The favorite strategy of long-term investors and their financial advisors is about to get more complicated.
Exchange-traded funds, with lower costs and built-in ties to benchmarks like the S&P 500 or themes like technology, are the go-to option for independent advisors helping clients, particularly younger ones, plan for major expenses like college, home-buying and retirement. The funds trade on exchanges like regular stocks and offer exposure to the broader market or segments by “passively” mimicking an index or other factor.
Plus, they carry a particularly generous tax benefit: Unlike mutual funds, ETFs can switch up their holdings without socking a buy-and-hold investor with a capital gains bill on paper profits for individual trades, even if the fund eventually posts a loss.
Bloomberg News
More than half of registered independent advisors, or 52%, make ETFs the core element of a client’s portfolio, according to Broadridge Financial Solutions, a data company for financial services that’s based in Lake Success, New York. That’s well above the rate for brokers at Wall Street’s traditional wirehouses (36%) and independent broker-dealers (31%). The bigger an RIA is, the more likely it is to make ETFs the main course for clients.
But this year, there’s going to be a lot more on the ETF menu to digest, thanks to several factors that add a twist to their passive investing method.
First, many indexes are concentrated in a handful of large technology companies. With giants like Apple, Microsoft and Google owner Alphabet only getting bigger, index funds that hold them are less diversified and thus less insulated from risk — a concentration that goes against one of the core tenets of prudent investing.
“Diversification, our industry’s one universal risk management tool, has now become opaque,” wrote Lily Taft, a portfolio manager at Main Street Research, a $1.5 billion, fee-only wealth management firm in Sausalito, California, and Greenwich, Connecticut, in an emailed Jan. 13 research note that was published by ValueWalk.
Second, new breeds of higher-cost ETFs that run on secretive strategies or follow unproven benchmarks, like those for sustainability, are making a play for investors’ wallets. At stake with many of these so-called active ETFs — which have a fund manager choosing stocks and blur the line between the low-cost passive approach that’s synonymous with traditional index funds and the higher cost of stock picking — are a veil of secrecy around holdings and potentially higher costs for investors. Around 60% of the nearly 500 ETFs launched last year, a record, are actively managed, according to Morningstar data cited by the Financial Times on Dec. 31.
On the tax front, a top Congressional leader called last September for the tax benefits of ETFs to be revoked and for investors to owe capital gains levies anytime a fund generates a profit by switching up its holdings. The proposal by Sen. Ron Wyden, a Democrat who chairs the Senate Finance Committee, hasn’t made it into formal legislation and for now appears to have withered on the vine.
But while the tax benefits of the $5.4 trillion U.S. ETF industry appear set to stay, Planet ETF is going through some big changes.
The most basic funds track a broad index like the Dow Jones Industrial Average or Nasdaq 100 top non-financial stocks. Other funds track specialized benchmarks that mirror specific themes, like the MSCI Growth index of large and mid-sized U.S. companies that are poised to grow. Lance Roberts, the chief investment strategist at RIA Advisors, a fee-only investment advisory firm in Houston, said that seven in 10 of his firm’s clients were in ETFs. “Most people can’t really deal with the volatility” of investing in mutual funds or directly in stocks, he said. “ETFs extract out some of the emotionality.”
But the no-brainer, unemotional proposition of tracking a benchmark is getting more complex as new ETFs that resemble their higher-cost mutual fund cousins flood into the market. So-called active ETFs don’t sit back and passively mirror an index or a theme, but instead have a portfolio manager actively picking stocks within a given theme or sector that she hopes will beat an outside measure. Active funds are more expensive because they involve a human, not a computer algorithm, to do the work. Some of the new active funds are mutual funds that have converted or plan to switch to ETFs, like the $10 billion in mutual funds that J.P. Morgan Asset Management plans to recast in 2022.
What’s new is that the workings and holdings of active funds can be partly or wholly opaque to protect the secret trading strategies of the fund managers overseeing them. And that can leave an advisor and his client not knowing what they’re invested in. A Jan. 13 report by Boston research firm Cerulli Associates said that many of the new active funds require “additional diligence from advisors and home offices” because they won’t provide as clear a picture about what they hold.
The new active ETFs are largely focused on investing in popular themes, like emerging technologies, sustainability and cryptocurrencies. That makes them a way for investors to buy into a trend without picking individual stocks. With wealth management increasingly focused on custom, personalized investing plans, they might seem an ideal fit for independent advisors. Broadridge’s ETF 2020 Outlook report found that 83% of advisors somewhat or strongly agreed with the statement, “I hope my favorite active mutual funds are introduced as nontransparent actively-managed ETFs.”
Active ETFs took off after a 2019 SEC ruling that said they don’t have to disclose their holdings on a daily basis. The underlying holdings of regular, passive-index ETFs are always clear to investors.
At the time of the ruling, two SEC commissioners sounded a note of caution. Noting that stocks or other securities held by an ETF “can sometimes trade at a price higher or lower than the value of the actual assets held in the fund,” they added that nontransparent ETFs “come with real risk that, in moments of limited liquidity, ordinary investors will … get prices that do not accurately reflect the value of their shares.”