3 Reasons Alternative Investments May Be Your New Key to Success in Changing Times
For some, recent headlines have been unwelcome harbingers of changing tides in the advisory business, many of which are rooted in the DOL fiduciary rule.
News has finally been trickling out about how the new rules will actually impact “business as usual” for commission-based firms, and major brokerages have announced huge policy changes as a result. Some are opting to maintain commissions for retirement accounts. Others are shifting to a 100% fee-based environment. Some are even taking commission IRAs off the menu completely and banning the use of mutual funds in IRAs altogether. Another fallout is that broker-dealers and product distributors are already dramatically reducing the numbers of products available to advisors, and some are eliminating all commission-based products.
It’s a radical transformation that’s bound to impact not only your business model and how you work with your clients—but also your ability to compete in a playing field where an unprecedented number of advisors are abandoning the stability of working for a large wirehouse and opening up shop as independent advisors. As the industry as we know it continues to shift, there are three big questions to answer: How can you adapt your business model to deliver solutions that support your clients’ needs; how can you set yourself apart from your competition; and, on top of it all, how can you ensure the profitability and sustainability of your practice?
The answers are not simple, and while there’s no single solution, many advisors are finding that there is one approach that can help address —at least to some degree—all three challenges: Alternative investments. Here’s why alternative investments may be an answer you’ve been looking for:
1: Alternatives can help you stand out in a crowded playing field.
Whether you are battling brokerage firms, the “guy down the street,” or robo-advisors, one way to stand out from the crowd is to deliver clear, tangible value to your clients. First, alternative investments are an important diversification tool within your clients’ portfolios. Second, they’re simply not on the menu at most larger brokerage firms—or on robo-advisor platforms. Plus, many of the advisors you compete against may shy away from the research required to analyze and select appropriate alternatives. If you’re willing to do your homework, alternatives may just be the differentiator you’ve been looking for.
2: Alternatives are well suited to today’s market environment.
Low interest rates, high volatility, and an aging bull market have many investors wondering if it’s time to rethink a passive, equities-based approach to retirement planning—especially if higher yields are needed to reach their investment objectives. Because alternatives are positioned to generate returns in rising and falling market environments, a more active approach to portfolio management that leverages alternatives has the potential to help increase returns. Plus, when combined with multiple asset classes such as stocks, bonds, currencies, and commodities, alternatives may help provide the all-important diversification element that your client’s portfolios require.
3: Alternatives can open the door to conversations with your clients.
The days are gone when you could “set and forget” your client relationships—much less your clients’ portfolios. Alternatives offer a great reason to reach out to existing clients and have a new conversation. And initiating that conversation is one of the most important actions you can take to re-establish yourself as your clients’ trusted advisor. It can assure them that lower-cost or even free investment advice that they may be considering does not provide the guidance they need to achieve their goals.
For tips on talking to your clients about alternative investments, please read my colleague Jason Plucinak’s article, “3 Tips for Talking to Clients about Alternative Investments.”
Of course, alternative investments aren’t the only answer to managing the storm of change across the industry, but by including alternatives into your client portfolios, you may be able to create the portfolio return and the client differentiation you need to stand out in a ever more crowded playing field. Now is the time to research the options, determine which alternatives make the most sense, and then start the conversation with your clients. Your clients will value your active guidance and, ultimately, your proven dedication to helping them achieve their investment goals. That, in the end, is every advisor’s key to success.
Understanding ETF Liquidity and Trading
Written by: ProShares
ETFs offer attractive features—access to a broad range of asset classes, sectors and styles in a liquid, transparent and cost-effective vehicle. But before using that vehicle, it’s helpful to understand how it works, especially the sources of ETF liquidity and the mechanics of trading them. Understanding these points may help you improve execution when buying and selling ETFs.
The Primary Market—Creation/Redemption of ETF Shares
Most investors trade ETFs on stock exchanges in the secondary market. But the actual creation and redemption of ETF shares occur in the primary market, between the ETF and authorized participants (APs)1—the only parties who transact directly with the ETF. The APs’ ability to continuously create and redeem shares allows them to meet the supply and demand needs of investors, making them key liquidity providers in the secondary market.
Creation. This is how APs introduce new ETF shares to the secondary market.
- In-kind—The AP creates ETF shares in large increments—known as creation units—by acquiring the securities that make up the benchmark the fund tracks in their appropriate weightings and amounts to reach creation unit size (blocks ranging from 25,000 to 100,000 fund shares). The AP then delivers those securities to the ETF in exchange for ETF shares.
- Cash—Alternatively, APs can create ETF shares by exchanging the appropriate amount of cash for ETF shares, for what’s known as a cash create. Often, ETF shares are created using a combination of securities and cash.
- The AP then offers the ETF shares for sale in the secondary market, where they are traded between buyers and sellers on an exchange.
Redemption. This follows the same process in reverse.
- The AP redeems ETF shares in large increments—known as redemption units—by acquiring them in the secondary market and transferring them to the ETF in exchange for the underlying securities or cash (or both) in the appropriate weightings and amounts.
The Secondary Market—Costs and Mechanics of Trading ETF Shares
Costs of Trading. In the secondary market, firms that specialize in buying and selling ETF shares—APs or market makers2 (liquidity providers)—trade them to provide market liquidity and make a profit. This profit margin is embedded in the bid/ask spread, which reflects the implicit costs of trading ETFs.
Bid/ask spread is the difference between the bid—the highest price at which a buyer is willing to buy shares—and the ask—the lowest price at which a seller is willing to sell ETF shares. Three key factors impact the bid/ask spread:
- Creation/redemption fees charged by the ETF provider to the AP.
- Spread of the underlying securities—The bid/ask spread and liquidity of the securities that make up the ETF affect the liquidity and the bid/ask spread of the ETF itself. When there are many bids and offers on a security, it is easy to buy and sell, thus the bid/ask spread tends to be tight. When securities are less liquid, the spread is wider, making the cost to acquire them higher. The higher the cost of acquiring the underlying securities, the wider the ETF bid/ask spread.
- Risk or hedging costs—Holding ETFs entails certain risks, which need to be hedged. Liquidity providers use a variety of financial instruments, including futures, options and other ETFs, to hedge this risk. The more instruments they have to choose from, the lower their hedging costs and the lower the bid/ask spread. The higher the risk, the wider the spread.
ETF bid/ask spread = Creation/redemption fees + spread of underlying securities + risk
Executing Large Orders—Tapping Into Deeper Pools of Liquidity
There are two common ways to execute larger trades directly with liquidity providers, both allowing investors to access deeper pools of liquidity than those offered in the quoted secondary market alone:
- Risk trade—A liquidity provider will quote a price for an ETF at a given size. If that price is accepted, the trade is executed and the liquidity provider assumes the market risk of providing the liquidity at execution.
- Create/redeem—For orders that are large enough, it may make sense to work with an AP to create or redeem shares. This type of transaction is usually executed at either the closing market price of the ETF or at the NAV of the ETF plus fees or commissions.
Mechanics of Trading. To fully consider an ETF’s total costs, it is important to understand the dynamics of trading. In general, two types of orders are commonly used to trade ETF shares:
- Limit order—Buy or sell ETF shares at a specified price. One way investors decide at what price to enter a limit order is to look at the IOPV3 as a guidepost. Limit orders may help investors get the best price, but there’s a risk the order will not be filled.
- Market order—Buy or sell immediately at the prevailing price available at the time. With market orders, execution may be faster, but the investor has limited control over the execution price.
While a large number of transactions are executed using limit or market orders, investors often find their order is larger than the quoted market. There may be “hidden” liquidity within the quote that can be accessed in the market using limit or market orders. However, in some cases, it may make sense to execute trades directly through a liquidity provider. How and when to place an ETF order can depend on many factors, including price sensitivity, level of urgency and overall goals for the portfolio. Determining what factors matter most can help determine the best execution strategy.
Questions? Our capital markets experts can help. Learn more about our ETFs here.
1 An AP is a U.S. registered, self-clearing broker/dealer who signs an agreement with an ETF provider or distributor to become an authorized participant of a fund.
2 A market maker is a broker/dealer that buys and sells securities (or ETFs) from its own inventory to facilitate trading in those securities. Most APs are market makers, but not all market makers are APs.
3 IOPV is the Indicative Optimized Portfolio Value—the intraday net asset value of the basket of underlying securities
Investing involves risk, including the possible loss of principal. ProShares are non-diversified and each entails certain risks, which may include risk associated with the use of derivatives (swap agreements, futures contracts and similar instruments), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. Please see their summary and full prospectuses for a more complete description of risks. Carefully consider the investment objectives, risks, charges and expenses before investing. This and other information can be found in the prospectus; read carefully before investing; obtain at ProShares.com. There is no guarantee any ProShares ETF will achieve its investment objective.
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