How and When to Blend Mutual Funds and ETFs

Jennifer Hutchins, co-CIO at Avantax Wealth Management, says flexibility is key when it comes to portfolio construction.

Financial advisors should embrace an agnostic perspective when it comes to building client portfolios, Jennifer Hutchins told etf.com in this installment of the Advisor Views series.

Based in Dallas, Hutchins said she considers mutual funds and ETFs in the context of the underlying investment strategy.

Jeff Benjamin: What can you tell us about the Avantax persistency studies?

Jennifer Hutchins: The purpose of the Avantax persistency studies is to determine where active management has the best chance of consistently outperforming an investable index. And on the flip side, the studies inform us where it may make sense to use passive investments to represent an asset class.

Ultimately, the goal of our persistency studies is to determine which asset classes are more efficient or less efficient, and we factor that information into our active-management decisions.

JB: Where are you seeing opportunities in active management in this market?

JH: A few asset classes that we like for active management are small caps, including factor ETFs, emerging markets and emerging markets small caps. These asset classes are areas where we believe active management tends to shine longer term. In small caps, 40% of the companies within the Russell 2000 are not profitable. That right there should give active management an edge.

JB: Are there areas where passive strategies look attractive?

JH: We like passive strategies in domestic large cap, particularly large cap growth and blend.

We have completed persistency studies in these areas and found these two sub-asset classes to be very efficient. Also, when we think about portfolio construction for U.S. clients, domestic large cap tends to be the most significant weight.

Additionally, this is an asset class you really want to get right since it can drive a large portion of your return. And we have seen time after time where active management has disappointed in this asset class. So, if we do use an active manager, for example in large cap value, we tend to hedge our active risk with some passive exposure as well.

JB: How do you decide whether to invest through a mutual fund or ETF?

JH: First, there is the active-passive decision. Typically, if we decide to invest in a passive manner, we will look to use a low-cost ETF. If we decide to go active, then we will determine the manager whom we believe best represents the asset class in our portfolios.

We consider factor ETFs in this active decision as well. When we run our screening process, we will screen for both active funds and ETFs. If we end up selecting a manager with both a mutual fund and a similar active ETF, apples-to-apples, we prefer to use an ETF over a mutual fund due to their tax efficiencies and their tendency to be lower cost than mutual funds.

However, we will also consider any management style differences between the ETF and mutual fund and the historical track record, as well as the size of the ETF and the liquidity of the market.

JB: How are these financial markets suited to factor ETF strategies?

JH: We have found that factor ETFs can fill a specific need within portfolios especially if you are seeking investments focused on dividends, quality, low volatility, etc.

These factor ETFs, tend to strike a balance in fees, somewhere between ultra-cheap passive ETFs and more expensive active managers. We tend to use factor ETFs within our income strategy for distinct tilts.

Currently, we favor factor ETFs with a dividend component with an added quality aspect. We have found this can lead to an above-average yield, while helping avoid some of the value traps with a pure dividend-focused strategy. Additionally, the factor ETF serves to bring down the cost of the overall portfolio and can be an offset to some more expensive managers in our income strategy.