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ETFs vie for business in crowded marketplace

Every year in January, South Florida hosts the Inside ETF Conference — the largest of its kind. What began ten years ago as a modest gathering of financial advisers has grown into a massive congregation which this year attracted over 2,200 participants and scores of vendors. In its early days, only a handful of Exchange-Traded-Fund vendors existed but this year's conference occupied three floors in the Diplomat Hotel where dozens of firms compete for investor attention in what has become a rather crowded marketplace.

In a previous column, I wrote about the rapidly growing ETF industry which has been firmly overtaking the traditional mutual business (“The ETF Revolution — The Royal Gazette, September 15, 2015.) Since then, the trend has only accelerated. According to London-based ETFGI LLP, 270 global providers now control more than $3 trillion in assets held within more than 6,000 individual funds. ETFs have been marketed as relatively liquid, low-cost, tax efficient index funds typically focusing on “passive” investing. Aggressively promoted by the largest banks and brokerage houses, assets values have soared. Unlike traditional mutual funds, ETF shares trade all day long with the price moving up or down, at least theoretically, in lockstep with the movement of a specified index, such as the S&P 500 or MSCI World Stock Index.

What's new this year is the proliferation of so-called “Smart Beta” strategies which are designed to replicate factor-based quantitative investing models. Quant investing is designed to eliminate human emotions from the decision-making process by implementing a rules-based methodology wherein a “black box” computer program makes all of the buy and sell decisions. The underlying models are based upon back-tested results which have shown successful performance over time. Typical factors include quality, value and size. The smart beta category presently holds about $500 billion in assets.

Fixed income is another sector of the ETF universe gaining momentum. According to one conference speaker, more than 300 bond ETFs now exist and collectively, these vehicles generate over $7 billion in daily trading volume. One advantage of fixed-income ETF's is allowing smaller investors to access a market where size really matters. Investors in this space may participate in all aspects of the credit markets including investment-grade, high-yield, tax-free and floating-rate securities.

Then there are the “fun” ETF's, with clever tickers. “JETS” buys you a basket of airline stocks; “SLIM” invests in companies which tackle obesity such as Weight Watchers International; “WSKY” is the ticker for companies dealing in liquid spirits; and more recently, “SHE” is the ETF for companies run by women. These funds are relatively small in size and tend to attract a different type of investor.

Another trendy class of funds are those purportedly investing in companies with “sustainable business practices”. Environmental, social and governance factors, or “ESG” strategies fall into this group. ESG sustainable investing encompasses a broad spectrum of corporate government where an index designer selects only those companies deemed to be ethical, efficient, and long-term focused.

Unfortunately, there are no hard and fast rules as to what exactly makes a business “sustainable”. But that hasn't stopped a flood of new market entrants from jumping into the latest hot sector. Passing by one ESG vendor's booth, I picked up a fact sheet which showed the fund allocated the largest amount of their holdings to the conventional oil and gas business.

The sales representative apologetically informed me that, for these selections good corporate governance more than compensated for the massive amounts of toxic hydrocarbons the energy extraction companies regularly release into the environment. I guess beauty is in the eye of the beholder.

Investors should be wary of smaller, trendy funds. A large and growing number of newer ETFs never reach critical mass and are therefore forced into dissolution.

While these shares are ultimately backed by the value of the underlying securities, the workout can be a messy and expensive process. Last year, the industry shut down a record 108 ETFs, taking the total toll since 1993 to 568 vehicles, according to Morningstar.

The irony of the ETF industry's proliferation, is that rather than making things easier by providing investors the simplicity typically associated with passive investing, the process has actually become more complicated. Investors can now be more confused about which of the over 6,000 funds to select. For example, over the past five years the largest ETF by market value, “SPY” has outperformed the fourth largest fund, “EFA” by a whopping 59 per cent! SPY replicates the performance of the S&P 500 and EFA tracks the performance of developed markets outside of North America.

Selecting the right individual ETF or portfolio of ETFs is a critical decision and employing a more dynamic research and monitoring process usually yields the best results. For this reason, a growing herd of financial planners have carved out a niche advising clients on ETF strategy. Value is added here through asset allocation, setting goals and benchmarking performance.

For me the best part of the conference is hearing from exceptional forward-thinking strategists such as Wharton professor Jeremy Siegel and bond veteran Jeffery Gundlach, who both presented last year. This year's line-up included Bob Doll of Nuveen Investments, Dennis Gartman, editor of the Gartman letter and my friend John Mauldin of Mauldin Economics. Also informative were a number of active managers who hosted breakout sessions which stood out from the crowd.

Some active managers are exploiting the inefficiencies of the ETF paradigm to their advantage. For example, quite frequently an entire market sector is bashed by a particular news headline or presidential tweet.

Because ETFs represent baskets of securities with no intelligent oversight, some individual securities inside the basket, not fundamentally impaired by the news, are often taken down along with the others.

Across-the-board programmed dumping typically creates opportunities for those who have done their homework. During these times, retail investors with trigger fingers over their online brokerage accounts are effectively throwing the proverbial babies out with the bathwater.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

So much choice: ETFs cover numerous sectors and categories and are having an increasingly large influence on financial markets

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Published February 21, 2017 at 8:00 am (Updated February 20, 2017 at 11:38 pm)

ETFs vie for business in crowded marketplace

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