With ETFs, you need to look under the hood

Exchange -traded  funds (ETFs) can represent a specific index such as the SPY or even an underlying commodity, but many are created to capture smaller slices of an equity sector. How they are labeled can too often be about marketing and can inaccurately represent what they hold. If you make investing decisions based on a name and not a careful analysis of the underlying equities within an ETF, and their weighting, you may be getting something you did not plan for. Worse, you can accurately analyze market fundamentals, but still lose by picking an ETF that doesn’t quite represent the specific market sector you are looking at.

Consider the recent introduction of the Department of Labor’s new Fiduciary rule, the first major change in the laws governing how financial professionals manage retirement assets since the introduction of ERISA in 1974. The elevation of advisors to the level of fiduciaries led many to conclude that the entire investment industry was about to undergo a revolution, with the biggest losers being independent broker-dealers whose profits depend on advisors selling commissioned products that would run afoul of the new rule. Enter the iShares U.S. Broker-Dealers & Securities Exchanges ETF (IAI), part of a suite of funds offering exposure to different parts of the financial services sector and the only pure play brokerage fund on the market. For a while, IAI did seem to track the debate of the proposed new rule. The brokerage industry had been under intense regulatory pressure for years until Donald Trump’s election helped it regain some lost ground with IAI benefiting from the “Trump Trade” after his election. But fast forward to 2017 and something went wrong as IAI continued to outperform even as the Fiduciary rule began to be implemented last June.

Some traders might be wagering that a Republican Congress will be able to overturn or water down the rule, but the fund doesn’t deserve all the blame for its strong performance as very few broker-dealers, especially independent brokers, are even publicly traded and those that are: LPL Financial Holdings (LPLA), Ameriprise Financial (AMP) or Raymond James (RJF), are large enough to employ small armies of lawyers and compliance specialists to digest the 1,000+ pages that make up the Fiduciary rule. In fact, many of the firms unloading their brokerage arms are insurance firms who decided that the regulatory costs of having a captive sales arms outweighed any benefits. Metlife (MET), AIG (AIG) and Prudential (PRU) have all sold their brokerage arms.

IAI was designed to offer representation to a wide swathe of the financial sector including investment banks, discount brokerages and exchanges. This was necessary to build a sector fund to keep it from being too concentrated, especially given the relatively few publicly traded firms. It doesn’t leave a lot of room for a pure brokerage play. Even then, IAI is both heavily concentrated in just 26 names and has a modified market cap weighting system, which results in more than 60% of the fund’s assets being in just the top 10 holdings (see “IAI: It’s not what you think” below). This means that while you’ll see big independent broker dealers like LPL Financial in the fund, it has less than 3% of the assets, while a similar firm like Ameriprise isn’t included at all. Instead, the top spots include larger firms like investment banks Goldman Sachs (GS) and Morgan Stanley (MS) who are less dependent on their wealth management teams to bring home the bacon and more capable of managing the new rule. Futures exchange CME Group (CME) is one of IAI’s top holdings. How did it get in an ETF of U.S. Broker-Dealers & Securities Exchanges?

What this shows is that when buying an ETF, just like with food labels, it’s important to look at the list of ingredients.