7 
7 ON JANUARY 22, 1993, THE SPDR S&P ETF LAUNCHED. THE investment world has not been the same since. ETFs are collective investment vehicles that combine the features of mutual funds and individual stocks. ETFs trade like other stocks on the exchanges, but because of their structure, they generally trade at or near their net asset value over time. Investors (and traders) can now trade broad baskets of stocks and other asset classes throughout the trading day.
The introduction of ETFs was revolutionary, but they did not cause a major transformation right off the bat. It took some time for ETFs to really take hold and begin changing the way investors invest. After starting off with a single ETF in 1993, the domestic ETF industry has grown steadily to where it now includes over a thousand ETFs with over $1 trillion in assets under management. Despite this growth, it was not until recently that investment advisors widely embraced the use of ETFs. ETFs are now also making inroads in products like 401(k) plans, where mutual funds had once ruled.
For decades mutual funds were the preferred investment vehicle for most Americans. There even was the aptly titled Mutual Fund Magazine that catered to the investor class. Mutual funds haven’t gone away. As of October 2011, according to the Investment Company Institute, the $11.66 trillion held in open-end mutual funds dwarfed the $1.055 trillion held in ETFs. But despite the numbers, interest in mutual funds has been edged out by interest in ETFs. Not too long ago, anyone who managed the Fidelity Magellan Fund was big news. Recently the firm changed portfolio managers, and the news was noted in passing by the media. The age of the star mutual fund manager is largely over.
Like all upheavals, the ETF revolution has both its benefits and its drawbacks. On the whole, ETFs have made investing easier, more diverse, and cheaper. On the other hand, the introduction of ETFs has changed the actual underlying nature of some markets, and the rapid introduction of new ETFs has diluted the benefits seen early on. Unlike many revolutions, we are not likely to see a counterrevolution unseating the ETF regime any time soon.
Innovation is rare in the investment world. If you think about it, investors continue to trade instruments like stocks and bonds that have been around for centuries. Open-end and closed-end mutual funds have been around since the 1920s. For investors there have been two big innovations in the past decades. The first was the introduction of listed options trading, and the second was the introduction of ETFs. Both options and ETFs caught on because they materially changed the way investors can structure and manage their portfolios.
The first ETF wasn’t based on some new and novel asset class. As mentioned earlier, it was based on the most widely used investment benchmark, the S&P 500. It is not a coincidence that the SPDR S&P 500 remains the largest ETF based on assets under management. The striking thing about a current list of the largest ETFs is that it is so diverse. The list includes funds that invest in gold, emerging market equities, developed market equities, TIPS, investment-grade corporate bonds, and small-cap equities. In short, it looks a great deal like a balanced portfolio.
This access to a wide range of asset classes and strategies is one of the great advantages of the ETF revolution. Once investors became comfortable with the ETF structure, it was quickly adapted to include other parts of the investment world. Within the world of equities early on, we saw the major benchmark indexes covered. Soon thereafter, sector funds followed, and today seemingly every trendy theme has a dedicated ETF.
International equity was a natural extension for ETFs. One could argue that the introduction of ETFs based on single countries helped bring international investing more into the mainstream. By providing visibility, access, and transparency to the international investing process, ETFs accelerated the existing trend in global investing. Once most of the equity waterfront was covered, quite naturally the ETF industry pushed into other asset classes.
Fixed income was another logical extension. There are now well over a hundred fixed-income ETFs covering Treasuries, corporate and high-yield bonds, municipal bonds, and emerging and developed market bonds. There are also bond ETFs that target specific maturity dates. Essentially, the bond waterfront is pretty well covered. However, most, if not all, of these asset classes were accessible via open-end mutual funds. Where ETFs have really caught hold has been in the world of commodities.
At first, investors in ETFs had few good options to invest in commodities. They could invest directly in commodity futures or could buy and hold the actual commodity, for instance gold coins or bullion. But neither of these was a particularly cheap or easy solution. The introduction of commodity ETFs that either hold commodities directly or simulate the return via futures contracts really opened up the wider world of commodities—so much so that commodity ETFs now constitute some 10% of ETF assets.
ETF providers have not stopped at variations on various equity indexes. The frontier in ETF innovation is funds that follow novel strategies that include the currency carry trade, hedge fund replication, and other return factors. These are strategies that are either difficult or costly to implement for anyone other than large institutions. One can argue whether most investors need these funds, but the fact of the matter is they now exist.
While improved access to novel investment strategies is important, ETFs have had their biggest impact when it comes to costs. A constant complaint of mutual fund investors was that open-end mutual funds charged too high fees for too little performance. The one thing that ETFs have always had was a cost advantage over open-end mutual funds. This cost advantage directly translates into a performance advantage but has also struck fear into the traditional investment management industry.
ETFs are able to provide lower costs in part because their structure is simpler and more streamlined than that of traditional mutual funds. The biggest advantage may be that ETFs were introduced using passive indexes instead of being actively managed like most mutual funds. By following an index such as the S&P 500, ETFs can charge less because there simply is less work to do. This advantage has been sizable. For most of the life of the ETF industry, ETFs have had expense ratios that were 1% less than the ratios for open-end mutual funds.1 In a world where equity market returns are hard to come by, this translates into real money. Indexing was available before the widespread introduction of ETFs from companies such as Vanguard Investments, but the visibility of ETFs has helped to mainstream the idea of using broad (and narrow) market indexes.
It wasn’t the idea of low-cost indexing that initially brought attention to ETFs. It was the novel structure that provided investors, and, more important, traders, the ability to trade shares of ETFs throughout the day. Open-end mutual funds, in contrast, provide in and out access at the end of the trading day. The ability to trade minute by minute isn’t something long-term investors really need, but it is comforting to know it is there, especially in times of heightened market volatility.
ETFs really caught on because traders embraced this flexibility. Prior to the introduction of ETFs, traders had to trade futures or index options for broad-based market exposure. The flexibility that ETFs provide goes beyond the actual trading mechanics. Now many of the largest ETFs also have options that trade alongside them. Investors interested in hedging their portfolios now have the ability to use inverse funds or simply sell short broad-based indexes.
ETFs also mitigate another big complaint with open-end mutual funds, and that is taxes. Because of their structure, ETFs are far more efficient in the way they handle taxable distributions. This is in stark contrast with open-end funds, which have a tendency to generate capital gains for investors even in years where the fund itself has lost value. The process by which this occurs is not magic, but simply represents a new way of doing business. This tax issue is one that is often downplayed relative to the benefits of ETFs, such as costs, access, and flexibility. Taxes are likely underplayed because the past decade hasn’t generated net-net all that much in the way of capital gains to deal with.
If nothing else, our brief description of ETFs highlights the breadth of opportunities available to traders and investors. Like any other tool, ETFs can be used safely and intelligently or can be dangerous when abused. The challenge for investors is to recognize the difference.
ETFs have in a very real sense democratized investing by making available to individual investors tools that were exclusive to institutional investors but a few short years ago. To boot, the ETF revolution has made these tools available at prices that were unheard of not all that long ago. Matt Hougan has been tracking what he calls the “world’s cheapest ETF portfolio” for a few years now. Hougan assembled a globally diversified portfolio using six ETFs, with the goal of minimizing the expenses paid. From 2007 to 2011, this theoretical portfolio has seen its blended expense ratio drop from 16 basis points, or 0.16% per annum, down to 12.35 basis points, or 0.1235%.2 Two findings are worth noting. First, 16 basis points was pretty low to start and is in line with what institutions paid not all that long ago. Second, the expenses keep coming down. Some of the new entrants into the ETF space have chosen to use price as a differentiating factor. If we stopped here, this analysis in and of itself would be a big advertisement for ETFs.
The story on costs gets even better. Within the past year, many of the major online brokerage firms have started programs that allow their customers to trade certain ETFs commission free. The one advantage no-load mutual funds had over ETFs was that investors avoided paying a commission, however small, to trade. Now, with commission-free trades, that advantage goes away. Commission-free ETF trades make strategies like dollar-cost averaging and rebalancing largely friction free. Free trades should be just a minor factor when it comes to designing and implementing a trading or investing strategy. Well-conceived trades are worth doing with or without a commission.
ETFs have become increasingly popular because they now provide access to asset classes and strategies that were previously off-limits to individual investors. ETFs can play an important role in helping investors implement an asset allocation strategy. What investors should be wary of is investing in a novel ETF if they don’t understand the strategy as laid out by the fund manager. Complexity in and of itself is not an effective strategy. If you don’t understand how and when an ETF is supposed to generate returns, then you should move on to the next one. There is no shortage of ETFs to choose from.
ETFs can also be helpful at tax time. We have already noted how ETFs are more tax efficient than open-end mutual funds. ETFs can be helpful in managing your tax bill from investing. Later we will discuss in detail the importance of tax-loss harvesting. For the time being, suffice it to say that investors can benefit by selling securities at a loss in the current tax year to offset any gains they may already have made. ETFs are useful because you can often find an ETF to swap into that is similar enough to maintain an exposure to a particular asset class or strategy without running afoul of the rules surrounding wash sales.3
Another area in which ETFs have made things easier for investors is portfolio hedging. ETFs have made it simple to get short exposure to either speculate outright or hedge your portfolio. There are now dozens of ETFs that provide inverse returns (−100%, −200%, even −300%) on broad equity indexes, sectors, and even bonds. Prior to the introduction of these inverse ETFs, investors had to short stocks or go to the futures or options market to gain some short exposure.
Using inverse ETFs to hedge your portfolio seems straightforward, but there are a few things to keep in mind. The first is that purchasing an inverse fund requires using up capacity in your portfolio. Second, these ETFs tend to have higher-than-average expense ratios. Third, and maybe most important, many of these inverse funds are leveraged. Historically these leveraged ETFs, both inverse and regular, have disappointed investors. These funds really are designed with short holding periods in mind. If held for longer periods of time, especially in volatile markets, the returns on the funds can diverge dramatically from their stated goals.4 This occurs due to the way returns are compounded. So if you need to reduce your portfolio risk for an extended period of time, it makes sense to look for additional ways to get that done.
Like any other tool, ETFs can be used intelligently in the context of an entire portfolio. In the wrong hands, ETFs can be abused and cause immeasurable damage to your portfolio. The key to using any tool is to understand how it works and what its limitations are. This is a particular challenge with ETFs, where the label on a fund oftentimes falls short of being accurate and is sometimes misleading.
For a long time, the ETF industry has been the scrappy upstart taking on the established mutual fund industry. Therefore, criticism of the industry has been relatively muted, with cheerleaders outnumbering skeptics by a wide margin. The afterglow of innovation has made some investors less skeptical than they should be when it comes to looking inside the inner workings of novel ETFs.
We have already seen an example of how a class of funds like leveraged ETFs can work as promised but still disappoint investors. The mismatch between ETF returns and investor expectations occurs all the time. Most, if not all, of these misunderstandings occur because investors don’t fully understand the structure of the underlying fund. Because when it comes to ETFs, structure matters a great deal.
When ETFs were first introduced, things were pretty straightforward. The funds held a broad basket of stocks that tracked widely followed indexes. In short, the components of the fund accurately reflected the label. As the industry has grown and spread into asset classes beyond equities, things have gotten more complicated. Indeed, the industry is now more properly called the ETP industry because that term covers structures that are far removed from the traditional fund format.
This labeling issue comes into play whenever you see a new ETF that invests in a very narrow sector or theme. Whenever you have one of these hot themes, it usually doesn’t have much in the way of liquid, investable names. Therefore, fund sponsors can’t construct a portfolio that is either diversified enough or liquid enough to pass muster. And so the ETF sponsors add bigger, more liquid names to the portfolio that are peripherally related to the trend in question to get around these restrictions. Unwary investors end up paying higher fees for a more diluted experience.
The introduction and rapid growth of commodity ETPs has been one of the great success stories of the industry. Yet commodity ETPs have also been one area where investors have been most disappointed by the promise of the funds and their actual performance. There are two ways in which commodity funds operate. The first is a physical model where the fund actually owns the underlying commodity. In the case of precious metals like gold, silver, and platinum, there are funds that own actual bars of metal in a warehouse. Investors pay the ETPs to hold and store these metals. The performance of these funds is therefore pretty straightforward, with changes in the price of the metal offset by the expenses accrued.
The other class of commodity ETPs relies on futures markets and swaps to replicate the returns on the underlying commodity. This derivative-based structure is used where commodity storage is more costly or complicated. This structure was widely used to create funds that attempted to track the returns of the energy complex, including crude oil and natural gas. The futures markets for oil and gas are some of the most liquid in the world and would seemingly represent a good opportunity for fund sponsors.
These funds were particularly popular in the run-up in energy prices in 2007 and 2008. Unfortunately for investors in these funds, they were not able to closely replicate the returns to spot crude oil or natural gas. Research shows that the flood of money, from ETFs and other index investors, fundamentally changed the nature of the oil futures markets.5 Oil futures that usually were in backwardation flipped into contango. Contango is a technical term that denotes when futures contracts are trading above the price of the underlying commodity. The drag on returns from contango greatly diminished the returns to these ETPs. Investors who thought they were going to get the returns based on the headline prices of crude oil and natural gas were greatly disappointed.
Despite their flaws, these funds remain quite popular, especially with traders. Fund sponsors have come out with new funds that attempt to mitigate the costs (and risks) of contango; however, the fund sponsors cannot get around the fact that futures contracts on a commodity are not equivalent to the commodity itself. For investors who understand this distinction, these funds can represent viable trading vehicles. One way in which fund sponsors have tried to circumvent this issue of benchmark risk is to create products that directly track an underlying index. By issuing exchange-traded notes, or ETNs, fund sponsors promise investors the return on an index less any fees. The only problem is that ETNs are debt instruments, not actual funds.
Investors in an ETN don’t have a claim on the underlying assets of a fund; rather they have a claim on the assets of the issuer, which is usually a large bank. Under normal circumstances, investors are willing to make the trade-off of index returns for credit risk. However, in 2008 the bankruptcy of Lehman Brothers brought to light the risk of the ETN structure. At the time of its bankruptcy, Lehman sponsored three, albeit small, ETNs, the holders of which had to go through the bankruptcy process like other Lehman creditors. While the risk of bankruptcy for most ETN sponsors, who are some of the world’s largest banks, is hopefully remote, it is not zero. Investors who invest in ETNs should be aware that there is an additional layer of credit risk inherent in whatever index they are looking to track.
One other major issue comes along with the diversity of ETP structures, and that is taxes. There are five different tax structures, including ETNs, worth noting.6 By and large the tax situation for each fund is driven by the nature of the underlying assets. However, each fund structure presents its own unique tax situation. For instance, commodity ETPs are often structured as partnerships and pass along the gains and losses from their underlying futures contracts via a K-1. These differences are material and worth noting. Investors therefore need to look past the name of the fund to get a better sense for how after-tax returns will be generated.
The bottom line for investors is that before you put one dime into an ETF, ETP, or traditional open-end mutual fund, you have to understand how that fund works. For most investors, this level of detail is neither fun nor interesting, but it is necessary. Going back to the analogy of ETFs as a tool, if you don’t understand how a tool works, don’t pick it up, let alone start using it. Said another way, “Know what you own.” Complex fund structures are one of the main arguments for most investors sticking with traditional ETFs based on well-constructed indexes. This reduces the chance of surprises and mismatches between your expectations and actual returns. The pressure to invest in new, untested funds is only going to grow because that is where the ETF industry sees its future.
The ETF industry has embraced a complex set of fund structures because it allowed for the rapid introduction of novel fund types. The ETF industry is on a 20-year growth path and is projected to continue taking share from traditional open-end mutual funds. To truly understand the ETF industry and its impact on the financial markets, you have to understand that ETFs are a business, a big business. The logic of the ETF industry only makes sense once you understand the desire, and need, for growth in assets under management.
The ETF industry has long since grown out of its humble origins. According to McKinsey & Company, from 2000 to 2010 assets under management in ETPs in the United States grew at a 31% annual rate compared with the overall fund industry that grew at a 6% rate.7 Don Phillips calls the period from 2005 onward as the “ETF explosion.”8 During this period, we have seen over 1,000 ETPs launch in the United States. The ETF industry recognized that there were only so many broad-based, index-linked ETFs they could launch. To generate more assets under management with higher fees, they would have to embrace novel asset classes and more narrowly defined niches.
This strategy has worked. Don Phillips breaks down the development of the ETF industry into “three waves.” The first wave reflects the introduction of ETFs based on broad-based equity indexes, the second wave reflects a broadening out of coverage, and the third wave is the explosion previously mentioned. According to Phillips, the industry was able to boost its average expense ratio from 0.17% for those funds launched in the first wave to 0.35% for the second wave all the way up to 0.63% for the current wave.9 So the strategy of introducing more fund types has worked in increasing average fees. Along the way, this expansion has reduced the advantages ETFs held over mutual funds. Over time the fee spread has narrowed, portfolio turnover has increased, and volatility has increased as well. Despite this dilution, there is every reason to believe that the ETF industry is still poised for growth.
McKinsey & Company projects that through 2015 the global ETP industry should grow on the order of 16.7% on the low end and 26.7% on the high end.10 This level of growth far and away exceeds anything expected for the overall asset management industry. The rapid growth is attracting an increasing number of asset managers interested in getting in on what is an important distribution channel. This competition has led to the side effect of fewer ETFs being able to reach critical mass. The McKinsey numbers show that back in 2003 nearly every (93%) new ETF introduction garnered $100 million in assets under management within two years of launch.11 By 2009 that number had dwindled down to 26%. In short, new fund launches are now a much riskier proposition.
The rapid introduction of new and untested ETF types has led to a situation where an increasing number of funds are languishing with assets that make them unprofitable for the fund sponsor. These funds are sometimes described as “orphans,” or more colorfully as “zombie ETFs.” The fund sponsors keep them open in the hope that a particular niche will get hot and attract a viable amount of assets. Investors need to be wary of these funds not only because they are going to be more costly to trade, but also because they are more at risk of being liquidated in the future.
It is surprising to most investors whenever their ETF ends up in the zombie category. When one of these highly focused ETFs launches, it is often accompanied by a back test that shows the superior performance of the fund prior to the fund’s launch. This is not altogether surprising because who wants to buy a new fund that has been underperforming? Narrow niches and novel strategies come with the increased chance that they simply won’t perform up to their historical record. The introduction of a niche ETF often coincides with a peak in interest in the theme it covers. Investors who dabble in these funds should be prepared for disappointment.
We can liken the approach of the ETF industry to that of a supermarket. Retail analysts note that supermarkets frequently place the staples of our diets along the perimeter of the store. Here you will find fruits, vegetables, bread, meats, and dairy. These categories are the least processed and presumably healthiest products in the store. In the interior aisles of the store are the more highly processed, less healthy, and presumably higher-profit-margin goods. Some might call this “junk food.” The ETF industry is similar in its approach by offering low-cost, broad-based funds alongside higher-cost niche funds. Consumers, or investors, have the choice among these different categories. Most investors would do well to stick with the basics and not waste their time and effort on “junk” funds. The ETF industry hopes that investors will push their cart into the middle of the store in search of more highly processed fare.
The ETF industry has succeeded in spite of a propensity to launch narrowly focused funds that fail to achieve critical mass. The industry has created so many hits that the misses fade in comparison. The industry’s hits have become so popular that they have changed the nature of the markets they purport to track.
The ETF revolution has scooped up all manner of asset classes over time. Starting with domestic equities, international equities, fixed income, international fixed income, currencies, and commodities, the industry pretty much has the asset class scene covered. Within these niches, industries are now well represented alongside more narrow thematic plays, alternate-weighted indexes, and strategies that seek to replicate hedge fund returns and even plays on volatility. There are numerous examples that show that when one of these ETFs becomes popular, it can actually change how the underlying market trades.
This can occur when the ETF becomes so popular that in a certain sense it becomes the market. We saw this in the case of crude oil and natural gas ETFs, which were among the biggest buyers of futures on these commodities. Some market players believe that the complex of ETNs that tracks the CBOE Volatility Index (the VIX) now has a disproportionate effect on how VIX futures trade. The sponsors of these funds likely had little belief that their funds would become popular enough to influence markets, but they did. In a very real sense, these funds became the tail that wagged the dog. Not only do very popular niche funds risk changing the dynamics of the underlying market, but they also represent a warning sign to investors that the particular market has become overheated.
Another way in which ETFs can change a market is by making available an asset or strategy that was previously off-limits to the vast majority of investors. A prime example is the physical gold market. Prior to the introduction of the SPDR Gold Trust back in November of 2004, investors who wanted gold exposure were forced to go through the costly process of buying physical gold and storing it. Otherwise they could purchase futures contracts on gold or the shares of gold miners. The introduction of the SPDR Gold Trust, now the second largest ETF by assets, has changed the gold-buying calculus.
Exchange-traded gold funds have made it a trivial exercise to buy, sell, and trade physical gold. Anyone with a brokerage account can participate. This has been a boon to investors who have been in the fund from the time of its launch, since they have seen the price of gold increase from $444 to nearly $1,800 an ounce at present.12 Gold has been viewed for ages as a store of value or safe-haven asset. The question for gold investors is whether having so much physical gold tied up in ETF-type structures has changed the way investors look at gold. Said another way, is gold simply another ticker symbol on investors’ screens that investors now feel comfortable trading at a moment’s notice?
One of the great tricks that ETFs have been able to accomplish is to generate liquid vehicles for assets that are generally less liquid. This has been the case with corporate bond ETFs that track investment-grade and high-yield bond indexes. The iShares iBoxx Investment Grade Corporate Bond Fund and the iShares iBoxx High Yield Corporate Bond Fund have become so big and liquid that active bond fund managers have started tracking these indexes more closely.13
Sometimes a simple index quirk can affect markets. For instance in 2010–2011, tech giant Apple constituted more than 20% of the popular PowerShares QQQ fund—this despite the fact that Apple’s weighting in the underlying Nasdaq 100 index was much lower. After an index reweighting, Apple’s weight came down well below 20%, but it reflects how simple decisions that index providers make when ETFs are small in stature can have big effects later on once assets have swelled.
If, as many expect, ETFs continue to take share from traditional fund types, then issues related to their size and market impact will become more common over time. The growth of the ETF industry has generated a number of funds that are likely to fail because they are unable to attract sufficient assets. The bigger issue for ETF sponsors, regulators, and investors will be funds that get too big for their own good and end up altering the markets they attempt to track.
It used to be the case that ETFs were based on an index, either one that was already well known to the public, like the S&P 500, or one that was designed specifically for the purpose of the ETF sponsor. ETF sponsors have gotten increasingly aggressive in their desire to generate ever-narrower niches. ETF sponsors have now embraced indexes that are more dynamic in nature. These strategy ETFs seek to alter their exposure to the market based on various indicators. It is pretty much the case that if a fund sponsor can think of a strategy and categorize the rules involved, it can serve as the basis for an ETF. It’s therefore not that big a step to go from custom-designed, dynamic indexes to ETFs that are actively managed.
Given the history of the ETF industry, this should not come as a shock. The rapid introduction of new ETFs has come along with a rise in expense ratios. Actively managed ETFs are the ultimate excuse to raise fees. The business of managing broad-based indexed ETFs is now highly competitive, and fees are beginning to approach the single digits in terms of basis points per annum. A rapid introduction of actively managed ETFs seems inevitable, but it is not clear than this is a boon for investors.
The push into active ETFs is not at present being driven by investor demand. Actively managed ETFs now make up less than 1% of U.S. ETF assets.14 McKinsey & Company notes how active ETFs could, over the next decade, make up 10% of ETF assets. Given this potential, the current flood of applications by traditional managers to set up actively managed ETFs isn’t surprising, albeit if they are doing it as a defense mechanism. Most of these managers have seen how the rise in ETFs has siphoned off assets and put pressure on fees. It is only logical that they would want to protect their core businesses. Some will try to accomplish this through fund conversions; others will simply launch ETF versions of their already existing funds.
People are going to look back at the introduction of the Pimco Total Return ETF as a watershed for the actively managed ETF business. The fact that Pimco, which is the largest bond fund manager in the world, is launching an ETF version of its most popular fund has put everyone on notice. The new Pimco ETF is essentially providing institutional-level pricing for this strategy in an ETF form.15 This—along with the intraday liquidity, tax benefits, and transparency that come along with the ETF structure—should make for a compelling alternative to Pimco’s already existing funds.
Other fund managers are working very hard to try and bypass one of the attractions of ETFs, and that is their transparency. The ETF structure works today because it requires fund managers to disclose their holdings so that participants can create or redeem shares as needed. Some active managers are unwilling to jump into the ETF fray if they have to manage their portfolios in an open fashion. They fear that their trades will be front-run by others to the detriment of their performance. Some managers are going to great lengths to create new structures that would allow them to sidestep the traditional, transparent ETF structure.16 It isn’t clear that the information is all that valuable, nor is it clear that investors have much interest in buying into a “black box” when alternatives abound.
It’s ironic that the investment management industry would come to embrace the active ETF format. One of the main arguments for ETFs is that they provide investors a chance to trade intraday. The investment management industry has always preached a long time horizon for investors in actively managed mutual funds. Therefore, the liquidity of actively managed ETFs seems to be at odds with the standard industry line and will likely serve only to muddy the message to investors.
The convergence of ETFs and open-end mutual funds is a worrisome trend. The open-end mutual fund business has not served its clientele well. David F. Swensen wrote in an op-ed: “Too often, investors believe that mutual funds provide a safe haven, placing a misguided trust in brokers, advisers and fund managers. In fact, the industry has a history of delivering inferior results to investors, and its regulators do not provide effective oversight.”17 In that light, the prospect for an ETF industry that looks and acts more like the traditional mutual fund industry is not an altogether pleasant prospect.
Then again the ETF industry has been moving away from its original reason for being for some time now. Don Phillips writes: “The steady descent toward mediocrity of ETFs hasn’t been pretty and will get worse. Still, investors have many great ETFs from which to choose, and we are seeing traditional funds finally lower their fees and marginally improve their practices in response to ETFs. In that sense, the ETF revolution will likely lead to lasting benefits for all investors.”18 On the whole, the ETF revolution has been a boon to those investors who have used ETFs in a thoughtful fashion.
Investors sometimes forget that just because the fund industry comes up with a novel fund type does not mean you need to embrace it. Active ETFs will succeed or fail based on their ability to outperform their benchmarks, not on the fact that they are ETFs. The vast majority of investors need not look beyond the most basic ETFs. For those that do, it is important to avoid faddish funds or ones that require complex replication strategies or entail taking on undue credit risk.
What investors need are “good ETFs” that are liquid and accurately track their benchmark. David Merkel, who writes on what a good ETF looks like, comments: “There are many ETFs that are closed-end funds in disguise. An ETF with liquid assets, following a theme that many will want to follow, will never disappear, and will have a price that tracks its NAV.”19 Good ETFs are therefore likely the minority of funds launched today. Selecting ETFs that meet the criteria of a good ETF becomes even more important when you look to diversify your portfolio internationally.
The introduction of ETFs was a real financial innovation providing access to novel asset classes, lower fees, and greater flexibility for investors.
ETFs are useful tools that have helped make life easier for investors, especially in lowering expenses. However, like any other tool ETFs can be misused and/or abused by inexperienced investors.
Structure matters for ETPs. For example ETNs are most definitely not ETFs. ETP structure can affect investment results in a number of ways, not least of which is taxation.
To understand the ETF industry you have to recognize that is a big business. In that light, the rapid proliferation of novel fund types makes sense for the issuer, less so for investors.
The popularity of certain ETFs has changed the underlying dynamics of the markets they attempt to track.
The ETF industry is intent on launching more actively managed ETFs. On the other hand, investors are well served by focusing on good, basic ETFs and avoiding most novel fund types.