ETF Innovations: Good (or Bad) for ERISA Plan Sponsors?

At last week’s The Art of Indexing Summit 2010 at the Westin in New York City, industry experts gathered to talk about the state of the indexing industry. A round robin panel opened the proceeding. The group spoke of upcoming innovations in the ETF marketplace. Dr. Seddik Meziani, Professor of Finance and Economics, Montclair University – who also chaired the Summit – acted as moderator for the panel. Panelists included: Vinny Catalano, President and Global Investment Strategist, Blue Marble Research; Alan Rosenfield, Managing Director, Harmony Asset Management; and, Thomas Heck, Chief Investment Officer, Ball State University Foundation. Among the more interesting points they pondered including the idea the ETF industry – if it becomes too popular – might be heading over a cliff. Might be. Fiduciary News takes you right into the chat and we’ll let you decide.

Here’s a summary of the opening panel discussion:

Meziani: Innovation can be a good thing, but it can also be a bad thing. We have a lot of ETFs out there. What makes a good ETF?

Catalano: You want the ETF to do what it’s supposed to do – have a low tracking error; have sufficient volume (so we can be confident the ETF will be around for a while).
Rosenfield: The real key is based on the client – the underlying investor. First and foremost, you need to truly understand the client. ETFs were a problem in the flash crash, but only if you traded them. You need to look at the structure of the ETF. Fees are important – when everything else is even – but fees are the last thing I look at.
Heck: An ETF must be a low cost way to accurately represent a market.

Meziani: What do you think of the proliferation of ETFs?

Catalano: Professionals use ETFs to fill in a sector in a portfolio. Retail investors don’t do this. They chase performance.
Rosenfield: ETFs are a great tool. But, typical of Wall Street, things are made to be sold, so we need to expect that at some point ETFs will be oversold. You need to look at it for what it is and ignore all the noise.
Heck: I want my ETF to be very reliable. I’m not interested in something new or real niche-y.

Meziani: Most of us are new to the proliferation of ETFs. It has its positive and its negatives. How can you help the audience understand this?

Heck: On the plus side you have the ability to do more fine tuning. On the negative side, if there’s a total amount of dollars that is going into the entire ETF market, these new products may impact the liquidity of the more reliable ETFs.
Catalano: I’d like to see more, especially like ETFs based on hedge-fund replication strategies. They key thing is liquidity.
Rosenfield: The advantage is the ability to focus on specific areas. On the other side, you have to understand what the game is and who you’re playing against. There’s a lot of potential danger and a lot of counter trading that could take advantage of you. The other negative is that you might get exposure to inappropriate assets. For example, currencies and futures have evolved from being a hedge to being speculative.

Meziani: How do ETFs affect the advisory business?

Rosenfield: I think it was huge. The basis upon which we built our firm was ETFs. It allows for a smaller RIA to compete with the big guys. This is important because a lot of the big guys do second-rate work. With ETFs you can get exposure to markets you’d otherwise need a slew of analysts for.
Catalano: The unfortunate aspect of ETFs individual investors don’t take advantage of is to learn market conditions by watching ETFs.
Heck: It has an impact on investment committees too. The focus is now more on asset allocation instead of manager selection.
Rosenfield: There’s one issue with ETFs – you can’t easily evaluate them like you can with individual securities.
Heck: It’s also difficult to conduct the due diligence on the underlying managers.

Meziani: People have been saying that the ETFs industry will be the leader of the index industry. But ETFs is still only a fraction of the mutual fund market because they haven’t cracked the retirement plan market. Can ETFs crack that market?

Catalano: This is more an administration question than an investment question. Because ETFs are treated as an individual stock, you risk opening the door to all individual stocks.
Rosenfield: It’s happening. Things have changed because Fidelity, Schwab, etc… are the custodian of these retirement plans, it’s easier to place ETFs into them. The key issue, though, is participant education.
Heck: If ETFs will take over the index market, then ETFs will be the only way for those plans to get the index funds.

Q: (for Vinnie regarding letting ETFs being fruitful and multiplying): When will we approach ETF-itis?
Catalano: I don’t think we’ll ever get to that point. As opposed to individual stock-it is, which is a concept of diversification.

Q: Do you think that another advantage of the proliferation will be the further reduction of fee?
Rosenfield: It’s possible, but, like I said, I’m less concerned with fees.

Q: It’s hard to look under the hood of an ETF. How do you do that?
Catalano: It’s more applicable to understand the general index or economic sector that the details of the actual ETF. Go to Yahoo Finance and run a report.
Rosenfield: Bloomberg is very good for fixed income, but it’s also the only source where I can tear apart an ETF and analyze the individual holdings.

There you have it. The bottom-line appears to be while ETFs may be useful as part of broader portfolios like one sees in pension plans and profit sharing plan (and less so in 401k plans), as always, caveat emptor.