Lessons From The Morningstar ETF Conference

By Chuck Jaffe
A DOW JONES COLUMN

If an investment expert says something important, funny or clever in a forum where no one reports it, does it make a sound?

That's not a philosophical question-it's the dilemma I had this week upon returning from the first-ever Morningstar ETF Invest Conference in Chicago last week. Sprinkled throughout the event-which got little mainstream media coverage-were some great lines, the kind of real-life lessons that individual investors not only should hear, but analyze.

Here are the lines that stood out to me:

Rick Genoni, principal, Vanguard ETFs: "You would hope that clients would have come out of [the 'flash crash'] understanding the dangers of market orders, but they are still using them."

This may have been the most alarming comment of the entire conference. The "flash crash" of May 6 saw the Dow Jones Industrial Average (DJI) lose 1,000 points, then recapture 650 before the close. In one stretch, lasting about 15 minutes, the market lost about 500 points, and then got it back.

Unlike traditional mutual funds-which only trade at the end of the day, after that kind of action has been sorted out-exchange-traded funds are bought and sold like stocks, moment by moment on the open market. Many ETF investors set stop-loss orders-prescheduling a sale to protect profits if the share price drops to some predetermined level-but that didn't minimize their pain in the flash crash, as the market busted many of those orders, flying past the limits because there were no buyers at those prices. Desperate to get out with the price-limit breached, many ETF investors executed trades at the "best possible price at the current time."

As a result, losses during the flash crash were maximized. Meanwhile, investors with stop-limit orders did not have their trades executed and got lucky when the market rebounded.

Anyone investing in ETFs and anxious to protect themselves against downturns needs to know how to do it properly; most experts believe that involves limit orders. If ETF customers are sticking with market orders, as Genoni said, it means they learned nothing from the last short-term market meltdown and are vulnerable to the same mistakes the next time the market goes crazy.

Rob Stein, Astor Asset Management: "Buy-and-hold works, you just have to be willing to sit through 50% declines."

Stein was on a panel discussing sector-rotation strategies, something many investors are gravitating towards whether they know it or not. With investors turned off to buy-and-hold because of the market's disappointing last decade, many people now make strategic moves around a core portfolio. They have a slug of stocks and bonds, but they tilt the portfolio one way or another based on what's working in the market.

Of course, pushing the portfolio in the direction of what's working now makes many investors feel like they are chasing returns or are vulnerable to market-timing mistakes.

Stein's remark was a good reminder that investors don't have to become active traders, but they do need to recognize that no strategy works if you're not prepared to stick with it through the difficult times when it is out of favor with the market.

Jim Green, Rosetta Capital Management: "Investors tend to look at commodities as a total basket. If the rising tide will raise all ships, then commodities could move as one. But if you buy an ETF because you want to increase commodity exposure, you are likely to be disappointed."

Many investors are excited about the prospect of having easy access to commodities through ETFs. Green maintained, however, that commodities are not an asset class, because each type of commodity has its own fundamentals and moves with little relation to the others. As a result, Green suggested that investors are making a mistake when they add "commodities" to the portfolio, rather than thinking that they want gold, silver, pork bellies or some other specific investment for their mix.

Lee Kranefuss, former chief executive for iShares: "There's no point in launching something if there is no customer need."

It's good to know that the industry recognizes this, but the problem is that every new fund comes complete with a push from marketing over why the consumer "needs" the new fund.

Genoni: "No one is asking for active management in an ETF structure."

That's interesting, because active managers are looking at putting their products into an ETF structure. If customers aren't asking, that means they don't want it, and clearly customers don't need actively managed funds given the options they have in traditional funds. Still, expect the industry to ignore Kranefuss' advice and introduce a growing number of actively managed ETFs.

Ben Fulton, managing director of Invesco PowerShares: "Over the next five years, you will see more closures, where new products don't work."

This is why investors don't need to rush in to new ETF products; the industry has no shortage of new products, but it's not sure which ones will work.