ETF Strategists: With Growth Comes Growing Pains

[This article originally appeared in the ETF Strategist Supplement for Inside ETFs.]

When one giant falls, people stop and take notice. When two or more tumble, people look for lessons. That's what happened in the "ETF strategist" space in the last few years.

In what could well be described as an unfortunate coincidence, the world of third-party, ETF portfolio managers—or ETF strategists, as they're often called—has been rattled by three of its biggest players falling roughly at the same time.

If the challenges these firms have faced are unrelated to each other, they've all led to the same outcome: asset outflows.

5 Quarters Of Outflows

According to Morningstar data, ETF strategists now manage $75 billion in assets as of the end of September 2015. However, that number has fallen, as ETF strategists have now seen five-consecutive quarters of asset outflows from ETF managed portfolios (through the third quarter of 2015), despite the fact that U.S.-listed ETF assets—by and large—have continued to grow.

The first to fall was F-Squared.

The Wellesley, Massachusetts-based ETF strategist had, in many ways, become the poster child of third-party managers, having grown to become one of the world's largest thanks to its proprietary "signals" that triggered tactical portfolio changes.

In many ways, F-Squared epitomized the here-to-stay quality of ETF model portfolios, and the bright future of the ETF industry as a whole—which is why its demise was so spectacular, and rattled so many.

First To Fall

The firm first got embroiled in a scandal in 2013 when regulators started an investigation into its use of backtested returns data as actual returns data in marketing materials. Within two years from the first suggestion of fraud, the company's former Chief Executive Officer, Howard Present, had stepped down; a $35 million fine by the Securities and Exchange Commission had followed; and by last July, F-Squared had officially filed for bankruptcy.

From powerhouse in 2013, to $21.8 billion in assets coming into 2015, to bankruptcy six months later—one giant came down.

Concurrent to F-Squared's troubles was Good Harbor's struggle to deliver on its promise of outperformance. The Chicago-based darling had quickly risen through the ranks thanks to its tactical approach designed to deliver outsized gains. The company saw millions of dollars in inflows month in and month out, but then started to bleed as the performance of its portfolios faltered.

Then Good Harbor

Coming into 2015, Good Harbor had more than $3.6 billion in assets, making it one of the biggest ETF strategists in the U.S. But by the end of September, that number was less than half, at $1.2 billion, according to Morningstar. In the 12 months ending Sept. 30, Good Harbor saw more than $4.9 billion in losses.

Then there was Windhaven Investments. One of the largest ETF strategists in the world saw its founder and Chief Investment Officer Stephen Cucchiaro step down for personal reasons in 2014.

His departure opened way for Schwab's Chief Investment Strategist Liz Ann Sonders to take the helm of the company, but it also led to outflows amid uncertainty. By the end of the third quarter, Windhaven had seen some $4.8 billion in outflows in 12 months, according to Morningstar.

'Bad Timing,' Not A Harbinger

In the end, having three key players struggle at the same time was all a case of "bad timing," as Morningstar's Ling-Wei Hew put it, and not a sign of trouble in paradise for the ETF strategist space. But that doesn't mean there weren't lessons to be learned; nor does it mean business will go on as usual.

For starters, F-Squared's and Good Harbor's falls were an important lesson in the role of due diligence.

"Because of what happened to F-Squared and Good Harbor, home offices and gatekeepers are starting to go through strategies with finer combs," said Hew, an analyst heading Morningstar's ETF Managed Portfolio Research. "People are now paying more attention. They usually don't care when things are going fine; but we've seen that models can fail in certain market conditions."

Short-Term Expectations

Another important lesson, she says, is the problem with performance-chasing. The exodus of investor dollars, in Good Harbor's case, is a good example of what happens when investors are focused on short-term performance only. They need to think long term, and pay attention to portfolio fit, she adds.

Being a registered investment advisor (RIA) today is getting more complicated. It's harder to provide value and raise assets, with technology making it easier for investors to do it themselves. Many need to outsource money management, especially smaller firms lacking a repeatable process to pick ETFs and produce asset allocation models that withstand market conditions as volatile as we've seen in 2015.

If advisors need strategists, strategists now have to prove their value more than ever following these companies' declines.

"What's happening is that a lot of advisors are now comparing these managers to the broad equity market in general—the value proposition of these managers is harder to support, particularly when the equity market does well," Hew said.

TOP ETF MANAGED PORTFOLIO ASSETS BY FIRM AS OF 9-30-15

*Morningstar assets include assets of its 3 subsidiaries: Morningstar Associates, Ibbotson Associates and Morningstar Investment Services
Source: Morningstar

Similar To Mutual Fund Maturation

Still, the growing pains the segment has faced in recent years is really no different than the ups and downs mutual funds faced in their early days, according to Newfound's Vice President of Investment Strategies Andrew Gogerty.

Think of PIMCO, or American Funds—firms that have seen highs and lows in the mutual fund space.

"What's a little different here is that all the events and outflows have happened around the same time period, but for different reasons," Gogerty said. "We are just catching up to the realization of the risks and potential rewards and the level of due diligence required in this space.

"The ETF model has made gaining access to these types of strategies a lot easier than it ever was in the mutual fund channel," he noted.

'Normal Evolution'

The ease of use of these portfolios, ETF as a technology in and of itself and the growing technology at platforms have all made the rise of ETF model portfolios—and third-party managers—swift and impressive. But the hiccups are "a normal evolution" in a changing segment, "much like the one that took place in the mutual fund space 60-70 years prior," Gogerty said.

"The ongoing move among RIAs and custodians toward a fiduciary way of managing money and asset-based pricing suggest ETF strategists are here to stay," he added.

And the good news about all that has happened is that ETF strategist assets are now less concentrated, which means risk is less concentrated in this segment. And smaller firms are now getting their shot at some of those mandates.

"Broker-dealers, wire houses, issuers, robos—they're all looking to offer advisors ETF portfolios as turnkey solutions," Gogerty said. "That's good, because not being tied to a single provider for investments is a prudent way to invest."

"Even with volatility this year, the ETF industry growth hasn't slacked off," he noted. "To have firms such as CMG and Ibbotson double assets under management in two years is significant. Demand for this type of solution is going to remain strong."