ETF Advisors Breaking Away

[This article originally appeared in our July issue of ETF Report.]

Behind the more than $2 trillion now invested in exchange-traded funds are advisors who, for various reasons, decided it was time to strike out on their own and put ETFs at the center of their money management businesses.

Their motivations for breaking away vary, from a disenchantment with various aspects of the old ways to an unequivocal insight that the ETF is the only sensible way to build a cutting-edge 21st-century advisory business.

What unites them all is a view that cheap, transparent and tradable ETFs canvassing swaths of the investment universe broad and narrow opened up new possibilities of accessing a multitude of asset classes—and outperforming—with index ETFs. Who needs to pick stocks, use Morningstar "Style Boxes" or even use active mutual funds in 401(k)s when it can all done with ETFs?, the pioneers asked.

Lonely Early Days
"If you have high ethics and you know something is not the right way to do things for clients, then everything else doesn't make sense—you don't sleep well at night," said Tyler Mordy, president and co-chief investment officer at Toronto-based Hahn Investment Stewards. He says that many big banks notoriously charge clients too much, have inferior outcomes and, worse, are "calcified" in their ways.

"We felt like we were a rock band touring for 10 years in dingy bars and pubs. We were not an overnight success. There were some lonely, lonely days," said Mordy, who joined his partner Wilfred Hahn in 2001, as he says, "in the ashes of the dot-com bust."

The idea of finding opportunity and of new ideas getting traction in the wake of crisis is as old as capitalism itself and, true to form, the ETF revolution has manifested in waves, each seemingly prompted by an economic downturn.

The first exchange-traded fund, the SPDR S&P 500 ETF (SPY | A-98), launched in January 1993 at the end of the lengthy post-1980s downturn. The ETF truly came of age in the wreckage of the subprime mortgage crisis of 2007-2009. Indeed, most entrepreneurs who have started an advisory firm during or since the market crash of 2008-2009 have chosen to use ETFs pretty much as a matter of course.

First Rumblings Of Change
Plenty of ETF advisors say that they were early adopters of ETFs. But David Kotok, chairman and chief investment officer of Sarasota, Florida-based Cumberland Advisors, has one of the more plausible claims. Kotok's tale takes us to the glory days of the dot-com bubble and to the heart of what is so powerful about ETFs.

"When you think of the history of ETFs, the first one was in '93, the second one was '95," said Kotok, laying out the fact that the lack of funds in the early days precluded anything like thoughtful asset allocation.

"In 1999, we had a problem because the tech-sector weight was huge, and people had this idea that if they owned Microsoft and Applied Materials and Cisco, they had a diversified portfolio," he said, remembering that the combined market value of Microsoft and Cisco of $1 trillion at that time was 1/30th of the market value of all stock markets on Earth.

"The sectors SPDRs [launched in 1998] provided us a way to get into the rest of the world without the tech sector being so heavy. The need to reduce tech-stock exposure in 1999 drove us to a separately managed account using ETFs only," Kotok noted.

Kotok says the more enduring insight culled from the tech bubble was that there was really only so much that investors can learn about single stocks without wasting precious time and effort and even running afoul of securities laws to get an edge.

"ETFs enable me to use valuation techniques, economic techniques, sector analysis—broader themes," Kotok said. "With ETFs, I don't have to try to find a piece of information that somebody else doesn't have. That reality hit us in 1999 when we started to use ETFs, which is why we persisted."

Building Toward Critical Mass
Beyond the SPDR sector funds, the ETF market continued to develop slowly but steadily, notably with the addition of a growing range of international ETFs as well as the first fixed-income ETFs. A watershed moment came in November 2004, when the SPDR Gold Shares (GLD | A-100) came to market. Its astonishingly quick acceptance—it gathered its first $1 billion in just three days—made clear that the ETF market was coming of age. GLD rendered a historically difficult-to-access asset class accessible to anyone with a brokerage account, making GLD a metaphor for the vast democratizing power of ETFs.

"My boss looked at me and said: 'We can't ignore this [ETFs] anymore,'" Mike Venuto, chief investment officer of New York-based Toroso Investments. He took the plunge and started ETF-focused Toroso in 2012. A late arrival perhaps, but it was a long time coming.

He'd been a student of the ETF space for a long time, consulting for Emerging Global Advisors in 2006-2007 to help get that emerging-market-focused ETF firm off the ground in 2008. In addition, Venuto was an early and successful public investor in WisdomTree Investments, the ETF firm that's now at the center of the white-hot world of "smart beta" ETFs.

Financial Crisis As Inflection Point

RiverFront Investment Group, the Richmond, Virginia, RIA that is now the No. 3 ETF strategist by assets, launched in 2008 in the middle of the financial crisis. When the veteran team of advisors that made up RiverFront left Wachovia following its acquisition by Wells Fargo, they were managing $75 billion, with about 10 percent of that in ETFs.

The decision to abandon that gravy train and go all-in on ETFs was based on a view that enough ETFs were now available to do thorough asset allocation.

"Back in 2000, you just didn't have as many degrees of freedom," said Rob Glownia, a fixed-income analyst at RiverFront. "But from 2008 on, the product availability was there."

Glownia said that availability enabled RiverFront to put its "glass walls" ethos of ETF-derived transparency front and center. The firm is known for tightly focusing on time horizons in construction of its ETF portfolios and for letting its clients know what trades it is making, almost in real time. That transparency remains impossible in the world of active mutual funds.

Who Needs Alpha, Anyway?
Another noteworthy firm that got its start in the ashes of the Great Recession is Boston-based Newfound Research. Its approach to investing centers on tactical overlays that attempt to manage changing risks in the markets and the economy—a task of ongoing pivots that the ETF is perfectly suited to handle.

The guiding light there is Chief Investment Officer Corey Hoffstein, whose intellectual gravitas belies his still-boyish demeanor. As he tinkered on a computer managing his own modest portfolio in his dorm room at Cornell University, and wrote the software that became the backbone of the Newfound approach to constructing and managing risk in portfolios, it was always with ETFs in mind.

"Millennials aren't looking to beat the benchmark anymore; they have more of a financial planning mindset," Hoffstein said of a cohort that has seen two nasty bear markets in less than a decade. "It's not about alpha anymore. It's about achieving their wealth needs, and active risk-managed strategies that focus on capital preservation are very strongly tied to that millennial mindset that was created by the dot-com bust and then the financial crisis."

A Holy Grail Called 401(k)s
Mike Venuto, chief investment officer of New York-based Toroso, said the seed of the idea to start the firm came in 2008 when he was at Horizon Kinetics, overseeing private client portfolios. Venuto says the portfolios were massively overconcentrated in too few individual stocks, hurting them significantly in the crash. A collection of transparent, liquid ETFs would have cut those investors' losses, he adds.

"ETFs are amazing tools and, if you use them properly, you can express just about everything today and in five years everything," Venuto said, noting his business is built on deep fundamental research surrounding particular ETFs and on a focus on asset allocation with shorter time horizons.

Toroso's big idea is to market ETFs in 401(k) retirement plans using collective trusts—401(k)s being the holy grail of the ETF market's penetration into the world of mutual funds. More than half of the firm's $75 million in assets are in this realm.



Cool New Products …
Beyond the independence ETFs have given advisors, ETF strategists themselves are creating their own funds, particularly in the realm of fixed income.

RiverFront, for example, was instrumental in designing and providing seed money with client assets for both the PowerShares Senior Loan Portfolio (BKLN | C) and the Global X MLP & Energy Infrastructure ETF (MLPX). Both are designed to diversify sources of income for investors anxious about both paltry bond yields right now and heightened risks of capital losses as rates start to head higher.

A number of ETF strategist firms have also put their own ETFs into play—among them RiverFront and Sage Advisory Services in Austin, Texas, both of which market their own bond funds. Even Kotok's Cumberland—a firm with deep expertise in the municipal bond world is now planning to market an actively managed muni-bond ETF that will show off that expertise in an ETF wrapper.

… And Their Dangerous Cousins
Still, the overriding concern among advisors who have made the leap to independence on the back of ETFs is that some of that innovation is simply not sensible for investors. It's overly complex both in structure and in purpose, undercutting the transparency that's at the very center of what makes the exchange-traded fund so powerful.

"My conviction on ETFs has grown for the last 15 years—no question about that," said Cumberland's Kotok.

"The issue now is about opacity," Kotok added. "The list of opaque ETFs is growing. They are not transparent, and they are being bought by people who don't understand what they own, and therefore are making investment decisions that are uninformed. And that's because an ETF sponsor always has to keep finding a new hook."