Eight Reasons ETFs Deserve Attention Now
It's hard to believe that some top financial advisors are ignoring one of the hottest financial products of these times. It's even harder when you consider that this product ends in the word "fund."
For many financial advisors, mutual funds were the meal ticket of the 90s. Of course, demand for mutual funds has slacked off in the 00s, especially in the High Net Worth market. But are you taking a serious look at another kind of fund that can enhance your business model-exchange-traded funds (ETFs)?
After evaluating ETFs extensively, I've concluded that they offer all the right stuff at just the right time. If you are among advisors who now regard ETFs as either a nuisance or a threat, I hope to change your mind with eight reasons why ETFs deserve your attention now.
ETF Background
Most ETFs are organized as open-end investment companies, the same structure used by mutual funds. They typically are passively managed portfolios designed to track an index or sector by holding its component securities, similar to an index mutual fund.
Like closed-end funds, ETFs offer shares that can be traded on exchanges at competitive bid/ask spreads throughout the day, and these shares can be margined. Management fees and expenses are low -typically from 0.08% to 0.50% on domestic funds and 0.40% to 1.00% on international funds. Standard brokerage commission rates apply on purchases and sales. Unlike mutual funds, ETF shares can be shorted.
The main difference between ETFs and closed-end funds is a feature that eliminates the large discounts (to NAV) at which many closed-end funds trade. That feature is the ability to purchase large blocks of shares, called "creation units," and redeem shares (usually in 50,000 minimum blocks) in exchange for the underlying securities. Since arbitrageurs can buy small blocks of ETFs and package them into creation units, the free market keeps discounts to NAV relatively low.
ETFs organized as open-end investment companies can reinvest any income received. A few ETFs are organized as unit trusts, and these may not reinvest income.
According to the Investment Company Institute, the U.S. market offered 108 ETFs as of October of 2002 divided into the following categories: 36 U.S. equity index funds, 33 U.S. equity sector funds, 35 global or international equity funds, and 4 fixed income funds. Total assets in ETFs were $100.7 billion as of 10/02, of which $92.0 billion was in domestic funds. For historic reference, five years ago there were just two domestic ETFs and the industry's total assets were less than $5.0 billion. The leading packagers of ETFs include Merrill Lynch (HOLDRs), Barclays Global Investors (iShares), State Street Global Advisors (streetTracks), Standard & Poor's (SPDRs), Vanguard (VIPERs), and Nasdaq (Cubes).
#1: Fee-Based Implementation
Some financial advisors took a first look at ETFs and turned up their noses. Clients can buy ETFs for one brokerage fee, hold them years, and never pay the advisor another dime. That's not motivating for transaction-based advisors. But the compensation chemistry changes in a fee-based brokerage account or discretionary separate account. In these accounts, ETFs can be used as either buy-and-hold or dynamically-managed implementation tools, while the advisor earns a continuing asset-based fee. Unlike mutual fund trails, these accounts can offer fee discounts to win competitive cases and breakpoints to attract more client assets. ETFs make great sense for advisors who have already made a commitment to fee-based client relationships.
#2: Cost-Efficiency
At first glance, ETFs appear to offer modest cost advantages over actively managed mutual funds, and minimal cost benefit over traditional index funds. But look closer at who pays costs, and they start to magnify. In a fee-based relationship, clients are becoming more cost-conscious while focusing on their total ("all-in") cost. Trends suggest that in the future a significant part of the market may be willing to pay no more than about 2.0% annually for all fees and expenses combined. At that threshold, the typical mutual fund wrap account, with two levels of fees, can become unrewarding for advisors. If ETFs can reduce the cost of underlying funds by 20-50 basis points, which is typical, the advisor potentially can pocket that much more revenue without meeting price resistance. Over time, it can accumulate to significant compensation advantages. ETFs have a structural cost advantage over mutual funds because they don't bear the burden of holding accounts and issuing statements for thousands of investors.
Reason #3: Top-Level Strategies and Index Tracking
According to recent research, a growing segment of the High Net Worth market wants a "top-level" investment strategy implemented on an advisory basis. For this segment, the top-level strategy is perceived to have greater value than the specific product selection or active management of underlying investments. Top-level strategies can include strategic or tactical asset allocation, market timing, sector rotation, and tax optimization. Often, these strategies depend on underlying investments that accurately track a designated benchmark. According to a study conducted by Bloomberg, ETFs are slightly more accurate in index tracking than corresponding index mutual funds, mainly because mutual funds are required to wait until the end of the day to reinvest dividends. ETFs organized as open-end investment companies can reinvest immediately.
Reason #4: Tax Efficiency and Optimization
ETFs have a significant advantage over all mutual funds in their ability to minimize the impact of taxable distributions, because they are not subject to shareholder redemptions and portfolio liquidations. According to the Bloomberg study, capital gains distributions in ETFs were just 0.31% of NAV for a recent period studied, compared to 5.87% in index mutual funds. This resulted in ETFs delivering more than 1.0% of extra after-tax return. In the future, ETFs will be used extensively in "tax optimization" services which seek to track performance of designated benchmarks while maximizing after-tax return. For example, a sector-based optimization strategy might periodically sell the worst performing sector ETF to "harvest a tax loss." This loss then can be used to offset the client's other investment gains, or deducted against ordinary income up to $3,000 per year. (If Congress increases the annual deduction limit above $3,000, demand for tax optimization will grow.) Some wealthy investors will pay 0.50% more annually for a top-level strategy with a tax-optimized overlay. Some RIAs and financial planners are using software to offer this service, while capturing higher ongoing fees.
Reason #5: Tax-Lot Accounting
Along with tax optimization, the High Net Worth market places extra value on strategies in which the advisor's CPA can specify individual securities lots to sell for tax advantages. Delivering this service requires ability to capture and track tax-lot accounting data on client statements. This data is being consolidated in brokerage accounts more efficiently than it can be captured and evaluated from an assortment of mutual fund groups. Even before ETFs became hot, many advisors recognized the difficulty of delivering to CPAs a hodge-podge of tax data from various fund groups, in a variety of formats. A common solution was to transfer mutual fund shares into a brokerage account with tax-lot tracking capability. Unlike mutual funds, ETFs were designed to take advantage of the tax-reporting and consolidating efficiencies of brokerage account custody.
Reason #6: Alternative Asset Classes
The recent popularity of hedge funds has demonstrated demand for new asset classes, including market-neutral strategies and short equities. Since 1997, mutual funds have had the ability to own short positions, but most fund groups have been slow to open access to alternative investment. One small group, Rydex, currently dominates the market for short and leveraged index funds. Rydex funds are expensive to own and have demonstrated a spotty record of tracking designated benchmarks accurately.
Unlike mutual funds, ETFs can be sold short on much the same basis as individual stocks. A companion product, Single Stock Futures (SSFs), made its debut in the U.S. on November 8 through two new exchanges, Nasdaq Liffe Markets and OneChicago. SSFs allow highly leveraged long and short positions in individual stocks and leading indexes. It is possible that ETFs and SSFs together will become so successful in implementing alternative strategies that they will preempt expansion in this area by mutual funds. Since ETFs and SSFS can be bought in cost-effective and transparent brokerage accounts, they also may steal momentum from hedge funds, with their costly and opaque structures.
Reason #7: Real Time Monitoring
The advisory market is about to be transformed by sophisticated real time portfolio monitoring services -including style analysis, risk monitoring, and performance attribution. Delivered online, these services can "flag" portfolios that deviate from pre-determined criteria and alert advisors to make changes "on the fly." Several of the more sophisticated services have chosen to evaluate individual securities, not actively managed funds, because it's too difficult to track the moment when specific securities are added by fund managers. ETFs can be evaluated on the same basis as individual securities, so it's easier to integrate them into real time monitoring services.
Reason #8: Momentum, Publicity and Demand
ETFs appear to have unlimited potential in terms of the variety of funds they can offer or volume of assets they can capture. Soon, you'll see ETFs that mix 10-15 different stocks. You may also see ETFs that steal the thunder of "Rydex-style funds" by mixing long and short positions in one exchange-traded vehicle.
You know a product is huge when it turns other products into dinosaurs. ETFs won't turn mutual funds into dinosaurs, especially in the retirement plan market. But they've already turned traditional closed-end funds and unit trusts into dinosaurs. Before long, ETFs and SSFs together may make some hedge fund structures obsolete too.
The financial press loves to tell investors how to save money, so favorable publicity about ETF cost benefits may grow. If a millionaire client asks whether your investment discipline will work as well with ETFs as with mutual funds, what are you going to say?
In Summary
It may be a coincidence that ETFs have hit the market just as many advisors and clients are turning to fee-based relationships. But it's a great opportunity for fee-based advisors to expand the range of assets classes they offer, while increasing their portfolio services and revenues.
To get in the ETF game, some advisors face barriers. For example, they may be reluctant to add new asset classes that clients want, because it means obtaining new software and creating new allocation models.
My advice is to confront those barriers now, not later. At a minimum, add a real estate asset class to your models, and use ETFs to do it -e.g., streetTracks Wilshire REIT or iShares Cohen and Steers Realty Majors, both Amex-traded. If you are using a mutual fund wrap product that doesn't allow ETFs, start looking for alternatives that do. Don't let ETFs turn you into a dinosaur!
Addressing the 2F Opportunity
FreeERISA creates opportunities to demonstrate your services to plan decision-makers. One such service, which we'll call the "2F Opportunity," can help many plan decision-makers sleep better at night, because it addresses what may be their deepest fear in today's climate: litigation-minded lawyers.
Under ERISA, plan fiduciaries can be held personally liable, to the full extent of their personal wealth, if they violate duties of loyalty, prudence, diversification or adherence to documents governing the plan. They enjoy no corporate shield of limited liability, and any manager or vendor who exercises discretion in regard to plan assets can become a fiduciary and lawsuit target. In the wake of a deep bear market, lawsuits brought by plan participants always rise. In this particular bear market, publicity regarding 401(k) losses at Enron, WorldCom and other high profile companies have increased fears of ERISA litigation.
How to Identify Opportunities
The 2F Opportunity will help you demonstrate to plan decision-makers that you can help them manage their fiduciary risk, especially in participant-directed plans like 401(k)s, where individuals make poor investment choices, blow their nesteggs, and then blame fiduciaries for losses.
As you access FreeERISA's 5500 filings, you will see on Line 8a a series of "pension benefits" listed by code in boxes. Code 2F indicates a plan that intends to meet the conditions of regulation 404c, adopted in 1992 to offer plan fiduciaries limited relief from liability for investment decisions made by plan participants. A plan listing 2F inside a box has taken the first step toward protecting its fiduciaries from poor investment choices made by participants. But other steps must be taken, for this protection to be meaningful.
2F gives you a two-sided opportunity:
- On Line 8a, boxes 2G and 2H indicate participant-directed account plans. If either of these codes are indicated and 2F is not, you should inquire why. Unless the plan offers only guaranteed investment choices, it means fiduciaries are voluntarily increasing their personal risk. Make sure decision-makers understand the consequences.
- If Box 2F is indicated, offer to cover a checklist of other steps the plan should take to make sure fiduciary protection is as strong as possible.
What 404c Requires
Some fiduciaries have skimmed summaries of 404c and concluded that they are "safe" if the plan offers participants at least three diversified investment choices, along with opportunity to make frequent changes among them. However, the regulation clearly specifies that participants also must have "sufficient information to make informed investment choices." A subsequent Interpretative Bulletin issued by the Department of Labor (96-1) clarifies what this means, as well as the potential loss of 404c protection for companies that offer participant investment advice.
A checklist of questions that you can cover with plan decision-makers is below. Web links to the 404c regulation and 96-1 IB follow.
- Have all eligible participants been clearly informed that the plan intends to comply with 404c?
- Have participants been given the name, address and phone number of the plan fiduciaries responsible for providing investment information?
- Does the plan have a written Investment Policy Statement (IPS) and does it explicitly state that the plan intends to comply with 404c?
- Has the plan's annual Summary Plan Description been checked against specific requirements of 404c? Has this process been documented in the plan's compliance file? Have plan documents been reviewed by an ERISA compliance attorney?
- Does the plan have a published schedule of participant information and education events? Is a document file maintained, containing copies of all communications with plan participants? At every meeting with plan participants, is a list of attendees recorded and filed?
- Have any restrictions on transferring to or from an investment choice been clearly communicated to participants?
- Have all transaction fees and commissions that affect the participant been disclosed? Specifically, have participants been given a description of the annual operating expenses of each designated investment alternative?
- The DOL has defined four specific categories of participant communication that do not constitute "investment advice" for purposes of limiting 404c protection. They are: 1) plan information; 2) general financial and investment information; 3) asset allocation models; and 4) interactive investment materials, such as worksheets, PC illustrations, etc. The common denominator of all four is that they don't steer the participant in any particular investment direction. Does the plan's investment advice meet this test?
- If an asset allocation model identifies a specific investment alternative available under the plan, have participants been advised that investment alternatives with similar risk and return characteristics also are available?
- If calculators are used in investor education, are they based on generally accepted investment theories? Do they clearly disclose the "what if" assumptions on which they are based, such as retirement age, income levels, inflation rates, rates of return, and all plan investment alternatives?
- Has the plan taken a survey of participants to determine their level of investment knowledge? Are plan communications written in a style and language that participants can clearly understand?
- Are plan fiduciaries aware of specific duties that may not be delegated or protected under 404c, including prudent selection and monitoring of investment menu choices?
- Does the plan have a formal process for evaluating investment managers' adherence to fund objectives, including a written evaluation report?
- Does the plan have fiduciary liability insurance from a carrier such as American International Group (AIG); Lloyd's of London, Reliance Insurance, Travelers Property Casualty, or Chubb Executive Risk? The cost of this coverage typically is about 5% of the coverage limit purchased -$25,000 per year for a $5 million policy. Premiums can double or triple for participant-directed plans that offer either of two investment choices: 1) company stock; or 2) a self-directed brokerage option.
The 404c regulation is published by the DOL here:
http://www.dol.gov/dol/allcfr/PWBA/Title_29/Part_2550/29CFR2550.404c-1.htm
For more information, see DOL Interpretative Bulletin 96-1 located here:
http://www.dol.gov/pwba/regs/fedreg/final/96_14093.htm
By helping plans in your market understand all necessary steps to gain the protection of 404c, you will demonstrate your professional knowledge, while also showing that you care about decision-makers and their priorities. In today's climate, keeping retirement dreams from becoming legal nightmares can be a high priority for any fiduciary.
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