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The Growth of ETFs/Index Funds
May 18, 2017
More Wall Street Follies
As reported by the Wall Street Journal on May 6th, Morgan Stanley has been considering a compensation structure for its so-called ‘Financial Advisors’ (often just sales people) that discourages the use of low cost Vanguard funds. Specifically, if a Morgan broker puts a client into a more expensive (annual costs of the fund/ETF) Morgan Stanley product, then he would get paid his advisory fee on those funds. However, if the advisor chose a lower cost Vanguard fund for the same client, he would not get paid his advisory fee. Remember, large brokerage firms like Morgan, whose ‘advisors’ are often held to a lower, non-fiduciary standard (meaning they just need to do what is suitable for a client, not what is in the client’s best interest - in this scenario, putting the client in a more expensive Morgan product when a lower cost alternative is available is considered ‘suitable’) fought hard to keep the fiduciary rule from applying to them. The change of rules was supposed to go into effect this past April, but pressure from big brokerage firms successfully put the implementation of the rule on hold. Ironically, large Wall Street firms argued their clients would be worse off if the fiduciary rule applied to them. Bottom line: understand any conflicts of interest that might exist with the person or firm advising you on your financial affairs.
The Growth of ETFs/Index Funds
Not everything that comes out of Wall Street is bad. Once in a while, products are created that are actually to the benefit of the average investor. Once such development, the index fund (and related ETF), has allowed retail investors a way to diversify broadly at a relatively low cost. In the beginning there were just a handful of such ETFs known affectionately as the ‘Spies’ (for SPY, the S&P 500), the ‘Diamonds’ (for DIA, the Dow Jones 30 Industrials), or the ‘Cubes’ (for QQQ, the NASDAQ 100). Today there are more index funds listed than there are publicly traded stocks (in the many thousands). So when someone says that all they need to do is to buy an index fund and leave it alone, that begs the question, ‘which one?’ If you were in retirement, or needed money in the near-term, and owned SPY in 2007, you saw the value of your account drop by more than 50%, even while some assets like bonds and gold rose in value.
Today more than ever investors need sound, objective (see above), professional money management advice to navigate the complex world of financial products and services. What are my goals? How should my assets be allocated between different asset classes like stocks, bonds, cash, commodities (e.g. gold), real estate, and the like? Within each asset class, what are the best investments? Should I own small cap stocks, large cap? Growth? Dividend/value? Domestic only? International? Emerging markets? In what proportions? How do I know a given asset class is getting overvalued and is ripe for sale? Or if one is becoming attractive to enter into or add to existing positions? The same analysis must be done for each asset class. Heard that bonds are a ticking time bomb headed for big losses when interest rates rise? Does this apply to all bonds? What about TIPS? Floating rate bonds? International bonds? What impact will currency fluctuations have on my various holdings? Should I invest directly in gold and store it somewhere (and insure it), buy an ETF that tracks gold, or invest in actual gold mining companies? What about other commodities like oil?
This notion that you can buy a single index fund and then forget about it applies to very few people. Even with the benefit of index funds offering some diversity in and of themselves, it often takes several to get the proper exposure to various asset classes, regions of the world, etc.
Further, our financial lives are constantly evolving. A lineup of stock dominated index funds might be appropriate today but not a few years from now as we approach or enter retirement. How about tax harvesting to minimize tax obligations? Which assets should be sold? And do you just automatically repurchase those in 31 days, or look to deploy the capital elsewhere? If an unexpected emergency arises, where should the cash come from? Stock sales? A temporary line of credit? The number of questions that needs to be asked and answered is large and ever-changing, and for many people having an objective third-party professional who dedicates his or her work life to navigating these complex and important matters can be very beneficial. Not to mention the value of having an objective, rational voice there to keep you from making bad, emotion based money decisions during inevitable market sell offs. You could construct the perfect portfolio, but if you panic as many people do during times of crisis, then hard earned gains can turn into permanent capital losses quickly as stocks are sold in a panic, the cash only to be put back to work when things are ‘clearer’ (which translates into stock prices being higher).
As with any field, there is good innovation and less than beneficial changes. There are strong players and some bad apples. By working with someone who takes the time to explain things to you carefully, who constructs a plan that makes sense – and can help instill the discipline to stick to it - you will increase the chances that you reach your financial goals, which is the whole point. Not to buy into the latest triple reverse ETF, not to ‘beat’ some arbitrary benchmark, but to move towards your financial goals in a steady, understandable way - including understanding and even expecting the inevitable setbacks along the way towards a successful long-term outcome.
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