Do exchange traded funds promise too much? No doubt they are beneficial tools for investors, but they aren’t without risks. With new ETFs launching seemingly every day, investors and advisers shouldn’t base decisions only on a name or style label, argues Edward Rosenberg, head of ETFs for American Century Investments. When you buy a car, you should understand what’s under the hood; the same goes for ETFs.
That said, some concerns are overblown, he says. “People talk about ETFs causing problems in markets. They don’t cause the problems, they’re the result of them,” he says. As for day traders using ETFs to move in and out of the markets rapidly? Not a concern for a disciplined investor, he says.
Rosenberg has over two decades of experience with ETFs, having launched funds for Vanguard, Russell Investments and, most recently, as head of Northern Trust’s Flexshares. He joined the $165 billion American Century Investments firm last year to bring out its first line-up of ETFs, and in November, licensed Precidian Investments’ ActiveShares structure to build actively managed funds based on American Century’s investment strategies. He will be speaking at the Inside ETFs conference in January.
WealthManagement.com: You clearly see the benefits of ETFs, and some advisors and investors only hear the positives of investing in that structure. But what are the risks?
Ed Rosenberg: ETFs are really just mutual funds traded on an exchange. You have to trade an ETF correctly to get the right price. Say you have a wealthy individual who wants to buy 100,000 shares of an ETF. Putting in a market order for all the shares isn’t the appropriate way to trade. You’ll drive the price up and will execute at a price you didn’t expect.
The other risk is buying an ETF on name only. Strategies have gotten complicated. Just because it says “dividend” or “international” in the title doesn’t mean it will operate in a way you’ll expect.
When you buy a car, you want to look at more than the name. You want to understand how the engine works. It’s the same with an ETF. If you understand how the engine works, you’ll understand how it works in different markets.
If you buy just on a fund’s name, its recent performance or the cheapest price, you aren’t buying on the ETF’s philosophy and an understanding of how it will perform in your portfolio. Understanding what you’re buying and how it will operate is important.
WM.com: Some analysts have expressed concern that as fast as investors are going into ETFs now, they may just as quickly reverse and get out when markets get wobbly, exacerbating declines and volatility. What’s your view?
ER: People talk about ETFs causing problems in markets. They don’t cause the problems, they’re the result of them. Investors should understand that if they own a large-cap stock fund and large-cap stocks struggle to trade, their ETFs will struggle to trade.
When Third Avenue froze redemptions from its high-yield fund in 2015, the three main high-yield ETFs still traded with tremendous volume. There is always at least some percentage of buyers. As people get out of a market, contrarians find it an opportunity to buy.
Moreover, every sale of an ETF doesn’t mean a redemption, in contrast to mutual funds. ETFs are generally a secondary market. Only 20 percent of ETF market volume leads to the creation or redemption of securities.
WM.com: There’s also an argument that some ETFs, such as double- or triple-leveraged funds, encourage short-term, destructive trading. What do you think?
ER: I love buy and hold, but other trades don’t affect the remaining shareholders. The speculators only hurt themselves. If you’re trading a large-cap value ETF, and you sell after two days for a tiny profit, that’s not the intent of the fund. But it’s a nice thing when it is possible to do. I don’t know if day trading is appropriate for retail investors, but the nice thing is that other shareholders aren’t impacted.
The day trading funds are designed for a particular use, and investors must understand them. With double-leveraged funds, you must understand that every day, you start at zero. If the ETF falls 10 percent one day and then rises 10 percent the next, you haven’t erased your loss. It goes back to looking under the hood and truly understanding how that product works.
WM.com: What are the most interesting recent developments with ETFs?
ER: The next phase is active, non-transparent ETFs, [where American Century Investments is getting involved]. When you look at an index, it’s probably a first generation ETF. Non-traditionally weighted indices are the second generation. Now you have to create different solutions. Firms that are creating new ETFs now have to continue improving products for clients. There are areas that are underserved, liked fixed income. You can bring some uniqueness by creating strong differentiated products that solve the needs of investors.
WM: Why aren’t there more fixed-income ETFs? Is it because it’s difficult to buy all the bonds in an index?
ER: That’s part of it. A lot of bonds don’t trade publicly. Do you choose by quality or something else? What can you do that adds uniqueness over a basic index? Not every firm is gifted when it comes to fixed income. It’s a harder process to create. The bond market is opaque, it’s dealer-based.
How do you work within all those parameters to innovate? With the right group, you can get creative. You can have a better opportunity for income and growth. There is still room for innovation in equity ETFs too. It just has to be targeted. There are tons of room in all spaces, except Treasurys.
WM.com: What do advisers do well, and where can they improve when it comes to guiding clients on ETFs?
ER: What they do well is in advising clients how to use ETFs, whether it’s an all-ETF portfolio or partnering ETFs with other kinds of investments like mutual funds. A lot of this goes into planning for clients and what they do.
Where advisors can improve is in really understanding what the individual ETF does. Once you’ve decided on allocation, just choosing the cheapest ETF leaves too many things on the table. Have a goal of what you’re really looking for, and then use secondary criteria to help you choose. There is a lot of talk about expense ratios and trading volume, which doesn’t affect the ETFs themselves.
When you’re looking at emerging-market stock ETFs, for example, how do they get their exposure? Futures? ADRs? Does it use a standard weighting for countries? These are the important questions.
Edward Rosenberg is a senior vice president and head of ETFs for American Century Investments. He will be speaking at Inside ETFs 2018 in January.
