Not even the “flash crash” could dent the popularity of exchange-traded funds. The losses of that sudden plunge on May 6 still have not been fully recovered, but the ETF parade rolls on.
There have been more than 100 new ETFs this year, and about 20 in July alone. These passive, benchmark investments are obviously popular, and for good reason. It’s one of the best and cheapest ways to get into the market. And with their structure ready-made to trade, they can be used for tactical positions as well as the core of a portfolio.
But have we reached a saturation point? Providers have been pumping them out for more than 15 years, and now we have almost 1,000 to choose from. Marketers in all fields, from financial products to consumer goods, have used a mantra of more-choice-is-better for years, at least in the U.S. But people who study marketing and decision-making have done studies that show more choices often impede a customer from making a decision. It often takes longer to decide, and sometimes people simply don’t make a choice at all.
There are definitely too many ETFs—as well as too many mutual funds, which number about 6,700—for any one investor to consider, says Paul Justice, director of ETF research at Morningstar. But the “democratization” that ETFs bring to the table makes them a very worthwhile part of the market, and a viable part of anyone’s portfolio, Justice says. Indeed, there are some areas of the market that investors simply weren’t able to access before the advent of ETFs, even areas that seem as basic as gold or oil. So now, the problem is the opposite one: investors have the burden of many options.
Sam Stovall, a strategist at Standard & Poor’s, added that individual investors (read: your clients) are often the ones who are drawn to the newer “exotic” ETFs, as opposed to the institutional investors. And he cautions that whenever there is a wide spread between the bid and ask in an ETF’s price, that indicates that there is not a lot of volume. And that should be a red flag because you may have a hard time selling it down the road.
The good news is, at a glance, it appears that investors are indeed sticking with the tried and true. The top 10 ETFs hold 37% of all ETF assets, says Justice. The biggest, by far, is the SPDR S&P 500 [SPY] with $74 billion. Rounding out the top five are: SPDR Gold Shares [GLD], iShares MSCI Emerging Markets Index [EEM], iShares MSCI EAFE Index [EFA] and Vanguard Emerging Markets Stocks [VWO].
The caveat is, there’s really no way to tell how much of that money comes from individual investors and how much is institutional. But it’s a reasonable bet that the small, exotic ETFs aren’t appealing to the institutional money as much as your clients.
Which brings us to the ever-present question: How does all of this affect you, the advisor? What should you do if your clients want to invest in that lithium ETF because they suddenly feel the need for some exposure to batteries in their portfolios?
Simple: start asking questions. Determine whether your client really has a good reason to want this investment, beyond the fact that it’s the new sexy thing to own. Ask him what his projected growth rate is for this industry; ask what the projected growth rate is from Wall Street; ask about the risks and the opportunities.
And who knows, maybe your client really does have a well thought-out reason for buying it. But if he or she doesn’t, you have to talk about the basics yet again. Morningstar’s Justice says you can construct a very basic, diversified portfolio with as few as four ETFs: Stocks, bonds, emerging markets and maybe a commodity/alternative fund. And if you want to get a little fancier and parse out large-cap and small-cap, you’re probably looking at seven or eight funds. Anything more than 10, he says, is probably overdoing it for most people.
So are there too many options for ETFs? Yeah, probably, at least for most people. But the choice is still yours (and your client’s). You’re just choosing from a much bigger menu.