ETF Fact or Fiction?

5. All ETFs are low-cost, tax-efficient and useful.On the other side of the coin, just because something is labeled “ETF” doesn’t necessarily make it a good investment. In fact the new generation of “fundamental” or “quantitative” ETFs frequently carry expense ratios double or triple their category average. Isn’t this a steep price to pay for new and unproven investment theories, compared to comparable index mutual funds? It’s always wise to research the cost of funds tracking the same or similar indexes. In many (but not all) cases, ETFs win. Both Charles Schwab and PowerShares offer funds tracking the same exact FTSE RAFI “fundamentally weighted” indexes, yet Schwab’s mutual funds have noticeably lower expenses. (See chart on previous page.)

With regard to utility, it’s true that many new ETFs are walking the outer limits of financial usefulness. Faddish funds or those with questionable investment merit probably don’t have a place in a serious money account. It behooves informed advisors to separate the good from the bad because your clients are relying on you for direction.

6. ETFs aren’t actively managed and this puts investors at a disadvantage. The evidence continues to demonstrate the vast majority of portfolio managers are not adding value, but subtracting it. Seldom-discussed problems such as closet indexing, style drift, excessive portfolio turnover and window dressing plague some of America’s largest mutual funds.

In contrast, ETFs protect financial advisors and their clients. Take, for example, portfolio turnover: how long a mutual fund holds the stocks in its portfolio. The typical equity fund averages 100 percent annual turnover. In basic terms, this means the securities in the fund have completely changed in a year’s time. Does that sound like long-term investing to you? All of this activity indicates that many funds aren’t the long-term investors they purport to be, and academic research reveals that the trading costs that high turnover generates can have a detrimental impact on performance.

The danger of hyperactive portfolio management can largely be avoided by using ETFs. Focus your attention on traditional market-cap weighted funds, such as those offered by Barclays Global Investors, State Street Advisors and Vanguard. The indexes behind many of these funds do an excellent job of keeping portfolio turnover low and minimizing the negative impact of index changes. ETFs with a fundamental or strategy-based slant can also have low relative turnover, but be selective.

FACT AND FICTIONThese six myths represent just the crest of the wave of controversy, debate and criticism that’s currently breaking in the ETF marketplace What will you believe? If you’re using ETFs to manage your client’s portfolios, are you able to defend your investment decisions? Help your clients not to be tricked by the financial fiction that’s spreading about ETFs. You’re their only hope of getting it right.

If you’re among the shrinking number of advisors not yet using ETFs in portfolio management, why? The reasons to start using ETFs are too compelling for you to ignore. Furthermore, you risk losing your competitive advantage by not using world-class financial products just because they’re bought and sold in non-traditional ways.

Think about the number of ETF investment strategies at your disposal. There’s core/satellite, tax-loss harvesting, sector rotation and hedging, among the more popular strategies. Also, don’t forget about the broad asset class exposure into currencies, commodities, real estate and other new areas that ETFs are forging into.

Naturally, all of these financial choices call for diligent evaluation and discriminating selectivity. It’s up to educated and trained financial professionals to separate the facts from the fiction. You can do it!

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.