Tom Dorsey: ‘ETF Alchemy’ Is The Future

May 17, 2013


Dorsey (cont'd.): But in times of market consolidation, you want something in that combination that has some brakes, and that is the Standard & Poor’s Low Volatility Index. I can do the same thing with our PowerShares DWA Emerging Markets Technical Leaders (NYSEArca: PIE), our emerging market ETF. It outperforms, hands down (NYSEArca: VWO) and (NYSEArca: EEM) which is another story unto itself. But why stop there? Take the PIE, let's say, and add it to (NYSEArca: EELV), which is emerging market low volatility. Combining those two I have a better product.

I only mentioned our products because that’s mostly what we have worked with in putting these into our backtester. And by taking these together, you’re creating something that, working in combination, is better than any one of them by themselves. And you can create models in this way, and I think that’s ETF alchemy. The “alchemy of ETFs” is combining things together to make better products, and that is really where this is going to end up being the biggest play for portfolios. You’re saying that the ETF world is quite possibly saturated already. But this ETF alchemy frontier is going to afford a whole new impetus to allocate to the exchange-traded approach. So, what does this mean for mutual funds?

Dorsey: Well, for mutual funds, as long as there is a commission trailer, and as long as it’s beneficial to the advisor selling the mutual fund, I think you’ll see flows continuing to go into mutual funds. If they were able to, say, make mutual funds equal to ETFs, where you just had one fee and there was no trailer, nothing combined to it, I think at that point you would find that mutual funds would begin to lose a lot of money, and that it naturally would be put it into ETFs. Until that happens, and you still have the trailers, and it’s beneficial for the broker to own mutual funds, you’re going to see still a lot of money in mutual funds. At the risk of sounding a little snarky, you’re saying that as long as the gravy train of brokerage fees in the form of a trailers, for example, remains, that will be what preserves the mutual fund—even though that’s probably not in the interest of investors in terms of taking some of their returns out of their pockets and into the pockets of brokers?

Dorsey: Yes, this is not telling stories out of school or anything like that. It’s the trailers. If you’re an advisor and you’re getting that trailer, and it means more money to you to be recommending that, then firms are going to want you to do that.

The key for the ETFs for the advisor is being in a program in which the advisor is the portfolio manager, like where the broker charges a fee for what he does. Then the ETF is going to make more sense to him at that point in time. ETFs are now 20 years old—the SPDR S&P 500 ETF (NYSEArca: SPY) was launched in January 1993. And this ETF alchemy, as you're describing it, is the new frontier. In terms of time, when do you see this ETF alchemy manifesting and becoming a bigger part of how ETFs are  used and integrated into investment portfolios?

Dorsey: Well, it's already happening. At Dorsey Wright, we’re probably the first ones to have begun modeling ETFs out there. We’ve had models actually running for iShares since 2002, and we were modeling long before that. People have picked up on that, and as more people create models, they’re fundamental, they’re technical, they’re built in many, many different ways. Ours are 100 percent relative strength, where we compare and contrast different things like our PDP. Our technical leaders are the 100 strongest relative-strength stocks out of 1,500. And that’s updated every quarter.

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