The favorite strategy of long-term investors and their financial advisors is about to get more complicated.
Exchange-traded funds, with lower costs and built-in ties to benchmarks like the S&P 500 or themes like technology, are the go-to option for independent advisors helping clients, particularly younger ones, plan for major expenses like college, home-buying and retirement. The funds trade on exchanges like regular stocks and offer exposure to the broader market or segments by “passively” mimicking an index or other factor.
Plus, they carry a particularly generous tax benefit: Unlike mutual funds, ETFs can switch up their holdings without socking a buy-and-hold investor with a capital gains bill on paper profits for individual trades, even if the fund eventually posts a loss.
More than half of registered independent advisors, or 52%, make
But this year, there’s going to be a lot more on the ETF menu to digest, thanks to several factors that add a twist to their passive investing method.
First, many indexes are concentrated in a handful of large technology companies. With giants like Apple, Microsoft and Google owner Alphabet only getting bigger, index funds that hold them are less diversified and thus less insulated from risk — a concentration that goes against one of the core tenets of prudent investing.
“Diversification, our industry’s one universal risk management tool, has now become opaque,” wrote Lily Taft, a portfolio manager at Main Street Research, a $1.5 billion, fee-only wealth management firm in Sausalito, California, and Greenwich, Connecticut, in an emailed Jan. 13 research
Second, new breeds of higher-cost ETFs that run on secretive strategies or follow unproven benchmarks, like those for sustainability, are making a play for investors’ wallets. At stake with many of these so-called active ETFs — which have a fund manager choosing stocks and blur the line between the low-cost passive approach that’s synonymous with traditional index funds and the higher cost of stock picking — are a veil of secrecy around holdings and potentially higher costs for investors. Around 60% of the nearly 500 ETFs launched last year, a record, are actively managed, according to Morningstar data
On the tax front, a top Congressional leader called last September for the tax benefits of ETFs to be revoked and for investors to owe capital gains levies anytime a fund generates a profit by switching up its holdings. The
But while the tax benefits of the $5.4 trillion U.S. ETF industry appear set to stay, Planet ETF is going through some big changes.
The most basic funds track a broad index like the Dow Jones Industrial Average or Nasdaq 100 top non-financial stocks. Other funds track specialized benchmarks that mirror specific themes, like the
But the no-brainer, unemotional proposition of tracking a benchmark is getting more complex as new ETFs that resemble their higher-cost mutual fund cousins flood into the market. So-called active ETFs don’t sit back and passively mirror an index or a theme, but instead have a portfolio manager actively picking stocks within a given theme or sector that she hopes will beat an outside measure. Active funds are more expensive because they involve a human, not a computer algorithm, to do the work. Some of the new active funds are mutual funds that have converted or plan to switch to ETFs, like the $10 billion in mutual funds that J.P. Morgan Asset Management
What’s new is that the workings and holdings of active funds can be partly or wholly opaque to protect the secret trading strategies of the fund managers overseeing them. And that can leave an advisor and his client not knowing what they’re invested in. A Jan. 13
The new active ETFs are largely focused on investing in popular themes, like emerging technologies, sustainability and cryptocurrencies. That makes them a way for investors to buy into a trend without picking individual stocks. With wealth management increasingly focused on custom, personalized investing plans, they might seem an ideal fit for independent advisors. Broadridge’s ETF 2020 Outlook
Active ETFs took off after a 2019 SEC
At the time of the ruling, two SEC commissioners sounded a