If there is one lesson that the recent economic downturn solidified in the minds of high-net-worth investors, it is probably the importance of protecting the wealth they have worked hard to acquire. As financial markets change and investment products evolve, so do the means for advisors to better diversify high-net-worth portfolios, and to grow and protect wealth.
Over the last 17 years, exchange-traded funds have made great strides in capturing the attention of the wealthy. Since the inception of the first ETF in 1993, the industry has grown to over 850 ETFs with more than $750 billion in assets. Much of the recent growth has been the result of innovation from ETF providers as they look to offer new and enhanced strategies.
Many of these new features focus on wealth protection-a high priority for high-net-worth clients. ETF fee structures are one example of this focus. ETFs generally fall on the lower end of the investment spectrum with respect to fees. Lower fees mean less money is being taken from the investment capital and more is being left to work toward the investor's objective.
For example, take the 515 mutual funds and 92 ETFs that fall into the Morningstar category of U.S. mid/small-cap equity. Within this group, the average A-share mutual fund has a net annual expense ratio of 1.43%, while the average ETF costs 0.51%, not including trading commissions.
ETFs also offer potential tax advantages by giving the investor more control over when to incur a capital gain. This is accomplished through the in-kind share redemption process.
When authorized participants, usually a large financial institution, want to redeem shares of an ETF, they send the shares to the fund sponsor, who in turn exchanges a corresponding amount (in-kind) of the underlying basket of securities to the authorized participant. The ETF sponsor typically transfers out securities with the lowest cost basis, which raises the overall cost basis of the securities remaining in the ETF portfolio.
Maintaining a higher cost basis reduces the likelihood of the ETF incurring a capital gain within the portfolio if it ever has to sell securities. If the ETF does not incur capital gains, then there are none to pass on to investors. In an environment of rising tax rates, it is increasingly important to maintain the ability to incur capital gains when they fit best into the investor's broader tax situation.
ETFs also provide many opportunities for advisors to diversify portfolios for their high-net-worth clients. With the recent market turmoil, fixed-income ETFs have become a popular option. The wide range of fixed-income ETFs available allows advisors to customize portfolios with varying credit qualities, maturities and tax treatments, and provides convenient access to targeted global fixed income opportunities. With a diversified fixed-income portfolio, investors are better positioned to cope with changes in market conditions and interest rates.
Inflation, meanwhile, is another risk that can be addressed through the adroit use of ETFs. The global policy responses to the economic downturn have flooded the markets with a level of liquidity that could be difficult to drain quickly. If and when banks increase their lending and the velocity of money picks up, inflationary pressures could increase.
Gold ETFs are among the more popular products for those looking for a hedge against inflation. Gold is one of the oldest forms of money and has long been considered a good hedge against a devalued currency. Beyond gold, ETFs have also expanded access to a wide array of commodities and real estate opportunities, both of which are often considered to be good hedges against inflation.
More recently, ETFs have begun to offer exposure to currencies and currency strategies. For investors who are concerned about the changing value of the dollar both at home and abroad, currency ETFs offer an efficient way to hedge foreign currency exposure or to act on a conviction about the direction of the dollar. Business owners who are being paid in foreign currencies may be able to manage some of their exchange rate risk through currency ETFs.
Other ETFs provide access to alternative-like investment strategies utilized by hedge funds, but without many of the drawbacks, such as high fees and lockup periods. Hedge funds charge fees ranging between 2% and 10%, along with performance fees and early redemption fees, while the typical ETF will generally have fees below 1%. Additionally, ETFs are generally considered a much more liquid investment. While some hedge funds lock up investors for a year or two, ETFs allow investors to liquidate their shares without any restrictions. ETF investors could even short sell a fund if they chose to do so. The transparency rules requiring ETFs to disclose their holdings allow investors to know exactly what they hold daily. Hedge funds, by comparison, have historically been very reluctant to disclose holdings. This level of transparency is essential for advisors seeking to maintain a diversified investment strategy for high-net-worth clients.
As the number of ETF products has increased, so have the opportunities to use ETFs in strategic and tactical asset allocation strategies. Because ETFs are generally very liquid investments, investors can quickly realign their portfolio for strategic reasons. ETFs were originally designed to follow broad-based passive indexes such as the S&P 500 or Nasdaq-100. ETFs now allow access to individual market sectors, investment styles, themes and various indexing methodologies, such as equal-weighted and fundamental-weighted portfolios. Other ETFs include buy-write and 130/30 long-short strategies. Leveraged and inverse ETFs also give advisors the tools to implement short-term tactical trades or market hedges.
For high-net-worth investors who are business owners, ETFs can offer a means of hedging out industry-specific risk. ETFs are publicly traded on listed exchanges so they can be sold short just like a publicly traded stock. If a business owner is concerned about a downturn in business for his particular industry or sector, he can hedge against that risk by shorting a sector- or industry-specific ETF. For example, the owner of an information technology consulting firm could short an ETF that offers sector-specific exposure to information technology or even to an industry within the tech sector, such as software.
Exchange-traded funds offer many advantages for high-net-worth investors looking to build and protect wealth in an uncertain financial environment. With fees generally lower than many other investment options and a tax-efficient structure that allows for limited capital gains distributions, ETFs offer investors the potential to keep a larger portion of their investment working for them. Whether they're used as a fixed-income or alternative investment vehicle, ETFs offer advisors a plethora of options to meet their clients' investment objectives.
Joseph Becker is education marketing manager at Invesco PowerShares Capital Management LLC (www.invescopowershares.com).