Trends in Advisors' ETF Decisionmaking and Usage
How advisors use these increasingly popular investment choices in their practices

  
As the markets continue to gyrate wildly, advisors are increasingly turning to exchange traded funds (ETFs) for their flexibility, transparency and lower expense ratios. In fact, nearly all advisors (83%) who took part in  the Rydex AdvisorBenchmarking November survey  believe that ETFs will be a primary investment vehicle for them in 2009. And while ETF assets have fallen 12.9% over the past 12 months to $495B from $568.7B, the number of ETFs on the market has climbed 16% during the same period—with greatest growth in global/international offerings (According to the Investment Company Institute, there are now 226 ETFs in this category vs. 160 a year ago–a 41% increase). Some industry pundits even see ETFs encroaching on mutual fund territory. In fact,  an April 2009 Lipper report notes “Sales of new ETFs appear to be replacing sales of new mutual funds over the past several years. ETF launches now exceed 30% of all new (fund) products.”

Decision Criteria for ETF Investing     
With the number of ETFs on the market standing at more than 700, selecting the right ETF for a client portfolio is more daunting than ever before. Advisors use a number of factors in selecting ETFs, with investment objective/index exposure ranking as the most important criteria according to 59% of advisors surveyed. The second and third most important decision-making criteria are fees (46%) and benchmark tracking accuracy (35%). It’s interesting to note that more than a third of advisors (38%) do not find Morningstar rankings (or rankings from other research providers) important as a decision criteria for investing in ETFs. Advisors also see provider name as a “nonimportant” or “neutral” criteria in selecting an ETF (38%).

Advisors' Selection Criteria for Investing in ETFs

When advisors research different ETF choices, more than half (55%) use the Morningstar ETF center, 40% use the Yahoo! Finance ETF center and about one third (34%) use ETF provider sites. Exchange web sites (25%)—such as the NYSE and NASDAQ, The Wall Street Journal ETF screener (24%) and Barron’s (18%) also ranked highly.

Most of the advisors (55%) surveyed review the ETF universe and their clients’ ETF holdings monthly.

Frequency of Reviewing ETF Universe and Clients' ETF Holdings

Exchange Traded Funds vs. Exchange Traded Notes
In recent years, the next generation of ETFs has entered the scene–exchange traded notes (ETNs). First created in 2006 by Barclays, the number of ETNs has grown to 87 in February 2009 from 39 in February 2008 (Source: National Stock Exchange).  ETNs are now also issued by Morgan Stanley, Credit Suisse, UBS and Goldman Sachs. ETNs are similar to ETFs in that they trade on an exchange like a stock and can be shorted and track an index, but the similarities end there. The primary differences between the two are:

1. More exotic exposure. ETNs oftentimes provide exposure to more exotic investment choices—such as commodities and futures—than more traditional ETFs.
2. Product structure and credit risk. ETNs and ETFs have different product structures. ETNs are structured products created as a senior debt note by an issuing bank, meaning that the ETN is dependent on the credit of the underlying bank. In contrast, ETFs represent ownership in the actual underlying product and are not subject to such credit risk.
3. Tracking. ETNs do offer a distinct advantage over their ETF counterparts—they track their product/index exactly (minus fees) while ETFs are subject to tracking error.
4. Taxes. ETFs must pass on yearly capital gain and income distributions, which are taxable events for the holder. ETNs do not make these distributions so the investor can defer taxation until the ETN matures or is sold. However, because not all ETNs are subject to the same tax treatments, it’s essential that the accountants who work on your client accounts be well-versed in the differences.

Accountants aren’t the only ones that may lack a thorough understanding of the differences between ETFs and ETNs.  According to our research, only 8% of advisors rated themselves on the differences between ETNs and ETFs as “very knowledgeable” while 74% of advisors said that they are “knowledgeable” or “somewhat knowledgeable on the differences.

Advisors seem most confident in their knowledge levels on the tax consequence differences between the two products, with almost all of them (76%) believing that they are at least somewhat knowledgeable on this character difference.

Advisors are less confident in their knowledge of credit-risk differences, exposure to difficult markets and tracking-error differences.

Knowledge Base of the Differences Between ETNs vs. ETFs

With the increased popularity in exchange traded funds and projections for the ETF market to reach the $1 trillion mark (per Reuters, Feb 2009) in the next two years (from its current global assets of $725 billion  at the end of 2008, according to Strategic Insight), having a solid understanding of the differences in these products and ensuring that your clients have fundamental knowledge is crucial.

And this may mean an opportunity for advisors to help get their clients up to speed and better educated on ETFs. According to a survey by Cambridge, Mass.-based Cogent Research LLC, of 4,000 investors, 49% of so-called self-directed ETF owners (or individuals who invest for themselves—without the help of a financial advisor) show more awareness and commitment to exchange traded funds than their advisor-directed peers.

With increasing interest in ETFs and ETNs, advisors who gain an in-depth knowledge of the differences between the products will be well poised to better help clients in today’s widely fluctuating market—and to continue building their business.

Take the 2009 AdvisorBenchmarking survey and benchmark your practice against your peers. The first 100 survey participants will receive the book:Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E. Woods. All other survey participants will receive a $5.00 Starbucks gift card.