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Understanding Today’s Most Popular Investment: ETFs

Gary Stroik, ETFs
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With Gary Stroik, Chief Investment Officer, WBI Funds

Exchange Traded Funds (ETFs) have exploded onto the investment scene because they offer a lot more flexibility over mutual funds.

ETFs were created as an inexpensive way to get broad exposure to different kinds of investments like stocks and bonds but can also focus on specific sectors such as technology, biotech, commodities, international stocks and bonds, and much more. ETFS can be structured to offer significant tax benefits, leading to the fact that they have become one of Wall Street’s most successful products.

There is such a broad range of ETFs available in the market today that virtually every investor can find one or more ETFs that cater to his portfolio’s specific needs – everything from hedging exposure to foreign countries as small as Greece to playing the Japanese or emerging markets as well.

However, ETFs may have unexpected tax consequences, enhanced volatility, or speculative characteristics that can hurt you if you don’t know how to use them. It’s important to make sure you understand your ETFs or choose an expert advisor to help you.

Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital.  Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions.  Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances.  The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.

Read The Entire Transcript Here
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Steve Pomeranz: Gary Stroik has earned the CFP designation and is Vice-President and Chief Investment Officer and Lead Portfolio Manager of WBI Investments, which offer funds and ETFs.  He’s also a periodic contributor to Financial Advisor Magazine, and today we’re going to talk about what has become, I think, the most popular investment of the day—exchange traded funds or so-called ETFs.  Hey, Gary, welcome to the show.

Gary Stroik: Hey, thanks.  Thanks for having me.  It’s great to be here.

Steve Pomeranz: A lot of people know what ETFs are, but for those who don’t, give me the quick down and dirty definition of an ETF.

Gary Stroik: Well, an ETF, as the name suggests, is a mutual fund that is exchange traded.  It means it trades all day long.  A regular open-end mutual fund that most people are familiar with are…the price is whatever it is at 4 o’clock, you get it after the close, whatever that price is, and any buys or sells you do during the day don’t count until the market closes.  An ETF, you can buy and sell all day long at whatever the value is at that moment in time.

Steve Pomeranz: Right, and there are other things, too.  That means if it’s traded like a stock, you can short it if that’s in your interest.  You can have calls and puts and write against it, so it’s a more flexible kind of form, and the fact that you can trade it during the day is a big plus.  Are there tax differences to the investor?  If I’m an investor in an ETF that invests in a certain basket of stocks, and I invest in a mutual fund that invests in a very similar basket of stocks, is there one advantage over another tax-wise to an ETF?

Gary Stroik: Yeah. I think because of the way ETFs are created and destroyed, if you will, created and redeemed by a special kind of market maker, an authorized participant, they can do tax-free exchanges of shares for baskets of shares, so you can wash away some  tax effect that otherwise would happen from the buying and selling of the shares.  One of the things that people found in the past with mutual funds is that if a portfolio manager sells appreciated stock, those gains pass through to the shareholder even if he just showed up yesterday and bought the shares.

Steve Pomeranz: Yeah, I know.  It’s a terrible thing and has caught a lot of people by surprise.  A good advisor would know how to handle something like that, but you’ve got to be extremely carefully. How are they used?  What’s the best way to think of an ETF and putting it in your portfolio?

Gary Stroik: Well, they have a few uses.  I think the big use, that was part of the genesis is, it was a very, very inexpensive way to get a broad array of exposure to something, and that has since morphed into an inexpensive way to get an exposure to something that would be difficult to get some other way.  If you wanted to buy a portfolio of emerging market bonds, for example, an ETF would be an inexpensive way to do that instead of trying to go out and do that on your own, or commodities, or real estate investment trusts, or just consumer discretionary companies.  It has really expanded to allow people to get almost unlimited exposure to almost anything they would want to invest in.

Steve Pomeranz: Yeah, it’s actually been one of the most creative and successful areas or products that Wall Street has created since a time that I can remember.  Being a creative business, there’s a lot of new entrants into this market all the time, and there’s a lot of different choices which is a positive and a negative, but the one thing that is indicative of an ETF is its general low cost, right?

Gary Stroik: Yes, and the reason for the low cost I think for most ETFs, not all, but most ETFs are designed to follow an index because that’s what the Securities and Exchange Commission allowed.  An ETF is a mutual fund, but it operates under a special exemption that allows it to trade all day.  It breaks all the rules of mutual funds, if you will, under an exemption that’s been granted, and that exemption was originally granted mostly just for index replication.

Steve Pomeranz: Yeah.

Gary Stroik: If you’re just reproducing the S&P 500 or some other index, you can do that at a very low cost.  There’s not a lot of people you have to hire to do that.  As the ETFs start pursuing more aggressive strategies or more diversified strategies, or what’s commonly called today the smart data or alternative beta strategies, those costs have gone up because the work involved in putting them together and running them has gone up.

Steve Pomeranz: It’s not only stocks we’re talking about.  Well, you did mention commodities, but bonds also are included in this ETF family now, so if you wanted to buy a portfolio of a mixture of government and corporate bonds or municipal bonds or just pure governments, if you wanted to bet in a particular fashion of interest rates going down or going up, you could.  If you wanted to invest in the group of foreign countries making up the big index over there, or you just wanted to invest in France, or you wanted to short Greece, whatever you wanted to do, those are all now available.  With all this new product comes some dangers here.  Tell us about those.

Gary Stroik: I think one of the dangers can be that people misunderstand what’s going to happen to the ETF in different environments.  They think it’s going to do one thing, and it really does something very, very different.  There can be unexpected tax consequences.  We mentioned there are tax advantages to ETFs, but some ETFs are organized as grantor trusts or partnerships that people file their tax return and they think they’re done, and then a K1 or a grantor trust letter comes in the mail, and they think what’s this about?  I have additional tax work to do, and those things tend to come pretty late, so that can be a surprise, and it can be a surprise if you think that a German market index type ETF is going to behave pretty much like any other kind of index would behave or an emerging market index would behave like others will.  They can be a lot more volatile, and I think like any other, it’s a great tool, but you have to use it right.

Steve Pomeranz: You know, years and years ago, a client came to me and he said he wanted to make a bet on oil prices, and so I went and  bought him an ETF based on the price of oil.  In that ETF, they actually bought futures contracts, but, it turned out, the way it was structured, and I won’t go into the details, it didn’t actually move with the price of oil.  There was some kind of aspect to the way the futures were trading which negated the ability of this particular ETF to move with the price of oil.  The price of oil moved up, but this thing just didn’t do anything, and I was like, wait, what happened here?  There was more going in there that I just originally thought.  I was young and naïve back then, and actually ETFs were rather new, so that was a lesson that I had to learn.
One of the things that we were talking about off-air too was this idea about looking at the highest rate of return when choosing your ETF.  Why is there certain danger in that?

Gary Stroik: Well, you know, people understand that they want a high return and they want the biggest gain they can get, but usually what they forget about is that also comes with the biggest loss you can get.  The volatility is up and down, and the problem is that the down hurts more than the gain gives you.  I’ll give you an example.  If you lose 20% of your money, you need 25% on what’s left just to get back to where you started.

Steve Pomeranz: Yeah.

Gary Stroik: If you lose 50% of your money, you must get a 100% return just to get back where you started.  The NASDAQ, as we’re talking here today, is just now over 5,000.  It was 5,000 15 years ago.  Not a lot of people have a bunch of 15 year time periods where they can wait just to get back to even because they were chasing the 80-some percent return that the NASDAQ had the year before it started to fall.

Steve Pomeranz: That’s a very good point.  Also the idea that it’s not just that high rate of return …  well, let me make one other point.  Emotionally, too, it’s been proved that the feeling of pain of a loss is greater than the pleasure of a gain, so not only is it harder to make your money back, but when it goes against you, if it’s a very volatile investment and more volatile than you expected, you may make an indiscreet investment decision based upon some emotional factor rather than using calm reasoning to do that.
We were also talking about this idea that the series of returns really matter.  This is off the ETF subject, but using your example of losing 50% and having to earn 100% to get back to even, so if you’re just entering retirement, couldn’t that hurt you?

Gary Stroik: Oh, you’d never get that.  You’re going to also start beginning liquidatin or taking income from the investment.

Steve Pomeranz: Yeah, at the same time.

Gary Stroik: You’re going to stop putting money into the pot.  I don’t know how you ever would recover from that.

Steve Pomeranz: Yeah.  My guest is Gary Stroik.  He is the portfolio manager of WBI Investments, which offers funds and ETFs.  He’s also a periodic contributor to Financial Advisor Magazine, which is how we found him.  Hey, Gary, thank you so much for joining us and spending your time.

Gary Stroik: It’s been my pleasure.  Thanks for the conversation.

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