I am excited to announce the formation of YieldShares, a new exchange– traded fund (ETF) Sponsor. YieldShares, as its name suggests, will focus on the income ETF segment. The firm’s efforts will be supported by a number of business partners including Exchange Traded Concepts and the International Securities Exchange (ISE).

The creation of YieldShares occurs in the midst of a challenging environment for income investors. Yields are historically low and investors are searching for new avenues to increase investment income. The ISE High Income Index, developed jointed by the ISE and YieldShares, is the first step towards providing investors fresh choices when it come to income investing.

On a personal note, I am looking forward to returning to the ETF industry as an ETF Sponsor. Since forming Magoon Capital in 2010, I have enjoyed advising potential and existing ETF Sponsors on product development, marketing and distribution. It has also been rewarding to share thoughts on investing and ETFs through platforms including the Wall Street Journal, Index Universe, Twitter and Seeking Alpha.

I am excited to begin building YieldShares alongside a variety of exciting partners. Much more to come!

The Westin Diplomat hosted the Inside ETFs conference.

To review, in part one of this series I addressed the prominence of both Vanguard and iShares in relation to the other ETF Sponsors at the conference. The tension present at conference concerning active ETFs was another insight I outlined. In part two, I’ll cover ETF model portfolios and social media usage at Inside ETFs.

ETF MODEL PORTFOLIOS 

ETF model portfolios are portfolios of ETFs put together by analysts or registered investment advisors to meet an investment objective or strategy. Both financial advisors, and in some cases, retail investors can then invest assets based off these models. A fee is then paid to the model’s creator.

ETF model portfolios couldn’t be ignored at the conference. If there wasn’t an ETF model portfolio manager on every third panel, I would be surprised. Not that I disagree with their participation, as they provided practical insight on the practice of selecting, managing and trading ETF focused portfolios. In fact an exclusive ETF model portfolio manager closed door session was held at the conference for the crowd to share ideas and best practices.

It is clear that this “prepackaged” ETF solution is a major driver of the ETF industry. Index Universe highlighted ETF models as being responsible for “massive inflows” into ETFs over the last year. The larger ETF providers with low cost ETFs also went out of their way to offer ETF model portfolios airtime on panel discussions. ETFs with lower expense ratios are attractive to ETF model portfolio managers and advisors who use them because there is less performance drag due to product fees. Also lower expense ratio ETFs may allow for more room to charge higher fees on the model or for the implementation of it.

As briefly mentioned earlier, the secondary iShares booth was promoting at least a half a dozen model ETF portfolios from what appeared to be registered investment advisors (RIAs). The booth had no iShares product literature, instead it had racks of individual third party ETF model portfolio manager brochures and a robust iShares reference guide on dozens of ETF model portfolios. Here is just a sample of the ETF model portfolio literature at that booth.

Literature at the iShares booth promoting ETF model portfolio managers.

Clearly ETF Sponsors see the potential to garner massive allocations from ETF model portfolio managers. They have begun to essentially market these portfolios in one way or another. It will be interesting to watch this unfold as the politics and legalities of lining up with certain RIA’s ETF models will become ever more complicated. Indeed, the last growth stat I read from Morningstar was that assets in ETF models rose 45% through Q3 2012 and 65% year over year. These numbers handily surpassed the impressive growth rate of ETFs themselves.

SOCIAL MEDIA

As an avid participant in social media like Twitter (follow me @ChristianMagoon) I was shocked to see the lack of social media engagement by the vast majority of ETF Sponsors. What a wasted opportunity! Index Universe, a variety of advisors, media and industry experts were actively highlighting information and opinions in real time. Here’s a snapshot of what I am talking about.

Inside ETFs: A Small Slice Of The Twitter Conversation

Only iShares and Vanguard were active in this conversation. Both used Twitter to highlight insights, direct advisors to resources and even to remind people to meet various representatives at scheduled events. These were not product pushing Tweets, they were communications that provided value and another form of interaction. One of the best Tweets was from iShares. They said goodbye to all the conference participants and provided a link to be able to “take iShares home with you.” What was the link? The official iShares app — something I downloaded and didn’t know even existed before!

It is incredible to me that the majority of ETF Sponsors ignore free social media resources, especially Twitter. Do they know that media outlets like Barron’s, Index Universe and CNBC were making real time comments on discussions, ETFs and ETF sponsors in real time? Do they know that investment advisors — their clients — were also doing the exact same thing? Talk about a missed opportunity.

Especially ironic was that a keynote speaker at the conference was the cofounder of Twitter, Biz Stone. As if that couldn’t be any funnier, Biz was introduced and sponsored by ProShares, an ETF provider not even using Twitter! (At least ProShares didn’t have to listen to the realtime ridicule…)

Demographic research from the Investment Company Institute (ICI) shows that ETF users are more educated and tech savvy than mutual fund investors. Indeed just ask an ETF sales person what they think of the average advisor using ETFs. Answer: tech savvy. If Vanguard and iShares can do it, the rest of the industry can take advantage of this platform too. (Indeed firms like AdvisorShares and PowerShares are usually active on Twitter but were absent on the conference hash tag #InsideETFs.)

The 2013 Inside ETF conference was a success. It cemented its place as THE “must attend” ETF event. Top notch experts,the quality of discussions, out of the box luncheon keynote speakers, breadth of attendees and premium facilites were just some of the ways Inside ETFs set itself apart. I’m already looking forward to being a part of next year’s event.

A view toward the ocean from the Westin Diplomat.

CNBC was on hand to broadcast live from the event. Bob Pisani interviewed product providers on their outlook toward ETFs and the markets overall. I was invite to be part of a group that rang the NYSE Opening Bell from Inside ETFs to celebrate the 20th anniversary of the first ETF, which trades on the NYSE ARCA platform. The following day I moderated a panel of experts discussing crisis investing using ETFs. Needless to say, this three day conference was a whirlwind of activity and I thought I’d take moment to deliver several insights from the event.

ETF SPONSORS WHO LOOMED LARGE

First, it seems as though Vanguard and iShares are head and shoulders above the other ETF providers in terms of their presence and commitment to the ETF space. Yes, on face value Vanguard was the premier or “Diamond” Sponsor of the event and thus had the most invested in the conference. Martha King of Vanguard was a superstar as a conference chair. She wisely threw her support behind the need for professional financial advice. One memorable quote went something like, “Financial advisors are the difference between making a wish list and having a plan.” Two sponsorship levels below resided iShares however, and their presence was felt almost as strongly. Before I get into that, here’s a visual summary of the top tier sponsors from the Inside ETFs homepage.

The “higher level” Inside ETF sponsors.

Both Vanguard and iShares went beyond the typical booths and essentially had compounds at the conference. Vanguard had the prime location outside the entrance of the exhibition hall. Perhaps 30 feet long, this piece of Vanguard real estate was staffed by several and featured several computers and flat screens. Oddly enough, though perhaps not in a crowd full of registered investment advisors, I never saw it very busy.

iShares was directly inside the hall facing the entrance. Their small compound actually (which looked a bit like this) had a mini lounge with chairs and plated glass partitions. I never saw this booth empty of attendees! In addition iShares had another more standard booth which essentially promoted managed ETF portfolios, but more on that later. Both Vanguard and iShares dwarfed all the other standard booths and certainly made an impression visually and sub consciously. I heard more than one advisor say to another, “I’ll meet you at the Vanguard area or the iShares lounge.” Not only are these leading ETF providers in terms of assets, they were physical points of reference at the conference. Well played Vanguard and iShares!

TENSIONS ABOUT ACTIVE ETFS

Another observation from the conference was the anti active ETF sentiment expressed by a variety of participants — especially financial advisors. The historical roots of the ETF industry — passive / index investing — are very strong. One session I attended had an advisor stand up to ask a question that instead ended up turning into a rant against active ETFs. His point, “active ETFs are only going to benefit ETF Sponsors, not investors.” Why? “Because active management doesn’t work.” That financial advisor’s opinion was addressed by the panel composed of several ETF veterans, including a top tier index based ETF Sponsor now launching active ETFs as well. The response was that “not everything could be easily indexed” and that “in some cases active management might be more appropriate due to the flexibility it offers.” What was likely not lost on the crowd however is that very few active ETF products actually are investing in so called “challenging” areas. Nevertheless, the anti active management crowd was alive and vocal.

Active ETF opponents will not be too happy over the next year however as Index Universe CEO Jim Wiandt pointed out that of around 50 new ETF issuers on file, many seek relief to launch active ETFs. What remains to be seen is whether active management proponents begin to increase their influence in the industry. Currently only AdvisorShares is a consistent advocate of active management. Perhaps PIMCO, with their active ETF success, will elevate the representation of active management in the ETF industry. For now however, passive investing sentiment dominates, with only a hint that active management is anything other than foolish.

PART TWO

In part two of this article I will share several other insights on ETF model portfolios and social media usage from the conference.

ETFs are increasingly becoming a portion of investor’s portfolios due to their efficiency, transparency and flexibility. However ETFs are not for everyone nor are they best investment vehicle in every case. So in that spirit, here’s an annotated list of investors who may want to stay away from ETFs.

1. Most Fans Of Active Management — Despite the recent advances in active ETFs from the likes of PIMCO, AdvisorShares and Northern Trust, the active ETF space is still not robust. Most investors will be challenged to find a selection of active ETFs to choose from in a variety of asset classes. The good news however is that more active ETFs are coming and their efficient and transparent approach should offer a compelling value proposition.

2. Arm Chair Quarterbacks — Sometimes the lack of daily transparency offered by mutual funds is a blessing in disguise. Most ETFs disclose their portfolios daily which on balance allows investors better information to make decisions with. However some investors are better served only knowing their portfolio holdings once a quarter, the requirement for mutual funds. This controlled access prevents investors from being as subject to the emotion of the markets. So if you are a daily portfolio watcher with an itchy trigger finger, ETFs may not be for you.

3. Premium Shoppers — There are always consumers and investors that are not fazed by costs. By and large ETFs are like the Costco of investing. They provide access to some of the most compelling opportunities in the marketplace but at a warehouse price. Mutual funds however are similar to the Department store model which seems to attract those less price sensitive. Thus mutual funds offer a premium experience when it comes to fees. Unfortunately that premium experience is not often mirrored in the performance of mutual funds.

4. Max Taxers — This group of investors is either not concerned about taxes or believes paying the maximum amount of taxes is patriotic. We have heard this last sentiment about taxes a lot during the Presidential election cycle. The problem for investors in this “max tax” camp is that ETFs operate in a structure that is tax advantaged. Thus an ETF is a poor investment vehicle for this group. Instead traditional mutual funds make more sense.

As mentioned above, ETFs are not for every investor nor are they the perfect investment. The four groups of investors above would fare best avoiding ETFs going forward given their unique views and needs.

Identity Crisis

The ETF industry is certainly a big tent. There are ETFs structured in a variety of ways including traditional 1940 Act funds, non traditional leveraged and inverse 1940 Act funds, unit trusts, commodity pools and grantor trusts. Many of these different underlying ETF structures produce unique tax consequences, risks and outcomes. Consequently the term “ETF” has lost much of its meaning to many investors.

The ETF industry would be wise to recast itself as a broader group — Exchange Traded Products (ETPs) perhaps — and then define and standardize criteria and naming conventions for each type of underlying structure known today as an ETF. For an industry built around the concept of transparency, this seems like a logical choice to be proactive about. Ignoring it risks the quality of investor experience with ETFs and may invite regulators to create their own standardization.

Revenue Crunch

The great news for investors is that ETF price competition is alive an well. Vanguard and even iShares have deployed successful price point campaigns against market leading ETFs. While investors benefit the ETF industry is in a revenue crunch. Besides diminished pricing power, more brokerage firms are now seeking to gather revenue from ETF sponsors that has been lost by declining mutual fund sales. Product approval blockages, lack of ownership data and service agreements are beginning to crop up at brokerage firms as a way to get ETF Sponsors into the traditional “pay to play” mutual fund model.

If that pressure was not great enough, broker dealers like Schwab, Scottrade and Vanguard are tightening the belt by offering free ETF trading for account holders in proprietary ETFs. The advantage of having the economics of an execution business combined with an ETF product line puts more pressure on firms that are not broker dealers. Indeed, we have already seen several broker dealers without ETF lineups begin to offer free trades in selected ETFs from selected ETF Sponsors. This leads to more revenue compression on ETF Sponsors and should increase ETF closures and ETF company acquisitions going forward.

Distribution Dilemma

ETFs have still not made a dent in the significant amount of existing defined contribution assets or inflows. This space continues to be dominated by mutual fund offerings. ETFs must begin to get on the menu of DC plans as their inflows are consistent and massive. While ETFs may not be as attractive in a non taxable entity, it is no doubt an opportunity to not just grow assets and but increase awareness of ETFs. Remember millions of Americans are only familiar with the types of investments found in their DC plans. By simply becoming a widespread DC plan option, ETFs would achieve a significant victory.

Finally, the indexing based roots of ETFs are strong and will continue to be the lifeblood of ETFs. However, with active mutual funds dominating mutual fund investor assets, actively managed ETF offerings need to increase in order to bridge the gap between the ETF industry and the mainstream investor. As we have learned from the mutual fund industry, most investors will always prefer active management. To ignore that large group of investors is to walk away from an opportunity to showcase the transparency, efficiency and flexibility of the ETF structure. The ETF industry will become healthier and more diverse through a robust effort to capture active assets. It will also be doing investors committed to active management a much needed service.

These three challenges are just several the ETF industry is grappling with. The good news is that what some would call “problems” are really “elegant problems,” meaning problems caused due to size and speed of growth of the ETF industry, not decline.