Lee Kranefuss has worn many hats in the ETF industry. His latest is as co-founder of an investment management firm building global ETF portfolios for advisors, 55 Capital Partners. According to Kranefuss, the firm aims to solve the increasingly difficult task for advisors of sifting through growing numbers of ETFs and building portfolios in an ever-challenging world.
ETF.com: Why start a new investment management business? What sets 55 Capital apart?
Lee Kranefuss: 55 Capital grew directly out of my experience both in the U.S. and now living in London running Source ETFs. There’s a crisis that advisors around the world are facing; one that’s twofold.
First, we've gone from the point where there are a lot of ETFs to a point where there's just too many to sort through. There are thousands of ETFs, and all of them have claims from basic to the most exotic, but understanding the structure, understanding how to use them, understanding what they really do versus what the name says they do, is just befuddling people.
At the same time, there is a crisis in investing. There's a new normal, where people have yet to figure out how to deal in the advisor space. It's a world in which markets are very chaotic, where interest rates are at sustained low levels, including negative interest rates. Some 95% of sovereign debt in the world today is yielding less than the 30-year Treasury rate now. And much of it is negative.
So we have a flood of potential tools to use—too many to explore—and at the same time, the need to come up with a portfolio that has the opportunity and ability to perform without missing out in a much-more-complex investing environment.
ETF.com: Do advisors need a new road map to portfolio construction?
Kranefuss: You can't just rely on what we were all taught for decades, that the 60/40 portfolio was where you start. With that, you were getting equity market participation. You're taking some of the downside risk away. You're giving up some of the upside as well. And you're getting yourself steady income that's better than the dividend yield on stocks. That's not true anymore.
If you own a 30-year bond, and interest rates go up 1%, that part of your portfolio is going to be 15%. And you're stuck with that unprecedentedly low interest rate till 2046. But today there's a combination of too much choice, people trying to tell you that here's a better mousetrap for this or that slice of the market.
We’re all trying to find better ways to invest. That’s the motivation. We started working very hard on this about a year ago—myself and Vinay Nair, who is a lead investor in the investment management firm.
One of things we realized is that people have been addressing this problem in the institutional market for a long time. It's not the best-kept secret, but it’s also not something that gets trumpeted much.
The idea is to expose yourself in a more global environment, and with more tools. And with ETFs, you can do this now—capture many more return drivers so you don't miss out. You also have to carefully manage the risk you take.
The idea is to provide people with a core portfolio that's far more diversified, both in terms of geography and in asset classes. But it takes a fair amount of work, and how to do it is not a secret, but it takes a really large, fixed effort to understand how to do that so you don't inadvertently own exposures and take risks that cancel each other out.
ETF.com: On your site, you talk about “dynamically managed” global ETF portfolios. What exactly is this concept of dynamic management? Is it like hedge- fund-type investing?
Kranefuss: Hedge funds are in crisis, too. They're failing to deliver, because many of them are just repackaging security selections in one way or another. What people lack is good asset allocation.
By being dynamic, we're trying to explain it as neither a long-term, somewhat static strategic approach nor a short-term tactical one. We look at a broad array of markets and their historical and current relationships. We then try to get a very broad portfolio that has the opportunity to pick up things that might improve or gain value while at the same time being able to exit.
At times, the trading will be more active because there's more shifting going on, and one's trying to be more defensive and get out of potential harm's way. And other times, it can be more static. It's really driven by what's happening in markets.
The world has often defined itself in asset allocation. I used to run the asset allocation and target-date retirement funds businesses at BGI. I would get caught up in this false dichotomy of strategic, which gets you back to your 60/40—which I don't think makes sense to talk about anymore—or tactical, where you're always trying to trade your way to something.
We’re trying to get a broad set of exposure return drivers—which you can do with ETFs—and then shift exposures so as to minimize downside risk while trying to maximize upside capture, and doing it in a way that is premised on really understanding the underlying ETFs, not only the economics of the portfolio.
I'll give you an example. There's a lot of interest in currency-hedged foreign investment. If you're buying a currency-hedged ETF for Japan, you're taking a position on currency expectations. Everyone thinks of it as reducing risk. But you might not be. It may be that you've actually inadvertently increased risk and decreased return. Your overall risk/return has gotten worse.
You have to think about where else might you have exposure to currency that may pop up somewhere else—in parts of the U.S. economy or sectors that do a great deal of business with Japan, for example.
These are the kinds of things that get passed over a lot. People tend to think of a portfolio not as the integrated whole of all the elements and how they interact, but rather as a piece of this, a piece of that. And unfortunately, people can end up paying more for positions that are offsetting one another.
ETF.com: Is 55 Capital going to pitch a flagship series of strategies, or will you customize portfolios that solve the equation on a client-to-client basis?
Kranefuss: It depends on the size of the client. Initially we're targeting RIAs who already outsource to traditional fund companies or strategists. We'll have sort of flagship strategies that will begin with entry-level ones into some larger ones.
Entry level might be five or six ETFs for someone who's trying to invest maybe a trust fund they set up for their grandchildren, e.g., they have $20,000. We don't have to balance that many positions in that.
It’ll go up to our more dynamic strategies, where we're moving a lot, not only changing weights of asset-class exposure but also exposures within assets classes—what parts of those markets look good. In those, we might take 40 or 50 positions.
ETF.com: Should RIAs look at dynamically managed portfolios as the new core?
Kranefuss: Yes, I'd say it's the core. Every client's different, because there are real estate holdings and illiquid stock and the like. But if somebody has a totally liquid portfolio, you might put 50% into this strategy. You don’t want to run the risk of combining too many ETFs and approaches and getting mud. They used to call that, in the institutional market, the “closet indexing.” You hire 50 active managers, and when you throw them all together, on average, they own the index.
Although everyone is taught portfolio theory, it's one of those things that's hard for most people to get their arms around. You have to have a way of monitoring and assessing if two managers are just canceling each other out, and you’re paying a lot for that. You need a more holistic view in light of the current environment, and to understand what you're investing in.
ETF.com: What’s your take on the ETF industry today? We've seen a proliferation of thematic, very narrowly focused niche ETFs, and multifactor strategies coming in all shapes and sizes. Are we living through the “spaghetti-at-the-wall” phase of ETF development?
Kranefuss: There’s still room for product innovation. We know there are probably things out there that aren't there that we would like to have in order to build core portfolios in a disciplined way. But I would say there’s an awful lot of spaghetti against the wall at this point.
Many of the thematic ETFs come with a basket that plays into something that's currently being spoken about—the habits of millennials, or drones. That's no different than chasing hot stocks. There's often no investment hypothesis behind it, and they may be, in fact, taking on an extraordinary amount of risk.
I think the industry has gone off in a bad direction here. I liken it to people trying to write hit songs. They're catchy. But they’re trying to come up with thematic ideas rather than provide building blocks that work.
If you look over into the institutional space, where people have a bevy of advisors and institutional asset managers, you don’t see them really using these strategies. They're looking for tool kits. Today people can easily construct a portfolio that has an institutional-quality core strength with existing ETFs, but the industry is devolving into spaghetti against the wall, in many cases.
ETF.com: Asset flows into ETFs this year have been a lot slower than last year. Should we expect a slower growth pace for ETFs, or is this linked to market performance?
Kranefuss: It's been a slow start all around the world, for the reasons I described. You have a bit of a perfect storm here. There’s quite high volatility in equity markets, but in a way that people are not accustomed to. Usually, volatility is synonymous with markets moving downward. And what we've seen essentially is a sideways market for the past three or four months, depending on where you are. But sideways here means up 4%, down 5%, and the like. It’s significant.
People are paralyzed because they fear getting caught in long-term bonds and having rates go up, and being stuck with the lowest bond income yield for the next 30 years, or a capital loss that's substantial. They also fear taking on more credit risk to try and get more out of the bond market. And they fear going into equities because they just look at their local market and see that it’s not stabilizing but kind of wandering around.
These are exactly the sorts of times when you don’t want to stick to an old asset allocation formula that worked in the past; you have to think about how assets and exposures might fit together in different environments. There are a lot more parts and tools that are available today. It’s challenging to understand, and it’s very challenging to do it yourself.
ETF.com: On a personal note, do you still have your role at Source and at Warburg Pincus?
Kranefuss: Yes. I'm the executive chairman of Source. Last year we gained share; I think we're No. 5 or 6 in Europe. It's actually been very beneficial for me to be able to see things from the other side of the Atlantic. And I'm still involved in that capacity with Warburg Pincus.
ETF.com: Is there any conflict to having a role in an ETF issuer and having a role in an investment management firm that builds ETF portfolios?
Kranefuss: I don't believe so. We're an open architecture platform. We're going to pick the best ETFs that serve the needs of clients. Not one ETF provider provides everything you need. You want diversification across providers. And so, as chairman in both cases, I'm not making decisions on this one, that one, the other. And it does me no good to spin it one way or another, even if I could. But really there's no need to do that. This is a different end of the business. That's why I think an awful lot of the value is shifting in the industry.
To your point about spaghetti against the wall, I think that one of the things we've noticed is the barriers to entry in the ETF market are relatively low. You can get an ETF up and running for a few hundred thousand dollars. But the barriers to success are getting quite high. There's a lot of value shifting now toward what you do with all these ETFs, and which ones you should consider putting into a portfolio.
Contact Cinthia Murphy at [email protected].