The ETF industry has grown by leaps and bounds over the past several years, with each new product launch marking yet another stride forward in democratizing the investment process. What better person to offer insights into the evolution of the industry than an ETF veteran himself. Meet David Fry, author and founder of the ETF Digest with more than three decades of experience in the finance industry. David is a well-known commentator and presenter on ETFs at conferences and his extensive experience as a portfolio manager and market strategist has earned him a respected reputation among self-directed and institutional investors alike. David Fry recently took time out of his schedule to discuss hurdles and opportunities that he sees in the space as well as his thoughts on the evolution of the ETF industry as a whole.
David Fry (DF): I’ve been in the financial industry for nearly 40 years and took interest in ETFs as early as 1999 as I found their structure and liquidity appealing compared with mutual funds. I started the ETF Digest in 2001 where at the time there were just a handful of ETFs available to investors. When the mutual fund timing scandal hit in 2003, ETFs grew in popularity due to their positive attributes—intraday liquidity, transparency, low-costs, etc.—making them immune to the issues that plagued mutual funds post scandal. Today there are well over 1,400 ETFs available to investors sliced and diced in every conceivable way.
In my opinion, ETFs are still the best choice for investors to build diversified, long-term portfolios. As an ETF strategist, it’s important to me to structure portfolios that are flexible and varied enough to suit all investors from conservative to aggressive. At the ETF Digest, premium subscribers can choose from four all-ETF portfolio categories that include an Active ETF Portfolio that utilizes a Global Macro Long/Short strategy, Lazy-Hedged ETF portfolios, and Lazy ETF portfolios. Subscribers can also build a customized ETF portfolio from my handpicked selection of ETFs.
ETFdb: Why do you think many financial advisors have generally been slow to embrace ETFs in their practice?
DF: First, it’s important to understand that for many years I was a financial adviser so I understand their business model and can empathize with them. Since the 1980s, the business model for advisers was built on formulating and having portfolio structures tailored to meet a variety of client objectives. Mutual funds provided the means that would meet both their clients’ and business needs. Advisers primarily liked the 12b-1 mutual fund structure that provided them a trailing commission, which in turn provided them with business income while they gathered more assets from existing and new clients.
Unlike mutual funds, ETFs don’t provide any trailing commission for advisers. As ETFs rose in popularity, clients started to demand their use in portfolios. To do so, advisers had to restructure their business model. This led to a “wrap fee” where clients would pay the adviser a fixed fee, possibly 1%, for account assets with the firm. Then advisers could incorporate low-cost ETFs in lieu of mutual funds. But keep in mind that some advisers are forced to choose from firm “approved” ETFs that are really in the best interests of the firm rather than the investor. This is why it’s important, in fact imperative, for an investor to do their due diligence.
Investors need to do their homework and get independent guidance in selecting the best ETFs and navigating the markets. As mentioned earlier, there are well over 1,400 ETFs in the marketplace, which is overwhelming—even for an adviser.
ETFdb: Aside from the well-known benefits offered through the ETF wrapper, what do you personally embrace about this product structure?
DF: ETFs have leveled the playing field so to speak. As product issuance has grown to other sectors, including leveraged and inverse funds, and alternative sectors, investors and advisers have the power to structure almost any style of portfolio without the extensive costs, risks and complexities that existed previously. Sophisticated portfolio construction techniques and access to hedge funds that once were available exclusively for the 1% can be replicated for the 99% by using ETFs. Gone are the days where you need to pay a minimum amount of a $1M to be a part of a hedge fund. With proper education and due diligence, you can replicate hedge fund strategies for your clients or on your own using ETFs.
ETFdb: What do you expect in terms of ETF adoption going forward? What types of investors have been slow to adopt or are potentially major beneficiaries of embracing ETFs?
DF: The ETF market is here to stay but perhaps we can’t say the same about investors as two bear markets in a decade plus trading blunders with high frequency trading (HFTs); a general distrust of markets (QE) and Wall Street (Lehman, Repo 105s, Madoff, Corzine etc.); changing demographics; and economic uncertainties have driven many investors to the sidelines.
In the charts below, the blue line demonstrates the significant declines in assets in U.S. equity ETFs and mutual funds from 2001 through 2012. Take note that those numbers are in the billions.
Source: Investment Company Institute
ETFdb: What are your thoughts on active ETFs? Are you using them in your practice?
DF: There are large quantities of active ETFs filed with the SEC by many large firms and mutual fund sponsors. That being said, it could be a long time before these active ETFs are issued. This is due primarily to large firms being careful not to cannibalize already profitable mutual fund products. Overall, while PIMCO with its excellent brand name is able to attract assets to a few of its active ETFs, for me, performance and traction for this area remain too new to rate.
Here are a few issues that I (and others) have with active ETFs:
- Lack of an index that I can rely on and track
- Fees are comparable to typical mutual funds
- Less transparency. As we speak, providers are lobbying the SEC for more transparency relief, or a delay in posting their holdings intraday for example as noted in this WSJ article.
- Who is the portfolio manager? If you’re familiar with the portfolio manager by reputation or results then you might find them suitable for your investing needs. However, unless you know them, I would avoid them.
ETFdb: What are your thoughts on how the industry has evolved in the last few years? Going forward, what do you see as the potential growth areas for ETFs?
DF: Have we reached saturation point? As mentioned earlier, there are well over 1,400 ETFs in the marketplace with at least 45 issuers. A 2012 McKinsey & Company report sees total ETF assets increasing to between $3.1 trillion and $4.7 trillion in the next five years, while Cerulli Associates predicts they will exceed $3.8 trillion by 2016.
In my opinion, the U.S. Equity ETF market is saturated and many issues are repetitive. With the recent closing of ETFs from providers like FocusShares, DirexionShares, and Russell Investments it’s not surprising to me that U.S. based ETFs may have hit its threshold. With plenty of ETF issues being duplicative or having low volume and little assets, there are more ETF closures on the way. Just look at the financial sector for example, there are 40 ETFs devoted to this space alone!
From the standpoint of the issuer, they too have to be mindful of their business. If the fund is not profitable, there is a chance the provider will consider closing the fund. So as I state in my upcoming ETF ebook series due out in September, investors need to be cautious using ETFs with little traction in the marketplace. To avoid a situation like this, investors should let new issues incubate and gain satisfactory amount of assets under management (AUM). I believe ETFs should accumulate at least $25M in AUM and have an average daily volume in excess of 50K shares. Then you’ll have some confidence the issue will stick. Investors should be wary of any ETFs below these numbers.
On the other hand, I do believe that ETF providers need to consider investor trust into the equation as they ponder closing funds. Why would we put money into new ETF issues when a provider has a track record of closing them? Overall, it’s important for investors to remember to separate their investment goals and objectives from the business interests of ETF providers.
Bottom Line: growth in the industry has brought forth a number of innovative, and previously difficult-to-reach, strategies at the fingertips of self-directed investors; however, with evolution also comes complexity, and ETFs are no different. Investors need to take a good look under the hood and be sure to perform their own due diligence before jumping into a fund.
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Disclosure: No positions at time of writing.