Cracking the ETF code for clients

By Dan Jamieson

Aug 12, 2012 @ 12:01 am (Updated 5:24 pm) EST

With some 1,400 ex-change-traded funds covering just about every asset class, the ETF universe is daunting for anyone investing in it for the first time.

But experienced financial advisers recommend considering ETFs for their cost and tax advantages.

That said, many advisers use both mutual funds and ETFs in client portfolios, choosing the best product for the situation.

For starters, many active strategies aren't available in an ETF format.

And the tax advantages of ETFs, which can avoid capital gains distribution via their in-kind creation and redemption process, might not matter all that much in tax-deferred accounts, said Scott Dunbar, managing director of advisory services at Arnerich Massena Inc., which has $17 billion under management.

Observers said advisers need to be aware of trading and liquidity issues with ETFs, as well as the credit risks with exchange-traded notes and situations that may keep the products from tracking underlying indexes.

For beginners, using ETFs for passive exposure to core market beta is the obvious place to start.

Many ETFs based on broad stock market indexes have become commoditized, so advisers tend to screen them for low costs and good liquidity, which keeps transaction costs down.

Advisers suggest looking for products that have been around for a few years, with enough assets to avoid the possibility of being shut down by a sponsor.

“I don't want to have to tell clients that this portfolio is no longer in existence,” said Vern Sumnicht, founder of Sumnicht & Associates LLC, which manages $280 million, and iSectors LLC, which runs $170 million under a series of licensed ETF model portfolios.

“Especially in a taxable account, the last thing you want is an esoteric, thinly traded fund that a sponsor shuts down,” thus creating a tax liability, Mr. Dunbar said.

Experts also suggest looking under the hood to make sure you understand the underlying index and the actual portfolio.

“There may be differences be-tween the title [of an ETF] and the fundamental economics,” Mr. Dunbar said.

For example, companies in a “high-dividend” ETF may not be able to maintain payouts, he said.

Eric Pollackov, managing director of ETF capital markets at Charles Schwab & Co. Inc., noted that in 2010, 17 biotechnology ETFs varied in performance by as much as 68 percentage points due to differences in the types of stocks that they held.

Liquidity is the biggest concern overall with ETFs, especially since the May 2010 flash crash.

High bid and ask spreads, and differences between quoted prices and the underlying net asset value of the portfolio, can eat up any cost advantages ETFs provide, observers said.

The top 10% of ETFs by size account for about 80% of ETF trading volume, Mr. Pollackov said.

This means even a 100-share order in one of the less liquid products could hurt the execution price.

That is why limit orders are recommended in most cases.

Mr. Pollackov also advises against trading near the open or close of markets, when they tend to be more volatile, and spreads wider.

A lack of trading volume in an ETF doesn't necessarily mean a lack of liquidity, observers said.

An ETF “is as liquid as its underlying components,” said Tony Davidow, a managing director and portfolio strategist at Guggenheim Investments.

CREDIT RISK

Exchange-traded notes carry their own risks.

“The big difference is that an ETN is a debt instrument, and with that, you get credit risk,” said Brad Zigler, founder of B.L. Zigler & Co., an industry consulting firm.

Credit is a serious concern, given that a majority of ETNs are issued by European banks such as Barclays PLC and Credit Suisse AG, he said.

Another risk is that ETN issuers can stop issuing new shares, depending on their own credit needs and ability to hedge. That can cause an ETN to decouple from indexes.

The most notable case in point is the iPath Dow Jones-UBS Natural Gas Subindex Total Return ETN (GAZ), which began trading at premiums after Barclays stopped issuing new units in 2009. Prices are now set by supply and demand rather than being held to the underlying index by arbitrage.

Advisers also must be wary of ETFs that invest in commodities futures.

Funds that roll over expiring futures into higher-priced, longer-dated contracts can see returns diminish and experience tracking error. The phenomenon of contango occurs when longer-dated contracts trade at higher prices.

“Even if spot prices are rising, if contango is large enough, you could see losses,” Mr. Zigler said.

“You see it most dramatically in crude-oil futures,” where contango has been persistent since the summer of 2008, he said.

Most advisers should avoid leveraged and inverse ETFs, as they are designed more for traders who readjust positions frequently.

djamieson@investmentnews.com Twitter: @dvjamieson