ETFs: Why so complicated?

  @Money September 10, 2012: 3:02 PM ET
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Used right, EFTs are cheap, tax-efficient investments. Too bad some advisers are tapping them to create needlessly costly and risky portfolios.

(Money Magazine)

Tune in at 9 a.m. on Tuesday mornings to news and sports radio station ESPN 1510 AM in Kansas City, and you won't hear chatter about knuckleball pitchers or star quarterbacks. Instead, for an hour the talk revolves around another hot performer with a fervent fan base: exchange-traded funds.

Every week a trio of investment pros field listener questions ranging from which ETFs hold Facebook stock and gold to how to use ETFs to play rising corn prices.

chart everybody loves etfs 2

"The ETF Store Show," sponsored by a local investment firm that uses nothing but, you guessed it, is one of the more colorful examples of the growing enthusiasm for these low cost and tax-efficient funds.

Originally designed to track broad market segments like the S&P 500, ETFs deliver the diversification of index funds. Yet because you can buy and sell shares all day, you get the trading flexibility of stocks.

While traditional mutual funds still hold far more money, ETFs are winning the popularity contest. Assets have doubled in the past five years to $1.2 trillion, and nearly 700 ETFs are poised to join the 1,486 you can buy today. The field now includes ETFs pegged to an ever-increasing number of market niches.

Institutions and individuals have long been fans. Now the most zealous converts to the cult are professional advisers. Three out of four use ETFs for clients, a 2011 survey by the Financial Planning Association found, vs. 40% in 2006. Driving this shift is disillusionment with actively managed funds, long a mainstay of the adviser business.

Making ETFs the go-to investment, however, has opened the door to a slew of potential problems, from mind-numbing complexity and new layers of fees to advisers "adding value" by jumping in and out of the market.

"What I worry about with ETFs is when a very nice passive style of investing turns into more active management," says FPA president Paul Auslander. "A lot of advisers are not trained in that capacity."

The ETF Store Show pros, though unabashed boosters, also strike a cautionary tone. "We think investors should focus on asset allocation and minimizing expenses," says host Nate Geraci, "rather than using ETFs as trading tools."

In this story, the second in a two-part series about the changing face of the financial services industry, you'll learn seven ways ETFs are making it easier for your adviser -- and you, for that matter -- to muck up your portfolio (Read part 1, "The Truth Behind Target-Date Funds," ). Plus, you'll find out the moves you can make to stay out of trouble and enjoy the benefits of one of the cheapest and best investments around.

Trying to outscore the market

You might think that switching from mutual funds to ETFs would simply mean new names on your account statement. Not necessarily. The shift to ETFs is also bringing about a change in how advisers manage your money.

In an era of low returns and high volatility, the strategy of settling on a few traditional funds and sticking with them can be a tough sell. It doesn't help that over the past five years 62% of actively managed U.S. equity funds fell short of the S&P 500, reports SPIVA Scorecard; 78% of foreign stock funds trailed their benchmarks.

The fix: Weave in and out of different assets in the hopes of delivering market-beating returns with fewer steep falls along the way. Nearly 60% of advisers have adopted this so-called tactical asset-allocation strategy, according to the FPA.

While shifting money is nothing new, ETFs, by allowing for quick trading among an ever-widening range of asset classes, are fueling today's vogue for staying nimble. "There are few things more frustrating than watching the market go down and having to wait till 4 p.m. to know the price of a trade," says Cincinnati adviser Nathan Bachrach, who has moved most of his clients' portfolios to ETFs.

Frustrating, perhaps, but the record suggests that patience can be more rewarding. Tactical asset allocation is, in the end, a form of market timing. And few pros or amateurs are very good at that.

In an analysis of 2000 to 2010 mutual fund returns, Morningstar found that investors, including advisers, typically bailed out of stocks at market bottoms only to pile in well after the next rally --and shortly before the next crash.

Related: 3 things to know about target-date funds

It's hard to imagine the scorecard will be much different with ETFs. Example: Between January 2010 and July 2011, right before gold prices peaked at more than $1,800 an ounce, $5.8 billion poured into SPDR Gold (GLD). Since then gold has fallen 15%.

Financial services consulting firm Cerulli found that in 2010 and 2011 mutual fund and ETF accounts run by fee-based advisers had average annual returns of 2.1%, far less than a 60% stock/40% bond mix, up 8%. "Advisers were better about lowering risk in down markets," says Cerulli analyst Sean Daly, "but didn't reinvest in time to catch the upswings."

Best move: Whether you use an adviser or go it alone, sort out a suitable asset allocation for your goals and risk tolerance first. Then rebalance periodically -- once a year is fine -- and you're done.

Searching for a new superstar

Not every adviser has the experience -- or time -- to dabble in a Chinese yuan ETF (or even less esoteric fare). So nearly half are turning over at least a portion of their portfolio management to outside managers, according to the FPA.

That outsourcing has brought about a boom in ETF strategy firms, which design and manage model portfolios for advisers to sell (for the most part, only high-net-worth investors can buy directly).

Ask how your financial advisor is paid

About 120 are in business today, compared with just 25 in 2008. The managers can have strong pedigrees. Windhaven, owned by Schwab, has been running ETF portfolios since 2002. AlphaSimplex boasts MIT finance professor Andrew Lo as chairman and chief strategist. Morningstar and Wells Fargo are players too.

Over the six months through March, Morningstar estimates that managed ETF portfolio assets grew by 34%, to $45 billion. And getting into a portfolio is becoming easier: Broker LPL, which has seen model portfolio assets rocket 73% since January, slashed its minimum investment from $100,000 to $25,000 in July.

Debbie Taylor, an adviser in Franklin Lakes, N.J., is relying on several ETF strategy firms, including Morningstar and BlackRock, to manage portions of her clients' money. "The investing world has grown so large that we could spend all day researching it," she says, "but there are managers out there who can do this in a better way."

What you'll find at these firms varies widely. Some portfolios are standard stock/bond mixes, rebalanced three to four times a year. Other firms take a more active approach.

Related: Asset allocation -- Fix your mix

"We manage the changing business cycles," says James Peters, CEO of Tactical Allocation Group. With advisers, tactical seems to win out. At Wells Fargo Advisors, the buy-and-hold strategic ETF portfolio has $500 million in assets; the two active ones have $3 billion each.

Often, what you're signing up for are complicated hedge-fund-like strategies with short track records. Managers use quantitative models or macroeconomic forecasts to make rapid trading decisions, all in the name of limiting losses or enhancing returns. Other portfolios whipsaw from one asset class to the next. The Tactical Equity Sector Rotation strategy from Braver Capital Management, described as aggressive, can invest 100% of assets in just three sectors -- or go completely into cash in extreme cases.

Your adviser may be no better judge of ETF portfolios than he is of the wider investing world. The tools to sift through them are only now becoming available. And if just a slice of your money goes into an ETF portfolio, that creates another planning challenge.

"Admittedly, some advisers have a difficult task," says Ken Courtney, senior manager, wealth management at TD Ameritrade Institutional, which runs sales platforms where advisers can buy portfolios. "These strategies are so tactical in nature that at times a manager can be 100% in cash for a month. How does that fit within the overall confines of a portfolio?"

Best move: Pose that question to your adviser if he suggests an ETF portfolio. Ask him to describe the strategy. If he can't do so in clear way, pass on the tip (or look for help elsewhere).

"You hear ETFs and think safe," says Robert Talbot, a professor at the University of San Francisco School of Law and founder of the school's investor justice clinic, "but there might be risks you don't understand."

Pinning hopes on fantasy stats

Mutual funds have been in business for decades. You have ample ways to see how they've fared over time. Not so with ETF portfolios, 30% of which are less than three years old, says Morningstar (which began keeping tabs on the group only last year).

Another new resource, a quarterly guide from iShares, lists returns for ETF portfolios with one-year track records. But the tools are far from comprehensive.

The past returns you do find aren't always what they seem: ETF portfolios with short track records may have theoretical historical returns. To get this, a firm will "back-test" performance, or calculate how the portfolio would have done had it existed in years past. That's disclosed, but mutual funds and ETFs themselves can't publish such data.

Building off of what's worked best recently is standard industry practice -- but a dubious way to invest.

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