Happy Together: ETFs and Mutual Funds

Decision-Making Processes
Burns asked the panellists what their thought processes were when deciding between mutual funds and ETFs?

Stein said it is important consider the context of the market. A couple of years ago, he said he used an ETF for developed international equities exposure, but then switched to an active manager last year when the European sovereign debt crisis hit, as he felt an active manager would make adjustments to the portfolio to avoid certain assets more at risk.

Ratner shared that it depends on his team's expertise. While he feels comfortable using ETFs for U.S. equities, he is less familiar with asset classes such as distressed debt or international equities, and as a result, tends to use active managers for exposure to those asset classes.

ETF Preferences
Burns followed up asking the panellists when they prefer to use ETFs?

Ratner said he uses ETFs for predictable beta or for a specific risk target. Aside from style drift, active managers might also manage the portfolio for liquidity, which could change the characteristics of the fund. Ratner also likes to use ETFs for momentum strategies, again because ETFs provide predictable beta.

But while ETFs can provide precise exposure to an asset class, Thompson noted that it is always important to know what you own, as different index may classify certain securities differently. She also highlighted to pay attention to when an index rebalances because the characteristics of the ETF could change. For example, the MSCI Emerging Markets may move Taiwan and South Korea to the developed markets index this year. These two countries currently comprise about 25% of the MSCI Emerging Markets index.

Ratner also uses ETFs to adjust his portfolios when his active managers' holdings do not exactly match his asset allocation plan. In other words, if he has an active fund that is too heavy in small caps, he will short a small caps ETFs.

ETFs vs. Index Funds
Burns also asked about how the panellists decide between using an ETF or an index mutual fund.

The basics apply-check the fees, the tracking error, the premiums and discounts. If these are too high, use the index mutual fund. Thompson said that if you want trading flexibility and plan to hold for a short period, use the ETF. Stein said he prefers ETFs because they are accessible across platforms, so all his advisor clients will be able to implement his strategy.