Playing it Safe By Beverly Goodman

Special Report on ETFs. Three well respected advisers tell Barons their strategies for ETFs.

“At least 90% of your returns are determined by your asset allocation,”

With some $1.4 trillion invested in exchange-traded funds and 157 new products launched in the past six months alone (that’s more than one per business day), ETFs are at their most popular—and their most confounding.

Though the term “ETF” is often used for the entire category of exchange-traded products, there are many distinctions worth noting, especially as many new products test the boundaries of what is necessary, or even acceptable, for most investors’ portfolios. Leveraged products, exchange-traded notes, and actively managed ETFs all have burst onto the scene, leaving investors, even some of the professionals, confused (see related story, “Everything Wants to Be Called an ETF These Days”).

So we thought it was a good time to huddle with some experts. We assembled a panel of advisors who have used ETFs in one way or another for several years.

A managing director for investments at UBS in New York, Ron Vinder runs an all-ETF portfolio for his ultra-high-net worth clients. “At least 90% of your returns are determined by your asset allocation,” he says. “ETFs allow me to implement my clients’ asset allocation with precision.”

Raj Sharma is a managing director of investments for Merrill Lynch, and runs the advisory practice Sharma Group in Boston. He uses ETFs tactically, generally for bets that don’t go beyond 18 months. “There’s a misconception that an ETF is a strategy,” he says. “It’s a conduit and a vehicle, just like a separately managed account or an actively managed mutual fund. I use separately managed accounts for tax efficiency, and the ability to harvest tax losses. I use actively managed mutual funds where the funds have the flexibility to go anywhere, which isn’t found in a separately managed account, and I use ETFs tactically for investments with a six- to 18-month horizon, and also to fill some niche areas.”

Nathan Bachrach, an independent advisor for the Financial Network Group in Cincinnati, is switching his clients to an all-ETF portfolio, largely as a result of the financial crisis of 2008. “I agree completely with Ron that asset allocation is 90% of your performance,” he says. “ETFs allow us to efficiently get a pure and transparent allocation.”

Barron’s: Let’s begin with your portfolio strategies, and how you use ETFs to execute them.

Vinder: I’ve been following ETFs for 15 years, but I had been using actively managed mutual funds. My main focus is on asset allocation based on each client’s particular needs, and I was finding that using money managers wasn’t allowing me to be as precise. Plus, after fees and taxes, it was very difficult for those managers to beat or even equal the returns of the index averages. So in 2008, when the whole market was coming undone, I decided to sell all the actively managed funds and move everything into ETFs. My clients had had a lot of gains, so that was a tax-efficient time to sell. It also lowered their fees. It’s worked out great.

Sharma: I really believe the paradigm has shifted today. It is more about risk allocation than asset allocation. For 75 years, we had about 10 major markets around the world that dominated everything. Today, it’s more than 100, and a huge number of investors. So volatility and higher correlations are here to stay. Clients need a strategic base allocation, but you also need to have a tactical sleeve to it, so you can dial things up or down as needed. That’s what I use ETFs for.

Bachrach: My clients pay me to determine their asset allocation, and ETFs are a more precise way to ensure they’re getting what I decide is right. They also let me tweak allocations faster and easier. I’d say it’s only in the past three or four years that you could create an all-ETF portfolio to achieve the kind of diversification we all think is credible. This reminds me a bit of a celebrity-chef television show. The three of us would go in the kitchen, and Raj would use one salt, Ron another, and I’d use another. The question is what kind and amount can they best tolerate? What kind of a diet should they be on?

So ETFs allow you to better handle client expectations? Was it hard to convince them to move to an all-ETF portfolio?

Bachrach: We explained how picking the right equity sector is more important than the right equity-fund manager. We compared the performance of the top-quartile managers in the worst-quartile sectors and the worst managers in the top-performing sectors over 11 years. Investors would have been better off with the worst managers in the top-performing sectors by an average annual spread of 7.48%.

Sharma: Nathan, you are assuming your client is going to stay on track for those 11 years.

Bachrach: Well, I’m assuming that’s what they hired me for. Nobody has ever walked into my office and said, “Your job is to beat every index under the sun.” They’ll come in and say: “I want to make sure that my kids get to college. I want to make sure that I can pay for two weddings. I want to make sure that my money doesn’t die before I do. I want to make sure that it goes to the next generation.”

Raj, can you give an example of an area where you’re using an ETF to get more exposure?

Sharma: Emerging markets. There are some two billion consumers in emerging markets, and they’re largely under 35, which means they’re consuming a lot—cars, washing machines, you name it.

I use the EG Shares Consumer GEMS (ticker: ECON) to get at this. It targets the consumption boom. When emerging markets fell 10% earlier this year, this ETF was down just 1%. So there are niches we can exploit.

I also like the iShares S&P Emerging Markets Infrastructure ETF (EMIF) for similar reasons. Some $2 trillion is going to be spent building roads and other infrastructure projects in the next year or so.

It’s interesting you mention two emerging-markets ETFs, since that’s an area where people argue you need active management.

Sharma: I agree 100% that active management is especially useful when an asset class is inefficient, as it is with emerging markets. We use active managers for our core exposure to emerging markets; these ETFs are for niche exposure to specific sectors. So if we think a 10% allocation to emerging markets is appropriate for a client, 7% of that would be in the core fund, while the remainder would be split between the niche areas.

There’s been something of an indexing backlash, given how the Standard & Poor’s 500 was essentially flat for a decade. You’re using indexes to execute an active management strategy, though. Is that hard to convey?

Vinder: I’ve actually done the work on this. If you put all your money in the S&P 500, you made 15.1% in the 10-year period ending Dec. 31, 2010. If you had put 50% in the S&P 500 and 50% in the US Aggregate Bond Index, you would have made 48.9% over that same 10-year period. Now, if instead of putting 50% in the S&P 500 you chose a diversified portfolio of large value and growth, mid-value and growth, small companies, international, emerging markets, all that, then walked away…you would have made 72.2%. If you had reallocated at the beginning of every year, your return would have been 82.6%. So, in a decade where the market basically did nothing, a diversified conservative portfolio that was rebalanced annually would have made 82.6%. Those are just the market numbers, that’s not manager performance.

Well, that was definitive. Why not?

Vinder: ETNs are generally senior unsecured, unsubordinated debt securities that are designed to provide investors a return that is linked to the performance of a market index. Many are derivatives-based. Basically, in an ETN, you aren’t investing in the underlying securities, because there often aren’t any. It’s really just a debt of the issuer, and therefore you are also adding the credit risk of the issuer. If you had bought a Lehman Brothers ETN, you would have lost everything.

So why were ETNs created? What can they do that ETFs can’t?

Vinder: Good question.

Bachrach: Make more money for the bank? If I don’t understand what’s going on under the hood, I don’t want to own it.

OK, so ETNs are clearly not popular in this crowd. What about actively managed ETFs?

Sharma: Active management still has a big role; managers can add a lot of value with good stock or country selection, especially in inefficient asset classes. That said, there is a major paradigm shift coming with actively managed ETFs. Right now, there’s more than $1 trillion in ETFs, but only $5 billion in actively managed ETFs. Once that changes, it’s going to change the way we look at asset allocation and separately managed accounts. There’s going to be a lot of fee compression for advisors, mutual funds, money managers of all sorts. That’s something we’re watching with great interest to see what develops.

Right, and more than 50% of that $5 billion in actively managed funds is in just three, mostly debt-related funds— Pimco Enhanced Short Maturity Strategy (MINT), WisdomTree Emerging Markets Local Debt (ELD) and WisdomTree Dreyfus Chinese Yuan (CYB). Meanwhile, less than $90 million is in actively managed equity ETFs. How do you expect this to shake out?

Sharma: The big splash is going to be made when Pimco Total Return comes out. [Editor’s note: Pimco, the world’s largest bond-fund manager, has announced its Total Return Fund ETF will trade under the ticker TRXT and will have an annual expense ratio of 0.55%, or around 30 basis points lower than its retail mutual fund. It will most likely start trading at the end of this year.] It’ll be very interesting to see if they can make it tax-efficient and cheaper, like other ETFs, with the same performance of the mutual fund. If they can do that, it’s going to be a tsunami in the industry.

Every major actively managed mutual fund will come out with an ETF equivalent that can be traded throughout the day. If I can essentially get an actively managed, separately managed account for about 50 basis points, why would I pay the manager 100 points…?

Bachrach: But at the end of the day, it is still going to be Pimco Total Return.

Sharma: That’s right.

Bachrach: And if Bill [Gross, portfolio manager of Pimco Total Return] blows it, if Bill misses it, I’ll tell you what it will do: If you thought 3 o’clock to 4 o’clock was exciting, buckle your seat belts.

What do you mean by that?

Bachrach: Raj is suggesting that, over time, the mutual-fund industry will go through a dynamic change, and ETFs are a part of it. When you look at an open-end mutual fund now to see what’s in it, the information is 60 to 90 days old. You really have no idea what it owns. That isn’t helpful.

With actively managed ETFs, all of a sudden you will be able to get real-time data. That’s great. But it will put a lot of pressure on the industry to have these actively managed ETFs as alternatives to their funds, which ultimately will cut their margins. From a consumer standpoint, that isn’t a bad thing. But as more and more people start opting for the actively managed ETFs, and trading them whenever they want based on whatever information they just got off their smartphone, there’s going to be a lot of end-of-day trading.

Why is that?

Sharma: You have so much computer-driven trading, the high-frequency trading. At any point and time it can account for 10% to 15% of the trading volume. It will be very interesting to see if everything can be traded every second. Unfortunately, I don’t think we’ll go back to the placid days when you bought a stock and hung around for the value to emerge.

Any other issues regarding actively managed ETFs?

Sharma: There’s still a question as to how transparent they will be. BlackRock has filed for a version that’s essentially a blind trust, and will grant only a few providers access to the portfolio. That’s understandable, because an actively managed ETF gets at the question as to what is the manager’s alpha, what’s he adding?

So that’s the root of the reluctance to expose their strategies. Whatever happens, once BlackRock gets in the game, it will dictate the market. But ultimately, I think it will be a boon for consumers and advisors. As Nathan mentioned, when you have all these loaded pistols that nobody knows how to use, there’s a bull market for intelligent advice.

Ron, I understand that actively managed ETFs generally go against your investing philosophy …

Vinder: Correct.

Is that the understatement of the year?

Vinder: It goes against everything I do.

So are you concerned about an influx of actively managed ETFs and how they might affect the market?

Vinder: I don’t have the same concerns Nathan does. It’s more about fees; instead of separately managed accounts, you’re going to have the same thing in an actively managed ETF. Instead of charging 100 basis points, they’re going to have to charge 50 or 60.

Volatility has been a serious issue for owners of leveraged ETFs, which aim to deliver two or three times the return of the index they track. It seems that many investors weren’t quite sure how to use them.

Bachrach: Leveraged ETFs and similar products have convinced me more than ever that investing is not a do-it-yourself, at-home proposition. In the wrong hands, it’s like giving more chips to a gambler; it’s feeding an addiction. Leveraged ETFs reset every night, so the longer you hold them the less your return will be what you expect. You need to trade them daily.

Sharma: People don’t understand the risk of these things. If you are three times short and the market goes against you, you’ve wiped out 70%, 80% of your capital.

What, if anything, do investors need to know about the liquidity of their ETFs?

Sharma: Some of the smaller, niche ETFs, like those with just $20 million in assets, don’t have as much transparency. Some of them are country-specific ETFs, and oftentimes their markets are closed while U.S. investors are trading. In cases like that, we always use market or limit orders, so we know what we’re paying.

Vinder: I don’t really swim in that pool. I wouldn’t invest in an ETF with just $20 million in assets.

Are there other reasons to be cautious of ETFs with low assets?

Sharma: There is also the economics of running an ETF. There are regulatory filings, and people needed to manage and sell them. I think we’re going to see a wave of consolidation. We have every single sector covered; how many of them are going to exist five years down the road? So it makes sense to play it safe, and go with the broader, deeper and profitable ETFs, which will be around for a while. Otherwise, your specialized nuclear-energy ETF will end up merged into a broader energy ETF.

Ron and Raj, you both have ETF research departments. Nathan, you mentioned that you hired five analysts to help choose ETFs. With more than 1,000 ETFs, what are the key factors investors should consider?

Sharma: I wouldn’t go for the brand-new ETF or the brand-new strategy. Let it mature so you would have a track record.

How long a track record do you want to see?

Vinder: It would have to be a minimum of three years old for me to even look at it, but I prefer to see five years.

What else?

Vinder: Fees are the primary disruptor; that’s what causes tracking error, which means your returns may not be akin to the index’s returns. You have to pay attention to fees.

Bachrach: Complicated and sophisticated doesn’t always make it better. I’d recommend investors only buy ’40 Act funds.

By that you mean ETFs that are subject to the Investment Company Act of 1940, which also governs open-end mutual funds. Why is that so important?

Vinder: Diversification, for one thing. The ’40 Act says that no individual stock can be more than 25% of the portfolio. And it limits the use of derivatives—ETNs and other exotic versions aren’t part of the ’40 Act.

Bachrach: It also means a company can’t be both a sponsor and a swap counterparty. In other words, you can’t be the sponsor of the fund and also be an investor that has taken the other side of a transaction.

Thanks, gentlemen.