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ETFs are 'actually great price discovery vehicles' for the market: Expert

ETF Think Tank Director of Research Cinthia Murphy joins Yahoo Finance Live to share the latest in the ETF space and what to know about direct indexing.

Video transcript

[AUDIO LOGO]

DAVID BRIGGS: The International Monetary Fund says policymakers should re-examine ETFs. The IMF report saying, quote, "ETFs can increase nonfundamental volatility in asset markets and amplify the sensitivity of cross-border capital flows to global financial conditions." Here to attempt to put that in layman's terms, Cinthia Murphy, ETF Think Tank Director of Research as part of our ETF report brought to you by Invesco QQQ. Cinthia, can you put that in layman's? Should we re-examine ETFs?

CINTHIA MURPHY: Seriously, what a mouthful. It's a-- in the ETF world, we kind of have gotten used to getting this kind of really dramatic language of the world is coming to an end anytime the markets perform poorly, and ETFs get all of the bad rap. I think the problem ETFs face in situations like this that trigger these kinds of reports one, is it's just great headline making. I mean, seriously, everybody stopped for a second to look at this study.

Second because ETFs are trading vehicles. So when you're concerned about market action volatility, you immediately look for things that trade a lot and are they the culprits of market volatility. In truth, from where we sit, this is a lot of fanfare, but there's really nothing here.

If you actually read the study, their biggest concern is mutual funds, not ETFs because ETFs are actually great price discovery vehicles that allow people to understand what's going on in the market, react tactically, implement different things in a way the mutual funds can't. So mutual funds really are more of a risk in a crash than ETFs are, but ETFs always get the bad rap. But we've seen this a lot. We saw this in 2008. We see that every time there's a big market crash there's the big headlines about ETF risk.

SEANA SMITH: Well, Cinthia, despite some of the bad rap that you're saying that the ETF industry gets, certainly it is a popular investment vehicle. You can tell that just simply by looking at the fund flow numbers. I do want to bring up, though, the people that do have this appetite for investing in index funds or ETFs or is a different way to go about that, and that, of course, is direct indexing. This is the other option that's out there at this point. And, I guess, when you're trying to compare the two, what would you say are maybe the biggest differences when it comes to direct indexing versus ETF and what will make the most sense?

CINTHIA MURPHY: Yeah, so direct index is an interesting new trend. In truth, direct indexing is a really old concept, is basically what Separately Managed Accounts have done, SMAs, for high-net worth clients. It's more of a story now really because of technology has evolved and developed in a way where direct indexing can be accessible now to everyone, which basically is ETF is a basket of stocks that are tracking an index for the most part, most of them are passive.

Direct indexing, you're creating your own basket of stocks. The advantage of it relative to ETFs is just this idea that you can customize it. Customization is really the big story here. So say, for example, you work for Cisco Systems, and you have a lot of company stock as a benefit of your job there. So do you want to own an ETF that's also heavily allocated to Cisco, then you may have too much risk in that stock.

So through direct indexing, you can have a basket of stocks that you may have through an ETF, but you can customize that position away, and that's to date easy to do through technology. And most asset providers, asset managers out there have either acquired that technology or developed their own so that you can actually start creating all these really customized portfolios at a retail level before-- it takes a lot of assets. It requires an advisor. It can be cost prohibitive if you're only doing it in $1,000 here, $1,000 there. But technology has made this more mainstream.

The other advantage of it is just the way you can tax manage your positions, which in ETFs, truthfully, ETFs are very tax efficient. So at the portfolio level, ETFs are doing a great job at tax loss harvesting, making sure they're constantly lowering the cost basis of the portfolio. I think last year, less than 8% of all ETFs issued any capital gains. So ETFs are super tax efficient.

But the argument goes that indirect indexing, you can take that to another level because you can do it a single stock level yourself and really manage that tax exposure in a way. So the story really is, is it a replacement to ETFs? You know, time will tell. I mean, SMAs have existed forever. This is more of a mainstreaming of that concept. But it's really just another technologically-enabled way to invest that has its pros and cons relative to what else is out there today.

SEANA SMITH: All right. Cinthia Murphy, always great to get your perspective, ETF Think Tank Director of Research. Thanks so much.