Are You Judging ETFs the Wrong Way?

Judging Today's ETFs by Yesterday's Standards

One of the comments I've heard most often throughout my career comes from investors, advisors, and even ETF sales teams.

"I'd like to see the fund gather a few more assets first."

"The trading volume is still pretty light."

"The spread is wider than I'd like."

Those are reasonable observations.

But they may not be the best way to evaluate many of today's strategy ETFs.

When ETFs Were Built for Market Access

For much of the ETF industry's history, there was a race to provide every type of market exposure imaginable.

There were ETFs for the S&P 500, international markets, sectors, industries, commodities, currencies, and eventually almost every index you could imagine.

The objective was straightforward: provide investors with efficient, low-cost access to a particular market.

Those products shaped investor expectations. Investors became accustomed to ETFs with billions of dollars in assets, penny-wide spreads, and portfolios that changed only when an index rebalanced.

When I entered the ETF industry nearly three decades ago, I had the opportunity to witness much of that evolution firsthand.

Much of my career as a market maker was spent helping investors gain access to markets that were often difficult or expensive to reach.

I was responsible for making markets in ETFs providing exposure to countries like South Korea and Taiwan, broad international and European indexes, thematic funds tied to industries like gold miners and coal, rare earth strategies, and even frontier markets like Egypt.

Whether it was a country ETF, a thematic ETF, or a frontier market fund, the common thread was the same, they were designed to provide exposure to a market or theme.

The portfolio management was largely driven by an index.

Back then, the challenge was giving investors access to a market.

Today, the challenge is helping investors achieve an investment objective.

From Market Exposure to Investment Solutions

Today's ETF industry is different.

While new index and thematic ETFs continue to launch, much of today's innovation is focused on delivering investment strategies rather than simply market exposure.

These strategies aren't designed to replace broad-market index ETFs.

They're designed for investors with specific objectives.

Some seek higher levels of income through professionally managed option strategies.

Others are designed to reduce downside risk during periods of market uncertainty.

Some dynamically increase or decrease leverage based on market volatility, while others tactically allocate among multiple asset classes or actively manage portfolios based on changing market conditions.

These aren't simply index funds packaged inside an ETF.

They're professionally managed investment strategies delivered through the ETF wrapper.

Why Traditional ETF Metrics Don't Tell the Whole Story

As a result, they shouldn't automatically be evaluated using the same metrics investors often use for large, broad-market ETFs like SPY or QQQ.

For example, I often hear investors express concern about a strategy ETF having a wider bid-ask spread than one of these large index ETFs.

The spread is important.

But it's also important to understand why the spread is what it is.

A broader spread may simply reflect the additional complexity involved in pricing and hedging options, multiple asset classes, international securities, or actively managed portfolios.

It may reflect the cost of implementing and managing a more sophisticated investment strategy rather than a lack of liquidity.

Of course, there are exceptions.

Occasionally, wider spreads may indicate that market quality could be improved or that an issuer should work more closely with its liquidity providers.

In my experience, however, issuers with an experienced ETF capital markets professional monitoring their funds tend to identify and address these issues quickly.

Those situations are far less common than many investors assume.

Liquidity Evolves Over Time

I can still remember standing on the AMEX trading floor when the QQQs first began trading.

I was making markets in other ETFs just a few feet away.

It's easy to forget today that one of the world's largest and most actively traded ETFs didn't begin with penny-wide spreads.

Early on, the market was measured in dollars rather than pennies.

Part of that reflected the fact that many of the underlying Nasdaq companies were younger, faster-growing, and considerably more volatile than they are today.

But it also reflected an ETF ecosystem that was still evolving.

As investors embraced the product, technology improved, market makers gained confidence, and the market matured, spreads naturally tightened.

That doesn't mean every strategy ETF will eventually look like QQQ, and it shouldn't.

But it does remind us that liquidity evolves.

A wider spread at launch doesn't automatically indicate a problem.

It often reflects the complexity of the underlying investment strategy, along with the time required for investors, market makers, and the broader ETF ecosystem to fully understand and efficiently price what the ETF is delivering.

In other words, a wider spread doesn't automatically mean something is wrong.

Success Should Be Measured by the Objective

The same can be said for assets under management and trading volume.

A strategy ETF designed to solve a specific investment problem may never gather the assets or trading volume of one of the industry's largest index ETFs, nor should we expect it to.

Its objective is to successfully deliver the investment strategy it was designed to provide.

No one compares a professionally managed mutual fund or separately managed account to a broad-market index fund and concludes it's unsuccessful because it has fewer assets or follows a different investment process.

Many of today's strategy ETFs deserve that same perspective.

A New Way to Evaluate ETFs

The ETF wrapper hasn't changed.

What's changed is what's inside it.

Perhaps the biggest evolution in the ETF industry is that we've moved from building products designed to provide market exposure to building products designed to provide investment solutions.

As the ETF industry continues to evolve, perhaps our expectations should evolve with it.

Rather than asking whether every ETF looks like one of the industry's largest index ETFs, perhaps we should ask a different question:

Is this ETF successfully delivering the investment solution it was built to provide?

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.