Business

ETFs win the battle, but they may not help you win the war

A nail gun is a handy tool, so long as you’re not shooting yourself in the foot with it.

The same can be said for exchange-traded funds.

It’s now official that ETFs — which are mutual funds built to trade like a stock — are the most popular investment vehicle for investment advisers, but the very survey that revealed that showed how it may be possible that some investors who work with pros may not recognize that they are aiming at their own bunions.

The Journal of Financial Planning and the FPA Research and Practice Institute released the 2015 Trends in Investing Survey this week and it showed that ETFs are now the “preferred investment vehicle” among advisers, with 81 percent of the wealth counselors surveyed using or recommending ETFs to clients.

That makes ETFs the top tool for advisers for the first time in the history of the study. When the study began 10 years ago, the 2006 results showed that just 40 percent of advisers were using or recommending ETFs to their customers.

Further, more than half of the advisers surveyed plan to increase their use or recommendation of ETFs in the next 12 months, far outstripping the increased usage of any other investment type.

It has been obvious that ETFs were winning the war with funds for ages now; I declared exchange-traded funds the winner back in 2011, but suggested that investors need to focus mostly on picking good investments rather than which type of fund to own.

At their core, exchange-traded funds and traditional funds are the same thing, a way for investors to pool their money in order to receive diversification and professional management and strategy at a reasonable price.

Both are mass-transit vehicles for your money; you are deciding whether the best way to travel is by train, plane or automobile, and the right answer typically depends on individual circumstances.

The biggest difference is that ETFs trade like stocks, minute by minute, and can pursue some complex investment strategies (such as using leverage) that struggle in the traditional fund format, while old-school funds trade once per day. ETFs traditionally have been based around indexes — though that is changing with the evolution of more active options — while traditional funds offer those same kinds of passive indexing strategies but also come in an unlimited variety of actively managed flavors.

ETFs also have some tax and cost benefits, and shareholders can see exactly what an ETF owns in real time, as opposed to learning what their traditional fund holds on a delayed basis.

It’s analog (traditional) to digital (ETFs) or black-and-white to color or whatever technological advancement you want to compare it to.

That doesn’t mean investors should just go dump their traditional funds, and the surveyed advisers clearly stated that there was room in an investment portfolio for both types of investment.

But here’s where the potential for wounding your feet comes in.

The evolution of ETFs has created a lot of new options — notably “smart-beta funds” — and have encouraged investors to take a more-active approach. ETFs were built as a trading vehicle, so it makes sense that investors will trade them; traditional index funds, by comparison, were built to buy and hold.

So when an adviser puts a client into an ETF portfolio and then runs that customer’s money, you get active management of a portfolio of passive investments.

That’s still active management.

And if you want proof that it’s happening more and more, consider that the survey also showed that a majority of advisers (61 percent), believe a blend of active and passive strategies provide the best overall performance, but it also showed that nearly a quarter of those advisers have increased their use of passive funds in the last 12 months.

That translates into increasingly active management of passive investments.

You might think you are a passive investor because you have index-like investments, but your account statements — if they show a lot of movement — say otherwise.

Lump the adviser’s fees onto the mutual fund’s expense ratio to get the true cost you are paying for a pro to run the money. It’s possible to buy low-cost funds but to still have a high-priced portfolio, where a “cheap ETF” feel a lot more expensive.

If you buy ETFs because you dislike active management, then trading them is playing directly into the strategy you don’t want to follow.

It’s like people who say they have no interest in gambling but who find themselves playing the slot machines every time they stay in a hotel with a casino.

“It's important for advisers to ensure they fully understand the nuances of the ETFs they're recommending and that their clients understand what they're investing in, as well as the cost and potential risks involved,” said Valerie Chaillé, president of SummitView Financial in Indianapolis, Ind., and practice management director for the Financial Planning Association.

The 2015 Trends survey also showed that advisers recently have been re-evaluating asset allocations, often with an eye to possible tax-law changes, but also with market concerns in mind.

The conversion of the financial planning business to one that thinks ETFs first, traditional funds second is, ultimately, good for consumers, but only if the public recognizes that it gets the bulk of the benefits from ETFs by using them exactly like traditional funds, as core holdings that ensure that the portfolio will deliver market-like returns.

If consumers, however, wind up using ETFs as trading vehicles – perhaps encouraged by those advisers now adopting ETFs – they’re just finding a new way to come to the same old result, the one where the fund investor’s return winds up lagging the funds they invest in, the market as a whole and, potentially, the level needed to meet their goals and expectations.

Chuck Jaffe is senior columnist for MarketWatch and host of “MoneyLife with Chuck Jaffe.” You can reach him at cjaffe@marketwatch.com and tune in at moneylifeshow.com.

  Comments