I met a broker from Rochester at breakfast on the second day of an ETF conference in Albany New York. I was a speaker on the first day and a moderator on the second and was curious about the audience’s knowledge level and how the message was getting through. “Do you use ETFs in your practice?” I asked. He admitted that he had purchased some SPDRs (Standard & Poor’s Depositary Receipts, SPY) for his largest client. “I went to a meeting with her auditor and all he said was ‘I see that your broker bought an ETF for your portfolio, he must be doing a good job for you!’. I am here to find out what I bought and why they are so good!”
There is a halo effect over ETF use that transcends their undeniably beneficial use in portfolios. But we, in the industry, should not rest on our laurels. There is a directness that has accompanied the electronic revolution and social media that can bite, so making ETFs just another offering on the investment product buffet could be dangerous.
Take for example the Ally Bank ads that portray conventional bankers as insensitive to clients. Clients are portrayed as kids in the commercials. Fine print, exclusionary offers, undisclosed information, run-arounds, and the now ubiquitous “egg management fee” are offered as proof of big bank practices that “even kids know” aren’t fair. It could be argued that banks deserve this treatment. But mutual funds could be tarred with the same brush and with them, the entire investment profession. In Canada, the major banks, through branches and wholly-owned brokerage firms, account for two thirds of all mutual fund sales. And yes, mutual fund fees seem inexplicably large in relationship to what they deliver particularly when compared with ETF fees. But mutual funds still provide retail investors with professional management and diversification while sharing expenses. That their structure is out-dated is not entirely their fault: lack of transparency in an era of full disclosure, once-a-day pricing in a 24-hour-a-day global market, bundled fees when everything is being unbundled (except cell phone packages, strangely enough). The traditional mutual fund format struggles to keep up.
The same fate may await practitioners if they treat ETFs like just a bunch of mutual funds and stuff them into client portfolios like “last year’s hot performer”. ETFs should be used to provide the kinds of solutions, continuous client value and vehicles for managing risk for which they are so well suited with costs justified and construction communicated simply and effectively.
Managing an expanding ETF universe
There are lots of ETFs and more each week. While there are many ways to sort them, keeping things simple has great appeal because it is easier to explain to clients. Ioulia Tretiakova, Director of Quantitative Strategies at PŮR Investing, classifies the ETF universe into two basic categories: those that are passive and those with embedded strategies.
“Passive ETFs follow a simple index or an unleveraged commodity. They are characterized by low fees. Those with embedded strategies are everything else. ETFs with embedded strategies often have higher fees. Leveraged and inverse ETFs and those that follow a manipulated index like revenue or fundamentally weighted, are examples. Actively managed ETFs are the most obvious examples of an embedded strategy.”
Explaining to clients that a low cost core of passive ETFs is an effective way to capture beta, or exposure to market returns will help. You could build a core of actively managed mutual funds or ETFs with embedded strategies that try to outperform your benchmark, but it is difficult to identify successful ones in advance, extremely difficult to pick them consistently year after year, and you risk the inefficiency from fund overlap (see AER Sept 2010 “How Many?). You do, however, know their cost in advance. Go with what you know, it’s logical and clients understand it.
With your passive core established, consider the manageable characteristics of ETFs (or other assets) that make the most impact on portfolios, cost and diversification are the most important followed by liquidity, tax efficiency and tracking error. This column has examined each of these in the past.
What about returns? They can’t be predicted in advance, but by capturing the market return inexpensively with a core of passive products, you can select other “satellite” assets around the core that position the portfolio to perform. Diversified exposure to areas you feel will do well like small capitalization stocks, emerging markets, or commodities, can be added as individual securities, passive ETFs, mutual funds or ETFs with embedded strategies. If the satellite investments chronically underperform the core, you will know and so will your clients. But what to do about it will be clear. In coming issues we will examine the considerations for satellite assets more closely.
Keeping portfolio construction and classification of ETFs simple will help clients understand what you are doing, help dispel the mystery of the “egg management fee” and will distinguish ETFs as a signature part of the portfolio menu.
Mark Yamada is the President and CEO of PŮR Investing Inc. www.purinvesting.com