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Some Assets a Better Fit for ETFs Than Others

Christine Benz
Paul Justice, CFA

Christine Benz: Hi, I am Christine Benz for Morningstar.

Exchange-traded funds have taken off in popularity because they enable investors to build well-diversified portfolios at a very low cost, but not all investment categories lend themselves well to the ETF format.

Joining me to discuss that issue is Paul Justice. He is director of exchange-traded fund research for Morningstar.

Paul, thank you so much for being here.

Paul Justice: It’s great to be here. Thanks.

Benz: Paul, let’s start with the categories where you say investors should just go ahead; they lend themselves very well to the ETF format. What would those be?

Justice: I think those are the areas you've already identified as the core of your portfolio. So, large-cap equities, we naturally saw the ETF landscape evolve from that starting point. Things that have very liquid underlying tend to be good performers in the ETF structure. Large-cap equities, even credit-grade bonds would be a great place to go.

Benz: So higher-quality bonds.

Justice: Higher quality, the ones that already have a very developed market for them, that people are often participating in the market, making sure they're trading well. Even across borders, this still applies. It doesn't just have to be domestic equities; it could be international equities, and it could be investment-grade bonds outside of the United States. ETFs have done really well there.

Benz: So, Paul, ETFs can even work in areas where investors might have some preconceived notions that they are better off with actively managed funds, and you note that emerging markets is actually one space where investors can successfully invest in ETFs.

Justice: Certainly. Emerging-market funds have done fantastically well in the ETF structure. Not only have they garnered hundreds of billions of dollars in assets, they’ve performed very well. Many of the top-performing funds in the entire emerging-market category are in fact ETFs. It's some of the top 10 funds there, and they are passive by nature, they keep costs low, and it might surprise some people.

I think oftentimes when people venture outside of their circle of competence, what they are familiar with, you have that home bias, you know domestic equities really well, and you get comfortable with passive there. When you go outside into emerging markets, it seems exotic. It feels like something you don't know much about. You may tell yourself that you need the stewardship of an active manager to really navigate that landscape, and it's not necessarily the case. The low-cost passive ETFs have done very well there.

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Benz: So, let's segue now into some of the categories ... beyond the very liquid investments, where you actually might think twice about investing in an ETF. Let’s start with high yield and talk about what some of the impediments are for investors in the exchange-traded fund space.

Justice: This one worries me a little bit, because we’ve seen a lot of fund flows going into this area, and high-yield bonds tend not to be very liquid all the time, and even though they may seem liquid today, the liquidity can dry up very quickly, especially if any type of market crisis takes hold. And those are the areas in which we see, then, broad departures of the ETF performance versus what the index is doing, a lot of tracking error.

The reason being is, if you are going to go out and just purchase the issues that are in that index, you have to pay very wide, large bid-ask spreads, and those widen even more when the market dries up. That leads to a pretty bad investor experience at times. We’ve seen cases not just in high yield, but say in the muni bond space, issues can come. There may be a glut or dearth of issuances in the muni bond space, causing ETFs to perform erratically, developing larger premiums or discounts at times. So, you've got to be careful in those areas where the liquidity isn’t just guaranteed to be there, say, like it is in Treasury bonds or something like that. That would be an area of concern.

Another area I would say, is small and micro-cap stocks. Oftentimes, if the ETF has an index that it’s following and that index is going to have to reconstitute or rebalance, there are going to be some new names in there, and those might not be the most liquid names, and again, when you go out and buy those securities, you get a departure away from that index, and that’s usually not good for investors.

Benz: So you are not tracking the performance of that index; even though its stated performance is one thing, your ETF is going to diverge from it somewhat.

Justice: Right. And you are incurring what we call a market impact cost as well, going out and purchasing those securities. Somebody's actually got to go out and buy them to put them into the fund, and for illiquid names, those things tend to cause a performance drag. So it’s not just tracking error that’s randomly positive or negative, it’s usually there, and it’s usually negative.

Benz: So the illiquidity or liquidity, that’s the big swing factor.

One topic I’d like to touch on, a very popular category among our readers, the master limited partnership space, and there have recently within the past few years cropped up a bunch of ETFs designed to play on this space. What’s your take on that sector?

Justice: I’m viewing it with more caution these days. We’ve seen billions of dollars roll into these funds, really because there wasn't an option, say, in the mutual fund wrapper to gain access to these things, so they made it available to people. But I view the ETFs more as a convenient access vehicle than really opening up an asset class.

There are some shortcomings to these funds that people should be aware of. You should expect, say, if you buy an MLP ETF that has to go out and buy these things, it has to structure itself in a different legal form than a traditional fund company. It has to do it as a C-corporation, making it a taxable entity.

Now when, say, MLP prices are going up and it’s collecting dividends, it actually has to pay taxes at the fund level on those dividends, and then you have to pay taxes once you receive the dividend. Because there are some deferred tax liability, it causes performance to deviate away from the index, and it can be pretty large. We'd expect it to be, say, 65% correlated when the fund is going up, and let's say the fund goes into a loss later on, so all the MLPs are actually trading below what you bought them at, then I expect it to track one-to-one. So, on the downside, it could have a deeper slope of tracking that index poorly for you, but on the upside, not so much. So, I would certainly say, that's not the best fund structure for people.

Benz: So, I guess it’s hard to generalize, but if investors are stepping back and looking at some of these categories, where you're saying to think twice before ETFing in this space, what would be better vehicles if they wanted to pursue some of these specific investment types?

Justice: I'm going to give a pitch for the good old-fashioned closed-end fund. Say, you want to get into a less liquid area, the thing that might burden you the most is the activity of everybody else that's in that fund with you, the fund flows. When everybody else gets scared, and they're pulling out the money, that's when the performance really changes for you.

Benz: And that ability to take intraday redemptions or at least daily redemptions as you can with an open-end mutual fund, you don't necessarily have that opportunity with a closed-end.

Justice: Right. You still have to deal with the persisting premiums or discounts with that closed-end fund structure, but once you get comfortable with that and you understand how to navigate that, these can be great vehicles for you if you're going into those less liquid corners of the market, especially in any area that would have to employ leverage to get the returns, like a carry trade or something like that.

Benz: OK. Paul, thank you for sharing your wisdom on these topics. I know that these are hot-button topics for a lot of our readers, so we really appreciate you being here.

Justice: Great, thank you.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.