[This article appears in our May 2018 issue of ETF Report.]
Located in a suburb of Philadelphia, Mainline Private Wealth is an RIA that works mainly with high net worth individuals to deliver high-level financial planning, with comprehensive reporting. The firm’s average client size is $5 million. Gary Droz is Mainline’s managing director, with 30 years of experience. In his role, he oversees the firm’s strategic initiatives.
Tell me a little bit about your background and Mainline Private Wealth.
I’ve been an advisor for 30 years, which is a long time. I’m unique in one respect, which is that I’ve never worked for a brokerage firm. When I started my career, I was one of the first independent IAs maybe in the country. And I [always charged] transparent asset-based fees for my compensation. I was there at the beginning of almost every part of the IA industry. There were no IAs when we started. You either worked for Merrill or J.P. Morgan or Morgan Stanley—they were the advisors.
So I had a small firm in Pittsburgh; small meaning about $75-80 million in assets. We formed a new IA in 2012 in Philadelphia. Since then, we’ve grown about sixfold in terms of assets under management and gross revenues. We’ve grown rapidly over the last five or six years.
*RAUM refers to “regulatory assets under management”
AOA refers to “advised on assets”
What drew you to ETFs?
My interest in ETFs began literally at the dawn of the ETF industry. I was using a separately managed account platform that trained me to benchmark by using what was called the style-blended benchmark. William Sharpe developed the whole concept of style orientation; so, large growth, large value, small growth, small value, international and emerging markets—those are core Sharpe categories.
This firm trained me to develop a blended benchmark based on the actual portfolio composition. Clients then began to expect that the benchmark would be conveyed in this way; meanwhile, the firm lost its way performancewise. I would present this style-blended benchmark and quarter after quarter the portfolio would underperform by around 3%, which made me look incredibly stupid to my clients.
Around that time, in 2000, iShares introduced the real game-changing platform. The Russell 1000 growth and value, Russell 2000 growth and value, emerging markets and global developed funds all came out at the same time. It seemed perfect for me—I’d never be under the benchmark because I’d be the benchmark.
Literally the week the iShares came out, I started to migrate my clients from separately managed accounts to ETFs. I was so far ahead of the game in terms of where the industry is now, I was accused of being a moron: “How can you be right? Everybody else is doing anything but that!”
Long story short, the market sort of came toward me. So my experience with ETFs is long. Before that iShares platform came out, there were really only two ETFs—there was the SPDR S&P 500 ETF Trust (SPY), and the PowerShares QQQ Trust (QQQ) was very popular, because it tracked the Nasdaq-100. That was not that interesting to me, because I couldn’t allocate across the whole spectrum; with iShares, you could.
How do you approach investing with ETFs?
I’m a huge believer in asset investing. This is just my personal opinion, but whenever there’s an article written about the downside of ETFs, I think it’s written by firms that have a vested interest in separately managed accounts or fee generation.
We use, with one exception, cap-weighted indexes. We’ve looked at a lot of the smart beta. The only one we like is low vol, low beta. And we use some of that, but we like to have a preponderance of the assets be cap-weighted.
How do you choose the funds in your portfolios?
First, we only like to use large, extremely liquid ETFs. There’s one problem that can occur in ETFs, and it’s the variance between the NAV and the market price. The ETF industry has gotten so granular that you have these really small ETFs that, when you go to sell one, regardless of what the NAV is, you have a hard time getting somebody who wants to buy that ETF at that moment. Often, when you have small, illiquid ETFs, there’s this gap between the NAV and the market price. And we try to avoid that at all costs.
We like extremely liquid. We like very low variance, both from a bid/ask and from an NAV-to-market.
The other thing we look at is, we choose ETFs that give us a market diversity that fits our allocation style. I would characterize it as a classic Sharpe allocation style—so, style and asset class diversification. We just use large- and small-cap. We don’t use midcap, because they’re pretty much covered by large and small, and the low-vol ETFs that we do use end up being predominantly midcap ETFs. We just use large- and small-cap funds that are very large and liquid. It would be [primarily funds from] companies like Vanguard, iShares and Schwab.
There’s a difference in how emerging markets and international markets, for example, are classified. And one of the big differences is sometimes Korea is in emerging markets and sometimes it’s in developed non-U.S. We want to make sure we get Korea in a significant way, so we’ll usually use developed non-U.S. that includes Korea. So when we think emerging markets, we’re not thinking Korea; we’re thinking countries like Vietnam and the other parts of Southeast Asia, Latin America and Eastern Europe, and places like that.
We look at the composition, the diversification of what’s included in each one. And then we look at performance—that it’s doing what it’s supposed to be doing. And we track that every quarter for every ETF we use. Sometimes we see things change in an ETF that results in us not using it anymore. But by and large, if you stick with the big companies and the big, liquid ETFs, you’re usually in pretty good shape.
I started using ETFs primarily to eliminate tracking error, so I just wanted the beta for each style. Big brokerage firms like to tell you they’re going to get you alpha. In my view, there is no alpha. There’s just, get as close to beta as you can get. That was the initial reason we got into ETFs, so we could get that beta every year for our clients.
What ETFs are most prominent in the portfolios you put together?
Every major company has what I’m going to describe to you: large-cap, small-cap, growth and value, emerging markets and global developed. Whatever issuer we’re using, those are the generic ETFs that we’ll typically have in clients’ portfolios. And then we use a number of low-vol ETFs. Most of them track very similar indexes. And we use those on top of the larger, sort of generic ETFs.
We don’t drill down real deep into the granular areas of the ETF space. We look at big-picture assets. I always joke: It’s like you can buy an ETF for pizza shops in this neighborhood, that’s how granular they’re getting. When you start to delve into those granular ETFs, like sectors or industries, you’re just making a tiny bet on a sector, and we don’t think that’s a good idea.