ETF Insights: Q&A With Nathan Geraci

by on September 20, 2012

With more and more self-directed investors embracing ETFs as part of their long-term strategy, it’s interesting to highlight the differences in adoption rates among professional money managers. Industry veteran, Nathan Geraci, recently took time out of his schedule to discuss his thoughts on how the exchange-traded universe has evolved and where he sees more room for growth. As Chief Operating Officer at The ETF Store and host of the weekly radio ETF Store Show, Nathan has extensive experience in the industry with a specialty in portfolio management; in fact, his firm is recognized as being the first registered investment advisor to offer only exchange-traded funds.

ETF Database (ETFdb): How long have you been using ETFs for? Do you see this product structure as the preferred means forbuilding diversified, low-cost, long-term portfolios?

Nathan Geraci (NG): The ETF Store has been using ETFs in client portfolios since 2008, the year our firm was founded. Since the beginning, we have viewed ETFs as a far superior investment solution to build low cost, tax efficient, transparent, and highly diversified portfolios. We think investors are much better served concentrating on minimizing investment costs and focusing on asset allocation. We believe ETFs are the best way to do both.

The underperformance of actively managed mutual funds is well documented, as are the accompanying outsized fees. In addition, the track record of investors trying to actively select individual stocks and bonds on their own has been even worse. ETFs have changed the game by allowing investors to access asset classes that were previously only available to institutional investors or wealthy clients and do so very efficiently and cost effectively.

ETFdb: Are there asset classes where you’re more comfortable using ETFs and others where you prefer mutual funds or other vehicles?

NG: Our ETF Store portfolios are comprised primarily of ETFs. For equities and fixed income, we typically seek broad-based exposure to the U.S., developed international and emerging markets and we’re able to access that exposure at a very low cost through ETFs.  Furthermore, as I mentioned earlier, we’re able to invest in alternative asset classes such as gold, commodities, and real estate very efficiently and cost effectively using ETFs. We rigorously examine all aspects of an ETF before investing in it, regardless of the asset class covered, and we have yet to find an asset class that we want exposure to for which there is a better solution outside of ETFs. If we find that vehicle, we’ll use it.

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?

NG: Judging by mutual fund redemptions and ETF asset inflows, the trend of investors moving out of mutual funds and into ETFs shows no signs of slowing. Developed market equity mutual funds have seen nearly a half a trillion dollars in redemptions over the past four years while ETFs continue to see record inflows. Like any new product or innovation, there are always early adopters who have the wherewithal to vet a new product before handing it off to the mainstream and then ultimately late adopters who are effectively forced to use the product. Given ETF and mutual fund asset flows, we believe we’re at the point where the early adopters have passed the baton to the mainstream. We liken ETFs to the digital music on Apple iPods and view mutual funds more like CDs, or even cassette tapes. There are always people who will continue to use CDs or cassette tapes, but sooner or later, they will be rendered obsolete by the mainstream.

The next major catalyst to accelerate this trend, and we’re already seeing it, is in the 401(k) space. With new DOL regulations, 401(k) plan sponsors now have fee disclosure requirements to participants and additional fiduciary obligations. If I’m a plan sponsor and can have low cost, passively managed ETFs with no hidden 12b-1 or other fees in my 401(k) plan, I think I would sleep much better at night. 401(k) growth in the early 1980s helped accelerate the growth and acceptance of mutual funds and I think it will be no different with ETFs over the next 5 – 10 years.

ETFdb: ETFs have received some bad press over the past few years. Have you had any bad experiences with ETFs that turned you off?

NG: Much of the bad press has been directed towards levered or geared ETFs and some of the more esoteric ETFs that failed to gain traction. You give me an industry and I’ll show you bad products within that industry. It’s no different with ETFs. While we’re obviously big believers in ETFs, we also understand that there are both good and bad exchange-traded products out there. That’s why we’re very meticulous in our evaluation of ETFs for use in client portfolios. I think because of that, we fortunately haven’t had any bad experiences with ETFs.

Regarding bad press ETFs have received from other angles such as the “Flash Crash”, the short interest held in certain ETFs, or ETFs’ impact on IPOs, all of the subsequent analysis done on each of these have shown ETFs to have had no meaningful impact. Remember, there are billions and billions of reasons for the old mutual fund guard to disparage the ETF industry. They’re scrapping and clawing to keep investors in their expensive, actively managed funds.

ETFdb: There are some out there who believe ETFs have gone too far from their initial intention of offering broad-based exposure to buy-and-hold investors. What’s your take on the innovation in the ETF industry over the last several years?

NG: We view the innovation in the ETF industry as largely positive. As we discussed earlier, you still have to do your homework on an investment regardless of whether you’re considering ETFs, mutual funds, or individual securities. And it’s extremely important to point out that there are different ETF products for different investors. Some ETFs are targeted towards long-term, buy-and-hold investors while others are directed at sophisticated, institutional traders. Investors must understand the difference.

ETFdb: How are your strategies evolving in the low rate environment? What techniques are you using to deliver current income to your clients?

NG: Yield is extremely difficult to come by in this environment, especially without layering on unwanted risks. Generally speaking, we do see yield opportunities in emerging market sovereign debt and higher dividend paying emerging market equities. In addition, large cap, multinational, dividend paying U.S. equities offer a decent yield. The key for us is having a balanced approach. Delivering income is important, but risk management is our primary focus given the current market dynamics.

Bottom Line: ETFs are surely and steadily replacing their mutual fund counterparts as a growing number of self-directed and institutional investors become educated and more familiar with the ease-of-use, cost-efficiency, and transparency benefits associated with this product structure.

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Disclosure: No positions at time of writing.