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ETFs Pressuring the Fund Industry

The exchange traded fund (ETF) world has emerged with full force and continues to put pressure on the mutual fund industry.

ETFs are so attractive because they have opened up a new panorama of investment opportunities for all types of investors.  They enable investors to grab broad exposure to stock markets of different countries, emerging markets, sectors and styles as well as fixed income and commodity indices with relative ease on a real-time basis and at a much lower cost than other forms of investing.  They can be traded intraday while enabling investors to remain diversified and have full transparency.  Additionally, they are so versatile that they can be bought on margin, are lendable, can be bought and sold at market, limit or as stop orders.  They don’t have any sales loads and carry expense ratios in the range of 0.05% to 1.60%. 

From a broad market perspective, these aforementioned low expense ratios make it feasible for investors to remain diversified while grabbing exposure to the three major U.S. indices.   For example the PowerShares QQQ (QQQQ) which has an expense ratio of 0.2% and enables one to grab exposure to the technology heavy Nasdaq.  Additionally, one can grab great exposure to the Dow Jones Industrial Average through the DIAMONDS Trust Series 1 (DIA), which has a low expense ratio of 0.17%.  Lastly, the S&P 500 can be accessed through the SPDRs (SPY), which has an expense ratio of 0.09%.

Another great characteristic of ETFs is that they have a unique daily creation and redemption process which enables them to keep their market price in line with its underlying Net Asset Value.   They can only be redeemed “in-kind” which is beneficial because it doesn’t create a taxable event. 

Just to get an idea of how the ETF world has emerged here is a brief landscape of the industry.  There are over 1,677 global ETFs with over 3,000 listings from 90 providers on 43 exchanges around the globe.  Additionally there have been 109 new ETFs that have came to market this year and plans to launch an additional 756 new ETFs are in the making. 

So why should mutual funds feel threatened?   A study done by New-York based research and consulting firm Novarica indicates the following predictions for the investment industry:

• The number of mutual funds will decline from 8,022 in 2008 to 4,237 in 2015 with assets declining from $9.0 trillion to $6.75 trillion over the same period
• The number of ETFs is expected to increase to 2,618 by 2015, with assets more than doubling to $1.15 trillion
• The number of actively managed ETFs will increase to 325 by 2015, currently there are ahandful of them offered by ProShares and Grail Advisors.

To add to these predictions mutual funds have continuously been seeing outflows of assets while ETFs have been witnessing an inflow of assets.  Additionally, as investors become more educated about the markets and the plethora of investment tools at their disposal, ETFs will continue to grow and remain attractive.  Lastly, ETFs are finally starting to make their way into the 401(k) world, which will just be icing on the cake.

To conclude, as investors become more active in managing their portfolios and seek ways to protect themselves from market downfalls and cut risks, the underlying characteristics of ETFs will continue to enable them to grow and be an attractive tool for investors.

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.