Advisors, Due Diligence Crucial To Asset Allocation

Advisor usage of ETFs to support asset allocation needs has continued to grow, according to a TD Ameritrade survey. Such adoption is consistent with the strong inflows CFRA saw in 2016 and the $40 billion of new money in January as well as from a recent discussion with Brett Mossman, head of BlackRock Portfolio Solutions.

Mossman’s team reviewed more than 7,500 wealth management portfolios in 2016, and he explained to CFRA there has been a greater usage of ETFs in portfolios in response to regulatory complexity. Mossman believes this is at the expense of both mutual fund holdings and individual securities, driven by a desire to reduce costs as well as to reduce the regulatory risk of advisors managing stock portfolios for clients.

Quest For Performance Raises Risks

Yet according to BlackRock, a financial advisor’s equity sleeves are taking on more risk, in part because equity mutual fund managers are taking on higher risk—reaching for greater opportunities and earnings growth—in their quest for performance. Mossman thinks this has led to unintended results like style drift and market cap creep that produce either more or different types of risk than was intended.

An actively managed equity mutual fund will be grouped into a style or peer group with similar funds from a third party based on the underlying holdings. But it is up to the advisor or investor to keep track of whether the peer group has shifted in recent years because fund management has discretion to hold on to winning stocks or seek out a range of ideas.

For example, Centre American Select Equity Fund (DHAMX) has shifted in the last five years from Lipper’s large-cap value style (2012-2014) to large-cap core (2015) to large-cap growth (2016). The fund holds approximately 50 stocks driven by its “economic value added” investment philosophy. The fund’s heaviest weightings were recently in Amazon and Facebook), consistent with many large-cap growth fund peers.

In ranking approximately 23,000 mutual funds based on a combination of relative performance, risk and cost metrics, CFRA uses Lipper’s investment styles and our proprietary holdings analysis.

More Style Drift

Meanwhile, American Century Income & Growth Fund (BIGRX) has moved from large-cap core (2012-2013) to large-cap value (2014-2015) and back to large-cap core (2016) in Lipper’s database. The fund “employs a risk-managed quantitative investment process” seeking out companies the managers believe to be undervalued. Alphabet and Johnson & Johnson are among the stocks that are well represented, consistent with many large-cap core funds.

However, there are risks to placing these and other active funds in a long-term asset allocation strategy to fill a style sleeve without regular monitoring. The asset allocation strategy can become more concentrated to core or growth funds than intended, while being absent the diversification of value funds.

Large-cap value funds, such as Dodge & Cox Stock Fund (DODGX) and Invesco Growth & Income (AGGIX) significantly outperformed other styles in 2016. These two funds are examples of products that remained in the Lipper’s large-cap value style category the last five years.

Index Rules Provide Consistency

In addition to benefits like (typically) lower costs, passively managed mutual funds and ETFs follow rules created by an index provider that provide a higher likelihood of consistency.

For example, the Guggenheim S&P 500 Pure Value (RPV) holds S&P 500 Index constituents that exhibit the strongest value factors based on price to book value; price to earnings and price to sales. The index is rebalanced once a year in December.

At the end of January, financials (32% of assets) and consumer discretionary (18%) stocks were approximately half of the portfolio. Top positions include Berkshire Hathaway and General Motors. RPV has a 0.35% expense ratio.

Meanwhile, the iShares Edge MSCI USA Value Factor (VLUE) also is constructed using price-to-book and price-to-earnings ratios, but uses enterprise-value-to-operating-cash-flow as its third factor.

However, the major difference between VLUE and RPV is the sector neutrality implementation. The MSCI-based ETF holds the most value-oriented stocks within each sector. As such, VLUE has more exposure to the technology sector, with Cisco Systems and Intel among the larger holdings. VLUE, which is rebalanced on a seminannual basis, has a 0.15% expense ratio.

The differences between these two value ETFs highlights the importance of conducting due diligence on any and all products being considered for an asset allocation strategy.

At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him at @ToddCFRA