In praise of ETFs and financial democracy

Author: Daniel Beckerman, Beckerman Institutional

Exchange traded funds have become one of the fastest growing segments of the financial markets. When ETFs were first being introduced they were sold as a simple way to access broad stock market strategies. For example, if more than half of active investment managers underperform the S&P 500, why not just own the S&P?

So you had some of the earliest ETFs introduced like the SPDR S&P 500 ETF Trust (SPY), SPDR S&P MidCap 400 (MDY), SPDR Dow Jones Industrial Average ETF Trust (DIA), and PowerShares QQQ Trust series (QQQ). Here one could invest in broad market indexes to get exposure to the S&P 500 index, the Mid-Cap index, the Dow Jones Industrial average, and the technology heavy Nasdaq.

One of the major differences of the ETFs versus index mutual funds is that ETFs can be bought and sold throughout the trading day. Mutual funds’ indexing vehicles and actively managed funds, on the other hand, have to be bought and redeemed at the end of the trading day. Therefore, ETFs have become very popular among more active traders and institutional investors.

ETFs also tend to have low costs when compared with other kinds of investment funds. They are often composed of broad market indexes that are primarily long term holdings. Therefore, on average, you have better tax-efficiency than in mutual funds.

Since SPY was introduced in 1993 followed by a handful of others, the ETF industry has grown exponentially. They have expanded to include all kinds of narrow market segments such as utilities, technology, and transportation. There are ETFs that use leverage. Do you want to bet with triple leverage on a daily basis against the 10 year treasury note? No problem, there’s an ETF for that.

Now, there are even fundamentally weighted ETFs that can be competitive with mutual funds.  ETFs can invest in companies based on factors such as dividends, rates of growth, returns on equity, and price to earnings ratios. These are traditionally factors that only active managers would consider.

The manager of the world’s largest bond mutual fund (Pimco) recently launched an ETF version of their flagship Total Return Bond Fund. It used to be that ETFs were where you could go for tax efficiency and broad market exposure. Now, you can get much more versatile and even granular within a portfolio.

A problem that I have always had with broad market indexes is that they were originally cap weighted. Whatever the biggest companies were within an index, that was my largest exposure. So, when you had the technology bubble in the 90s or financials running up prior to 2007, you were overweight those sectors if you were in those broad ETFs. Wherever the overvaluation in the market may be, the cap weighted indexes are vulnerable to it.

But now one can invest tactically and fundamentally in order to solve this problem. I have been investing with some of the WisdomTree offerings for a while. Here you can gain exposure to broad segments of markets with a fundamental twist such as weightings based on dividends or earnings.

There are also some innovative ETFs such as WisdomTree’s Emerging Market Local Debt EFT (ELD), which is an investment that holds bonds across different emerging market countries in their local currencies. This may be an attractive holding given that interest rates are quite low in the developed countries. Also, we have the European debt crisis and the looming fiscal cliff in the US.

This is a different background to the financial markets than what we experienced in the past. In past periods of global financial instability, it was usually the smaller emerging market countries that were getting into trouble. Today, it is these big developed countries like Spain and Italy that have high debt levels and severely contracting economies.

In response, we have seen a highly accommodative central banking policy in the US and more recently in Europe including low interest rates and quantitative easing.   There is always a risk of inflation down the road or a dilutive effect of currency with this kind of action.  Accessing the emerging market currencies allows investors to mitigate that risk.

ETFs today are also being used to access even less traditional strategies like convertible bonds and managed futures. There are a whole slew of alternative ETFs coming to the market.  It used to be that individual investors were shut out of these alternative categories because they couldn’t get access to the hedge funds. Now you have this democratization taking place in finance where asset classes are becoming more accessible.