When it comes to exchange traded funds, what financial advisers do well is “picking solid products with very low cost and strong issuers—the stuff my mom goes into,” says Eric Balchunas, ETF analyst for Bloomberg Intelligence.
Where they can do better is on implementing more actively managed ETFs, like so-called “smart beta,” or factor-based funds, he says. These funds can be concentrated and volatile over the short term, but if used correctly should help investors outperform the broader market over the life of the portfolio.
“But advisers would often rather have inactive smart beta, something that looks like an index,” Balchunas says. “They are worried about getting yelled at for lagging behind the index.” Advisers must get a little bolder and accept that the diversification provided by smart beta can be accompanied by a fair dose of volatility in the short term, he maintains.
Balchunas will participate in the Inside ETFs conference, January 21-24, at the Diplomat Beach Resort, Hollywood, Fla.
WealthManagement.com: What are some of the overlooked benefits of ETFs?
Eric Balchunas: Standardization, everything trades like an equity. People like standardization, whether it’s USB ports or gas pumps. That’s huge, especially for institutions. In addition, there’s anonymity. No one can trace who’s trading it. Big investors like that.
WM: What are the biggest risks confronting ETFs?
EB: I agree with [Vanguard founder] John Bogle about the risk of overtrading. Just because you can get in and out during the day or trade Russian small-cap stocks doesn’t mean you should. That’s the ultimate temptation.
This is an era of investment enlightenment. The current phase is low cost. The next phase is behavior. You saved all this money compared to mutual funds, but if you try market timing, you will completely eliminate the cost benefit. Sometimes people do worse in accounts with ETFs because they try market timing.
Another issue is vampiring. ETFs can become a victim of their success if they take too much liquidity from stocks. That will increase the cost of trading and create the potential for problems in a mass exit. You need single securities markets to be robust. ETFs won’t provide that. Only about 10 percent of ETFs touch their underlying securities.
When an ETF price rises above net asset value, that creates an arbitrage opportunity. But if the spreads of all stocks increase, then an ETF has to get that much further away before arbitrage is worth it. That would create more premiums [and discounts]. ETFs are riding off the tails of big and liquid stock and bond markets. We want to keep that. It’s not a huge worry now, but we see it in a few areas, such as gold miner stocks.
WM: What are the most interesting recent developments in the ETF space?
EB: The race to zero: low cost. I consider low cost to be the technological innovation for ETFs. The fact they can serve this up for 3 to 6 basis points is amazing. All the flows are going to low cost funds—70 percent to ETFs with expenses of 10 basis points or less.
In addition, there has been democratization of things you wouldn’t think of, such as packaged trades. Think long Japanese stocks but short the yen, or long a set of bonds, but short Treasury futures to eliminate interest-rate risk. These are the trades that institutions have been doing for a long time. Now retail investors can do it, and that will continue.
Smart beta and factor investing are important as well. There are ETFs that give you very well-run factor strategies in different spectra of intensity, so you can achieve your goals and don’t have any capital gains. Smart beta is an advance on active management. You are stripping out the high cost, emotion and taxes. JPMorgan is putting hedge funds through ETFs. Even hedge funds are in democratization mode.
Then there are theme products. Robo Global Robotics & Automation Index ETF (ROBO) started four years ago as the first fund of its kind. It’s a huge hit. ETF innovation happens in the independent world. The big managers aren’t on top of the game. That makes sense. Cool innovation with themes is something that only someone close to the ground can do.
That entrepreneurial, Silicon Valley spirit is another thing driving people to ETFs. You can get some whacky products where people roll their eyes, like the whiskey ETF. But you also get some things that four years later are ahead of the curve. BlackRock, Vanguard and State Street can’t innovate like that. The bigger guys come later. WisdomTree led the way on currency hedging. Now a lot of ETF managers do it.
WM: What interesting developments do you see ahead for the ETF industry?
EB: In five years, I believe you’ll be able to have a full portfolio of ETFs for only 1 or 2 basis points. That will be good for investors, but rough for the industry. You will also see stuff put into ETFs that you didn’t realize was stuff. Anything in Wall Street brain cells will be ETF-ized. Probably 19 will fail, but the one that wins will keep the system going.
WM: What do financial advisers do well when it comes to guiding their clients on ETFs, and where can they improve?
EB: They do well at the core, picking solid products with very low cost and strong issuers—the stuff my mom goes into. The problem is when it comes to smart beta or actively managed ETFs. The true active is high value smart beta. It can be volatile and concentrated, going down a lot or up a lot. But it should do well over time.
But advisers would often rather have inactive smart beta, something that looks like an index. They are worried about getting yelled at for lagging behind the index. Advisers often don’t bite on the active. They say they want smart beta, but they really want something that looks like the index.
They need to work on true diversification rather than worrying that clients will yell at them if they have a lot of tracking error. We’re setting ourselves up for another period like 2008, when smart beta didn’t do what people thought it would.
