July 18, 2019
Among the top goals for a financial planner is to maximize the investment return for their clients with an acceptable level of risk. Managing risk typically centers around diversification—not putting too many eggs into any one basket. Exchange-traded funds (ETFs) have proven to be an excellent vehicle for diversification due to the evolution of the ETF industry. It is probably fair to say that the growth of ETFs has been largely tied to the growth of the financial advisory industry and the democratization of investment advice and knowledge throughout our economy.
The FPA and Journal of Financial Planning Trends in Investing Survey found that 88 percent of advisers surveyed currently use or recommend the use of ETFs with clients, and 45 percent said they plan to increase the use or recommendation of ETFs in the next 12 months.
The largest ETFs are based on indices, funds that are designed to track asset classes and sectors within those asset classes. Financial planners typically recommend exposure to both equities and fixed income securities, and diversification among sectors of the economy and different economies around the world. ETF issuers have met this demand with index ETFs covering virtually every asset class, market capitalization, sector and geographic subdivision of the world economy.
New ETFs continue to be created with a trend toward applying a different angle, smart beta or active strategy, or implementation of investment philosophy to offer new twists on existing themes. The FPA and Journal of Financial Planning Trends in Investing Survey found that a majority of planners surveyed continue to favor a blend of active and passive management.
ETFs seem to be the vehicle of choice for the average consumer, with the notable exception of defined-contribution retirement plans. ETFs have a structural advantage, especially for taxable shareholder accounts. Financial advisers will likely continue to shift toward increased use of ETFs.
As the ETF industry continues to grow and evolve, three themes are dominating headlines today:
1.) Cannabis funds
There are currently four or five cannabis funds in the marketplace, with at least three more in registration. One cannabis fund already launched this month and another is expected to go effective in the coming week, issued by Innovation Shares and Amplify ETFs respectively. Most observers tend to believe there is space in the market for several funds, especially because each has a slightly different approach. Innovation Shares offers an index fund and Amplify ETFs plans an active strategy, for instance. As analysts begin to compare the funds and their styles, many believe the oldest fund, the ETFMG Alternative Harvest ETF (MJ), will suffer loss in assets as its alignment with the actual cannabis industry is thin at best. Time will tell, but the cannabis sector certainly has created a buzz.
ETFs that do not disclose their actual portfolio has been a goal for many portfolio managers, many of whom seem to believe that the rest of the portfolio management industry is anxiously trying to find out “just how they do it.” There is very little, if any, demand by the actual investor buying the ETF. To the extent a non-transparent ETF might coax a hesitant portfolio manager into offering an ETF, the investing public can potentially benefit.
Past efforts, particularly the NextShares program put together by Eaton Vance, have had decidedly mixed results. The overriding opinion from recent industry conferences on the subject seems to tilt toward an increase in ETF filings and new offerings. Whether the new filings will result in significant new assets in those non-transparent ETFs remains to be seen.
3.) Race to the bottom on fees
For index ETFs, there may be additional gimmicky entrants to the space touting low or zero-fee products. A careful consumer will need to determine how the ETF will compensate its issuer, as there is no such thing as a free lunch. Portfolio transaction fees, which are included in the portfolio performance rather than the expense ratio, are one source. Revenues from lending portfolio securities can also generate fees.
ETFs will likely continue to increase as a percentage of most financial planners’ and wealth managers’ asset allocation models.
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Read the original article in the Journal of Financial Planning.