ETFs: Why They Keep Growing on Advisors

For larger portfolios, Myers and his team turn to ETFs as a "strategic addition, either providing fixed income exposure or additional exposure to small- or mid-cap stocks, for example." The advisor says his approach does "tilt" toward value-oriented ETFs, and, if possible, equal-weighted ETFs. He also will use generic fixed income index ETFs.

Ron Hauf, an advisor with the Securities Service Network Advisory in Whitefish, Montana, who only has a small portion of his clients' portfolios in ETFs, has a somewhat different view of the product: "If there's an asset that doesn't need active management, I might employ an ETF. But quite frankly, with the compression [of fees] in this industry, active management is as competitive as passive ETFs. Nine times out of 10, I'll take active management with low expense ratios over passive management."

ETF Brands

The survey found that more than 80% of advisors favor ETF manufacturers with good performance/track records, low expense ratios, good reputations and sector availability. Likewise, 85% of those surveyed prefer certain platforms due to their low trading costs, reputations and wide choice of ETF providers. (Vanguard proved most popular among advisors in both categories.)

Yet many advisors interviewed are "fund agnostic," such as Patrick Sier, president of Advisory Services of New England in Barrington, Rhode Island. He primarily uses one large discount broker's platform but has access to others.

"It's the clients who bear a transaction cost, so to the extent they are looking at one ETF over another, if they want to avoid the cost, I can steer them toward an ETF with no transaction costs," Sier explains. "But that's such a [small] part of the puzzle. All things being equal, I go to the one with the lower transaction cost."

Other advisors share this opinion. Charles Scott, president of Pelleton Capital Management in Scottsdale, Arizona, states, "If I want to be in the tech space, [and one firm has a good ETF], then I'll go and buy it. I don't care who creates the ETF or platform." Most advisors say that if a more expensive product is performing better, even allowing for costs, they will opt for it as the best match for their clients.

Top Challenges

Two-thirds of advisors surveyed indicate that their clients are unfamiliar with ETFs, and more than half of respondents admit they themselves do not fully understand ETF structures and have at least some difficulty evaluating similar offerings. About 35% of advisors polled have concerns about liquidity mismatches, and 34% believe there is not enough objective research available on ETFs. Over a quarter prefer index mutual funds, while 22% worry about regulatory uncertainty in the ETF space.

Many wealth managers interviewed say clients, when they do ask about ETFs, just want to know what the acronym represents. Once advisors explain the products to them, the investors let them take the reins in creating and managing the portfolios. As one manager states, "It never fails to amaze me how many clients have no interest in wading into the weeds."

Discussions with clients, according to Butterworth, are "tied to tax efficiency, transparency and the clarity of ETFs, and knowing what you own." Since his group works with managed or actively traded ETFs, "We walk through an explanation of what we think is value-added for the clients' circumstances. We explain to them that ETFs are like individual stocks (traded throughout day) versus a mutual fund that is priced at end of the day," he says.

Properly evaluating ETFs "can be quite a challenge," Myers says. He usually starts with a "relatively" neutral source, such as Morningstar, and reviews its commentary and information. Next, he checks performance over two- to 10-year periods and determines which are most consistent.

Once he has narrowed down his search, Myers checks the ETF provider websites for additional details. "I am primarily looking for information on how the index is constructed, how often it is rebalanced, what the turnover is for the index, performance information, and the length of time for that performance history," the advisor explains.

Looking Ahead

Many advisors see the continuous rollout of new ETFs and illiquidity as possible stumbling blocks in the future. "We've seen a proliferation of ETFs that have since consolidated or have shut down because they don't have sufficient assets," says Butterworth.

"We are getting to a point that we are slicing and dicing the market into far too many sectors, and this has the potential of watered-down results," explains Myers. "In other words, a successful strategy could lead to a bubble that would lead to the demise of the strategy."

Shedd adds that using ETFs for index investing has become today's "fad." "It's not hard to pick winners right now, and those strategies are working for most investors. The test always comes when we have a downturn, a 5% plus or minus pullback. That's when the active managers earn their pay, weeding out the losers and hanging onto the winners," he states.

Hauf agrees. "People don't understand passive management and the risk involved with it," he says. "They understand cost, but wait until all hell breaks loose, and it will."

Courter, too, is concerned with the ETF illiquidity and volatility during a flash crash. Like other advisors, though, he still views ETFs as "the best investment vehicle there is."