the light. But they tended to be the ones with large, thriving practices. I remember one, seeing me walk out of the office holding a copy of “Active Index Investing,” Steven Schoenfeld’s tome that remains must-reading for any serious ETF geek, saying: “Well that’s a no-brainer!” Yes, he saw the light, and perhaps the lie of active investing as well. He too was an early adopter in the wire house world but, unlike me, had mega-clients with whom to share his money-saving insights about costs and returns associated with index funds like ETFs.

But, like I said at the beginning, something has changed.

Conversations I used to have about core-satellite strategies always put the mutual fund on center stage, with an ETF or two, like the iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM) or the WisdomTree India Earnings Fund (NYSEArca: EPI) at the perimeter.

Now those conversations put broad-based ETFs, like the SPDR S&P 500 ETF (NYSEArca: SPY), at the core of a portfolio, and relegate actively managed mutual funds, like Ken Heebner’s CGM Focus Fund (CGMFX), to a satellite role.

It’s all being turned inside out.

I suspect advisors are more aware than ever that clients are really focusing on costs these days after the two bear markets of the past decade. I also think more wire house advisors get the ETF gospel: Cheap, broad-based index ETFs, on average, will have higher returns over time than more expensive actively managed mutual funds. It’s hard to argue with the numbers, even though there are more than a few holdouts.

Let those dinosaurs miss out and start losing clients. I’m tempted to say that ETFs have made beta the new alpha, but I realize that maybe I’m getting ahead of myself.

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