ETF Model Portfolios Change Advisory Biz

June 27, 2014

ETF portfolio due diligence expert says advisors are increasingly embracing model portfolios comprising ETFs.

Advisors face a great challenge today, and that is determining which ETF model portfolio is right for their clients. As an industry, the ETF strategist space lacks standardization in terms of nomenclature—a so-called global tactical portfolio might not mean the same type of exposure to different strategists—as well as any sort of rating system that allows you to compare and contrast similar model portfolios from different providers.

That’s what Envestnet sets out to do. The firm combs through the various portfolios in an extensive due diligence process that looks to shed light in the murky space. In the end, advisors are offered a platform of pre-screened model portfolios that have been scored for risk, among other things. Brooks Friederich, director of fund strategist portfolios for Envestnet, is driving this effort, and he shared with some of his insights on the space, as well as the building blocks advisors are clamoring for these days. As an advisor, how do you begin the process of selecting an ETF portfolio from various ETF strategists? There’s no standardization in this space—what one strategist might consider a global tactical portfolio can be completely different from what another one calls it. How does an advisor start this process?

Brooks Friederich: We first have them fill out a traditional due diligence questionnaire with questions like, Can you use ETFs? What types? Can you use leverage or inverse ETFs? Do you prefer a specific ETF provider? And other questions like that.

We also have a risk score questionnaire to determine the flexibility around asset allocation in these portfolios, and that helps us, from a data standpoint, understand how flexible they can be.

We look at historical trades, and look at a qualitative assessment from the analysts—things like, “I know who these guys are. I know this model”—the human element of these strategies, if you will, so it’s not just purely data driven. We put all of these pieces together to give it an overall encompassing risk score.

In the end, the risk-score process helps categorize these strategists’ portfolios into certain risk profiles. And that helps advisors. But to your point about the qualitative aspect of things—things like naming convention—it’s becoming more of a marketing and sales gimmick sometimes.

“Tactical” means different things to different managers. And there's nothing wrong with them. But we have to take our stance and say, “Here is our definition of tactical,” which is simplistically just unconstrained: the flexibility to go 100 percent cash to 100 percent equity.

If you have that in your mandate, you get put in the tactical bucket. If you have to have certain guidelines like minimum and maximums—say, 50 percent equity and 50 percent bond—that’s going to be a different risk profile. We model that out and incorporate your historical allocations to differentiate them based on risk.

It’s a helpful process, because people were just lumping together all global tactical guys into one group, and looking at a 2008 performance number, and saying, “Well this guy was up similar to that guy.” Now, going forward, they’re more likely to differentiate. The biggest asset growth in the ETF model portfolio space has been on the strategic core, cheap beta. Why is that?

Friederich: Part of it has to do with risk. Many advisors can incorporate some tactical—the more aggressive tacticals are probably the most popular in that case—but they can only incorporate, say, 10 or 15 percent of a global tactical unconstrained strategy into their moderate client.

Of course if that client is aggressive, they can add more tactical exposures, but our data show that most clients today are profiled as moderate. We’re talking some sort of 30/70, 50/50 or 60/40 stocks/bond portfolio, that kind of middle-risk bucket.

So they need to have that core strategic beta foundation, and then they can buy slivers and combine the global tactical guys around that core foundation. We’ve seen more flows into strategic efficient cheap beta simply because they’re looking for that core foundational element. Outside of strategic beta, is there a particular tactical strategy that is resonating more with advisors in the current environment?

Friederich: On the fringes, depending on the range of risk their client is comfortable with, advisors are adding more unconstrained strategies, both on the equity and bond spaces, but probably more so on the fixed income as of the last six months.

We’ve seen a lot of development in unconstrained bond funds, and a lot of requests for that in terms of mutual funds as well as the ETF strategies, because given interest rate levels and the environment in the fixed-income market, you can’t just buy and hold as you might have done historically. Other than unconstrained bond funds, are there other building blocks that advisors are looking for when it comes to ETFs and ETF portfolios?

Friederich: There’s a lot of product out there. I think folks have done a good job of listening to client demands. Beyond unconstrained bond funds, there’s demand for sort of multi-asset income strategies.

We have all these higher-yielding ETFs that advisors have been probably buying and choosing on their own, but now they don’t know which one to buy next, or which one to sell.

Now, there’re strategist managers who do all the tactical trading around to get to a yield target—say, 5 to 8 percent—while making sure to protect capital. They go to advisors and say, “You’re searching for yield. Here is our yield target.” These have been just as popular even with shorter track records. ETF strategists today command about $140 billion in assets, based on some estimates. It has grown relatively quickly. Is there anything unique about the growth of this segment?

Friederich: When I made the transition over to the strategist space two years ago, I wanted to make sure for my career that this is here to stay, and continue to grow. When I think about my generation and what they want in investing, it makes a lot of sense to see the growing demand for ETF solutions.

I’m from South Dakota. It’s definitely moving off of Wall Street to Main Street. People are wondering, “What are these ETF things?” And they don’t know enough to pick their own. It’s somewhat similar to what happened in the mutual fund industry.

My uncle was an advisor in the ’60s and ’70s. He was one of the old stock pickers, but then mutual funds came to market, and, to quote his own term, he “outsourced the stock picking to the mutual fund guys.”

We’re going from the mutual fund industry where the advisor used to do the asset allocation by buying all these funds together, to where the advisor is going to outsource it to the third-party strategist. That’s more scalable. It all allows advisors to grow their businesses because they have more time to focus on client relationships.

Our data show that advisors spend two days a week on investment-related tasks. Now they have two days a week to… Golf with clients?

Friederich: Exactly. Advisors love that. “Oh, I get a day to golf?” Yes, you get a day to build your business. And how else are you going to do it? You golf with your clients. If you’re in Colorado, you go skiing.

That’s where I think the newer generation of advisors is headed. They want what’s most efficient. They want technology, they want to outsource, they want to grow their business. It’s still early on in the game, and I think the mutual fund industry will be there, the traditional active will be there, but this is a nice—and growing—piece of the game. Are there any particular risks associated with ETF portfolios that are inherent to the ETF structure versus, say, a mutual fund portfolio?

Friederich: That’s a good question. I think the only risk is that there are a lot of different ETFs in the market now, and a lot of them are not plain vanilla, but activelike and factor investing ETFs.

To the end investor, if they’re going to start incorporating more of these active ETFs, these style-factor ETFs, lower-volatility ETFs, it’s extremely important to understand what you own so that they don’t end up with huge tilts in their portfolios they didn’t want. The risk is combining these strategic beta ETFs with traditional market-cap-weighted funds, and knowing how they’re going to act or react, the overlap of exposures.



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