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Monday, July 2, 2007
Bulwarks of the Market
By MICHAEL SANTOLI
WHEN EXCHANGE-TRADED FUNDS FIRST GAINED prominence in the 1990s, they were generally viewed
as one of the easier ways for retail investors to build market positions on the cheap. And as hedge-fund assets
ballooned after 2000, ETFs increasingly were used by these opportunistic pros to buy or short the market on
the quick.
Yet, as the ETF market has matured, these funds' impact has nowhere been greater than on the way
investment advisers construct long-term portfolios for their retail clients.
ETFs -- essentially index mutual funds that trade like stocks on an exchange -- are suited to all the above
constituencies. Their combination of low cost (for the most part) and liquidity means that they work for the buyand-hold little guy as well as the trade-a-minute, hedge-fund trigger-puller. Their embrace by investment
advisers, however, is arguably far more pervasive.
A survey by Schwab Institutional, the division of Charles Schwab (ticker: SCHW) that provides support to
some 5,000 independent investment advisers, illustrates this trend. The poll, taken in January, covered nearly
1,400 advisers representing $347 billion in assets under management, and found that 76% of them currently
use ETFs in client portfolios. No other instrument had a higher usage rate. Fully 36% said they expected to
increase their ETF use, and one in five advisers who don't yet use them expected to begin doing so.
Barclays Global Investors, an ETF pioneer and manager of the iShares product line, reports that, as of March,
47% of iShares assets were held by retail investors through an adviser or full-service broker, the largest user
group. Another 44% of assets were held by institutions, and 9% by self-directed individual investors. That
compares with 38% for retail investors with advisers, 57% institutional and 5% self-directed in 2000.
Clearly, these funds have come of age, and more than ever comprise the core investments of advised retail
portfolios.
Yet with maturity comes challenges. As the number of exchange-traded funds approaches 600, and
increasingly contrived and niche-oriented permutations muddy the waters, advisers are complaining that the
industry risks alienating investors by offering more quantity than quality, while diluting the funds' essential
selling points: low cost, simplicity and transparency. Indeed, the crowding of the market with confusing and
overly specialized offerings makes advisers even more important arbiters of value.
The bedrock appeal of ETFs for investment advisers remains, however.
The core funds that cover the broad equity markets or major sectors are near-perfect renderings of their
underlying indexes. The thriftiest adviser can be cheered by total fund costs that are as low as nine basis
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points (or hundredths of a percentage point) for Standard & Poor's 500-tracking ETFs.
BECAUSE INDEPENDENT investment advisers and financial planners are fiduciaries, they are charged with
determining the cost-effectiveness of investments.
ETFs are easy to like by that standard.
And because most advisers and planners tend to be asset-allocators rather than stock pickers, the well-defined
asset-class divisions of the major ETFs fit nicely into the majority of portfolio schemes.
Because of their structure, too, exchange-traded funds are inherently tax-efficient and rarely kick off big taxable
distributions.
Rick Ferri, CEO of Portfolio Solutions, a Troy, Mich., investment-advisory firm specializing in low-cost, passiveindex strategies, notes some mechanical advantages of ETFs over standard mutual funds. For instance,
advisers service their accounts using custodians -- Schwab is one -- which charge lower fees for trading ETFs
versus traditional funds.
And, Ferri says, "There's greater flexibility. We all like to square up our portfolios by the end of the day."
Standard mutual funds would require buy or sell orders to be in by 2 p.m. Eastern time, in order for the trades
to take effect the same day, and the day-end net asset value is not knowable until much later.
But this creates the risk of a mismatch between the amount being sold and the amount to be reinvested,
potentially leaving an inefficient excess of cash. ETFs offer real-time portfolio valuation and precise
rebalancing of portfolios.
They also provide handy means to access hard-to-reach markets such as emerging-market stocks, real estate
and commodities.
Like many advisers, Ferri uses broad ETFs -- such as Vanguard Total Stock Market (VTI) -- to construct a
core asset allocation, and then selects among other, narrower ones to make geographic or sector plays. The
low expense ratio of core ETFs means that Portfolio Solutions' clients pay only about 42 basis points, all-in, in
fees, says Ferri.
TO MAKE THE LEAP to ETFs, of course, an investor and his or her adviser first need to accept the wisdom of
indexing, at least for core asset-class exposures, as opposed to seeking managers that try to outperform the
markets. On some level this will limit the ultimate penetration of ETFs, although probably at a much higher
level of usage.
As it is, ETFs have become such a pervasive and mainstream product in adviser circles that the asset category
is dealing with some adolescent awkwardness.
Natalie Lera, vice president for product management at Schwab Institutional, says that, with 76% usage among
advisers, "ETFs are much more a standard than they were even four years ago." She also sees a "blunting" of
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the advantages of newly created exchange-traded funds, a condition of diminishing marginal benefits as
issuance has surged.
Gerald Buetow, CIO of XTF Advisors, a New York firm that runs ETF-based portfolios, uses stronger terms to
lament the drift of the business. "The ETF industry is its own worst enemy at times," he says, adding: "I worry
about people just throwing anything against the wall," in terms of new products.
ETF sponsors have gotten aggressive in creating fringe, gimmicky products with no apparent ready demand
for them, simply because it's cheap and easy to do so. And the narrower, more specialized funds tend to have
higher fees, less diversification and lower liquidity, partially offsetting the principal benefits of ETFs.
There are, for instance, 18 HealthShares ETFs, each devoted to stocks of companies targeting particular
diseases, such as HealthShares Ophthalmology (HHZ) and HealthShares Autoimmune-Inflammation
(HHA). This is slicing health-care sectors too thin, at best; at worst, it's cynical marketing to investors
personally impacted by certain diseases.
There are also 22 separate state-specific ETFs in registration, each containing 50 stocks of companies based
in a single state. The usefulness of such a fund is hard to fathom, except for reasons of provincial pride or
cheap political gestures by, say, local government unions.
Then there are the well-intentioned but still eyebrow-raising efforts such as this one that hit the market last
week: the Claymore/KLD Sudan Free Large-Cap Core ETF (KSF).
There are even aggressive, derivative-based structures emerging -- such as, in Europe, ETFs based on creditdefault swaps that have opaque valuation mechanisms.
Says Buetow: "I worry that some derivative strategy will implode, and the whole industry will take it on the
chin."
He expects a "Darwinian" shakeout, as new entrants have trouble raising enough assets to feed a viable fundmanagement business and ETF attrition results.
PART OF THE REASON it's so easy these days to roll out new ETFs: regulators' tendency to approve nearly
any vehicle based on an index, however the ETF sponsor chooses to define "index." Is a U.S. state anyone's
real idea of a benchmark? How about a basket of stocks recommended by a handful of small research shops
(such as the Claymore/BIR Leaders 50 (BST))? Yet these are rendered as indexes for the purposes of
wrapping an ETF around them -- and might help to underplay risk factors.
There's nothing inherently wrong here. But calling a geographically or analytically screened stock basket an
index can spawn confusion among investors who might think they are getting passive exposure to a market
segment, when in fact they are adopting a specific -- and often untested -- investment strategy.
And yet with all the new products, advisers still complain that there are asset classes that are poorly served by
the ETF industry, whether because of liquidity issues in the underlying securities or lack of imagination. Some
fixed-income and alternative-asset markets in particular are a bit thin, leaving advisers to use mutual funds,
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closed-end funds or even the more expensive separately managed accounts.
Buetow laments that still more firms are creating Treasury-bond-index ETFs, despite the fact that the iShares
and State Street Lehman bond-index ETFs and others do the job quite well. Meanwhile, high-yield and other
credit-based bond products are lacking.
The crowding of the market and its remaining gaps have arguably made the services of advisers more
valuable, as they can sift through the many offerings, gauge their usefulness and search for alternatives in
instances where a proper exchange-traded fund isn't available.
In this way, perhaps, the growth of the ETF market is rapidly replicating what happened in past decades to
mutual funds: A product built to be handled directly by individuals becomes immensely popular, spurring waves
of innovation that foster excess specialization and too many redundant offerings. Thus does a do-it-yourself
market become a do-it-for-me market.
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