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 (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.