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Are ETFs About To Rule The World?

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It depends on how you use them

When I was a kid growing up in New Jersey, my mother would always remind my brother and me that we had plenty of choices in life.  Typically, this took the form of a statement such as “that’s why Baskin Robbins has 31 flavors!”  As I spent a day roving around the annual Inside ETFs Conference in nearby Hollywood, Florida, last week, I was reminded that the pace of change in the investment business has become so rapid, entire eras of investment history may pass by without us realizing what has changed.

For those not familiar, Exchange-Traded Funds (ETFs) are securities that represent a basket of other securities, similar to a mutual fund.  The key difference with many (but not all) ETFs is that the basket of securities is typically determined by a mechanism designed by the manager.  Back in 1993 (69 years after the first mutual fund was created), State Street came up with the pioneering idea that led to the launch of the first ETF.  The investor could buy a security that replicated the return of the S&P 500 Index, but could be traded during market hours, unlike mutual funds which are typically priced at the end of the trading day.

26 years and over 2,000 product launches later (in the U.S. alone), ETFs have become a staple for many institutional investors, traders, asset managers and individual investors.  However, I do get the sense that most investors still have no idea what ETFs are.  As an investment manager who has used them since the very early days, I feel I have quite a bit of historical perspective.

I also have some concerns, not with ETFs themselves, but with how investors are using them.  This was highlighted in the recently-released, 6th annual study of ETF usage by professional investors, including financial advisors, RIAs and institutional investors by Brown Brothers Harriman and ETF.com.  The survey found that while cost (“expense ratio”) continues to be the leading factor in these investors evaluating ETFs for portfolios, it is tied in significance with past performance.  The other highly-regarded factors for choosing ETFs included the brand (issuer) and to a lesser degree, the investment strategy.

I imagine you just breezed through that last paragraph, so I want to point out what is so startling to me as an investor: I am all for finding a lower-cost way to do things.  But past performance is, as every fund ad is required to say, no indication of future returns.  Try telling that to the people that pour billions of dollars into them!  This is a long-standing issue for investors, and smacks of the fever that led to chasing tech stocks to heights not sustainable around the turn of the last century.  It doesn’t seem to matter what the investment vehicle is; it’s still a “buy what just went up” attitude out there.

The brand issue is also, well, an issue.  So much ETF money is jammed into a small number of brands and strategies (S&P 500 funds and broad market U.S. bond funds, in particular) that two things occur, both of which will offer massive opportunities for those who don’t drink the Kool-Aid.  First, as I have written many times in this space, the S&P 500 will at some point topple under the weight of a “run for the exits” mentality.  The 15% drop in 3 weeks last December was a warning shot.  I have no idea when or what will trigger the next such panic, but I do suspect that “S&P 500 indexing” will one day be a dirty phrase…which will likely be the best time to step back in.

Related: S&P 500? More Like The S&P 50

But the most telling thing to me is that investors in this survey seem to be missing what I consider to be the most important thing about any ETF they would consider for their portfolios: the strategy involved, an assessment of when it is likely to do well or poorly (thus assisting the investor in determining if it should play a long-term or tactical role in the portfolio), and a real “look through” into the specific securities it owns.  Silly me, I thought that what is contained in the portfolio would actually matter.  But then again, I am also one of those people who checks the label of each packaged food product he purchases, to see what “junk” might be in it.

ETFs are now firmly established as an investment vehicle, and as the chart above shows, they continue to be issued at a steady rate.  As investors continue to have more ways to slice up the global stock and bond markets, either to complement stock or mutual fund holdings or via an all-ETF portfolio structure, the study I noted reminds us that there is still an open runway in the form of using ETFs to piece together portfolios that allow investors to get in sync with the dramatic changes in investment market behavior that algorithms, high-frequency traders, and other relatively new entrants have wrought.  I for one am looking forward to honing in on that currently under-appreciated aspect of ETFs…what they actually are, and how they contribute to the investor’s ultimate happiness via the wealth the protect and grow.

For research and insight on these issues and more, click HERE.
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