A young alternative ETF producer right now has two growth opportunities, says Reality Shares' CEO Eric Ervin.

The obvious play is getting advisers to see they can replace alternative mutual funds with ETFs as a liquid solution. The second is a fairly new development: convincing digital advice platforms they need alt ETFs to differentiate themselves.

"We're really trying to seek out innovation and cut through all the noise of the core traditional ETF issuers," Ervin says. "I haven't seen a ton of that yet, but I hope that market demand starts to force some competition to where they do start to innovate in that area."

Ervin's San Diego-based firm at the beginning of the year released its fourth offering, the DIVCON Dividend Guard ETF. Speaking with Money Management Executive, the former Morgan Stanley adviser shared his observations on where alt ETFs are headed.

What are some of challenges the market has faced amid the rise of passive?

The general theme across that spectrum is that two years ago, if you were able to look at a big open-ended mutual fund company or an asset management firm, they would have called ETFs a fad.

They used to say ETFs weren't necessarily something they were going to focus on, or that they would never get into the ETF business, but now it has completely been a 180-degree turn where everyone is saying, "We missed it. How do we get into the business and do it now? We can't afford to wait, we can't afford to build it ourselves, and even if we tried to build it ourselves, we probably don't have the expertise because it's not in our DNA. We have been selling against these ETFs all these years, so how do we change our whole mentality?"

Now you may see something like 12 deals announced in the last 12 months where a bigger asset management firm has bought a smaller ETF firm mainly for the expertise. That has been one of the biggest things that I've seen: these big industry players that haven't raised a dime, and many of which have actually gone backwards. They are starting to wake up and consider rethinking their approach.

Now with DoL rules coming into play, it is just the perfect storm for us, and not so much if you are a mutual fund company trying to figure out where your growth is going to come from.

How has the digital wealth management model left an impact?

At last count, I can't remember how many robo adviser firms there were, but at some point they're going to have to innovate because I think most of them are pretty average, plain vanilla, and they're not offering much value in the way of asset allocation or portfolio manager selection. It's really very, very basic.

In fact, I think Wealthfront makes the claim that they have over 100 different portfolio allocations. Really it's just 1% stocks and 99% bonds, all the way up to 99% stocks and 1% bonds. There is no innovation in the actual model itself.

Are young firms thinking about how to get on some of these robo platforms?

It has been a little frustrating from my own perspective because so many of them were averse to innovation.

The reason I pay a robo adviser is because they are going to give me access to something that I don't have the time or energy, or the capabilities, to research newer more innovative ETFs, or different asset classes. It felt to me that originally most of the platforms were focused on career risk, asking questions like, "How do we not look too different?"

We think those are the trend setters are the ones who are supposed to be saying, "We've adopted or embraced these new firms that have new cutting edge technology for dividend growth," for example. But, we're really trying to seek out innovation and cut through all the noise of the core traditional ETF issuers.

I haven't seen a ton of that yet, but I hope that market demand starts to force some competition to where they do start to innovate in that area.

Is there a happy marriage where you can add innovation and strategy and do it in a cost-effective way?

I think so. I think if you compare where we were to where we are - first, we have some pretty innovative products - we have one that's 100% institutional strategy that we brought into the wrapper, and that would, in theory, have that hedge fund style fee, which will be massive. It's 85 basis points, so relative to what you would otherwise compare it to, it's very, very cheap, but relative to SPDR, it is certainly not. It is something like 10 times as expensive.

One of the bigger areas of opportunity in innovation is in the alternative ETFs because you have all of these alternative mutual funds that are 150 up to sometimes 250 basis points, and they would argue that they are way cheaper than hedge funds. Then you could do the same strategy without the portfolio manager and that extra cost for the 70 to 90 basis points in an ETF.

You will see this proliferation of alternative ETFs as a liquid solution, especially with the DoL as people say, "How the heck am I going to be a fiduciary and offer my client 'the best' when there's a very cheap option out there to compete with my otherwise fairly expensive open end fund?"

Then when it comes to equity - one of our products is a dividend growth stock ETF and there is no long-short component or hedging - it's just finding the stocks of the companies that will grow their dividends the most over the next 12 months. That is priced at 43 basis points where an active money manager would probably do a similar job and charge 150 or 120 basis points.

I think that that is fairly cheap and we don't have hotshot portfolio managers that we have to pay $1 million a year, yet we are doing all of the things that that hotshot portfolio manager would otherwise. We're just doing it with rules instead of a human gut.

Has research become an essential part of staying competitive?

If you can come out with the next [PureFunds ISE Cyber Security ETF] HACK - which is an innovation that is very straight forward in a niche that hadn't been exploited - and there was some demand, then you won't need a significant amount of marketing or education. You can just be that answer. Outside of those, you really have to come up with ETF 3.0, which is really an actively managed style of returns in a passive index system.

You will need to do quite a bit of research and heavy lifting on that front end where you come up with, "What does that money manager do? How do they create alpha? What are the key attributes and how can I out that into an index? There is no human element, so how can I just chop off the emotional end of it and create a product based on that? But, then if I do that, and I do it well, then I have to go out and tell the world about it, and that causes a lot more marketing and overall education around why is this fund different than that fund?"

Have you engaged in education efforts with advisers about alternatives?

Yes. That was my world as a financial adviser. The clientele was a bit different in that they weren't your typical client that might say, "I am going to put my money in the market, and when markets go up I win, and when they go down I lose. I'm comfortable with that." They hated that.

They really wanted us to create something, knowing that they were going to win and lose sometime and knowing that the market was going to be the main driver, but at least we were going to try to find things that were unique or that could hedge, or that could offer returns. It became our biggest lead. Whenever we were talking to a new prospect or client, they loved that we were going to at least try. Often we were going to fail, but we were going to look for things that tried to avoid market corrections. Not only were we doing a good job for the clients, but it became a reason for the clients to reach out to their friends and say, "You should really talk to these guys."

What has resonated among advisers?

From that perspective there are advisers out there who have already somewhat embraced what alternatives can do, not only for the clients, but also for their marketing efforts because they are trying to do something different. That's really what a client wants to hear.

One problem that we found in the beginning was not all alternatives are created equal and there is an awful lot of junk. They are massively over diversified, they don't really offer any kind of return, and yet they have this huge fee associated with them. It is just not a good alternative, although it may have a clever name and a good marketing spiel, so it collects assets.

I made that same mistake and allocated to these things. Then after a year I would say, "What the heck? This hasn't done a thing." Then I started to learn some of those pitfalls. There are not that many liquid alternatives, however. For example, our DIVY was the first ETF that we launched. I think that ranks fourth in a category of alternative ETFs, but there are only 61 ETFs in there, on Bloomberg.

So, that area could grow significantly in terms of the quantity of products, which is going to confuse the market more, but it will probably be a good thing for the adviser.

You mentioned that some of the larger firms are buying up the smaller ones. Has this been something you've been approached about?

I would say we talk to firms about two or three times a year where there is a request.

Our conversations are pretty robust for these different asset managers. They are really interested in getting into the business, understanding the business and viewing ETF issuers as not just percentages of AUM. It's really about what are the assets of the firm, what is the ability to issue new products, create new products, the understanding of the regulatory environment, the ability to talk to an advisor about the difference between a fund and an ETF, and really educate them on all the trading capabilities.

That is what they are interested in; acquiring all of that and then just bolting it onto their system and then teaching their wholesalers how to use the product, and that they could create products off of that.

As soon as you talk to their sales people, they are tired. They have the same mutual funds and every day they wake up and bring in $2 million and watch $1.9 million go out the door. They're just on this hamster wheel wishing for something new and innovative. Every adviser they talk to says, "Sorry, I don't buy open-ended funds. I am switching over to ETFs and model portfolios, and it is just getting harder and harder for these wholesalers to continue and go after the grind."

That is really the biggest thing these mutual find issuers are looking for.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.