The Evolution of ETFs

 Blackrock, a leader in the ETF space, has begun to offer a target date product that gradually converts a portion of the allocation to an annuity that will provide a stable income in retirement. Some companies have adopted this product as the default option in their company-sponsored retirement plans. See article here: WSJ.

Single Stock ETFs

The primary purpose of ETFs is to create easily traded baskets of underlying securities. So, why would single stock ETFs exist since investors could simply invest in the underlying security directly? The answer is that single stock ETFs are generally either levered or inverse funds. See article here, CNBC.

Flight to Safety

As a response to significant risk, investors often undertake a "flight to safety." To benefit from this behavior, Direxion recently launched FLYT, which is an ETF based on a flight to safety strategy. The investments are split among utility and gold stocks, as well as bonds. You can find more information here, Direxion.

ETF Growth Continues

ETF assets reached a new milestone, passing the $4 trillion mark. Amazingly, the growth from $3 to $4 trillion took only two years. See article here, Investopedia.

Active Managers Underperform Again

Active managers are supposed to do better in volatile markets, such as in 2018. However, the results are in, and a lower percentage of active managers outperformed the market -- just 38%. Over the past ten years, this drops to 24%. See article here, WSJ.

Passive Funds Continue to Grow

As of the end of 2018, passively managed funds now represent about 48 percent of fund investment, and Bloomberg is reporting that they expect passively managed funds to overtake actively managed mutual funds by the end of 2019.

Zero-Fee ETFs?

The management fees on most mutual funds and ETFs have fallen significantly due to competition in the space. With some as low as .03%, can it go any lower? The answer is yes, as some are predicting a fee of 0% (or even a negative fee, with investors being paid to use certain products). How is this possible? With more assets, economies of scale allow for a lower fee. Further, asset managers can generate revenue on the underlying securities, primarily through lending to short sellers. So, who will win the "race to zero?" See article here, WSJ.

Cost Matters

Research continues to show that low fees are the most important driver of a fund's future alpha. Vanguard has a nice piece describing their findings. Click here to see the article.

Mutual Fund Performance Persistence

Do high performing mutual funds continue to perform well? This is one of the biggest questions among both investors and researchers. Recently, the WSJ (see article here) studied how funds with five-star Morningstar ratings perform in the years following their high ratings. The results suggest that performance does not persist.

An Update on Levered ETFs

Levered ETFs are designed to track a particular benchmark, but in an exaggerated fashion. For example, the Pro Shares Ultra S&P500 (SS0) is a 2X fund, meaning its performance should be twice the level of the index. However, this performance only matches short term. In particular, since volatility reduces compounded returns, levered funds "lose" performance through time. In fact, some funds may actually produce a negative buy-and-hold return during even if the underlying benchmark was positive. Unfortunately, many retail investors are flocking to these funds without understanding their risks. (See article here, Reuters.) In recent events, the SEC just announced approval of a quadruple-leveraged ETF, which will further exaggerate the issues described above. (See article here, Reuters.)

All Exchange Traded Products Are NOT Created Equal

Exchange traded products have exploded in both popularity and size. While most of these investments are ETFs (or Exchange Traded Funds), a handful are ETNs (or Exchange Traded Notes). ETFs actually hold assets in the underlying index the fund is designed to track. ETNs, on the other hand, are debt securities issued by the provider, whose return is intended to track a particular index. Because it is a debt instrument, however, there are additional credit risks, and many providers have pulled back their support of such products, leaving some investors holding illiquid securities. See article here, WSJ.

Passive Investing Continues to Gain Momentum

Actively managed mutual funds have lagged passively managed funds, particularly over longer investment periods. Much of this is likely due to the lower fees charged by passively managed funds. As investors have become more knowledgeable about this relationship, money has flowed at a faster rate into passively managed funds. See article here, WSJ.

Contrarian ETF

Contrarian investors seek to buy stocks that other investors are selling. An extreme example would be buying stocks that have high levels of short interest. A recently created ETF intends to do just that, with the goal of benefiting from potential price reversals, as well as from potential short squeezes that occur as short sellers rush to cover their positions. See article here, ETF.com.

Conflict of Interest in 401(k) Funds

Companies often hire third party administrators (TPAs) to manage their respective 401(k) plans. Some companies simply provide documentation and advice; however, other TPAs actually offer their own proprietary (in-house) funds as investment alternatives. New research (see Journal of Financial Research) shows that these funds often carry higher fees and have lower returns, illustrating the impact of a conflict of interest. This is particularly pronounced for banks and insurance companies acting as TPAs.

Target Date Funds and Dollar Cost Averaging

Target Date Funds simplify the investment process for investors, as such funds oversee changing asset allocations through time. A secondary benefit is that with these "set it and forget it" funds, investors are less likely to try to time the market. This is good since such activity generally hurts (rather than helps) most investors. In fact, staying the course allows investors to benefit from downside market volatility, as continued investment enables investors to buy more shares at lower prices, so-called dollar cost averaging. See article here, WSJ.

Mutual Fund Fees Continue to Fall

Passive funds have historically outperformed active funds, and much of this difference is likely driven by the lower fees charged by passive funds. A recent article (Financial News) discusses the impact on both investors and the industry. Moreover, the industry has begun to eliminate questionable fees, such as the 12b-1 fee (see WSJ article here).

Mutual Fund Fees

As we all know, fees impact net returns. For mutual funds, aside from any load, the two primary fees charged are management fees and 12b-1 fees. The management fees are easy to understand. The 12b-1 fees, however, are not. They are designed to cover distribution costs, but this is a broad term. In reality, much of this fee is used to pay brokers/advisors for directing client business to the funds. As a recent article (Investment News) suggests, the SEC may begin to limit such payouts.

Are ETFs Good or Bad?

Like many questions, the right answer is probably, "it depends." Whether ETFs are the best investment vehicle for a particular person likely depends on their goals and needs. However, with trillions of dollars being held by ETFs, their size has necessitated a broader discussion of their merits. This is particularly true in light of recent pricing issues where ETFs traded well below their NAV (such as in August of this year, as well as during the "flash crash" in May 2010). See a good summary article here: WSJ.

Lower Minimum Investment

Charles Schwab cut the initial minimum investment from $2,500 to $100 for most of the mutual funds on its Mutual Fund OneSource platform, which charges no transaction fees. At the same time, it cut the minimum for subsequent investments from $500 to $1. See article here, Financial Advisor Magazine.

Target Date Funds: Benefits and Disadvantages

Target date (i.e., lifecycle) funds are increasing in popularity, particularly among unsophisticated investors. These funds provide key benefits, as they automatically rebalance through time and also generally limit return chasing. Given the dollar cost averaging effect, the result may also be a higher (dollar-weighted) average return. On the downside, the target date funds may choose underlying funds in each category that benefit the fund family more than the investor. However, for most investors, the benefits would generally outweigh the potential disadvantages. See article here, WSJ.