ETFs have made their way into countless portfolios as investors of all walks have embraced the cost-efficient nature of these vehicles. Innovation in the exchange-traded universe has brought countless strategies and previously difficult-to-reach asset classes at the fingertips of mainstream investors. Despite the numerous advantages offered through the ETF wrapper, many professional money managers and advisors have been hesitant to dip their feet in the water for a variety of reasons. Casey Smith, founder and president of Wiser Wealth Management, recently took time out of his schedule to discuss his thoughts on the ETF industry and what he has embraced about the exchange-traded product structure [see 25 Things Every Financial Advisor Should Know About ETFs].
ETF Database (ETFdb): How long have you been using ETFs for? Do you see this product structure as the preferred means for building diversified, low-cost, long-term portfolios?
Casey Smith (CS): I have been using ETFs exclusively in portfolios since 2004. In 2007 we purchased another financial services firm and we transitioned the clients from that firm from all individual stocks to ETFs shortly after the purchase was completed. The ETF structure, especially those under the 1940 act, are excellent low-cost indexing vehicles that can be used in both long-term portfolios or shorter-duration plays.
ETFdb: Why do you think many financial advisors have generally been slow to embrace ETFs in their practice?
CS: I have seen other answers to this question that say it comes down to the fact that ETFs don’t pay a commission. There are no 12b-1 fees in ETFs, thus no trails for the advisor. I think that reason is very true but it goes a little deeper. I believe that it comes down to fiduciary versus suitability. At the conferences where I am invited to speak, I find that many of the advisors coming out are fiduciary advisors. If you have a fiduciary duty to invest in products that work in the best interest of your clients, you can’t ignore the benefits of ETFs.
Fiduciary advisors build their own portfolios with this in mind. Brokers who work under suitability rules are told what they can sell and you see this in their clients’ portfolios. If the portfolio is made up of all one fund company, you can’t convince me that company has the best manager in every single global asset class! A broker with the best intentions will always have to choose between feeding his family and doing what is in the best interest of his or her client. In the fiduciary fee-only business model we see a lot of ETF usage. The brokers try to copy this approach but the trading execution and ETF choices are a bit sloppy.
Another factor is ETF education. There are a lot of good resources now, such as ETFdb.com and IndexUniverse.com, to learn about and research ETFs. When we started we did all our back testing using raw index data and an excel spreadsheet. The commentary on ETFs was done by talking to the one salesperson at the fund company. Now we use MorningStar Office Edition to test theories and load new index data and iShares, State Street and WisdomTree call our office on at least a monthly basis. We see a lot of seminars and workshops popping up on the web or in major cities.
I don’t think that these conferences are just created without demand. The first year I spoke at the Inside ETF Conference in Boca Raton, FL, there were 400 people there. That was in 2008. Four years later in 2012 there were close to 2,000 delegates. This shows that ETF education is booming, and that offerings and assets under management will only increase as we move forward.
ETFdb: Aside from the well-known benefits offered through the ETF wrapper, what do you personally embrace about this product structure?
CS: First, transparency. A mutual fund manager will only disclose holdings on a quarterly basis. ETFs show you the holdings daily. On a more advanced level, I like the tradability of ETFs. While our firm does not trade frequently, I like the ability to move in and out of asset classes with a trading strategy. We recently did a company-wide rebalance. Our traders at Street One Financial were able to move out of stocks at an intraday high and into bonds. The next day the market fell apart and our clients were able to get their stock rebalance purchases at an intraday lower price as well as sell out of some bond funds which were moving up. While this strategy may only take place once or twice a year, we believe that we can add 70bps a year in performance just in how we trade ETFs.
ETFdb: Are there asset classes where you’re more comfortable using ETFs and others where you prefer mutual funds or other vehicles?
CS: I am comfortable with ETFs under the 1940 act in any asset class. Under the 1940 Act, if you buy an ETF you own the underlying holdings. If you own 50K shares of the ETF, then you have the option of exchanging the shares for the underlying holdings. If you do not have 50K shares, you own part of the 50K share block.
ETFs created within the 1933 Act will many times not own the underlying instruments. Most individual investors should not own these types of ETFs. iShares and Vanguard, two of the largest providers of ETFs, only have a small number of 1933 Act ETFs. I tend to shy away from these funds with the exception of commodities.
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?
CS: I see individual investors warming up to ETFs going forward. There seems to be more articles talking about ETFs in the do-it-yourself financial magazines. There are some great rewards to using a passive strategy with ETFs, especially with active management not living up to expectations based on the associated high fees. But I also see pitfalls with individuals trying to trade ETFs or getting sucked into a leveraged ETF without reading and understanding the prospectus.
ETFs on the institutional level will continue to grow. I see their usage especially beneficial to endowments where downside deviation is more of the focus versus a growth strategy. ETFs are a great tool to manage portfolio risk.
ETFdb: How are your strategies evolving in the low rate environment? What techniques are you using to deliver current income to your clients?
CS: We are continually looking for ways to increase yield while also not increasing the portfolio’s volatility as measured using standard deviation. Chasing yield is a dangerous bet, so to get portfolio yields of 3-4% you have to get a bit creative. There are many benefits of using dividend-focused ETFs in a portfolio to boost portfolio yield while maintaining the client’s stock-to-bond allocation and not increasing portfolio risk. ETFs like HDV, VIG and SDY will help accomplish this. Adding preferred stock through PFF will help supplement yield as well. New money in short-term treasuries pays virtually nothing so reallocating some of that asset class to short-term corporate bonds will boost yield slightly. Also using PIMCO’s MINT is a good replacement for that money market that looks more like a cash account. Both of the latter funds are higher risk than Treasuries or traditional money market, but most of our clients are okay with that.
The Bottom Line: ETFs can serve as viable tools when it comes to building a well-diversified, low-cost portfolio for financial advisors, institutional money managers and self-directed investors of all walks.
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Disclosure: No positions at time of writing.
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