More advisors are treating high net worth (HNW) clients and wealthy families like they’re small institutional investors. These advisors deploy endowment-like investment strategies. Alternative exchange traded funds (ETFs) are playing a key role in these developments.
Endowment Model
A true endowment model approach is characterized by only a small allocation to traditional U.S. equities and bonds and more to alternative investments. Advisors catering to the HNW demographic haven’t previously broadly applied this approach due to the typical allocations to highly illiquid asset classes like private equity, hedge funds and managed futures. Most of these strategies have traditionally only been available via the likes of liquid partnership vehicles and offshore funds, and at very high expense ratios. Additionally, individuals and their advisors largely haven’t had access to the advanced allocation modeling software that asset managers use to implement such strategies.
More Diversified Portfolios
The use of alternative strategies in ETFs has enabled advisors to create endowment-modeled portfolios for HNW clients that were likely out of reach as recently as five years ago. Due to the proliferation of these types of ETFs, advisors can now access many more asset classes, including the previously illiquid alternatives mentioned earlier. In essence, these ETFs, along with liquid alternatives in the mutual fund space, have democratized these strategies, resulting in much more diversified portfolios for HNW investors.
For example, the alternative IQ Hedge Multi-Strategy Tracker ETF (QAI) seeks to track the performance of the IQ Hedge Multi-Strategy Index. The index attempts to replicate the risk-adjusted return characteristics of hedge funds using multiple hedge fund investment styles, including long/short equity, global macro, market-neutral, event-driven, fixed income arbitrage and emerging markets. Alternative ETFs like QAI and others offer the next generation of beta exposures.
The Three Ts
Beyond just access to these previously illiquid strategies, ETFs seek to deliver the three Ts: transparency, tradability and tax efficiency. The benefit of transparency is being able to know what’s in a portfolio at all times. Thinking tradability, a more liquid portfolio makes rebalancing easier. The tax efficiency of ETFs can be especially impactful for HNW clients who are often especially concerned with minimizing the impacts of taxes.
Tax Ramifications
Some actively managed funds have embedded capital gains, which can result in tax consequences. As an example, 164 of the 288 funds in the Morningstar Intermediate-Term Bond Category distributed capital gains as of Dec. 31, 2015, with the average fund distributing a capital gain of $0.08 per share.1 By comparison, the structures of the IQ Enhanced Core Bond U.S. ETF (AGGE) and the IQ Enhanced Core Plus Bond U.S. ETF (AGGP), two smart beta ETFs that seek to enhance returns with comparable levels of risk to the fixed income market by employing a momentum investment approach, may offer a more tax-efficient solution by reducing or eliminating short-term capital gains on portfolio turnover, thus providing significant tax alpha. (There’s no assurance that the funds objectives will be met.)
Considerations
Advisors who are intrigued by the possibilities of this endowment-model approach should keep in mind a few considerations. The overall financial plan must be in accordance with the goals and circumstances of the individual client. This should include mapping out risk tolerances and where the individual is in life in terms of age, retirement goals and other investment objectives.
In many cases, even those advisors who’ve done all their homework maintain biases, like a home country bias, when it comes time to actually construct endowment-modeled portfolios. As a result, they often fall short of taking a true endowment approach. Advisors should keep this in mind when the time for implementation comes.
Thinking of success measurements, the endowment model isn’t for those operating within a one- to three-year time period and watching returns relative to a benchmark. The classic endowment model approach, which can lag over short time periods, is implemented with a 20-year time horizon, with the focus on an identified long-term goal. Interestingly, endowment models, on average, are less volatile than those portfolios that don’t use alternatives as they tend to better stick to a pre-defined plan.
Pensions, endowments and foundations are ongoing, perpetual organizations that take the long view. HNW investors often look to extend wealth to multiple generations in a similar way. Adopting an endowment-model approach can enable the HNW investor to do just the same. While alternative ETFs present the potential of a promising opportunity to be successful in creating endowment-inspired strategies, the approach isn’t easy. These strategies take discipline, fortitude and the guidance of a trusted advisor. When well executed, such an approach can deliver impactful and lasting value.
Endnote
1. Morningstar, as of Dec. 31, 2015.
Brendan Gundersen is head of Institutional Intermediary Business, MainStay Investments.