7 Talking Points to Demystify ETFs for Clients

Best Practices January 30, 2023 at 06:01 PM
Share & Print

When advisors mention exchange-traded funds, some clients are clueless, as though their advisor were speaking in a different language. And while some clients may know exactly what ETFs are, many others have nothing more than a vague notion, conflating them with mutual funds or index funds.

For advisors managing fund portfolios for clients, bridging this education gap is more important than ever. An explosion in new ETFs in recent years presents myriad opportunities for advisors to engineer portfolios for exposure and diversification while positioning for greater income.

Despite the bear market, ETFs took in more than $615 billion in 2022 — their second-biggest year ever in a history that began with the introduction of the first such product, SPDR S&P ETF Trust (SPY), in January 1993.

In 2022, ETFs in various areas posted record inflows, including defensive equity sectors, traditional U.S. value, smart beta, dividend stocks and Treasurys. Industry projections have total inflows rising to $1 trillion in 2023 — likely a realistic figure, judging from a strong close in 2022.

As a result of a market synergy where more inflows fuel variety and greater variety attracts inflows, ETFs are offering increasing opportunities for structuring fund portfolios with greater precision, lower costs and improved risk management.

As increasing inflows give rise to new ETF products, identifying opportunities for clients is becoming more time-consuming. A helpful resource for researching them efficiently and comprehensively is a screening tool offered by the ETF Research Center.

A lack of familiarity with ETFs understandably can lead to client resistance, so advisors seeking to add them to portfolios should plan for client meetings. Of course, advisors need to explain this fund form's fundamental advantages over mutual funds, including potentially higher income, trading flexibility, the absence of onerous minimums, loads and withdrawal fees, and avoiding inconveniently timed distributions.

This should help prepare the ground for a practical conversation about the growing variety of opportunities. Here are some talking points to keep in mind:

1. Using passive ETFs merely as a substitute for index funds was your father's ETF strategy.

No longer are these funds just a more flexible way to track major indexes or sectors. As they've come of age over the past decade, they've started enabling access to the full spectrum of investment markets.

Moreover, ETFs are going where other investment forms haven't, allowing tightly focused investment in specific industries, subsectors and themes — from clean tech to nuclear energy, investment banks to regional bank to global financial firms, and to highly specific technology themes (genomic developments, EV vehicles, commodities, managed futures), and so on. So abundant is ETF variety that if you just type a theme into Google, adding "ETF," you can usually find an example.

2. Compared with mutual funds, the structure of today's ETFs is like a Porsche Panamera versus a Hudson Hornet.

Rampant innovation in recent years has made this category a high-performance, agile investment, in contrast with relatively stodgy, clumsy mutual funds. To use a different metaphor, don't think about ETFs as basic flavors — chocolate, vanilla, strawberry — representing just major equity indexes and dominant sectors.

Instead, think in terms of Baskin-Robbins' 31 original flavors — times 100. The debut of a few hundred new ones in 2022 brought the total of U.S. ETFs to about 3,100.

3. There is now a wide variety of actively managed ETFs.

A change in Securities and Exchange Commission regulations in 2019 opened the floodgates for active funds, and cash has since poured in, fueling new products. In 2022, active ETFs gained $106 billion — up 22% from 2021. (About 30% of this was from mutual fund conversions.)

Though active ETFs now comprise only about 4% of a $7 trillion category, they had 11% of the industry's total inflows in 2022 — about $70 billion, according to Morningstar. Some of these products come with sophisticated management, which means higher fees. But in many cases, they're well worth it for the net returns they deliver.

4. All this flash does not come without cash for investors.

Growth in dividend-focused ETFs is creating more choices, enabling investors to flexibly position for dividend income while waiting for shares to rise. Dividend ETFs have posted positive inflows for 26 straight months, last year taking in $72 billion — 68% more than in 2021.

5. Today's ETFs cover the full gamut of asset classes, including various alternative assets, many of them paying substantially more income than bonds.

Alternative products include real estate investment trusts (REITs), some varieties of which benefited many investors in the real estate run-up of 2021. There are REIT ETFs that own cell towers, data centers, health care facilities, shopping malls and all manner of other leased properties, along with those that provide services.

Also quickly increasing have been various options-based ETFs (including buffered products), which can be used to generate income or manage equity risk. There were more than 120 such ETFs in late 2021, and more began operating last year.

6. Fixed income ETFs abound, especially now that bonds are paying actual yields again.

Bond ETFs took in nearly $200 billion last year, including a record $125 billion into government bond funds. Available fixed income products include ETFs owning preferred stocks, available in various permutation, including those owning variable-rate preferreds and those that combine preferred stocks with bonds and derivatives.

7. This abundance of choices can be bewildering, and it's not without peril, as it's easier to choose incorrectly.

Thus, it's best for many individual investors to use an advisor to select and manage ETFs, as with other types of investments.

Considering the multiplicity of ETFs available today, a good understanding of them by advisors — and their clients — can enable constructing custom client portfolios.


Dave Sheaff Gilreath, CFP, is a founding principal and CIO of Innovative Portfolios, an institutional money management firm, and Sheaff Brock Investment Advisors. Based in Indianapolis, the firms manage assets of about $1.3 billion.

NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.

Related Stories

Resource Center