Investors were well-served holding these names, but the move in the greenback combined with both the tax treatment of currency-forward contracts, as well as the lack of offsetting losses elsewhere in these funds, led to material capital gains distributions in 2014.
Again, this doesn’t make these products bad. They’re new tools for investors to use to get the exposure they want. In this case, they even generated alpha. It’s just that investors had less control on when to pay taxes on these gains.
From a liquidity standpoint, the rule tends to be that an ETF is as liquid as its underlying holdings. That’s a reasonable assumption, and we’ve certainly been beneficiaries of this many times in the past, as we’ve used specialized trading desks to enter and exit a product without much “on-screen” volume.
But what about some of these new products that tackle smaller and more esoteric markets, those with limited liquidity to begin with. Sure, these products will be liquid in that they can be traded daily, but one has to wonder just how easy they will be to get into and out of in size with limited impact, especially during times of market volatility.
Lastly, transparency seemed to be the last line in the sand for the traditional benefits of ETFs, and Eaton Vance’s big news in November detailing regulatory acceptance of its exchange-traded managed funds even shoves that into doubt.
Clearly, the industry is evolving.
With it comes a whole variety of new products that build off the original concept of an ETF. As you can probably tell by now, we’ll be the first to point out that this isn’t necessarily a bad thing. Like many things in life, it all comes down to a trade-off.
The good news is that investors are being rewarded with a greater number of tools to create the portfolios they want with greater accuracy. The bad news is that these new tools come at a cost. It is up to investors to decide if obtaining the exact exposure they'd like is worth giving up some of the traditional benefits of exchange-traded funds.
My guess is that one’s view of this trade-off will be skewed based on their approach to portfolio construction. Tactical strategies will place a higher value on obtaining the exact exposure desired, and strategic approaches will likely favor more conventional products that hit on all the traditional benefits of ETFs.
At Nottingham, we run a hybrid of the two, which helps us to better balance this trade-off within our portfolios.
The Nottingham Way
Using a core-satellite approach, we split the portfolio into two components. The larger part, the core, is designed to provide each of our clients with strategic exposure to an asset mix appropriate for their risk tolerance. Within this component, we place a high emphasis on gaining broad, efficient exposure, and we look for products that check the box on every one of the benefits listed at the start of the article.
In our core, you’ll see products like the iShares Core S&P 500 ETF (IVV | A-98), the iShares Core MSCI EAFE ETF (IEFA | A-94) and the iShares Core MSCI Emerging Markets ETF (IEMG | A-99).
The satellite positions within each portfolio are a collection of our best ideas here at Nottingham. These are very tactical in nature, and we use them to either generate alpha or reduce risk.
In this case, we are much more focused on finding the product with the right type of exposure regardless of some of the explicit or implicit costs of ownership. For example, we own USDU, the WisdomTree dollar fund I mentioned above. Is it our most tax efficient position? No, but it gives us the exposure we want, and it’s been a good trade.
Also, the first six months of 2014, we owned the Van Eck Oil Services ETF (OIH | A-35). Was it the most broadly diverse position we owned? No, but it gave us the precision we wanted. That’s just to name a few.
Know What You Own
While we feel we’ve found a way to balance the “give and take” that comes with the industry’s evolution, the various views on these trade-offs are likely to be as varied and diverse as the actual users of exchange-traded funds. The important lesson here is that investors should use a discerning eye when evaluating different products, especially new ones.
As the industry evolves, it is becoming increasingly clear that the generalities of the past no longer apply.
At the time this article was writen, the author's firm held positions in USDU, IVV. IEFA and IEMG. Contact Christopher at [email protected].
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