The Wizards of ETFs – Behind the Curtain (2/2)


This is a review of a session from the Money Management Institute’s 2012 Fall Solution Conference.  This is part two of a two-part series.  You can read part one here.

Moderator:

  • Benjamin T. Fulton, Managing Director of Global ETFs, Invesco Powershares Capital Management, LLC

Panelists:

  • Sam Turner, Director of Large Cap Portfolio Management at Riverfront Investment Group
  • Jill Iacono Mavro, Managing Director, Head of National Accounts, State Street Global Advisors – $337 billion in ETF assets globally, 94% in US, SPY launched in 1993
  • Dodd Kittsley, Senior Product Manager & Head of ETP Research, iShares

How much weight should advisors put on liquidity when evaluating an ETF?

There are two levels of liquidity: primary and secondary markets, Mavro said. On the primary market, an ETF is as liquid as the underlying index that it tracks. It depends on how easy is it for authorized market participants to trade the basket of securities that represent the index. On the secondary market, liquidity is defined by how often the ETF is traded. The more it is traded, the thinner the spread between the bid and ask prices. Advisors should look at both levels together, not just one or the other.

Turner disagreed and stated that primary market liquidity and fees are the two worst reasons to select ETFs.  Riverfront focuses primarily on exposure and have never had an issue getting out of an ETF due to lack of primary market liquidity, he said.

Secondary market liquidity can become an issue when investing ETFs according to Michael Jones, also from Riverfront Investments, who was in the audience.  He provided an example where Riverfront was the seed investor for an international ETF that was currency-hedged (The ETF happened to be DBX MSCI EAFE Hedged Equity Fund, symbol: DBEF). Primary market liquidity wasn’t a problem for them since they were working directly with the authorized participant and had great execution.  However the use of the currency hedge became more and more expensive to the point where they had to pull their investment due to the high marginal trading costs of bringing on each additional client, he said.

Should You Avoid ETFs with Low AUM?
An article in Barrons makes the case that low AUM is not a good liquidity indicator for ETFs:
“…asset levels aren’t always the best proxy for liquidity. Unlike a stock, an ETF can still have strong liquidity even if its trading volume is low or its assets are tiny. That’s because the underlying stocks’ or bonds’ liquidity is usually the best way to measure an ETF’s real ease of trading. Barron’s asked market-making firm Knight Capital to rate the liquidity of 30 small ETFs whose 2012 returns are about double those of the S&P 500 as of early November. If you judge ETF tradability by the way its components trade, as Knight does, you’ll find lots of low-asset ETFs with more-than-expected liquidity. “I wouldn’t shy away from ETFs that have low volume or low assets. You just have to be smart about how you trade it,” says Eric Lichtenstein, managing director of Knight’s ETF trading desk.”

behind-the-curtain

How can sponsors protect their margins on ETFs in light of the pressure from clients for fee reduction?

One of the benefits of ETFs is that they have a very diverse investor base, Kittsley noted.  They range from the world’s largest global macro hedge funds all the way down to self-directed individual investors.  Fee sensitivity is dependent on the user base and their time horizon.  iShares realized that long term investors are more price sensitive, so lower fee products are more compelling for them, he said.

Kittsley pointed out that the most overlooked due diligence question when evaluating ETFs is “who is managing your assets?”  Will the products close?  What is their quality?  We want to support a high-quality product that delivers what is promised and fees can’t go to zero or investors can’t be serviced properly.

What do advisors and managers expect from sponsors to support them properly?

The passive index products could see a race to zero for fees, Turner said.  Innovation is the key source of growth for all ETF providers.  There are many ways to add alpha and they’ve argued for many years that you can do that with ETFs.  Make institutional strategies that are made available to the mass market should command a premium price over index ETFs.  Looking at ETFs in a single industry group in any given quarter there can be performance dispersion of over 10%.  Picking the right ETF is important when investing in specific industries, he said.

Would a sponsor consider becoming a market maker or authorized participant?

Some sponsors, such as Invesco, might be interested in bringing those function in house, Fulton commented, if only to improve the level of service provided to clients.  US exchanges are determined to make sure all products they trade have the same rules, Fulton said.  There are 1,500 ETFs and they should have different rules.  Exchanges should separate the trading of ETFs from equities, he said.

State Street is an authorized participant on some ETFs, but not the only one, Mavro informed us.  You should have multiple authorized participants on your products, since they help keep each other in line, she said.

One of the reasons that the market works so well is due to competition, Kittsley added.  If sponsors started handling these functions, it could create conflicts of interest, he warned.

How many active ETFs will there be in two years that have over $1 bil AUM?  (Besides PIMCO.)

Kittsley isn’t bullish on ETFs that have complete transparency due to the risk of front running.  This would include products that have to disclose their holdings on a daily basis, especially in the equities space.  The current structure doesn’t allow portfolio managers to do what they do best.

According to Mavro, they’re seeing some advisors who are just watching their asset allocation funds to determine directional movements and working off that.  These advisors are using the funds as a guidance tool instead of an investment tool, she said.

Active ETFs can play a role in a portfolio when there is a need for diversification into a manager’s weak areas, Turner asserted.  For example, Riverfront has used the PowerShares DWA Technical Leaders Portfolio ETF (symbol: PDP) because it fills a hole in their strategy and also conforms to the “diversification of genius” goal that Mike Jones spoke about earlier, he said.

Related Stories
First Trust Plans Active Commodities ETF, IndexUniverse.com
Active vs. Passive ETFs, ETF Trends
101 ETF Lessons Every Financial Advisor Should Learn – A fantastic resource about ETFs that runs the gamut from the rudimentary basics (“ETFs are tax efficient”) to the esoteric (“Commodity ETFs Can Be Front Month or 12 Month”). It is also in my top ten of “World’s Longest Single Blog Posts” so make sure to block out some time if you plan to read the entire thing in one sitting.

How effective has introducing ETFs into SMA been in increasing diversification?

It has been a tremendous help, Turner proposed, since it allows access to areas that they wouldn’t normally be able to provide an SMA such as micro cap or small cap emerging markets.  ETFs help avoid the idiosyncratic risk of buying individual stocks.  Individual security decision aren’t as important as the asset allocation decisions, he said.

Check out some of our other wealth management content
Asset Allocation: Is Modern Portfolio Theory Dead?
Inside the Minds of Barron’s Top Financial Advisors

This is part two of a two-part series.  You can read part one here.

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