[This article appears in our September 2020 issue of ETF Report.]
Exchange-traded funds make it easy for advisors to get cheap access to markets, whether it’s through a plain vanilla ETF tracking the S&P 500, a thematic ETF that crosses sectors, access to a niche industry or one of the other myriad ways to invest.
But even as ETFs make hard-to-reach areas of markets approachable, many advisors still see ETFs as one tool of many as they build client portfolios.
“I’m a fan of using ETFs,” said Morgan Hill, CEO and owner of Hill & Hill Financial, a full-service advisory firm, citing ETFs’ main benefits: low fees, tax efficiency and tradability.
But ETFs are just one vehicle among many that Hill and his advisory service employ.
“ETFs are a great tool,” he noted. “But we use a variety [of vehicles], because I just haven’t found that any one tool does everything.”
Certain investment vehicles may be better suited to different clients and circumstances, he notes, and advisors need to be flexible. “At the end of the day, everybody wants to grow their money when times are good, and when something like COVID hits, nobody wants to lose money. They want some degree of safety and stability, and they want some degree of access to markets,” Hill explained.
His comments reflect remarks from several advisors and firms that work with advisors: ETFs complement an array of investment choices, rather than being the sole way they express a market opinion.
Hill’s firm creates several all-weather investment models that mix passive, indexed ETFs to access several markets and sectors, including international, domestic, value, growth, precious metals and more. He also uses targeted maturity-date bonds on the debt side as part of their diversified portfolios.
As the firm builds its portfolios, it includes active and tactical holdings, using dividend-paying stocks that may change quarterly, rather than using ETFs, Hill notes. He may use annuities, alternatives or private investments too.
Sharon Duncan, financial advisor at Selah Financial Services, concurs. She points out that she uses life insurance products and mostly active investments such as mutual funds. Duncan says she’ll choose passive ETFs “when it makes sense to use them.”
It’s in the client’s best interests for the advisor to have a variety of tools, she explains: “They all have advantages; they all have disadvantages. None are good. None are evil. There are different ones for different circumstances.”
The bottom line, Hill remarks, is for the advisor to get as close to the client’s goal as possible, and to be objective about which investment vehicles will do the job. Just because the industry comes up with different ways to access markets doesn’t mean they’re all worth using.
“We have a tendency in this industry to chase after the latest shiny nickel,” he said. “I try to not get distracted by shiny things. But if there’s a better tool that helps us move the objective further, and it meets the client needs? Awesome. If it’s just kind of the shiny, new, jazzy thing? No, thank you,”
Duncan’s firm uses actively managed mutual funds as the foundation to build portfolios. Advisors will incorporate ETFs when they want to target a particular sector, don’t like the mutual fund offerings in that sector or want to control the tax consequences.
“If we’re tax-loss harvesting, and we want to be in an equivalent holding to get past the 30-day wash rules, we’ll use ETFs for those,” she noted. “We’ll also use ETFs in really efficient spaces where there’s no point in having active management.”
Tools For High Net Worth Individuals
Jason Escamilla, CEO of ImpactAdvisor, uses ETFs, closed-end funds and mutual funds for part of his business, but his firm specializes in direct indexing. There are two benefits to direct indexing, he notes: better customization and even greater tax efficiency. Being based in San Francisco with clients in the technology industry and residing in a high-tax state such as California, direct indexing makes a big difference, Escamilla adds.
The tax benefit of direct indexing is that the software allows for greater ease of rebalancing and tax-loss harvesting, along with minimizing tracking error. But it’s not for all clients.
“Direct indexing is an incredible product for a high net worth person who has professional support from a CPA and an advisor,” he says, noting direct indexing brings a level of complexity. “If you do direct indexing, you start to lose your ability to do your taxes on your iPhone app.”
Escamilla says there are times when ETFs make more sense than direct indexing, such as for younger clients who are just starting to build wealth, or for those clients whose holdings reside mostly in individual retirement accounts. He also uses ETFs for cashlike holdings.
For less wealthy clients who have taxable accounts, another way he mitigates tax hits is to use closed-end municipal bond funds. Escamilla watches for sizable discounts to occur, such as what happened in the March sell-off, which gives him a margin of safety for clients while adding alpha over time.
Duncan wishes there were better fixed income strategies available, especially in the current low-yield environment. The choices, she observes, are limited—paying high fees to an insurance company, buying individual bonds or using funds.
“If you want something like a pension stream, then you can get an immediate annuity, but you’re still paying the insurance company margins, and significant margins sometimes,” Duncan said.
Higher Demand For Risk-Managed Strategies
Corey Walther, head of Allianz Life Financial Services, which offers several types of investment products, notes his firm is seeing a lot of demand for risk-managed strategies, regardless of the packaging.
“There’s a level of uncertainty out there that’s probably as great as it’s ever been, whether it’s because of the pandemic, the backdrop of the coming election and the political uncertainty there, and then interest rates are at record lows,” he said.
Walther observes his firm is seeing interest in a variety of products, including structured notes, life insurance products and annuities as advisors try to address longevity risk and concerns about tax-deferred accumulation.
He says he’s also seeing more financial advisors embracing holistic financial planning and more goals-based planning, defining clients’ wants and working to make the products fit the client. Technology helps advisors create packages that address costs, taxes and risks.
After the first-quarter market plunge, Walther saw greater interest in risk mitigation. Allianz is also observing interest in its AllianzIM Buffered Outcome ETFs, which debuted recently. In addition to Allianz, several firms offer defined outcome ETFs, such as First Trust and Innovator Management.
Buffered ETFs are designed to smooth out returns. Although they may cap upside, they also limit downside losses. For example, he explains that a buffered ETF may have an upside cap of 12%, even if the index it follows rises by 15%. On the downside, if a client held an ETF with a 20% buffer and the market fell anything less than 20%, they wouldn’t lose money. If the market were to drop 30%, the ETF would only lose 10%.
“You still have a much more favorable outcome than had you not had any risk mitigation in that portfolio,” Walther noted.