Andy Hagans sits down for an interview with Nathan Geraci, president of The ETF Store.
ETF Reference editor in chief Andy Hagans recently interviewed Nathan Geraci, president of The ETF Store. Mr. Geraci also hosts the weekly radio program The ETF Store Show and writes at the ETF Insights blog. The interview was completed over email in May of this year.
Andy Hagans: The traditional financial advisor/money management model seems like it is coming under fire. What do you hear from investors who seek you out as an alternative? Is there frustration with the way things have historically been done?
Nathan Geraci: Investors have grown increasingly frustrated with the industry status quo. High fees, conflicts of interest, the underperformance of active investments, and intentionally confusing financial jargon are just a few of the reasons why investors are seeking alternatives. Because of this, I believe the traditional advisor model is actually under full-scale attack. Investors are [wising] up to paying an advisor 1 percent to manage a portfolio of underperforming mutual funds, which themselves charge 1 percent plus. Investors are becoming more aware of conflicts of interest that may exist where advisors are peddling certain mutual funds or other investments because they or their firms receive kick-backs and other forms of compensation to do so. Investors want to know that you are putting them first, that your advice is conflict-free, and they want you to communicate with them in layman’s terms.
To a large degree, I believe that is why investors are seeking us out specifically as an alternative. Certainly, the tremendous growth of ETFs is a big part of our story. As investors develop greater awareness of the potential benefits of ETFs — things like lower costs, tax efficiency, and transparency — investors naturally seek advisors with a focus in this area. But I think it’s more than just an ETF story. We operate as a fiduciary, we receive no kickbacks from fund companies, we tell investors every single penny they will be paying from day one, we communicate with them in terms they can understand, and we focus on long-term, strategic asset allocation as opposed to chasing the hot stock or fund manager. I think investors find this approach refreshing.
Andy Hagans: There are more than 1,600 ETFs out there now, most of which don’t seem like they’re necessary for long-term allocation strategies. What portion of the ETF universe do your advisors actually consider when building a portfolio? What are your thoughts on the more niche — even bizarre — ETFs out there?
Nathan Geraci: The remarkable growth of ETFs has been both a positive and a negative for investors. ETFs have clearly helped to democratize investing, as everyday investors now have access to institutional-calibre strategies they could not have dreamed of accessing just 10 years ago. On the whole, I believe the more products available by which investors can express their views, the better. However, along with that comes the responsibility to conduct proper due diligence on these products. Not only do you need to understand the ETF itself, but also whether the ETF is right for your particular situation. Just because you can invest in a particular niche doesn’t mean you should.
But that also doesn’t mean the ETF should not exist. We like to think of ETFs as tools in a toolbox. You might have a hacksaw in your toolbox, but you likely won’t need it to fix your clogged sink. However, there might be a situation where you will be thankful you have that hacksaw. The same holds true for ETFs, even niche ETFs. Ultimately, the market is the final arbiter, and if an ETF is improperly constructed and/or doesn’t serve a particular investor need, the market will eradicate it. At The ETF Store, we will always consider the full universe of ETFs when building our portfolios. However, given that we take a long-term, strategic asset allocation approach to invest, we tend to focus more on broad-based ETFs in order to express macro views on the market.
Andy Hagans: Robo-advisors have been a hot topic recently. Your firm has been around for a long time as an alternative to the traditional advisor model; what’s your take on the Robo-advisor “boom”?
Nathan Geraci: Ultimately, the Robo-advisor boom is about leveraging technology to improve the client experience. It has always been our belief that technology is a critical driver of success in nearly every facet of an advisory business. Robo-advisors are helping to optimize the front-end or service delivery side of the business. We believe this is a positive for investors, and as an advisor, we embrace this technology. Just as we might automate our trading processes or utilize a CRM, we think it is important to use technology to improve the way we interact with clients. However, technology is only one piece of the Robo-advisor story.
The other part of the story is the fact that not every investor needs a “full service” advisor. Robo-advisors can help provide sound, low-cost investment guidance to investors who otherwise would not have access to it. At The ETF Store, we recently partnered with Upside to offer our own Robo-advisory solution, iPortfolios. We love the idea of being able to offer our foundation ETF Store portfolios to this segment of the market and do so by leveraging state-of-the-art technology. All that being said, I believe Robo-advisors are somewhat analogous to online medical websites (think WebMD). If I have what appears to be a minor medical condition, perhaps I’m comfortable perusing WebMD to help diagnose and treat my condition. However, if I’m coughing up blood, I’m likely not going to WebMD – I’m calling a real doctor. The same holds true in the advisory world. For basic financial situations, Robo-advisors can offer a lot of value. However, as financial situations increase in complexity, investors want guidance from a knowledgeable, experienced human advisor. It’s extremely difficult to program around human behaviour and emotions and the range of complex financial issues that can develop. Many clients expect financial planning advice in addition to portfolio management — we offer both.
Andy Hagans: Your firm is obviously committed to the exchange-traded fund as an optimal investment vehicle. A few prominent figures — Jack Bogle and Warren Buffett come to mind — seem to recommend index funds over ETFs. Do you believe the ETF is a superior vehicle to the index fund for long-term investors? Or is it just a matter of personal preference and temperament?
Nathan Geraci: I always find this to be an interesting question. First, I would suggest that most investors would be well-advised to take an index-based approach to investing. The fact is, the majority of active managers underperform the same indexes most ETFs and index mutual funds track. The ones who do manage to outperform have difficulty maintaining that performance over any period of time. At the end of the day, ETFs and index mutual funds are very similar. However, ETFs do allow intraday trading, and there are studies showing they can also offer greater tax efficiency than index mutual funds. So let’s just say the two products are essentially identical, but one provides greater control over buy and sell decisions, along with greater tax efficiency. Why wouldn’t I choose that investment?
My sense is that Mr. Bogle and Mr. Buffett have recommended index funds over ETFs to protect investors from themselves — in other words, they believe index mutual funds remove the temptation to trade during the day. That may be a valid point. However, that speaks to the investor or their advisor — not the investment vehicle itself. We certainly do not day trade, but it is nice knowing we have the option of buying or selling during the day if we need to exercise it. I would also note that index mutual funds may have minimum investment levels, front-end loads, and cash drag, three things ETFs do not. It is also my belief that ETFs offer more investment options in terms of asset class coverage.
Andy Hagans: One advantage of ETFs over index funds is, of course, the intra-day liquidity of ETFs. In your investment philosophy, you mention that you screen the universe of ETFs and only consider ETFs with sufficient liquidity. What are your specific rules or thresholds to rule out less-than-liquid ETFs?
Nathan Geraci: ETF liquidity is multi-pronged, in our opinion. First, how liquid is the underlying holdings of the ETF? For example, an ETF holding large-cap US stocks is going to be significantly more liquid than one owning frontier market stocks. Second, how large is the ETF itself — both in terms of AUM and daily trading volume? We believe you have to consider both of these in tandem. If the underlying holdings of an ETF offer sufficient liquidity, we would not be as concerned with daily trading volume. But an ETF in a relatively illiquid asset class with insufficient daily trading volume would raise a flag. Also, AUM certainly impacts daily trading volume and may indicate risk of ETF closure. Given that we typically take a longer-term position in our ETF holdings, we do not want to introduce ETF closure risk into the equation. The bottom line is there is a balance of several factors here, including the underlying liquidity of the ETF holdings, daily ETF trading volume, and long-term ETF sustainability.