Inflation Is Making Investing’s Free Lunch Expensive

Asset allocation ETFs reversing after decades of progress.

Based on the latest consumer prices data, financial advisors can't rely inflation vanishing any time soon. However, what is disappearing is an old standby, which might just open the door for some new active ETFs.  

Diversification has long been known as investing’s “free lunch,” ever since the late, Nobel Prize winning economist Harry Markowitz reportedly described it that way. That led to the study that produced Modern Portfolio Theory, which in turn produced one of Wall Street’s longest-running marketing pitches. And for some time, the numbers backed up the theory. By combining stocks, bonds and potentially other asset classes, investors could get more return for similar risk, or get similar return with less risk.  

This led to the development of asset allocation, or “balanced” mutual funds, which later helped revolutionize the 401(k) market, as employees not familiar with the workings of the financial markets could simply “check a box” and be invested, diversified, and allocated to a one-stop-shop. That came in the form of asset allocation funds. And, while they started with mutual funds, ETFs have been on the bandwagon too.  

Asset Allocation ETFs Under Fire

But in 2022, things started to change in the markets, and along with that the fortunes of asset allocation funds. Consider that since the end of 2021, the total return (not annualized) including dividends for iShares standard set of risk-level allocation ETFs have performed as follows:

• The iShares Core Conservative Allocation ETF (AOK): down 4.5%
• The iShares Core Moderate Allocation ETF (AOM): down 2.9%
• The iShares Core Growth Allocation ETF (AOR): down less than 0.1%
• The iShares Core Aggressive Allocation ETF (AOA): up 2.8%

While that's only a little more than two years' performance, warning signs are flashing. If inflation continues assaulting the bond market, and stock prices get stuck in limbo, the possibility exists that the holy grail, asset allocation, will go three, four or even five years without producing a positive return. Even if it doesn’t turn out that way, advisors can’t afford to sit by and let that happen. 

Otherwise they risk seeing the free lunches they provide for clients vanishing as well…because the clients might.

Active Asset Allocation ETFs: Marriage Material for Advisors?

This might be the ideal opportunity for matrimony, specifically between advisors and a new crop of actively managed allocation ETFs. Because asset allocation is obviously still an attractive concept to investors and advisors alike. But the concept is one thing and successful execution of that concept is another. And the latter is where the rubber meets the road in the eyes of the client. Any advisor can throw out buzz words in a pitch meeting, but it is what happens after the client is on board that determines success of whatever plan was agreed to when everyone was freshly acquainted.

Perhaps none of that group is more fit for the times than the $82 million VanEck Inflation Allocation ETF (RAAX), which goes beyond stocks and bonds to include assets such as real estate and commodities, and can go to an all-cash allocation in times of extreme market stress. Instead of a static allocation, the fund’s active managers combine technical, macroeconomic and sentiment indicators to allocate flexibly.  

Cloning Mutual Funds Into ETFs

And as with many in this category, the $84 million Leuthold Core ETF (LCR) allocates among several different types of stocks and bonds, but also delves deeper, using commodities, a portfolio of stocks it shorts, managed futures and even volatility-based positions. The ETF only dates back to 2020, but was created as an ETF clone of a mutual fund that started back in 1995.

Traditional asset allocation ETFs may indeed make a comeback. But can advisors afford to wait around and find out? By exploring and comparing a more dynamic class of active allocators in ETF clothing, the opportunity to treat clients to that free lunch can hopefully continue well into the future.