Morningstar Advisor - August/September 2011 - (Page 50)

Morningstar Conversation pick the structure that works best for their investment needs. We’re indifferent from a price standpoint and from a support standpoint because we’re going to support them equally. Handle With Care Culloton: How are advisors using ETFs? If you saw a broker or an advisor using your mutual funds or ETFs in a harmful way, or in a way that could potentially be harmful, what would you do? Flanagan: If we found that somebody was misusing a product or didn’t understand a product, we would engage very, very quickly, because it’s not in the investor’s best interest, it’s not in our firm’s best interest, and it’s not in the industry’s best interest. We are fiduciaries, and you just don’t want people to have bad experiences. So, I think that’s something that’s just a must, and I think the industry tries very hard to do a good job of it. And we do, too. Culloton: How are advisors using ETFs? Flanagan: We’ve always been in the advice we like to say that we make them “walk the plank.” Seriously, we will cut off relationships where we see a conflict with our core values. We’ve done it numerous times in our history— a few times it’s actually been played out in public. Not that we wanted it to be, but for whatever reason people thought that it would make an interesting story. So, we’re really strong on philosophical alignment, and we’re going to continue to be really strong on it. Obviously, you get into gray areas. If somebody is overweighting emerging markets by 20% versus how you think a global portfolio should be structured, is that an abuse? Probably not. If somebody is day-trading sector ETFs—a broker or a retailer investor, for example—that is abuse. We’re not interested in that kind of business. On how people are using them … our focus on the advisor side is to provide the basic building blocks. We want to give advisors core holdings that can serve as a great foundation for any portfolio. We are less interested in the esoteric ideas out there, some of which are, frankly, not all that well thought out, and some of which are legitimate, but again, not something that we have a particular interest in doing. Interestingly, this year we’ve seen incredible diversification among our funds and ETFs. It’s been the most diversified set of flows I’ve seen in years into the ETFs. I think it’s because we’re becoming even more established with a greater number of advisors. Our emerging-markets ETF continues to attract a decent amount of attention, both from advisors as well as from institutions. Dividend Appreciation VIG, MSCI EAFE VEA, REIT Index VNQ, and the broad domestic stock market— both Total Market VTI and S&P 500 VOO—have all attracted a fair—I won’t say equal, but within spitting distance—amount of money. The data is telling just what we hoped—these products are being used as foundation-builders. Culloton: When providing ETFs or funds as building blocks, is it possible that the blocks could get too small, too narrow, too splintered to be useful or perhaps even dangerous? McNabb: I’ll say yes. But again, this is an area where there’s a lot of room for reasonable debate. Flanagan: Right. McNabb: We’ve had a number of discussions internally about this issue. And in the marketplace, other folks have taken a different tack, where they’ve said: “Let’s carve things up as granularly as possible and let people put the pieces together.” Our view is if you’re going to get broad exposure, do it the most efficient way, which would be in bigger chunks. Flanagan: It all depends on the client again, right? I think broadly in the advice channel, it depends on who the client is, the sophistication, their broader portfolio. But you’re also seeing some very sophisticated financial advisors and, frankly, some of the institutions, capable of going more narrow and meeting their exposures with ETFs. But I agree with Bill. You can absolutely take it way too far. Culloton: How far is too far? The PowerShares lineup can get pretty narrow in some cases, with clean-energy ETFs and other things. Flanagan: If you look at the PowerShares lineup today and where we started as a firm, you would see an evolved ETF complex that has a wide range of exposure, income, alternative, and intelligent equity offerings to meet our diverse set of clients’ needs. I think that over the last number of years the lineup has matured quite substantially. That said, some of the clean-energy [offerings] and the like are very narrow. But you’ve seen a lot of institutions and advisors move toward it. Again, I think it’s a much broader lineup these days, and we think it’s very appropriate. Culloton: Bill, Vanguard’s lineup has gotten a little bit more granular in recent years, too, channel. That’s really our core. That’s our bread and butter. It’s what we believe in. But what we observed in 2005, when we purchased Invesco PowerShares, was that ETFs were evolving beyond the traditional cap-weighted indexes to fundamental and intelligent indices. We thought it was very complementary to what we were doing. But we were also seeing an evolution in the advice channel. What we were seeing was the beginning of mutual funds and ETFs being used together, and that you could take a core U.S. equity fund, and you can modify your exposure by using ETFs, core/ satellite concepts, and the like. That has continued extensively in the advice channel. We continue to see greater and greater evolution around asset allocation with ETFs. McNabb: If we see investors using any of our funds or ETFs in a potentially harmful way—everything [at Vanguard] is nautical, so 50 Morningstar Advisor August/September 2011

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011