Bullwarks of the market - ETFs - Michael Santoli - Barrons 7-2-07

Discussion in 'C++' started by NewsToBeRead, Aug 18, 2007.

  1. NewsToBeRead

    NewsToBeRead Guest

    Bulwarks of the Market
    By MICHAEL SANTOLI

    WHEN EXCHANGE-TRADED FUNDS FIRST GAINED prominence in the 1990s, they were
    generally viewed as one of the easier ways for retail investors to build
    market positions on the cheap. And as hedge-fund assets ballooned after
    2000, ETFs increasingly were used by these opportunistic pros to buy or
    short the market on the quick.

    Yet, as the ETF market has matured, these funds' impact has nowhere been
    greater than on the way investment advisers construct long-term portfolios
    for their retail clients.

    ETFs -- essentially index mutual funds that trade like stocks on an
    exchange -- are suited to all the above constituencies. Their combination of
    low cost (for the most part) and liquidity means that they work for the
    buy-and-hold little guy as well as the trade-a-minute, hedge-fund
    trigger-puller. Their embrace by investment advisers, however, is arguably
    far more pervasive.

    A survey by Schwab Institutional, the division of Charles Schwab (ticker:
    SCHW) that provides support to some 5,000 independent investment advisers,
    illustrates this trend. The poll, taken in January, covered nearly 1,400
    advisers representing $347 billion in assets under management, and found
    that 76% of them currently use ETFs in client portfolios. No other
    instrument had a higher usage rate. Fully 36% said they expected to increase
    their ETF use, and one in five advisers who don't yet use them expected to
    begin doing so.

    Barclays Global Investors, an ETF pioneer and manager of the iShares product
    line, reports that, as of March, 47% of iShares assets were held by retail
    investors through an adviser or full-service broker, the largest user group.
    Another 44% of assets were held by institutions, and 9% by self-directed
    individual investors. That compares with 38% for retail investors with
    advisers, 57% institutional and 5% self-directed in 2000.

    Clearly, these funds have come of age, and more than ever comprise the core
    investments of advised retail portfolios.

    Yet with maturity comes challenges. As the number of exchange-traded funds
    approaches 600, and increasingly contrived and niche-oriented permutations
    muddy the waters, advisers are complaining that the industry risks
    alienating investors by offering more quantity than quality, while diluting
    the funds' essential selling points: low cost, simplicity and transparency.
    Indeed, the crowding of the market with confusing and overly specialized
    offerings makes advisers even more important arbiters of value.

    The bedrock appeal of ETFs for investment advisers remains, however.

    The core funds that cover the broad equity markets or major sectors are
    near-perfect renderings of their underlying indexes. The thriftiest adviser
    can be cheered by total fund costs that are as low as nine basis points (or
    hundredths of a percentage point) for Standard & Poor's 500-tracking ETFs.

    BECAUSE INDEPENDENT investment advisers and financial planners are
    fiduciaries, they are charged with determining the cost-effectiveness of
    investments.

    ETFs are easy to like by that standard.

    And because most advisers and planners tend to be asset-allocators rather
    than stock pickers, the well-defined asset-class divisions of the major ETFs
    fit nicely into the majority of portfolio schemes.

    Because of their structure, too, exchange-traded funds are inherently
    tax-efficient and rarely kick off big taxable distributions.

    Rick Ferri, CEO of Portfolio Solutions, a Troy, Mich., investment-advisory
    firm specializing in low-cost, passive-index strategies, notes some
    mechanical advantages of ETFs over standard mutual funds. For instance,
    advisers service their accounts using custodians -- Schwab is one -- which
    charge lower fees for trading ETFs versus traditional funds.

    And, Ferri says, "There's greater flexibility. We all like to square up our
    portfolios by the end of the day."

    Standard mutual funds would require buy or sell orders to be in by 2 p.m.
    Eastern time, in order for the trades to take effect the same day, and the
    day-end net asset value is not knowable until much later.

    But this creates the risk of a mismatch between the amount being sold and
    the amount to be reinvested, potentially leaving an inefficient excess of
    cash. ETFs offer real-time portfolio valuation and precise rebalancing of
    portfolios.

    They also provide handy means to access hard-to-reach markets such as
    emerging-market stocks, real estate and commodities.

    Like many advisers, Ferri uses broad ETFs -- such as Vanguard Total Stock
    Market (VTI) -- to construct a core asset allocation, and then selects among
    other, narrower ones to make geographic or sector plays. The low expense
    ratio of core ETFs means that Portfolio Solutions' clients pay only about 42
    basis points, all-in, in fees, says Ferri.

    TO MAKE THE LEAP to ETFs, of course, an investor and his or her adviser
    first need to accept the wisdom of indexing, at least for core asset-class
    exposures, as opposed to seeking managers that try to outperform the
    markets. On some level this will limit the ultimate penetration of ETFs,
    although probably at a much higher level of usage.

    As it is, ETFs have become such a pervasive and mainstream product in
    adviser circles that the asset category is dealing with some adolescent
    awkwardness.

    Natalie Lera, vice president for product management at Schwab Institutional,
    says that, with 76% usage among advisers, "ETFs are much more a standard
    than they were even four years ago." She also sees a "blunting" of the
    advantages of newly created exchange-traded funds, a condition of
    diminishing marginal benefits as issuance has surged.

    Gerald Buetow, CIO of XTF Advisors, a New York firm that runs ETF-based
    portfolios, uses stronger terms to lament the drift of the business. "The
    ETF industry is its own worst enemy at times," he says, adding: "I worry
    about people just throwing anything against the wall," in terms of new
    products.

    ETF sponsors have gotten aggressive in creating fringe, gimmicky products
    with no apparent ready demand for them, simply because it's cheap and easy
    to do so. And the narrower, more specialized funds tend to have higher fees,
    less diversification and lower liquidity, partially offsetting the principal
    benefits of ETFs.

    There are, for instance, 18 HealthShares ETFs, each devoted to stocks of
    companies targeting particular diseases, such as HealthShares Ophthalmology
    (HHZ) and HealthShares Autoimmune-Inflammation (HHA). This is slicing
    health-care sectors too thin, at best; at worst, it's cynical marketing to
    investors personally impacted by certain diseases.

    There are also 22 separate state-specific ETFs in registration, each
    containing 50 stocks of companies based in a single state. The usefulness of
    such a fund is hard to fathom, except for reasons of provincial pride or
    cheap political gestures by, say, local government unions.

    Then there are the well-intentioned but still eyebrow-raising efforts such
    as this one that hit the market last week: the Claymore/KLD Sudan Free
    Large-Cap Core ETF (KSF).

    There are even aggressive, derivative-based structures emerging -- such as,
    in Europe, ETFs based on credit-default swaps that have opaque valuation
    mechanisms.

    Says Buetow: "I worry that some derivative strategy will implode, and the
    whole industry will take it on the chin."

    He expects a "Darwinian" shakeout, as new entrants have trouble raising
    enough assets to feed a viable fund-management business and ETF attrition
    results.

    PART OF THE REASON it's so easy these days to roll out new ETFs: regulators'
    tendency to approve nearly any vehicle based on an index, however the ETF
    sponsor chooses to define "index." Is a U.S. state anyone's real idea of a
    benchmark? How about a basket of stocks recommended by a handful of small
    research shops (such as the Claymore/BIR Leaders 50 (BST))? Yet these are
    rendered as indexes for the purposes of wrapping an ETF around them -- and
    might help to underplay risk factors.

    There's nothing inherently wrong here. But calling a geographically or
    analytically screened stock basket an index can spawn confusion among
    investors who might think they are getting passive exposure to a market
    segment, when in fact they are adopting a specific -- and often untested --
    investment strategy.

    And yet with all the new products, advisers still complain that there are
    asset classes that are poorly served by the ETF industry, whether because of
    liquidity issues in the underlying securities or lack of imagination. Some
    fixed-income and alternative-asset markets in particular are a bit thin,
    leaving advisers to use mutual funds, closed-end funds or even the more
    expensive separately managed accounts.

    Buetow laments that still more firms are creating Treasury-bond-index ETFs,
    despite the fact that the iShares and State Street Lehman bond-index ETFs
    and others do the job quite well. Meanwhile, high-yield and other
    credit-based bond products are lacking.

    The crowding of the market and its remaining gaps have arguably made the
    services of advisers more valuable, as they can sift through the many
    offerings, gauge their usefulness and search for alternatives in instances
    where a proper exchange-traded fund isn't available.

    In this way, perhaps, the growth of the ETF market is rapidly replicating
    what happened in past decades to mutual funds: A product built to be handled
    directly by individuals becomes immensely popular, spurring waves of
    innovation that foster excess specialization and too many redundant
    offerings. Thus does a do-it-yourself market become a do-it-for-me market.



    --
    Posted via a free Usenet account from http://www.teranews.com
     
    NewsToBeRead, Aug 18, 2007
    #1
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