B-Ds slow to stuff wraps with ETFs

Broker-dealers are slow to adopt exchange-traded funds in their wrap programs, according to new study by Strategic Insight. At the end of 2010, ETFs made up merely 25% of retail fund assets in broker-dealer wrap programs, the study showed. That's up only three percent from the end of 2008. ETFs were most popular in “rep as portfolio manager,” programs where the adviser has full discretion over the transactions in the account, without client approval. At the end of 2010, ETFs accounted for 54% of retail fund assets in those programs at two major broker-dealers studied by Strategic Insight. The biggest reason that ETF growth has been slow in broker-dealer wrap programs is because over the past few years, mutual fund companies have launched some less traditional actively managed funds. Advisers are opting for those offerings rather than passively managed ETFs, said Loren Fox, a senior analyst at Strategic Insight. “In the wake of the financial crisis, investors are clearly more interested in products that are not correlated to the equity markets,” he said. “As a result, funds like absolute return funds, commodity-based funds and go-anywhere funds have gained ground.” The most popular ETFs in broker-dealer wrap programs are emerging-markets-equity ETFs and “specialty” ETFs, a category that includes commodity-based and inverse ETFs, and taxable fixed-income funds. With the exception of inverse ETFs, these asset classes were also the most popular among mutual fund styles in wrap programs in 2010, according to the report. At two major broker-dealers studied by Strategic Insight, the second most popular ETF in terms of gross sales was ProShares Short S&P 500 ETF Ticker(SP). The tenth most popular in terms of gross sales was the ProShares Short 20+ Year Treasury ETF Ticker:(TBF). That sort of popularity at national broker-dealers is surprising, given that inverse ETFs have faced heightened regulatory scrutiny in recent years. Inverse ETFs use derivatives to achieve high returns when their benchmark indexes decline. In 2009, the SEC and the Financial Industry Regulatory Authority Inc. published notices warning investors about leveraged and inverse ETFs. “There was a big dip in the use of inverse ETFs in 2009 when lots of broker-dealers put restrictions on using them,” Mr. Fox said. “But a lot of those broker-dealers have since lifted those restrictions.” Dave Nadig, director of research at IndexUniverse.com, said it's not surprising that ETFs are slow to take off in broker-dealer wrap programs. Why? Because in most cases, advisers don't get paid the same way they do as with mutual fund wraps. Mutual funds usually come with 129b0-1 fees, and that's not always the case in wrap programs. Indeed, wrap providers often pay the broker-dealers to include their products, he said. “Don't underestimate the power of the traditional mutual fund sales force compensation,” Mr. Nadig said. But as more advisers move to a more straightforward fee-for-service model, ETF usage will pick up in wrap programs, he predicted. “The market we pay attention to is clearly going to be the one-on-one relationship where the adviser charges 50 basis points for management and the client pays their own expenses,” Mr. Nadig said. “That's the growing ETF market.” Mr. Fox isn't so sure that the slow growth of ETFs in broker-dealer wrap programs is due to compensation. “There may be issues of revenue sharing that ETFs cannot address, but ETFs can play other roles such as reducing some of the other expenses that can offset that,” he said.