The ABCs of ETFs
Twenty years is a long time. So it was surprising for me to read that of 735 financial advisors responding to a survey at Wealthmanagement.com, 25 percent reported that they do not use ETFs.
Their reasons for not using exchange-traded products were even more surprising: 42.5 percent asserted that “they don’t know enough about them,” 18.6 percent “felt mutual funds were better products,” and 18 percent felt they “were not appropriate for their clients.”
These startling results made me wonder how many individual investors were not using ETFs for similar reasons.
Over my long career as an advisor, it has been apparent that a lot of established financial professionals tend to stick with what they know—but so do clients. And that can be disadvantageous to wealth building.Let’s expand on some of the key points this survey has broached.
Information is Everywhere
Frankly, most ETFs are not that complicated—certainly not more than most mutual funds.
If your advisor claims that a lack of knowledge is the reason for not using ETFs, consider shopping for a new one.
Not only have ETFs been around for two decades, but also there is a wealth of information available at the click of a mouse: at the fund manager’s website, at websites such as Google Finance and Yahoo Finance, and at financial publishers such as Investing Daily.I can believe that 20 years ago advisors would ignore ETFs due to lack of knowledge or understanding, but I have a hard time accepting that advisors still do so today.
Besides, ETFs hold many advantages over mutual funds beginning with lower fees. But then again, that might really be why your advisor has stayed away from them.
Buh-Bye to Fat Commissions
In 20 years, the ETF business has grown from one ETF to a trillion dollar industry with hundreds of funds. But it is still dwarfed by the $23.8 trillion in mutual funds.
Along with other factors, ETFs have greatly influenced the way advisors conduct business today. When SPY first started trading in 1993, brokers and advisors still made most of their money through commissions.
However, since then the industry has shifted from away from commissions and toward fee-based business models. Rather than charge you per transaction, advisors are more likely to put your money in a mutual fund wrap account or a separately managed stock account, both of which normally charge you a percentage of assets under management every year.
Some advisors do still work on commission. But it is not easy earning commissions with ETFs, when you have to compete with discount brokerage firms that charge $5.00 – $10.00 per trade.
It is much more profitable for the advisor to sell you a mutual fund where they are likely to earn a payout generally between 1 percent and 5.75 percent of your money.
And not only are ETFs cheaper to trade, but also their internal expenses (the charges the fund assesses on an ongoing basis) is usually much lower than the internal expenses of a comparable mutual fund.
When considering fees alone, ETFs usually hold a significant advantage over mutual funds.
Are Mutual Funds Really Better?
In the survey, 18.6 percent of respondents said mutual funds were better products.
Now I’ve occasionally heard this claim made and it confounds me every time.
It’s not hard to tell which one is better, because ETFs can be compared with mutual funds point by point, just as you’d compare one mutual fund to another mutual fund.
A fund might be better than an ETF, but empirical data must exist to support the claim. If a particular mutual fund manager always beats the respective index and the net returns are superior to the most comparable ETF, that’s fine—buy the mutual fund.
But for an advisor to claim that “mutual funds” are categorically better than “ETFs” is ridiculous. Some are; many are not. You must compare them “apples to apples.”
A Rich Variety
Meanwhile, 18 percent of respondents felt ETFs were inappropriate for their clients.
That’s just crazy. There are ETFs of every shape, size and stripe. And the variations seem to grow every day.
I firmly believe that if not now then in the near future there will be a greater variety, and possibly a greater number, of ETFs than mutual funds. My job as an advisor and portfolio manager has been in part to stay on top of the developments in the ETF market. I thought they were appropriate and advantageous for my clients and used them liberally.
Researching the ETF market was both fun and beneficial. It certainly enabled me to bring exciting and useful investments to my clients—investments that other advisors might not have.
Active Management
Advisors have also claimed “active management” is a reason for preferring mutual funds over ETFs. But as I said, active management is only better if the investor is putting more money in his or her pocket as a result of it.
And that is always the bottom line. Don’t listen to the sales pitch; look at the hard data.
If an actively managed mutual fund has returned less than a comparable index or actively managed ETF, guess what? You might want to go with the ETF.
Don’t forget, there are many ETFs that utilize active management, with more launching all the time.
ETFs provide a tidy, low-cost means of diversification. They are not inferior to mutual funds, they are not difficult to understand, and they are not inappropriate. There is an ETF for just about everyone.
There are also great mutual funds. I just wouldn’t advocate picking sides. Advisors and investors should utilize all available resources to compare and contrast mutual funds and ETFs.
And if your advisor isn’t showing you all of the options, tell him to get his act together.
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Steven Orlowski is a 20-year veteran of the investment business. He has worked for some of the most prestigious firms in the world in a variety of capacities, including portfolio manager, trader and high net worth financial planner.