Two is a tour through the “ETF toolbox” with me as your tour guide. We will look at each asset class including equities, fixed income, and alternatives. We will spend some extra time in hot areas such as smart beta, currency hedging, China, gold, and liquid alts. The book will end with some parting thoughts from me as well as some resources for additional and ongoing education.
Now that we got that out of the way, let’s get started!
SECTION I
The ETF Phenomenon
CHAPTER 1
Why Are ETFs So Popular?
They say that as a customer you can only get two of these three things: fast/good/cheap. If it’s fast and good, it isn’t cheap. If it is good and cheap, it isn’t fast. And if it’s cheap and fast, well, it probably isn’t that good.
Turns out, I have found two things that prove this wrong: Vietnamese restaurants and exchange-traded funds (ETFs). Those are two times when fast, good, and cheap all tend to exist in wonderful harmony.
How this can happen requires a bit of background into what an ETF is.
Essentially, an ETF is the marriage of an index fund (passively managed with low-costs and diversification) with the trading features of a stock (intraday trading, price transparency). That is how most people know them. And that is true on a base level. But that is only half the story. Thanks to the ingenious way ETF shares are created and redeemed – something we will explore in Chapter 3 – an ETF has additional qualities that make it rise above the blunt definition of “a fund that trades.” I tend to agree with some in the industry who have called ETFs a “disruptive technology.”
As an analyst who has covered everything from mutual funds to hedge funds to closed-end funds, I have been amazed at the sheer number of advantages that ETFs offer up. They take many evolutionary steps forward and as such are fast becoming the investment vehicle for the twenty-first century.
The best way to support this lofty description is to just dive into the advantages. These are the things that make them fast, good, and cheap. This isn’t to say they are perfect. And there are many things you need to watch out for – which we will go over throughout the book – but they – like other great technologies – offer up several benefits in one shot that can make life easier.
Low Cost
ETFs are cheap. The asset-weighted average fee is 0.30 percent, which is less than half the cost as the asset-weighted average active mutual fund fee of 0.66 percent. And when you look at the top 20 largest ETFs – where a lot of the institutional money gravitates – the average fee is 0.19 percent, as seen in Table 1.1.
Table 1.1 Fees for the Top 20 Largest ETFs
Source: Bloomberg
And the good news is costs keep coming down. Some call it a fee war, but I call it “fee innovation.” After all, it is a technological marvel that issuers can offer these products at such low costs. At this point you can get a deep and diverse all-ETF portfolio for a blended fee of about 0.08 percent.
When the Schwab U.S. Broad Market ETF (SCHB) cut its expense ratio in 2013 from 0.06 percent to 0.04 percent, it took cheap to a whole other level. Since then, it cut it to 0.03 percent along with the iShares Core S&P Total U.S. Stock Market ETF (ITOT) SCHB and ITOT hold over 2,000 large-, mid- and small-cap stocks, that comes out to about 700 stocks per basis point in fees. SCHB and ITOT are leading what many are calling a “race to the bottom.” Some of the leaders in this race to the bottom can be seen in Table 1.2.
Table 1.2 A Race to the Bottom in ETF Fees
Source: Bloomberg
And the reason I listed this as the first advantage is that investment costs are one of the most important variables you can control. Performance is fickle, but costs keep coming every day, rain or shine.
When it comes to the fee war, low-cost king Vanguard in particular should be given most of the credit. When they enter a category with a new ETF, it is like Wal-Mart coming to town. They cause a gnashing of teeth from the other issuers, who typically respond by lowering their fees as well. This “Vanguard Effect” is evidenced in the fact that in categories where there is no Vanguard ETF, such as micro-caps or junk bonds, the cheapest ETF is 3 to 6 times more expensive than categories Vanguard has an ETF in. In other words, the fee war is more about the fear of Vanguard than anything else. In the end, though, the investor is the ultimate winner in all of this.
For investors used to buying pricey mutual funds, ETFs’ low cost is a godsend. But for massive institutions with loads of money, ETFs can actually be expensive compared to passive separately managed accounts (SMAs). They can get an SMA that gives them index exposure for next to nothing and have it custom-made for their needs. It is the equivalent of getting a tailored suit for $10.
“If I’m a large institution, I can go direct to a service provider and say, ‘I’m going to dump $10 billion on you and you’re going to give me [S&P 500 exposure] for one basis point.’ People are going to whine and complain, but guess what happens? The manager is going to say, ‘Yes, sir, we’re going to do it for one basis point.’”
And for many large institutions, every basis point translates into a lot of money. In the case above, let’s say the institution paid one basis point for the SMA instead of 0.03 percent for SCHB or ITOT, the cheapest broad-market ETFs in the world. Those two basis points equal $2 million a year. That amount could be several fireman pensions that are now funded. This is why the very largest institutions negotiate over every basis point, and even dirt-cheap ETFs lose if fees are the only criteria.
Like mutual funds, SMAs get more expensive the less you can pony up. So it isn’t a black-and-white issue, but certainly at the larger institutional fund levels, they can be a cheaper option.
However, cost isn’t the only consideration for an institution, and that brings us to our next advantage.
Liquidity
Liquidity may not be the most attractive feature of ETFs for retail investors, but for institutions it is beloved. ETFs trade throughout the day like stocks. If an asset manager wants to buy mainland China at 2:13 P.M., they could punch up the Deutsche X-trackers Harvest CSI 30 °China A-Shares ETF (ASHR) and put in an order and own it within seconds. They could then sell it a minute later or year later.
This is much more expedient than using a mutual fund or hedge fund or owning the aforementioned SMA. None of those things can be gotten into and out of so quickly and easily. That’s why the liquidity advantage is really about freedom – something institutions don’t have a ton of. With ETFs you can buy and sell whenever you want without having to ask anyone’s permission. Institutions in particular value this trait because much of their existence is slow moving and waiting for boards to approve things and dealing with redemption schedules of managers and the like.
“It’s less paperwork. There are no gates. It’s just easy to do business with ETFs because they are exchange traded.”
Since the financial crisis of 2008, institutions have been aware of the importance of liquidity in a portfolio. When it comes to liquidity, ETFs are now right up
