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  Back to Basics: Exchange Traded Funds

ETFs (exchange traded funds) have rapidly grown in popularity since State Street first launched the SPDR in 1993. As a financial advisor, you have likely received inquiries from your clients about ETFs. Questions like “What are they?” or “Should I add them to my portfolio?” are becoming increasingly common. Let’s go back to basics and review exactly what ETFs are, key considerations to weigh before investing in ETFs, and finally, options for implementing ETFs in your client portfolios.

1. What are Exchange Traded Funds?

In the simplest terms, exchange traded funds are, much like mutual funds, pooled investment vehicles that invest in a portfolio of securities. The vast majority of ETFs are passive, tracking indices like the S&P 500 Index. As ETFs have become increasingly popular, they have expanded to include a variety of actively managed and multi-asset class strategies.

While many ETFs aim to replicate index performance, much like a passive index fund, operationally, ETFs trade more like stocks than their mutual fund counterparts. ETFs are priced throughout the day and, when entering an order for an ETF, you must specify the number of shares based on the market price. Mutual funds, on the other hand, are priced once daily using a NAV (net asset value) calculated at the end of the trading day and orders are placed in dollar terms such that you may receive partial shares.

Advisor Tip: At a high level, strategic asset allocation strategies adhere to a buy and hold philosophy. If your client prefers a more tactical approach or has a separate “play account,” the trading distinctions between ETFs and mutual funds are worth noting. Additionally, some mutual funds have minimums for investing, whereas generally ETFs can be purchased in any increment down to a single share.

Three potential benefits of using ETFs are outlined below using the ETF acronym:

Expenses—Both ETFs and mutual funds charge expense ratios which can create a drag on performance. ETFs tend to be lower cost than mutual funds because they do not incorporate certain ancillary expenses such as accounting costs and 12b-1 (marketing) fees. Management fees are not the only expenses to consider, and investors who trade frequently should be aware of transaction costs, including the bid/ask spread which represents the difference between the highest price a buyer is willing to pay (bid) and the lowest price at which a seller is willing to sell (ask). Generally, highly-liquid, heavily traded ETFs have reasonably low bid-ask spreads, however it is important to look into the bid-ask spread for more thinly traded ETFs.

Tax Efficiency—Generally speaking, ETFs are more tax efficient than traditional mutual funds. Although both ETFs and mutual funds are subject to capital gains and the taxation of dividend income, ETFs are structured such that there are fewer taxable events. In order to accommodate cash flows (contributions and redemptions), mutual fund managers may need to transact in their portfolios more frequently, which can trigger gains. As previously noted, ETFs trade similarly to stocks, however, shares of ETFs may be redeemed in-kind rather than in cash which can limit the distribution of taxable gains to shareholders.

Flexibility—ETFs can be a low-cost option for investors to gain broad market exposure without excessive trading costs. The ever-expanding ETF universe provides investors with access to more than a thousand investment options across asset classes, geographic regions and sectors, making it relatively easy to construct a diverse portfolio that adheres to any strategic asset allocation model. Additionally, ETFs may provide greater transparency than mutual funds as mutual funds are only required to disclose their holdings less frequently1. The lag in mutual fund reporting time can leave investors susceptible to style drift if fund managers are straying from their stated objective. With ETFs, holdings can be obtained daily on many fund managers’ websites. In the aftermath of the global financial crisis, many investors place a premium on transparency which can make investing in ETFs very attractive.

Advisor Tip: You are likely already having conversations about taxes with your clients. Educating your clients about the potential tax benefits of ETFs is a worthwhile exercise.

2. Are ETFs Right for Your Clients?

Remember that ETFs are not an asset class, but rather they are an investment vehicle. When considering your client’s risk tolerance and overall asset allocation, the conversation about ETFs should be centered around active versus passive management, and by extension, your client’s expectation for alpha.

Passive investments, which include both index mutual funds and ETFs alike, tend to have lower turnover than actively managed portfolios. It is important to remember that most ETFs are designed to track indices, not to outperform them, whereas active managers seek to outperform their respective indices. If outperforming the benchmark is your client’s primary investment objective, then it may be more appropriate to incorporate active management or a core/satellite approach. Core/satellite investing uses index strategies for those asset classes that are more efficient and where it may be difficult for an active manager to generate alpha (i.e. large cap U.S. equity), but may employ active managers for more esoteric asset classes that require greater specialization (i.e., emerging market debt or small cap U.S. equity).

Advisor Tip: Understanding your client’s expectations is critical. Are they seeking to outperform the benchmark, or are they comfortable keeping pace with it?

3. Does ETF Investing Make Sense for Your Practice?

Having considered some of the potential benefits of ETFs, the next step is to assess whether they make sense for your client base and, if so, how best to implement them into portfolios. ETFs span across a broad array of asset classes and selecting the bestin- class options requires rigorous research and on-going monitoring. By engaging an ETF strategist, you will not only expand your client’s access to institutional caliber investment expertise, but you may also create efficiencies in your practice that allow you to focus on other critical areas such as relationship management and business development. Adapting your business model to meet the increasing demand for ETF expertise could potentially make your practice not only more scalable, but ultimately more profitable.

4. How Wilshire Advisor Solutions Can Help

As ETFs have gained in market share and become increasingly popular with retail investors, Wilshire has responded to the demand in the marketplace. Leveraging our more than four decades of thought leadership in asset allocation, investment research, and asset class risk and return forecasting, we have developed a suite of five risk-based, strategic asset allocation portfolios investing exclusively in ETFs. Portfolio managers for Wilshire Funds Management employ proprietary risk analytic software in an attempt to create portfolios that deliver the greatest amount of expected return for pre-determined levels of risk so that advisors can select the portfolio most appropriate for their client’s risk tolerance.

In building our ETF portfolios, Wilshire aims to achieve broad diversification with reasonable fund fees. The result is the Wilshire Global ETF Allocation Portfolios which provide exposure to more than ten distinct asset classes, making these portfolios an ideal solution for advisors seeking highly diversified, low cost asset allocation solutions for their clients.

1Effective June 1, 2018 mutual fund filings will be on a monthly basis.

Important Information
Wilshire Funds Management (“WFM”) is a business unit of Wilshire Associates Incorporated that uses mathematical and statistical investment processes to allocate assets, select managers, and construct portfolios and funds in ways that seek to outperform their specific benchmarks. WFM delivers Wilshire Advisor Solutions, which include models designed to provide a broad range of outcome-oriented investment solutions for advisors to use with their clients. Past performance is not indicative of future results and processes used may not achieve the desired results. This report should not be considered a recommendation or solicitation to purchase securities and may include estimates, projections, and other “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented.

This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. This material represents the opinion of WFM as of the date indicated. WFM assumes no responsibility to update any such opinions. 

Wilshire is a registered service mark of Wilshire Associates Incorporated, Santa Monica, California. 

© 2017 Wilshire Associates Incorporated. All rights reserved. Information in this document is subject to change without notice. No part of this publication may be disclosed, reproduced or redistributed, in whole or in part, to any other person or entity without prior written permission of Wilshire Associates Incorporated, Santa Monica, CA. U.S.A 

For more information about the Wilshire Global ETF Allocation Portfolios, please contact or call 1-855-626-8281.

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