ETF Prime Archive

Classifying ETFs

A key tenet of asset allocation is diversification across asset classes and subclasses having discernable differences in return and risk characteristics. Classification of equities according to style and sector characteristics (as well as capitalization and geographic coverage) enables index investors to “fence off” exposure and risk based on the composition of holdings.

Style attribution classifies a stock as “growth” or “value”. Growth stocks tend to have relatively high price-to-earnings (P/E) ratios and rapid earnings growth. Value stocks tend to have relatively low P/Es and price-to-book (P/B) ratios. Most style-based indexes, such as those of S&P and Russell, rely heavily on the inverse of P/B (i.e., B/P) to classify stocks as either growth or value.

Style, capitalization and geographic coverage are frequently used in combination. Exposure to U.S. all-cap growth stocks, for example, can be gained by using iShares Russell 3000 Growth ETF (IWZ) whereas exposure to U.S. small-cap value stocks can be gained via iShares S&P/Barra Small Cap 600 Value (IJS).

These classification “gradients” enable the disciplined investor to maintain tight control over exposure to assets having, by design, diversified performance and risk attributes.

Over-weighting, underweighting, eliminating or even taking on inverse exposure, whether for hedging purposes or otherwise, can be done with surgical precision via style and sector-based ETFs. 

Of the industry’s 751 ETFs as of July 31, according to StateStreet, 90 were style and capitalization-based equity ETFs, holding $232 billion, and 115 sector-based equity ETFs valued at $59 billion. Industry totals stood at 751 ETFs holding $640 billion in assets.

Is Your Advisor Using Leveraged and Inverse ETFs?

Bob Pisani hit the nail on the head in an article posted on cnbc.com today regarding leveraged and inverse ETFs.  He states that “financial advisors are not adequately explaining to the public what these ETFs do – and don’t do”.  I’ll take it a step further – a number of financial advisors simply don’t understand what these ETFs do and don’t do.  As is not uncommon at large brokerages, advisors have a tendency to simply sell the next “hot” investment to clients, a description that absolutely applies to leveraged and inverse ETFs which have seen assets increase by over $9 billion year-to-date.  The problem is that a number of advisors have pushed leveraged and inverse ETFs without explaining to investors how they work or what role they play in the portfolio’s overall investment strategy (because many don’t understand themselves).  As a result, and in the face of potential investor lawsuits, brokerages are suspending their use of leveraged and inverse ETFs by advisors (as UBS Wealth Management Americas did on Monday and Morgan Stanely Smith Barney and Charles Schwab are considering).

Unfortunately for large brokerage clients, this is just another example of corporate executives being forced to limit investment options because of potential liability concerns generated from sloppy, uneducated advisors.  These types of “risk management” decisions by large brokerages inevitably lead to watered-down options for clients and can cause confusion for investors.  A better approach might be to educate advisors so they can, in turn, properly educate their clients – though less educated clients often means more money for large brokerages.

 As Pisani pointed out in his article, FINRA (Financial Industry Regulatory Authority) recently clarified their guidance on this topic stating, “Leveraged and inverse ETFs can be appropriate if recommended as part of a sophisticated trading strategy that will be closely monitored by a financial professional.  At times, this trading strategy might require a leveraged or inverse ETF to be held longer than one day.”

 At The ETF Store, we spend countless hours educating ourselves on the intricacies of the more complex ETFs, such as the leveraged and inverse offerings.   We’re not hindered by the legal burden of uneducated advisors and can offer unique, sophisticated strategies to clients based on a thorough understanding of the investments products we offer.  Through our deep understanding of these products, we can educate our clients and expand, not limit, investment opportunities.

More Advisors Moving to ETFs

It appears that other advisors are starting to catch on to what The ETF Store has known for awhile – ETFs offer investors greater transparency and cheaper options than many mutual funds.  According to an article published in the Wall Street Journal today, a survey conducted by Cogent Research found that advisors expect to reduce their clients’ holdings in mutual funds over the next few years while increasing their use of ETFs.  Greater transparency and lower costs were cited as the primary drivers.

Cogent’s survey shows a continuation of a trend that has seen advisors reduce mutual fund holdings in client accounts from 35% in 2007, down to 30% currently, and an estimated 27% in 2011.  Compare this to advisors’ use of ETFs which has grown from 5% in 2007, to 8% currently, and an estimated 14% by 2011.  This is clear evidence that advisors are recognizing the benefits of including ETFs in client portfolios and reducing mutual fund holdings to take advantage of ETFs.  As Christy White, a principal director at Cogent, points out, the survey results highlight an “industrywide problem” for mutual fund companies – one that’s not going to go away.

Quick Snapshot: June ETF/ETN Data

National Stock Exchange, Inc. recently released Exchange-Traded Fund (ETF) and Exchange-Traded Note (ETN) data for June.  Some highlights:

• Total ETF/ETN assets at the end of June were approximately $603.5 billion.
• The total number of ETF/ETN products increased to 837 from 804 a year ago.
• Net cash inflows to ETFs/ETNs in June totaled approximately $12.4 billion.
• Year-to-date net cash inflows were approximately $41.9 billion, an increase of nearly 102% over the same time period in 2008.
• ETF/ETN notional trading volume totaled approximately $1.5 trillion in June, 32% of all U.S. equity trading volume.

 As the data shows, ETFs and ETNs continue to log impressive gains in investor assets.  With their low cost structure, flexibility, transparency, tax efficiency, and wide asset class coverage, it’s clear that ETFs and ETNs are quickly becoming the preferred investment vehicle for all types of investors.