The rise of Exchange-Traded Funds (ETFs) is a trend we’ve been actively watching for some time. The evidence points to the fact that since the financial crisis, financial advisors have been recommending ETFs more than mutual funds as investment vehicles. The 2017 TRENDS IN INVESTING SURVEY found 88 percent of advisors who responded currently recommend ETFs to their clients, compared to 80 percent who use or recommend mutual funds.
Many believe it’s a signal toward passive management strategies, since the use of actively managed funds is declining. But industry analyst Michael Kitces pulled together a thoughtful article about what he believes is happening. Kitces suggests advisors are increasingly taking an active approach, not a passive one, since there are more of them building portfolios with ETFs, stocks, bonds and private equity funds. They are using everything except third-party managed mutual funds. The entire article is available at this link in On Wall Street: HTTPS://WWW.ONWALLSTREET.COM/NEWS/KITCES-THE-PASSIVE-INVESTING-MIRAGE
Technology now allows financial advisors to develop portfolios that resemble managed mutual funds, with ETFs as fundamental elements. Advisors are essentially able to provide value for their clients by eliminating the cost of the mutual fund manager in the middle.
Kitces put it this way: “In the past, such a shift wouldn’t have been possible, as the administrative costs of actively monitoring and implementing an ongoing strategy were prohibitive. However, the rise of adviser technology solutions — in particular, rebalancing software that fully automates investment model implementation across an entire client base — means that any adviser can roll model portfolio strategies out systematically at a reasonable cost.”
The decline of actively managed mutual fund utilization might be connected both to cost AND performance, since 92.15 percent of large-cap, 95 percent of mid-cap, and 93.21 percent of small-cap managers trailed their respective benchmarks after expenses according to the S&P INDICES VERSUS ACTIVE (SPIVA) report over the previous 15 years.
Technology also provides the means to quickly show how advisors are performing as they increasingly take on the task of making investment decisions. Some may be tempted to measure performance using Global Investment Performance Standards (GIPS) for individual clients. Although GIPS is a highly respected benchmark, it is applicable only to model portfolios. Because of the custom nature of investments GIPS performance compliance may not be the best yard stick.
It is interesting to contemplate the survival of commission-based mutual fund companies and their products in a world where similar structured products (ETFs) are significantly less expensive and, at least for now, competing well relative to returns. They are more tax-efficient and lower cost for the most part. Another wrinkle in all this is that the marketplace is seeing the emergence of “actively managed ETFs” that are a little less passive and a little more expensive; essentially offering a blended approach toward indexing.
There have been issues with many ETFs lacking the same liquidity as open-end funds and with their response in fast moving markets (like a ‘flash crash’ where the pricing of the underlying holdings become greatly distorted when markets are in a fast decline). Those issues are legitimate concerns and kept some advisors from making the transition.
At Cutter & Company, we allow representatives to create model portfolios (or outsource that service to other managers who build their own). We don’t “force” them to use a home-office model. We believe that allows the financial advisor to deliver unique value and customization for each client based on their needs.