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Just Released: August 2016 ETF Edge — Learn More

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We recently had the chance to speak with ETF pioneer Ben Fulton, CEO and founder of Elkhorn Investments, and Graham Day, director-product development at EIkhorn. We discussed significant changes in the ETF industry, upcoming trends, the ELKU ETF, challenges for 2016 and much more.

ETFdb.com (ETFdb): Ben, you’ve worked in the investment industry for more than 30 years and spent nine of those with Invesco PowerShares, where you served as managing director of the global ETF business. More recently, for the past three years you’ve served as CEO of Elkhorn Investments. You’ve been described by many as a founder of the exchange-traded fund (ETF) industry. What would you say are the most significant changes in the ETF space in the past few years?

Ben Fulton (B.F.): A proliferation of ETF launches and the rise of smart-beta ETFs. Although these are marketed as smart-beta ETFs, we prefer to think about the access these strategies provide to investors more than anything else. We continue to see a surge in mutual fund companies entering the ETF space as well.

ETFdb: Besides smart-beta and mutual fund companies entering the ETF space, what products or ETFs were you surprised to see coming to the industry over the years?

B.F.: I think one that really caught the world by storm was the currency overlay product. I think that’s probably a good optic into what the future is going to look for also. The idea of taking known indexes and changing their characteristics, and in that case managing for the U.S. market whether you’re dollar-exposed or nondollar-exposed, was revolutionary. It all of a sudden highlighted the benefits of how currencies could benefit investors, or the risk that they could apply in a portfolio.

ETFdb: What are some trends that you believe are going to become more prominent over the next few years?

B.F.: We believe there will be growth in the fixed-income ETF space as investors look for more targeted exposure to this segment of the market. ETF issuers will also work more closely with institutions and RIAs to develop unique exposures that cater to their investors’ specific needs. We believe we have a unique position going forward to help these groups and others with their need for custom solutions.

ETFdb: Elkhorn launched the Elkhorn FTSE RAFI U.S. Equity Income ETF (ELKU ) on December 10. Can you tell us more about this fund?

B.F.: ELKU tracks the FTSE RAFI™ U.S. Equity Income Index, which consists of high-yield U.S. stocks screened for sustainable income. The index avoids large sector concentration bets by anchoring to fundamentals as opposed to market cap. Whereas most dividend ETFs are backward looking in screening for companies that currently have a high yield or strong dividend growth, ELKU ensures the high-yielding companies it has screened are financially viable to maintain a high dividend payout. This quality screen can eliminate potential value traps. The dividend yield on the FTSE RAFI™ U.S. Equity Income Index was 3.60% as of February 29, 2016.

ETFdb: The Elkhorn FTSE RAFI U.S. Equity Income ETF (ELKU) has outperformed the S&P 500 since its inception, returning 2.35% versus -2.50% (index returns). What is it about ELKU’s strategy that allowed the fund to outperform?

B.F.: ELKU taps into Research Affiliates’ fundamental approach to investing in quality, high-dividend companies. This can result in reduced volatility and enhanced returns like we have been seeing recently. Added income in down markets can help create a softer landing.

ELKU ETF Chart March 9

ETFdb: Regarding Research Affiliates’ fundamental approach to investing in quality, high-dividend companies, what overall attributes do these companies have?

Graham Day (G.D.): Research Affiliates defines quality, high-paying dividend companies as firms with stable earnings, no accounting red flags, and a strong debt coverage ratio. A firm with declining profitability may not be able to maintain or grow their dividends. Poor accounting policies can overstate the financial stability of a company. Finally, a company with a poor or declining debt coverage ratio puts equity holders and their dividends at increased risk. A company with poor debt coverage potentially faces increased economic risks like what we have seen materialize in some areas of the energy space. As oil prices have plummeted, some energy companies have seen their debt coverage ratios fall significantly. We don’t believe these are the types of companies you want to own just because they may sport a high yield.

ETFdb: What kind of investor should hold this ETF?

B.F.: Income-oriented investors looking for a forward-looking approach to accessing high-yielding U.S. equities. The overlap between this income-focused ETF and other dividend ETFs tends to be low because of RAFI’s unique strategy. For example, ELKU has less than 9% of its exposure to utilities, whereas the Dow Jones U.S. Select Dividend Index (DVY B+) has more than 38% of its exposure to this sector. This is attributable to the sustainability screen RAFI uses as well as its fundamental weighting.

ETFdb: Going forward, what do you think is the biggest challenge for investors in 2016?

B.F: Safely navigating the current market volatility and staying focused on an investment plan. Along with market volatility comes opportunities where investors can hedge or position themselves to benefit directionally and ETFs are great tools for this.

For example, looking at a strategy like fundamentals, historically when it has traded at a significant discount to market cap-weighted strategies, it tends to have strong mean reversion.

ETFdb: In your view, why do you think there’s so much volatility in the market? The first week of this year was one of the worst weeks in the past 80 years. What’s behind it?

B.F.: I think when you get into the late stages of a bull market it’s not uncharacteristic to see this much volatility because you’re probably setting up for a directional change, whether that comes in three months, six months, or 12 months. You start seeing what the leadership wants to drive. And frankly, if we didn’t have such depressed commodity prices, such low yields on bonds, and a very upsetting recovery, I think that probably already would have occurred.

But the problem is there’s not a logical place for money to go. The bond market is not that enticing, and yet it has still been the better performer. Commodities have been painful. People tend to come out of equities but then they look around and go okay, we’ve got to come back because it’s the only answer we have. There’s a struggle for what’s leading and where investments should go, and we believe that equals a lot of volatility. You can put it under the big word “uncertainty.” We’ve had an amazing last five or six years and I think a lot of people missed that. We had a market that outperformed and now it’s probably time for some alignment.

ETFdb: How do you think investors should navigate the current market volatility?

B.F.: Don’t overthink your investment strategies. If you can simplify the strategies you use to manage volatility, it will allow you to be better equipped to communicate the how and why a strategy is performing the way it is to your clients. What we have found is that simple strategies can often capture the exposure you are looking for and avoid potential pitfalls from often unnecessary complexities.

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