Money Really Does Grow on Trees

A Look at WisdomTree Investments

We've all heard the old proverb "Money doesn't grow on trees!" enumerable times in our pre-teen and teenage years. The lesson of this saying is straightforward become a productive member of your family and community, and gain your financial independence through work and service to others. Like many other life lessons, the principle is easy to grasp, but harder to execute, so the lesson is repeated until learned. We then build on this financial wisdom when we grasp the power of compounding, and learn that our money will work for us if we save and invest rather than spend and consume.

It is at this nexus of money, trees and investing that we find WisdomTree Investments, Inc., an emerging exchange-traded fund sponsor. WisdomTree employs the powerful imagery and natural association between money, trees and investing to brand its investment products. Through the use of famous quotes and historical passages on trees, this article takes a look at WisdomTree (Pink Sheets: WSDT) as a business and portfolio investment.

Someone's sitting in the shade today because someone planted a tree a long time ago. – Warren Buffett

WisdomTree is an investment management firm which develops domestic and international proprietary stock indices that serve as the basis for exchange-traded funds (ETFs). The WisdomTree Indices cover all major market capitalizations, both domestically and internationally. In contrast to capitalization-weighted indices, the WisdomTree Indices anchor the initial weights of individual stocks to a measure of fundamental value using other company specific economic factors such as dividends or earnings.

WisdomTree ETFs are differentiated from their competitors based upon their proprietary, fundamentally weighted indexes which introduce a value discipline, or tilt, to index portfolio construction. WisdomTree has a patent pending on the methodology and operation of its indices. WisdomTree believes fundamental values provide a more accurate picture of a company's intrinsic value than its market price alone. In other words, WisdomTree systematically employs Buffett’s security selection mantra "Price is what you pay. Value is what you get."

Recent research from Morgan Stanley "The "Value" of Fundamental Indexing" confirmed this value tilt and found that domestic fundamental indices, such as WisdomTree Indices and the FTSE RAFI US 1000, had high correlations with traditional value indices, such as S&P/Citicorp Value Indices. Additionally, Morgan Stanley researchers looked at risk adjusted returns (Sharpe Ratio) for various indices over 1, 3, 5 and 10 year periods ended 2006. The relevant WisdomTree Large-Cap, Mid-Cap, Small-Cap and Broad Market Cap indices generally had the highest risk adjusted returns in their class of capitalization-weighted, equal-weighted and other indices over the various time periods examined.

The creation of a thousand forests is in one acorn. -  Ralph Waldo Emerson

Acorns appear only on adult trees, and thus are often a symbol of patience and the fruition of long, hard labor. Such is the case with WisdomTree. Its principal sponsors have long labored in the investment field as investor, academic and regulator: Michael Steinhardt, one of the hedge fund industry’s most successful investors, Jeremy Siegel, one of the financial services industry’s most prominent academics from Wharton Business School, and Arthur Levitt, former Securities and Exchange Commission (SEC) Chairman and noted investor advocate.

WisdomTree’s ETF orchard opened for business on June 16, 2006 when it launched the first family of fundamentally weighted indices and ETFs with an initial 20 dividend weighted ETFs. This launch included the first international small cap ETF listed in the U.S. and the first family of ETFs that track indices comprised of high-yielding international equities. The first mover advantage has historically been significant in the ETF industry. For example, State Street Global Advisors (SSgA) introduced streetTRACKS Gold Trust (GLD) prior to Barclays Global Investors launch of iShares COMEX Gold Trust (IAU). GLD currently has total assets of approximately $10.8 billion compared with total assets of approximately $984 million for IAU at the end of March, 2007. WisdomTree International Small Cap Dividend ETF appears to have also garnered this first mover advantage and is now WisdomTree’s largest fund at $475 million as of May 9, 2007.

On October 13, 2006, WisdomTree introduced 10 international sector ETFs. These are the first ETFs to offer pure international sector exposure as existing ETFs are based on a "global" sector model and contain a mix of both international and domestic securities. On February 23, 2007, WisdomTree listed six domestic earnings-weighted ETFs.

They are like a tree planted near streams of water that yields its fruit in season; Its leaves never wither; whatever they do prospers. -   Psalms 1: 3

WisdomTree has been very strategic with its product introductions. It has focused its ETFs in the three largest product areas – Domestic equities (Large-Cap, Mid-Cap and Small-Cap), International, and Sector & Industry. According to Morgan Stanley research, these areas represent 45%, 26% and 12%, respectively, of ETF market share at the end of March, 2007. WisdomTree was not only first to market with a family of fundamentally weighted domestic indices of various capitalizations, but its international ETF product offerings provide great breadth and depth by geography, capitalization and sector.

Of its 36 existing funds, 24 are internationally oriented. While non-US equities account for approximately 55% of the MSCI ACWI (all country world index), most US investors have a substantially lower asset allocation to international equities in the 10% to 20% range. It would seem reasonable to expect US investor’s to increase their international asset allocations over time in an era of increasing globalization, more rapid growth opportunities abroad, and recent outperformance of international markets compared to the US.

Recent research from Morgan Stanley provides some early insights on the effectiveness of WisdomTree’s strategies. US-listed ETF assets grew $11.6 billion for the first quarter of 2007 to $477.1 billion, or at roughly a 10% annual growth rate. Total industry domestic Large-Cap ETF assets declined $1.7 billion to $149.9 billion, or roughly 5% annually, while WisdomTree ETFs in this category grew $241 million to $626 million. Total industry International ETF assets grew $5.2 billion to $126.1 billion, or roughly 17% annually, while WisdomTree category assets grew much more rapidly by adding $994 million to $2.4 billion.

He that planteth a tree is a servant of God, he provideth a kindness for many generations, and faces that he hath not seen shall bless him. -  Henry Van Dyke

While there are obvious economic and personal benefits associated with the innovative undertakings of the WisdomTree sponsors, some of the public statements of the principals also reflect some more altruistic motivations. The following is an excerpt of the April 30, 2007 Barron’s interview with Michael Steinhardt, WisdomTree Chairman and largest shareholder:

Steinhardt says he "was attracted to the idea of an investment product that would be superior in its performance and have at the same time low cost, great liquidity and total transparency." What also made these ETFs appealing is that they offered a good product to average investors, which in his view have not been well-served by mutual funds.

A fool sees not the same tree that a wise man sees. - William Blake, Proverbs of Hell, 1790

The market valuation of WisdomTree was broadly critiqued on limited information in a recent article in Economist on ETFs entitled "Revolution or Pollution?"

However, some worry that growth is getting out of hand, with valuations that recall the dotcom bubble. One ETF provider, WisdomTree, has seen the company’s own share price rise by 80% over the past year, even though it is yet to post a profit.

While WisdomTree has yet to post a profit, history tells us that successful investment advisory firms (Fidelity Investment, Vanguard Group, Fortress Investment, Blackstone Group) have been wonderful businesses to own. The attractiveness of the investment advisory platform reflects the relatively low fixed operating costs and significant operating leverage available with growth in assets under management. The greatest risk to the advisory model besides poor relative performance is runaway employee compensation. Wisdom Tree’s "passive" rather than active investment management platform significantly mitigates this risk. Meanwhile, history has not been as kind to most dotcom businesses.

Furthermore, unlike many dotcom companies whose only assets were intangible ".com" addresses and website hits, WisdomTree has $3.8 billion in assets under management (AUM) as of May 9, 2007 reflective of the tangible value of its intellectual property and its proprietary indices. Notably WisdomTree recently received two ETF industry awards for its innovative indexing methodology.

Do not be afraid to go out on a limb ... That's where the fruit is. -   Anonymous

So let’s inch out on a limb and review a few facts about the company before looking at valuation. Wisdom Tree is a development company and its shares trade on Pink Sheets. While WisdomTree does not currently file its financial statements with the SEC, its financial reports, including audited financial statements for the year ended December 31, 2006, are available at http://www.pinksheets.com/quote/finance.jsp?symbol=WSDT. WisdomTree recently announced that it intends to seek listing of its common stock on the Nasdaq Global Market by the end of 2007. In connection with that listing, the company would file periodic reports with the SEC. WisdomTree has 100.3 million shares outstanding and another 21 million of stock options, warrants, and restricted shares.

WisdomTree is engaged in a highly regulated and transparent industry. WisdomTree filed for and received exemptive relief from the SEC related to various provisions of the Federal securities laws necessary to create and market ETFs. The ETFs are marketed by WisdomTree Trust which is registered as an Investment Company with the SEC pursuant to the Investment Company Act of 1940. Its subsidiary WisdomTree Asset Management, Inc. serves as an investment advisor to the Trust and is a registered investment advisor with the SEC.

As of May 9, 2007, WisdomTree had an equity market capitalization and enterprise value (EV) of $702 million at $7.00 per share and assets under management (AUM) of $3.8 billion. This represents an EV/AUM ratio of 19%. This approximates the EV/AUM ratio (20%) at which AIG Global Investment Group and Atlantic-Pacific Capital, Inc. bought 18.8 million shares (15.9% of Company on a fully diluted basis) at $3 per share on December 22, 2006 when AUM was approximately $1.5 billion.

In addition to these new, sophisticated investors buying in at this EV/AUM level, existing stockholders and directors of WisdomTree also purchased 3,050,000 shares in this offering. WisdomTree closed at $7.80 or EV/AUM ratio of 52% after the AIG announcement. While the share price has languished since then, WisdomTree’s AUM has grown 153%, or $2.3 billion, to $3.8 billion on May 9, 2007 in the 4 ½ months since AIG made its investment.

Like an acorn, WisdomTree has massive potential for growth and ample opportunity to grow into its valuation. The ETF industry is still in its infancy. AUM for the industry has grown from $100 billion at the end of 2002 to $477 billion at the end the first quarter of 2007. ETFs are highly competitive investment alternatives to the $10 trillion mutual fund industry given their enhanced efficiency, transparency and performance reliability. WisdomTree ETFs were intelligently designed and strategically planted, and are being warmly nurtured by their disciplined caretakers for future generations to enjoy. As the business matures over the next decade and longer, holders of the WSDT common shares will find that with WisdomTree "Money Does Grow on Trees."

Full disclosure: Long WSDT in diversified, more risk tolerant client and personal portfolios.

World Series of ETFs

I am writing this piece on my return flight to Chicago from The World Series of Exchange Traded Funds (7th Annual) in Miami, FL on March 26, 2007. Various sources indicated that this is the most popular ETF conference. This was my first time at this conference so I am pleased to report that the popularity of the event is not solely due to the location and creative name (although major league baseball was my first career choice over finance and professional money management). Virtually all of the leading ETF families (Barclays Global Investors and State Street Global) and emerging ETF providers (XShares Advisors) were in attendance as well as several leading industry analysts and commentators. More importantly, the conference provided valuable information about current ETF industry trends and product developments.

We know from academic studies performed by Gary Brinson and his colleagues that asset allocation, rather than security selection, accounts for 90% of the variation in a portfolio's investment returns. We also know from studies by Ibbotson and others on the returns of major asset classes that stocks are the best performing asset over long periods. Most institutions, like the large endowments of Yale and Harvard University, have long adopted these and other academic findings in their investment processes. Unfortunately, a large share of the retail marketplace (individuals, families, etc.) has not. The retail world has adjusted its focus from individual securities to the portfolio level, but these investors have not fully embraced the advantages of strategic asset allocation, passive investment management (indexing) or the consideration of after-tax returns. The ETF industry is an emerging leader in applying academic theory to real world investing and making these institutional best practices available to the retail investors through their products. This article provides information on some of the product and other developments from the conference from the perspective of a potential retail investor.

One of the most significant take aways from this conference was that the ETF industry continues to be at the forefront of innovation in investment management. The industry as a whole is providing investors with valuable tools to manage risk at the asset class and portfolio level. There has been and will continue to be a proliferation of ETF products that capture various risk and return elements of the various asset classes. Optimally, these tools when effectively utilized will allow an investor to increase investment returns while lowering portfolio risk (variability in price). A critical element in chosing between various competing ETFs to achieve investment objectives is an understanding of the ETF structure - index construction and objectives, tax characteristics and liquidity. The following discussion will focus on index construction.

A review of the progression of the various ETF index structures is helpful in understanding these concepts. The initial criteria used to differentiate ETF products was primarily based upon existing index providers (S & P and Russell) and style classifications (Value, Growth and Core), similar to Morningstar's mutual fund classifications. An example of product risk segmentation at this level is large capitalization value ETFs (S & P 500 Value and Russell 1000 Value; indices favor lower price to earnings and price to book value stocks) as compared to various large cap growth ETFs (S & P 500 Growth and Russell 1000 Growth; indices favor faster growing companies with higher price to earnings and price to book value multiples). In addition to the porfolio composition differences at the index provider level (500 stocks versus 1000), each of these style based ETFs tries to capture a different risk-return element of the large capitalization domestic equity asset class based upon valuation metrics (PE and book value multiple).

More recently, the evaluation of risk and return elements of ETF products has progressed to strategic elements (active risk) with the creation of proprietary index weighting methodologies. These propreitary indexing methodologies generally did not exist prior to the introduction of the related ETFs and encompass strategies intended to generate excess returns relative to the market. Most of the more popular indices (S & P 500) used for ETFs are market weighted (index tends to hold more of the higher market cap and higher valued stocks). Proponents of alternative weighting regimes argue that there are better risk-adjusted indexing methodologies than market weighting and cite the 2000 and later bear market in which the higher valued S & P 500 market cap stocks suffered more than the S & P 500 as a whole. Alternatively weighted indices have emerged such as equal weighted ETFs (own 0.2% each of S & P 500 stocks) from Rydex Investments and fundamentally (strategically) weighted ETFs (weighted on fundamental factors like dividends, sales, etc.) from Wisdom Tree Investments, Inc. Since new ETF products are generally aggressively marketed at launch, it is very important to understand index composition to properly assess the level of active risk involved with these products.

An example of this product assessment would be the comparison of a marketed weighted S & P 500 ETF with about 20% of its portfolio in the top 10 names versus 2% for an equal weighted S & P 500 ETF. Although the level of active risk is far from the theoretically highest (single stock risk) by holding only the smallest, most volatile stock among the S & P 500, the equal weighted S & P 500 ETF certainly contemplates security "bets" very different from the market. Clearly, these ETFs should not be considered purely "passive" investments. Fundamentally weighted ETFs take a more pragmatic approach to the introduction of active risk than an arbitrary equal weighting and may have more practical use in an investor's portfolio construction process. This is particularly true if the investor has conviction that the strategic factor(s) (driver of security selection process) underlying the fundamental weighting and portfolio construction are likely to result in excess returns (expectation that active risk will generate higher returns). Wisdom Tree's fundamentally weighted ETFs may be the most appealing product currently available given that their predominant weighting factor is dividends. Dividends have been a significant component of total market returns (dividends plus price appreciation) over long periods of time. Regular quarterly dividends also tend to give managements and boards an additional element of focus and discipline. Wisdom Tree's backtesting of their weighting regime indicates significant outperformance at lower risk (volatility), but, of course, past performance is not necessarily indicative of future results.

A second highlight from the conference was that ETFs are a superior structure for alternative asset classes. This is most visible in commodity ETF products. For example, prior to the introduction of commodity based ETFs an investor seeking exposure to this low correlated asset class (reduces portfolio risk/enhances returns because commodity price movements have historically been mostly independent of stock and bond price movements) would have to pay 1.5% to 2.0% in management fees for access to an "actively" managed commodity pool, futures account or other product. Diversified, "passively" managed exposure to commodities (gold, silver, oil, natural gas, industrial metals, grains) can now be achieved cheaply through ETFs at approximately one-half the fees. As with equity ETFs, an understanding of a commodity ETF's index construction and objectives, tax characteristics and liquidity are critical to the investment decision. The ETF structure is also currently being used for investment in other low correlation asset classes and investment strategies generally not available to retail investors on a cost effective basis, such as currencies and leveraged and short (or inverse) exposures to equities.

A third benefit of the attending the conference was the opportunity to meet with two thoughtful, independent ETF research analysts. I recently subscribed to ETF research coverage provided by AltaVista Independent Research (http://www.etfresearchcenter.com/). I met with the company's president Michael Krause and was pleased to find we share a value orientation and an interest in country demographic trends as an indicator of future economic activity. AltaVista's extensive valuation and performance research on ETFs can be leveraged to manage risk. I also introduced myself to Richard Kang of The Beta Brief (http://www.thebetabrief.com/). Richard is a forward thinking, quantitative analyst on the ETF industry. His bloggings are generally thought provoking and informative and his contrarian views help keep readers alert to potential market risks and opportunities.

In summary, the World Series of ETF conference generally demonstrated that the ETF provider and analyst communtity are providing retail investors with useful, innovative and efficient products along with insightful research and analysis to properly assess these investment products. The ETF fund families together with an emerging independent analyst community are providing retail investors with practical tools and information necessary to adopt investment best practices commonly used by institutional investors - strategic asset allocation, passive investment management (indexing) and consideration of after-tax returns.

Five Investing Truths

Another year is in the books and it is a time again to reflect on the past year, to think about the lessons we've learned along the way and  to contemplate how to make our tomorrows better. 

This past year taught me that the topic of investing carries with it a great deal of angst and complexity for many.  I decided I needed to bridge this information gap in some non-threatening manner by reducing the topic of investing to its most essential truths.

Five Investing Truths That SERVE You Well

Save Regularly

• Rule of thumb – Maximize tax advantaged savings first through 401(k) and similar accounts

Ensure Liquidity

• Rule of thumb – Maintain at least six months of living expenses in cash or cash equivalent savings

Review Asset Allocation; Rebalance

• Rule of thumb – Starting point for equity allocation is 100% less your age with remainder generally in income producing securities; Adjust percentages based on tolerance for risk

Value Indexing over Active Management

• Rule of thumb – Indexing provides greater performance reliability; Most actively managed mutual funds underperform their benchmarks

Efficiently Invest Thru ETFs

• Rule of thumb – Exchange Traded Funds (ETFs) provide a great combination of diversification, lower costs and performance reliability 

Time For Index Funds

The November 2, 2006 edition of the Wall Street Journal featured an article by Diya Gullapalli  entitled "It May Be Time to Bet on Index Funds - Actively Managed Portfolios Are Pressed to Find Stocks That Can Beat Benchmarks" (subscription required).  The article highlights a slew of recent research that suggests index funds that track benchmarks could be the way to go in comings months.

Quotable quotes from the article include:

Merrill Lynch & Co.'s October report titled "Time to Index?" pointed out that while more than 60% of stocks in the S & P 500 stock index outperformed the index in 2001, that figure has declined to below 50%.  This could lower the odds active managers will spot big stocks that can beat the benchmark. 

"It may be time to move out of the active-manager realm and into the passive manager," said Bill Sickles, a former Lipper Inc. senior research analyst.

Large cap index funds have pulled in $3.8 billion in net cash through September, but actively managed peers have lost $8.8 billion.

And last but not least:

"I'm hearing people kind of mumbling about indexing my large-cap US stocks and then adding an active manager for small and international" areas, said Andrew Smith, chief investment officer of Northern Trust Global Advisors.

It makes no sense to mumble when discussing this issue with your trusted investment adviser.  Say it loud, say it proud!

Dear Trusted Adviser:

The active investment strategies we've pursued for years are not adding any value.  In fact, they are detracting from value, particularly after fees.  I am tired of my portfolio returns failing to best investment benchmarks due the underperformance of highly, compensated active managers. 

Lets try to be smarter with my life savings.  I want you to start using more intelligently designed investment products and services, like exchange-traded funds (ETFs), for their greater efficiency and performance reliability.  I would feel much more confident in achieving my investment objectives.

Yours Truly,

The Boss

ETFs Avoid Surprise Mutual Fund Tax Hits

The August 24, 2006 edition of the Wall Street Journal featured an article by Eleanor Laise entitled "A Surprise Hit For Small Investors" (subscription required).  The article is noteworthy in that it indirectly highlights several of the advantages of exchange-traded funds (ETFs).  The article discusses how manager turnover in an actively managed mutual fund inevitably leads to portfolio shifts which trigger capital gain income taxes.

The relevant points are highlighted in the following excerpt:

A change in fund managers could lead to higher tax bills for investors. Here's what they should watch for:

• New managers often dump unwanted holdings, triggering taxable capital-gains distributions.

• Investors sometimes flee funds that change managers, which could aggravate any tax hit for shareholders.

• Some types of funds, including index funds, are typically able to change managers without resulting in big distributions to investors.

One of the advantages of ETFs is that they are more tax efficient than traditional mutual funds.  Since ETFs are generally pure index funds, there is little concern about manager turnover.  Further, ETFs have lower portfolio turnover and fewer capital gains since portfolio changes would typically only occur with changes in the relevant index or basket of securities.  Exchange trading of ETFs further enhances their tax efficiency since ETFs are not required to sell securities to meet shareholder redemptions. In a traditional mutual fund, the fund must sell securities to redeem mutual fund shares from fleeing investors.  Such forced security sales may generate additional capital gains for the remaining mutual fund shareholders.

ETF Asset Growth - June 2006

According to the Investment Company Institute (ICI), the combined assets of the nation's exchange-traded funds (ETFs) increased 13% in 2006 to $335.1 billion at June 30, 2006.  The number of exchange-traded funds continued to outpace the growth of assets as a number of new financial institutions have entered the market in 2006.  The number of ETFs rose 31% to 263. 

Assets of equity-based ETFs also increased 13% to $317.5 billion with assets of international equity funds growing at a 27% clip to $82.8 billion.    The number of domestic equity ETFs grew 33% to 194 funds while international equity ETFs increased 29% to 63.

The growth in the net assets of ETFs was double that of the traditional mutual fund industry.  According  to ICI, assets for stock mutual funds increased 6% to $5,248.9 billion as of June 30, 2006.

Intelligently Designed Advice

When you see a sundial or a water-clock, you see that it tells the time by design and not by chance. How then can you imagine that the universe as a whole is devoid of purpose and intelligence, when it embraces everything, including these artifacts themselves and their artificers?— Cicero

The term "intelligently designed" as used herein simply means products and services that are best suited to meet the needs of individual investors.  It means product and service features as investors would have created on their own - efficient, independent and consumer-focused.

It has been approximately six months since Servant Financial was formed, and approximately one month later our first article was published on our corporate website.  Although six months is a relatively short time frame, we thought it an appropriate interval to take stock of the investment advisory industry and our investment and service philosophies. 

Already two very powerful investing trends have started to emerge.  Individual investors are increasingly showing a strong preference for more intelligently designed investment products and services - exchange-traded funds (ETFs) for greater efficiency and lower cost and independent advisors providing more advice-driven, consumer-focused services.

In our initial article "ETFs: Cutting-edge Technology Benefits Individual Investors," we shared the following views about the future investment landscape with the advent of ETFs (emphasis added)

Like iPods, ETFs share the winning attributes of lower cost and greater efficiency and reliability as compared to existing products. As so aptly pointed out by David F. Swensen in his book "Unconventional Success: A Fundamental Approach to Personal Investment", ETFs offer retail investors the efficiency and performance reliability of distributed institutional investment management at very competitive prices.  Like other dominant technologies, ETFs will be a very disruptive influence on the retail investment advisory industry.  ETFs will not only be a competitive challenge to the traditional mutual fund industry, but will also improve how investment services are delivered to individual investors.  Informed retail investors will be increasingly resistant to current industry practices in which an investor essentially pays an adviser to sell them investment products and services.  There will be limited room for high sales loads or commissions for ETFs because part of the technology gap these products address is the efficiency of current investment product distribution and sales practices. 

Accordingly, the investment advisory industry is in the nascent phases of a dramatic, secular change toward advice driven, consumer focused investment advisory services and away from traditional sales driven business models.  The return reducing costs of sales and marketing activities together with the potential for benchmark underperformance from active investment management will increasingly give way to an information driven cost/benefit focus by individual investors.

Taking a look at recent investing trends we begin to see the disruptive impact of ETFs.  The ETF industry is growing very rapidly as the product becomes increasingly popular with investors.  An April 25, 2006 Morgan Stanley equity research report stated that aggregate ETF assets totalled $350 million as of April 21, 2006 after strong net cash inflows of approximately $60 million in both 2004 and 2005 (Morgan Stanley compiled this data from information reported separately by each ETF advisor and trustee).

A recent article by Rob Wherry on ETFs in Smart Money magazine entitled "Too Much of a Good Thing?" provided the following comparative insight on ETF cash flows:

Exchange-traded funds are pulling in assets six times as fast as traditional mutual funds, as investors use them to get stock market exposure at rock-bottom prices.

The following excerpt from this article highlights the disruptive impact ETFs are having on the competitive balance in the investment advisory industry. 

Once an arcane niche, exchange-traded funds have attracted so much money that even jaded Wall Streeters have been forced to stand up and take notice. Last year alone investors poured $54 billion into ETFs, which are low-cost baskets of stocks that track indexes but, unlike traditional mutual funds, trade all day long on the stock exchange. The field is dominated by Barclays Bank and State Street but is quickly becoming crowded with competitors. Little wonder then that ETFs have caught the attention of two of the biggest names in the fund business: Vanguard has launched 21 ETFs over the past two years, while Fidelity slashed the costs on some of its index funds to better compete.

In addition to reassessing which investment products to use to achieve their goals, individual investors are also rethinking their investment advisory service relationships.  Individual investors are more frequently opting for the independent advisory business model that is best suited to provide the advice-driven, consumer-focused services they desire.

In the April 29, 2006 Saturday Edition of The Wall Street Journal, there was an insightful article by Jeff D. Opdyke and Lingling Wei entitled "Stockbrokers Loosen Up Their Ties" which highlighted the fundamental reasons for the increased popularity of independent advisors among individual investors.  This excerpt summarizes one key perceived benefit of independent advisors:

Wall Street's giant brokerage firms -- long the dominant force in the investing game -- are starting to lose their edge.

Increasingly, individual investors are turning over their money to independent brokers and advisers amid worries that big firms don't always have their best interests at heart. Over the past five years, independent advisers have nearly doubled their share of assets under management to 17%, according to discount brokerage firm Charles Schwab. 

It is apparent from the foregoing emerging investment trends that individual investors are showing a clear preference for more intelligently designed investment products and services.  We expect that these trends will continue to reshape the investment advisory industry.

NCAA Basketball And Investing

The March 15, 2006 edition of the Wall Street Journal featured an interesting article by Jonathon Clements entitled "Net Gains: How Watching Basketball Can Improve Your Approach to Investing" (subscription required).  The article discusses various basketball analogies that highlight the common behavioral and cognitive mistakes made by investors.   My favorite anecdote in the article deals with the eternal optimism of individual investors that they can overcome significant odds and consistently beat the market. 

The following excerpt summarizes these common behavioral mistakes:

How often does a college basketball team that's trailing at halftime come back to win? Allan Roth, a financial planner with Wealth Logic in Colorado Springs, Colo., often puts this question to audiences. He says people typically guess that between 30% and 60% of teams make a comeback.

In fact, Mr. Roth looked at over 3,300 college games played in November, December and January and found that, among teams trailing at the half, less than 20% came back to win. Why do folks think the number is so much higher? Mr. Roth figures there are two reasons.

First, we tend to be overly optimistic. "It's America," Mr. Roth says. "We believe in the underdog -- and we believe in the small investor." Even though studies suggest that most investors lag far behind the market, we like to think we can beat the odds and come out on top -- which helps explain why market-tracking index funds still aren't that popular.

Second, comeback victories tend to get the most media attention, so they stick in our minds. "It's the same thing with hot mutual funds and hot money managers," Mr. Roth says. "Because investors only hear about the winners, they think it's easy to beat the market."

A recent article I read about institutional  investment trends concluded that institutional investors have paid a huge price to buy Beta (or market returns) - paid in fees, risk and market impact.  If institutional investors have paid a huge price for Beta then individual retail investors have paid ever more dearly for the privilege of underperforming the market through even higher active management fees and the costs associated with conflicts of interests in the sale of in-house mutual funds.

My advice is to enjoy March Madness and even root for the underdog if you like.  But when it comes to investing please take what the market will give you by following a sound, risk-based asset allocation strategy and indexing through Exchange Traded Funds (ETFs).  ETFs offer investors the efficiency and performance reliability of distributed institutional investment management at very competitive prices. 

New SEC Rule for Financial Advisors

The January 28 edition of the Wall Street Journal featured an article "Wait, Let Me Call My ChFC - Your Stockbroker or Advisor Can Have Many Baffling Names; A New SEC Rule Might Help" by Jeff D. Opdyke (subscription required).  The article discusses a new SEC Rule on disclosure practices of advisors and provides some very good guidance on the different roles and responsibilities of the various types of financial professionals and their customer service philosophies.

The following excerpt summarizes the new SEC Rule:

In a small but important step to address concerns like these, starting Tuesday, the Securities and Exchange Commission is kicking off a new rule designed to make it easier for consumers to know what they're getting when they hire a financial professional.

The new rule mandates that stockbrokers who hold themselves out as financial planners must be clear about the role they're playing when dealing with clients. In other words, if they're clearly providing advisory services, then they're duty-bound to act in a customer's best interest, as are traditional financial planners. If they're acting as a broker -- in other words, essentially, a salesperson -- then they must be clear that's the role they're playing.

In addition, the article distinguishes between the two primary types of financial adviory professionals and the regulatory frameworks.

Generally, only two types of titles are scrutinized by regulators, and therefore offer consumers legal protections: broker-dealers and registered investment advisers. Broker-dealers (think: stockbroker) serve primarily as stock-market order-takers, facilitating trades on Wall Street and in the bond market. They report to the NASD, the brokerage industry's self-regulatory arm. Registered investment advisers (think: financial planners), which report to the SEC, primarily provide services such as building a financial plan or offering tax- and estate-planning advice.

Broker-dealers and advisers are held to different standards when dealing with clients. Brokers must abide by so-called suitability rules requiring they "know the customer" and offer investments suitable to a client's needs.

The concept of "suitability" can be murky, however, and brokers aren't obligated to act solely in your best interest. The NASD has been strengthening suitability rules in recent years. Still the organization last year fined the industry a record $125.4 million for transgressions including inappropriate sales of annuities and mutual funds.

By contrast, registered investment advisers are subject to a so-called fiduciary duty, a legal standard mandating they act solely in your best interest. Advisers also are subject to disclosure rules requiring they provide to clients Form ADV listing potential conflicts of interest, compensation practices and disciplinary proceedings.

Hopfully, the new SEC Rules and increased customer awareness from articles like this will serve to highlight for investors the unique customer service benefits of registered investment advisors. 

ETFs: An Approaching Paradigm Shift for Wealth Management

ETF Investor recently reprinted an essay entitled "ETFs: An Approaching Paradigm Shift for Wealth Management."  ETF Investor reprinted the essay in its entirety, including accompanying charts.  The introduction reads:

Tyler Mordy, a Research Analyst with Hahn Investment Stewards, wrote an excellent overview of wealth managers’ ‘revolutionary shift’ to ETFs. ETFs’ ‘threat to the typical business model of asset management firms is enormous,’ says Mordy.

The article reviews many of the technological benefits of ETFs as compared to competing investment products, highlights the importance of asset allocation, provides an update on the growth of the ETF market and cites examples of how the enormous benefits of ETFs represent a threat to the typical business model of asset management firms.   

The impact of technology on the business model of asset management firms continues to evolve.  We have seen its greatest impact on transaction processing services (ie. lower commissions) and are in the early stages of evolving changes in investment management services with the advent of ETFs.  Ultimately, these advances will change the relationship management services of asset management firms and drive a dramatic, secular change toward advice driven, consumer focused investment advisory services and away from traditional sales driven business models.