Why exchange-traded funds could alter the investment landscape

Earlier this week, Institutional Investor hosted a conference titled Exchange Traded Funds for Financial Advisors, Wealth Managers and Hedge Funds. (I gave a short talk outlining how hedge funds could better use ETFs.)

Here’s what was most surprising about the conference: almost all the speakers completely failed to address four critical ETF-related issues. Here they are:

1. Will financial advisors and traditional brokers be put out of business by the combination of ETFs, low-cost online brokerage fees and automated, online asset allocation and rebalancing? I’ve already described Ameritrade’s Amerivest program as the killer mass-affluent retail investing product. Yet the financial advisors at the II conference were swimming in complacency, as though they expect to be able to bill hefty asset-based fees for simple retirement planning and asset allocation services for ever. Even Jonathan Clements, who writes the Getting Going column for the Wall Street Journal, has failed to grasp the impact of technology and platform-independent financial instruments on retail investing. He berates his readers for failing to diversify, failing to pick low-cost index funds, and failing to rebalance. Yet he hasn’t acknowledged that Ameritrade now offers all of these in a single account, that E*Trade is now the leader in low-cost index funds and is the only company to offer mutual fund fee rebates, and that the online brokerages will continue to drive down costs. Instead, Clements continues to quote William Bernstein, whose index-fund-based asset allocation advisory service could be put out of business by the online brokerages in the next decade. FAs and brokers watch out!

2. Will ETFs survive the recent competitive onslaught from index mutual funds? Over the last few months, we’ve seen the beginnings of a vicious price war in the index fund business. E*Trade cut fees; Fidelity undercut E*Trade; and E*Trade cut its fees again to reclaim the title of lowest-cost index fund provider. Why are they doing this? (a) Because neither Fidelity nor E*Trade have a large enough index fund business to worry about cannibalizing their current revenues. (b) Because both firms realize that index mutual funds are stickier than ETFs (you try moving an E*Trade index fund to another firm), and therefore cement their customer relationships. In other words, the underlying structure of the business incentivizes the index mutual fund vendors to keep cutting fees. And if an index mutual fund has lower annual expenses than an ETF, why would you choose to go with the ETF and incur trading costs and spreads too? Yet nobody at the II conference addressed the fact that the competitive landscape for ETFs has recently changed - dramatically.

3. Why are the ETF sponsors pushing the wrong products? There are now too many U.S equity ETFs. Let’s be honest: who needs another sector ETF or style ETF? But Vanguard has continued to launch these ETFs, and Barclays recently launched a complete set of ETFs based on the Morningstar style boxes. (Yawn.) What the market actually needs are new ETFs that cover asset classes that are largely neglected by the index mutual fund industry, and are attractive to long-short traders: a U.S equity micro-cap ETF, commodity ETFs, foreign bond index ETFs, foreign real estate ETFs… You get the idea. Once those ETFs are available, anyone will be able to run a global macro fund from an online brokerage account.

4. Could the creation of ETFs impact underlying asset prices? The U.S gold ETFs have been in process for too long. (Gold ETFs are already available in the U.K and Australia.) Once they are approved, their impact could be dramatic. Think of it this way: retail investors cannot buy gold without incurring hassle (finding someone to store it), excessive commissions, and unfavorable tax treatment. A gold ETF solves those problems in one shot. Now ask yourself this: Given the risk that the dollar could decline significantly over the next few years, would it make sense for retail investors to put, say, 2% of their assets in gold? Ameritrade would add a gold ETF to its Amerivest portfolios, as would every other asset-allocator. But if 2% of total U.S investment assets flowed into gold, the impact on the price would be dramatic. And could the new iShares China ETF (NYSEARCA:FXI) imact the prices of the underlying stocks, given the narrowness of the index (only 25 stocks) and the possiblity that investors could flood into the ETF if a Chinese currency revaluation looked imminent?

These four issues seem to be important. But instead of discussing them, the speakers at the II conference devoted their time to repeating the mantras of indexing and the tax benefits of ETFs. I’m not sure why.

Links and article tools:
I wrote about Ameritrade's Amerivest product here; that article has links to other ETF-related articles.

Sign up for (no spam guarantee and easy unsubscribe) monthly email notifying you of new articles from Seeking Alpha and Tech Uncovered here.

Email this page to a friend (uses your own email program so you can add people easily from your address auto-complete or address book).