The ETP Decision Is Not All or None

Journal of Financial Planning; June 2014


Rick Ferri is author of The ETF Book. He continually monitors and evaluates the latest trends related to index funds and ETFs. His research appears frequently in many major media outlets, including The Wall Street Journal, Financial Times, New York Times, and Barron’s.

Shoebox design has not changed in 50 years. Shoeboxes are still the same shape, made of the same flimsy cardboard, and hold one pair of shoes. The colors and lid designs do vary among companies, but it’s not a big deal for shoe buyers. We’re only interested in what’s inside the box. 

The expansion of exchange-traded products (ETPs), which include ETFs, has provided investors and advisers with more choices. These diverse products have helped push down costs across the industry, and provided better access to previously clumsy asset classes such as precious metals and commodities. These are good things. 

As the ETP market expanded, some companies began promoting the idea that an all-ETP portfolio was a better approach to investing than all mutual funds or a combination of both. This message spawned an entire industry devoted to the all-ETP portfolio. Morningstar tracked 648 all-ETP strategies from 153 adviser firms with assets totaling $96 billion through December 2013. Internet-based “robo advisers” are gaining both momentum and assets with their online all-ETF portfolios. Each wirehouse brokerage firm now has its own model ETF portfolio strategy.

I see the all-ETP portfolio as the wrong approach to investing. It’s like buying shoes based on the shoebox rather than what’s inside. I believe advisers should give more thought to the risk exposures they’re seeking to put in a portfolio and the different ways of accessing those exposures rather than deciding to go with all ETPs first and limiting their clients to only those products. 

My way of selecting investments for client portfolios starts from a macro view. Once the overall risk level is decided using a broad asset allocation approach, I seek the unique risk within each asset class to provide a future risk premium and to potentially offset other risks in a diversified portfolio. An analysis of the fundamental differences within asset classes is at the essence of this work. Correlation analysis helps make this determination. My book, All About Asset Allocation, outlines this approach. 

The next step is to analyze the indexes that track each asset class that I’m seeking. Many different types of indexes have been introduced in recent years, and that has made this analysis more complex. It’s best to have a simple model to work from. My analysis starts with the broadest capitalization-weighted index I can find. This provides the purest form of market risk, or beta.

After an index is selected, I research the products that track the index. Sometimes these products exist and sometimes they don’t. When one exists, it might be an ETP or a traditional mutual fund, or there may be more than one product available and more than one structure. I’m not concerned if the product I select is a traditional mutual fund or an ETP. What matters is the diversification, overall risk exposure, the cost per unit of risk, liquidity, and tax efficiency in some cases. 

My search doesn’t stop with index products. On a rare occasion, there are actively managed mutual funds that represent an asset class better than an index product. Municipal bonds are a good example. Vanguard has actively managed municipal bond mutual funds that are more diversified and lower cost than municipal bond index funds or ETFs. A firm commitment to index products or a narrower ETF-only commitment would miss this opportunity.

After all the work is done, my portfolios end up as an eclectic group of ETFs, open-end index funds, and some actively managed open-end funds. They were selected for the risks that these products track, the cost to track those risks, liquidity, etc. 

My decision to invest has never been about the box it comes in—it’s about what’s inside. The growth in the ETP industry gives us more choices, and that’s good for our clients. The disadvantage is that more choices mean more time needed for analysis. But, that’s what makes us professionals.

Investment Planning