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inside the fund. This is a story you will see across many ETFs.

      It must be noted that there is a flip side to diversification, and that is single stock investing can pay off big when a stock surges. Single stock selection lets you feel every basis point of a positive return. Using an example from TAN’s holdings, if you were lucky enough to pick SolarCity Corporation (SCTY), you would have been up 246 percent in the past two years, compared to the diversified TAN, which was up (only) 87 percent.

      For those who put in the research and time and think they can pick the right stock (at the right time) and outsmart the army of analysts out there, the ETF probably doesn’t make any sense. But in cases where you don’t put in the time and research or don’t want to take on single-security risk, the diversification of ETFs is a huge benefit. This is also why ETFs are not just drawing away assets from other investment vehicles like mutual funds, but also from single security investors.

      Easy Asset Allocation

      Everyone will tell you that getting your asset allocation is much more important than picking the right securities. The narrower you go in your investment decisions, the less impactful those decisions become. And when it comes to doing asset allocation, ETFs are like hitting the easy button.

      “We’ll get broad exposure using ETFs. It’s a really easy, cheap way to accomplish what we are trying to accomplish, which is to own risk factors or asset classes, and it is the smart way to do it.”

Josh Brown, Ritholtz Wealth Management

      ETFs are both broad and precise. They have packaged up virtually every single asset class, strategy, region, country, and even derivative that you can think of. Any investor – both institutional and retail – can now immediately get exposure to everything from real estate companies to short-term high-yield bonds to corn futures to China A-shares.

      “What ETFs allow is a more focused or segmented approach than in the old days.”

Mark Yusko, Morgan Creek Capital Management

      While asset allocation is typically associated with long-term buy-and-hold investors, it is also employed by managers with shorter horizons as well. You’ve heard of stock pickers. Now there are ETF pickers – except they are called ETF strategists.

      “There are many people who pick stocks. If you walk down the streets of Boston, I would expect that 9 out of 10 investment managers you bump into pick securities. Yet at the asset class level, there are fewer people who compare assets. But the macro environments across the globe are not in sync, whether it is the economic cycle, credit cycle, or business cycle. So that creates opportunity to generate alpha through asset selection. ETFs are a perfect vehicle for that.”

Linda Zhang, Windhaven Investment Management

      This also touches on one of the most fascinating aspect of ETFs, which is how they are at once a replacement for a mutual fund, hedge fund, or an SMA as well as a tool for a mutual fund, hedge fund, or SMA. That makes them a two-headed monster. It’s also why institutional exposure to ETFs can come from direct usage and/or indirect usage via external managers.

      “What makes ETFs really different is that in addition to being a funds solution, they are actually a single security or exposure solution. That means they can be used as a substitute for an SMA or mutual fund, or they can be used as part of the SMA or mutual fund. And that’s what makes them unique.

Matthew Tucker, Blackrock

      Standardization

      We like it when things are standardized. Whether it is USB ports or gas pumps, it is easier when it works the same way regardless of other variables. When it comes to investing, ETFs have standardized every asset class so that they trade like equities. Investors love the fairness and price transparency of equity investing on a stock exchange. ETFs have simply equity-ized every type of investment.

      For example, bonds don’t have a common exchange. They trade over the counter (off exchange) in relatively opaque markets, whereas bond ETFs trade like stocks. Some other assets that have been standardized by ETFs include physical gold, oil futures, swap agreements, currencies, and hedge fund strategies. All of these things and more can now be bought and sold on a stock exchange just like shares of General Electric. This has standardized investing, and even more importantly, it has created another venue where investors can buy or sell the ETF’s underlying exposures

      While this standardization is mostly hailed as a breakthrough in convenience, it has also brought with it a few concerns. Just like Jurassic Park, when you try and bring ancient beasts into the modern world, you have to be careful. A popular example is junk bond ETFs. Those bonds are pretty illiquid while the ETFs that hold them can be very liquid. This creates a bona fide “liquidity mismatch” and is one of the issues we will look at more in Chapter 9.

This standardization of the financial markets has also challenged embedded taxonomies and structures all over the financial world. Nowhere is this symbolized more than on the Bloomberg terminal keyboard, which is divided by yellow keys for government bonds, corporate bonds, mortgage bonds, money markets, municipal bonds, preferred, equities, commodities, indexes, and currencies, as shown in Table 1.6. Each asset class has different functions, traits, and the like. Meanwhile, the ETF covers all the yellow keys. They are at once everywhere but nowhere.

Table 1.6 The Yellow Keys on the Bloomberg Terminal

      Source: Bloomberg

      This chameleon nature of ETFs is also making it difficult for companies and desks on Wall Street to figure out where to put them. The ETF desk could be part of equities or fixed income or even derivatives. Some are starting ETF-specific desks. The entire financial system is trying to figure out how to adapt to the “disruptive technology” that is ETFs.

      Democratic

      ETFs are democratic in two ways. First, they have democratized investing by providing retail access to many asset classes, countries, and strategies.

      ETFs have also democratized things by providing this access at the same cost. For the first time ever in the history of investing, big institutional investors and small retail investors are using the same investment products and paying the same expense ratios. Unlike mutual funds and SMAs, which have a fee system equivalent to a regressive tax – the less money you can invest, the more you get charged – ETFs are like a flat tax. So my Aunt Joyce investing $1,000 in an ETF gets charged the same annual expense ratio as would Yale University’s endowment or a hedge fund investing $100 million.

      In this way, you could argue that ETFs are like the Sam’s Club of funds. Just as Sam’s Club offers wholesale prices on everything, similarly ETFs are priced about the same as the institutional class of a mutual fund. This fairness provides a philosophical undercurrent that is totally in tune with the times and something that has made them a big hit with millennials who generally like fairness and transparency while distrusting anything Wall Street.

      While democratization is heartwarming and great for the little guy, how does this benefit institutions? The benefit to institutions is simple: more liquidity. That’s ultimately their favorite thing about ETFs. With retail and advisors using ETFs alongside institutions, they both benefit the increase in liquidity because it brings the bid/ask spread down and makes it cheaper to trade. This advantage is unique to ETFs relative to SMAs and mutual funds – the more users of the ETF, the better the user experience, be it a retail of institutional one.

      No Emotion

      Making an investment strategy is easy. Sticking to it is hard. This is because things change. Portfolio managers can get swept away in trends, groupthink, and fear and emotion. An ETF is immune to all that, and this is an advantage. This is a trait the ETF shares with index funds.

      An ETF is programmed to do nothing but track the index. They are like those spider robots from Minority Report that mindlessly fulfill their duty. ETF portfolio managers follow the rules dictated by the index to deliver index-like results. The holdings and

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