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Invest in ETFs? Here Are Five Questions Clients Should Be Asking.

During the slow summer months, investors should be examining their portfolios and levels of diversification. Here’s how.

By Matt Schreiber

As I write this, it’s 80 degrees and sunny outside, and summer is just around the corner. After several turbulent months in the year that has so far defied convention, such as the Dow Jones Industrial Average closing out April with a year-to-date loss for the first time since 2009, I’d wager that most investors welcome the slower summer months to exhale, reevaluate their portfolios, and make adjustments to try and finish the year strong.

That is exactly what investors should be doing this summer. Above all, they need to ensure they’re properly diversified. This is one pitfall of owning too many passive vehicles, such as index ETFs. They can give investors a false sense of security that their cash is much more strategically dispersed than it is.

To help investors properly examine their portfolios and the level of diversification, I came up with five questions to ask themselves this summer about the ETFs they own.

1. What’s my balance of active vs. passive?

Investors have poured a massive $9 trillion worth of assets into passive index funds and ETFs, and with fees falling to record lows, this trend could continue throughout 2018. However, I’ve long maintained that even the most pro-passive investors need to add some actively managed funds to their portfolios. For one, passive products typically lack risk mitigation as they don’t move to cash—the high returns investors love during a bull market can quickly turn to devastating losses in a bear market.

What’s more, the narrative that passive always outperforms active in a bull market isn’t even true. In fact, there were active mutual funds and ETFs that outperformed the S&P 500 last year. Our firsthand experience is backed up by the latest Morningstar Active/Passive Barometer, which found that 43 percent of active managers outperformed their passive counterparts in 2017.

2. What’s the active share for my ETFs?

Active share is a metric between zero and 100 that indicates how closely an ETF’s exposure mirrors that of an index. You should know this. The metric is simple: if an ETF has an active share of 95, its holdings are 95 percent different than the index. On the other hand, a passive ETF that tracks the S&P 500 would have an active share of just about zero.

For investors who own a significant number of ETFs, active share is useful in determining just how diversified their portfolios really are. Many passive ETFs—and even multi-factor, smart-beta ETFs—closely follow an index, so many investors unknowingly own the same stocks through multiple vehicles.

3. Am I invested in dividend ETFs?

I believe there’s never been a better time to invest in stocks that pay dividends. Dividend payouts are on track to have a record year in 2018, with 415 S&P 500 companies that pay dividends averaging a 13.9 percent increase in payments in the first quarter. This isn’t surprising as the corporate tax rate under the new tax law fell from 35 percent to 20 percent, giving companies a windfall of cash to reinvest in the form of CapEx spending, stock buybacks and dividends. Look at Apple—on May 1, they announced a $100 billion capital return program.

Investors may take advantage of this by investing in ETFs that own dividend-paying stocks. However, the largest companies in the S&P 500, like tech giants Facebook, Apple, Amazon, Netflix and Alphabet’s Google (referred to as FAANG), tend not to pay dividends, so investors who are disproportionately invested in passive ETFs that closely follow the index could miss out.

4. How liquid are my ETFs?

Liquidity refers to the degree to which an ETF can be bought or sold without affecting its price. Many investors believe an ETF’s trading volume is indicative of how liquid it is, but that’s not the case. Just because an ETF has volume doesn’t mean it can support volume. What’s more, many ETFs seem to be more liquid than they are because, for the most part, the markets have been rising, and there hasn’t been any selling pressure. In actuality, an ETF is liquid if the underlying securities it owns are liquid.

Why does this matter? Should an event like the dotcom bust of 2000 or the housing market collapse of 2008 cause investors to sell off their assets en masse, the $9 trillion invested in passive funds would create a dangerous liquidity trap, possibly causing the prices of these assets to fall dramatically. 

5. What are the expense ratios for my ETFs?

The ongoing decline in ETF fees has caused some investors to eschew active funds altogether, and active managers have responded by slashing their fees. However, investors shouldn’t just look at the fee when deciding whether to buy an ETF. They must also take into account the fund’s performance and the manager’s track record over time. Investors are wise to keep in mind how the fund is performing in a bull market, but, what is more important is considering how much risk protection it could provide in a bear market.

Expense ratios are useful in determining whether an active ETF’s fee is justified. This metric, derived by dividing the fund’s operating expenses by its assets under management, indicates the cost of operating the fund. Typically, the higher an ETF’s active share is, the higher its expense ratio will be, because it requires more active stock-picking.

For investors who own ETFs, it comes down to “knowing what you own.” Spending a little time during the slower summer months  answering these questions may help investors be well-positioned post-Labor Day.

 

Matt Schreiber is the President and Chief Investment Strategist at WBI, a leading provider of institutional and private client wealth management solutions with $1.6 billion AUM and a suite of actively managed ETFs.

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