Even as exchange-traded funds have developed over the past 22 years into an expansive universe of broad market, niche and highly specialized strategies, there is nothing quite so simple when it comes to building a portfolio for clients.
That's the general appeal among financial advisers who have become true believers in ETFs as tools of asset allocation.
“If you're going to have an all-passive portfolio, there's no need to do a whole lot of research and due diligence on the underlying investments if you just use ETFs,” said Daniel Lash, a partner at VLP Financial Advisors.
“You know that the index is the index, and that means you can free up a lot of time to do other things,” he added. “You still have to do the asset allocation, but you don't have to do all the research into how the performance was achieved, like you do with an active mutual.”
Mr. Lash, whose firm started using ETFs in client portfolios a half-dozen years ago, still believes it's important to include actively managed mutual funds to fill out client portfolios. But the temptation to go all-in with ETFs is discussed regularly at his advisory firm.
Not going all ETF
“We do the due diligence to find good active managers to help us with the risk-return profiles, but we discuss the idea of just using all ETFs on multiple occasions,” he said. “Even though it would probably be in the firm's best interest to do that, the answer we keep seeing is that it's not in our clients' best interest to go all ETFs.”
Even if Mr. Lash isn't yet ready to use only ETFs, he is part of a growing list of advisers embracing ETFs as portfolio staples.
“Right now, 99% of my clients are using ETFs, and any new clients I get will be almost exclusively ETFs,” said Rose Swanger, owner of Advice Finance.
Ms. Swanger transitioned about four years ago to ETFs from a heavy reliance on low-cost index mutual funds at The Vanguard Group.
“I find that ETFs offer better tax efficiency and other flexibility that mutual funds can't offer,” she said. “The fact that ETFs can be traded throughout the day means I don't have to worry about my clients being sitting ducks in a big market move.”
But even as a loyal fan of ETFs, Ms. Swanger remains open to what she believes are the best strategies for her clients.
For example, she still includes the $5.8 billion Fidelity High Income Fund (SPHIX), an actively managed mutual fund she describes as “a great fund.”
Vast migration
Michael Iachini, managing director of mutual fund and ETF research at Charles Schwab & Co., has been watching advisers migrate toward ETFs from a few different directions.
“A lot of folks get started using ETFs because of a very specific in-vesting strategy or point of view that they want to access,” he said. “That's a very common starting point.”
Mr. Iachini said financial advisers are often drawn to ETFs for the low expenses, liquidity and tax efficiency of a structure that almost never triggers capital gains distributions the way mutual funds do.
“We've found that advisers are using ETFs when they are looking for a specific niche, they want the low-cost diversification, or they are using ETFs to complete some exposure where they might not have the expertise, such as currency hedging,” he said. “It's also common to see advisers using ETFs as default portfolios for clients with lower balances.”
Schwab's 2014 ETF Investor Study, which included interviews with 1,102 U.S. investors, found that ease of access and understanding are popular reasons for using ETFs over other investments like mutual funds.
Of those surveyed, 71% said they are confident they can pick the right ETFs for their particular goals.
The survey of investors between the ages of 25 and 75, with at least $25,000 in investible assets, showed that ETFs currently account for 18% of ETF-investor portfolios. And half of ETF investors expect their allocations to increase over the next year.
The research found that most ETF investors can be divided into three main groups: 44% represent long-term investors who use ETFs as core holdings, 22% represent short-term investors who use them tactically, and 34% use ETFs both as core and tactical holdings.
Even though ETFs are traded on exchanges, just like individual stocks, the transaction costs are waived or reduced on many platforms.
Ms. Swanger said that as a fee-based financial adviser, she absorbs the transaction costs on behalf of her clients.
Tax efficiency
Beyond the ease of use and transparency, ETFs have built-in tax efficiency, as Mr. Iachini explained.
“We're a momentum shop, and we're in the market 70% to 80% of the time. But we will get out if things look shaky.”— Brian Power, principal, Gateway Advisory
“The first tax advantage has to do with the fact that most ETFs are based on indexes that rarely trade and therefore don't create any taxable gains,” he said. “But the second reason for the tax efficiency relates to the way ETFs work.”
Unlike a mutual fund, an ETF isn't directly trading the underlying stocks whenever there's a purchase or redemption.
“It is instead treated as an in-kind transfer, and the embedded gains get shifted off to an authorized participant in a way that does not impact ETF investors,” said Mr. Iachini.
These kinds of subtle distinctions that separate ETFs from mutual funds are why an estimated 70% of financial advisers currently use ETFs, compared with just 20% of individual investors, according to Mr. Iachini.
Brian Power, principal at Gateway Advisory, would fall into the category of using ETFs for tactical investing.
In-house management
At his firm, ETFs fit the bill a few years ago when the decision was made to bring the asset management in-house. It took about a year to accomplish the full conversion from outsourced asset management.
“Our clients really embraced it, and right now our client portfolios are about 90% ETFs,” he said. “As fiduciaries, considering the low cost, we felt using ETFs was something we should be looking at more closely.”
Mr. Power uses a tactical overlay strategy that he said cannot be employed with mutual funds or separate accounts.
“We're a momentum shop, and we're in the market 70% to 80% of the time,” he said. “But we will get out if things look shaky.”
As the ETF space continues to evolve and include more exotic strategies that can include leverage and even some active management, financial advisers who aren't already on board could become more reluctant to test the waters.
Or they might just stick close to the shore with what is safest and familiar.
“One time I was using an ETF that I thought was a market hedge strategy in a few client accounts, then I learned that it was not for buy-and-hold investors,” said Kristi Sullivan, owner of Sullivan Financial Planning.
“I still use some ETFs in my portfolios, but they tend to be plain vanilla index trackers,” she added. “No double-hedged, goat-chin-hair-farm in Brazilian currencies basket of investments for me.”
As far as we know, no such strategy currently exists in an ETF format. But that doesn't mean one isn't being developed right now.
