This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Christopher Hugar, portfolio manager, of Buffalo, New York-based Nottingham Advisors.
At Nottingham Advisors, we construct portfolios using exchange-traded funds. As a so-called ETF strategist, one of the big parts of our value proposition involves leveraging the distinct benefits of ETFs; namely, that they’re:
- Passively managed
- Broadly diversified
- Low cost
- Tax efficient
These are all the reasons we grew to admire ETFs in the first place. Lately, however, we’ve seen the evolution of the industry slowly push ETFs away from these core benefits as providers all work to deliver access to new types of investments. In fact, several of the newest products fail to hit the mark on several of the six points listed above.
This doesn’t mean that ETFs are no longer the best option for many investors (they are), but it’s at least enough to stop speaking in generalities.
Active And Factors And Screens
Let’s look at 2014, for instance.
A quick run of the numbers reveals 198 exchange-traded products stamped with a 2014 inception date. With the low-hanging fruit eliminated from 2005-2013’s torrid run in exchange-traded product development, issuers are now pushing past pure passive to provide investors with “new and improved” exposure to various types of investments.
In fact, the aggregate of alternatively weighted and actively managed strategies launched in 2014 equaled roughly that of traditionally weighted strategies.
For the indexing purists out there, this split alone is enough to make them squeeze their SPIVA scorecard (S&P’s empirical evidence of indexing superiority) just a little bit harder.
Zeroing In On Niche Markets
What’s more, a cursory glance at the 98 traditionally weighted ETPs launched in 2014 reveals that—absent a few additions to certain providers’ “core” product suites—the bulk of the new products launched provide exposure to various niche markets from Qatar to low carbon, and everything in between.
Gone are the days of wide-spread “broad market” launches.
One specific example is the PureFunds ISE Cyber Security ETF (HACK). HACK has 30 holdings, and it’s specifically designed to track the cybersecurity industry. This isn’t necessarily a bad thing, however, as HACK’s narrow view actually allows investors to have more precision.
Previously, ETF investors looking for this type of exposure could only use broad-based technology products to gain peripheral access. Investors have clearly taken notice, and since launching in November, several high-profile hacking scandals have propelled the fund to slightly more than $200 million in assets.
The chart below illustrates HACK’s steady growth since inception.
The ability to more accurately impart views is clearly a plus for investors, but it certainly comes at a cost. HACK currently has an expense ratio of 0.75 percent, or $75 for each $10,000 invested.
Costs Grinding Higher
With active management and so-called alternative beta playing a larger role in new launches, and traditional beta products getting much more granular, surely there’s an impact on cost.
After all, product cost structure is a lot higher when managers and analysts are being compensated to actively seek alpha. Similarly, investors have to pay for all the intellectual property associated with alternatively weighted schemes. For more “niche-y” products, it’s also hard not to expect ETF providers to try to make up for what they’ll miss in volume by charging higher fees.
The chart above shows the distribution of the expense ratios attached to all of the ETPs launched in 2014. Roughly 70 percent of the products launched sport an expense ratio between 40 and 100 basis points. In our opinion, that’s a lot.
Now, I understand that it’s all relative—providing access to some asset classes is simply more expensive than providing access to others. However, given the fact that you can get global, multi-asset-class exposure for just 8 basis points via Matt Hougan’s World’s Cheapest ETF Portfolio, anything over 40 basis points seems like a king’s ransom.
Either way, for particularly discerning investors, the cost differential between expensive ETPs and cheap mutual funds is starting to get a little blurry, and this will likely continue as the industry evolves.
The Rest Of The Story
Don't get me wrong. By and large, ETFs are still an investor’s best bet for all of the reasons mentioned above. It just seems that there have been a lot of exceptions to these rules of late. While the deviation in management style, diversification, and cost have been the most profound, there's also been subtle shifts in tax efficiency and liquidity.
Take, for example, long U.S. dollar exposure, one of the hottest trades of last year. In 2014, the Bloomberg Dollar Spot Index was up almost 11 percent. Popular ways to play this move involved the use of currency forwards on a stand-alone basis, like the WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU | 67), or as part of a hedged strategy, like the WisdomTree Japan Hedged Equity Fund (DXJ | B-57).
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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