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Ted Lucas

Vanilla Index Funds Won’t Be Enough

The past four decades have provided relatively good support for equity returns, which helped fuel the rise of low-cost, straightforward index funds. But there has been a fundamental shift in the markets, and the future won’t be nearly as kind to plain vanilla investors, argues Hartford Funds’ Ted Lucas.

The biggest story in ETFs over the past few years has been the rise of very-low-cost, plain-vanilla index funds as the core of most investors’ portfolios. But according to Ted Lucas, head of Investment Strategies and Solutions at Hartford Funds, these funds won’t be good enough in the years ahead.

Lucas thinks we’re sitting at a major crossroad, moving from a benign paradigm that’s persisted for the past 40 years to one that’s much less supportive of strong returns. He’ll be speaking about this paradigm—and what it means for investors—at the forthcoming Inside ETFs conference, taking place Jan. 21-24, in Hollywood, Florida.

In anticipation of the conference, he recently spoke with Inside ETFs CEO Matt Hougan about what advisors should be doing to preserve and grow wealth for their clients in the years to come.

Matt Hougan: You’re coming down to Inside ETFs to speak on our mainstage panel on “The Future of ETFs.” What is the future of ETFs?

Ted Lucas: To look forward, I think you have to start by looking back at what investors have experienced over most of our investment lifetimes.

For the past four decades, you’ve had a very robust environment for investor returns. Going back to the early 1980s, equities were trading in the U.S. at eight times earnings, the dividend yield was over 6 percent, 10-year Treasurys paid 14.5 percent and inflation was over 10 percent. You had stagflation, low-to-negative GDP growth and earnings growth, and compressed corporate profit margins. That all translated into very low expectations for investors. BusinessWeek ran its famous cover touting “the death of equities.”

Today we have a funhouse mirror image of that. Whether it’s valuations, interest rates, the inflation environment, the earnings growth environment, profit margins or investor expectations, we’re in a very different place.

Adding to that, if you look back over the last several decades, you had some very positive macro forces that helped unleash an anomalous period for equities and fixed income. You had broadly positive demographics, developing economies coming online, globalization, the spread of democracy and economic freedom, and productivity gains from technology. That all created a strong tailwind for financial assets, and that played directly into the rise of low-cost beta ETFs as a dominant paradigm for investors. Many of these macro tailwinds have now either played out or reversed.

MH: If all those bullish precursors have reversed, what does that mean for investors and ETFs? 

TL: In this environment, investors need to be thinking about two things. First, how do you durably enhance what will be weaker structural beta returns? And second, how do you incorporate a risk management process into your investment strategy?

That latter question is just as important as the former. Since 2009, a traditional 60/40 portfolio has compounded over 10 percent a year without a 10 percent drawdown. That’s not normal, and not sustainable long term.

We believe that traditional low-cost beta will struggle to generate the growth investors require, which is likely one of the reasons you’re seeing so much interest in factor strategies. But so far, a lot of the discussion around factor exposure and systematic strategies has focused on return enhancement. I think the idea of risk efficiency is really important, and will become a major focus of discussion for investors in 2018 and beyond.

We all know the math of investing: that ultimately losses and drawdowns are more influential than excess returns and if you lose 50 percent of your money, you have to double it to get back to even. 

I think there’s real opportunity for the ETF industry and real demand among investors for equity ETFs that offer a level of risk reduction, as well as returns. This will likely accelerate as the risk-buffering nature of bonds weakens in the face of rising rates and liquidity withdrawal.

MH: I generally agree with that, but why should we assume advisors will want to do that within ETFs as opposed to adjusting allocations at the portfolio level? In 2008-2009, we saw the rise of ETF strategists packaging ETFs together with risk management overlays. What’s the case for intra-product risk management as opposed to portfolio-level risk mitigation?

TL: That’s a great question, and the answer is that the approaches are not mutually exclusive.

We had a period from October 2007 into February 2009 where all risk assets had a solid downward trajectory. That meant that strategists with a simple trend-following methodology sidestepped part of that sustained decline. Those that re-entered the market in 2009—whether through luck or skill—built tremendous businesses and delivered very attractive returns.

That said, the market environment from 2009 onward—where short pullbacks were recovered quickly—has been more of a challenge for tactical timing. Many strategies experienced a degree of whipsawing. 

Timing is hard, and there is risk to be considered in being highly tactical at a macro level. I like to be more systematic about it and think about risk more holistically—at both the macro and micro level—using building blocks that will help me stay invested in the market.

People don’t talk enough about the penalty investors pay for buying high and selling low, and we see this in ETFs just as much as mutual funds. Products and processes that help people avoid that are tremendously impactful to long-term returns.

MH: One advantage of macro allocations is you can sidestep a market wipeout regardless of cause. When we talk about a product-level risk strategy, such as adjusting your sector or size of country exposure, how can you be sure you’re covering the right bases to lower your risk?

TL: You have to start with the premise that, while you don’t know exactly what will happen, you know something might happen. So you start with a pro-risk-management stance that looks to insulate the portfolio from downside risk, while maintaining factor exposure that will support your portfolio on the upside.

If you believe that structural beta returns are going to be challenged, you can try to enhance that return by exposure to well-known compensated factors: value, momentum, quality, etc.

But as you do this, you don’t want to overlook the defensive aspect of building that portfolio. That means looking through your holdings to examine your concentration at the company level, the country level, the currency level, the sector level and other risk attributes. Concentration risk is very important. You don’t just want to look back at your portfolio’s trailing volatility, but rather look forward to consider your future risk experience. The transparency of ETF holdings allows investors to do that real-time. Our strategies look at risk allocation through multiple lenses to try to mitigate those unforeseen risks.

MH: I’ll ask a simple closing question. The ETF market today is booming, but it’s still primarily concentrated in the market-cap-weighted beta. If I look out three years or five years, what does the ETF industry look like?

TL: Because I work at a firm offering risk-first, multifactor strategies, I can’t say I’m totally objective. For starters, I think the ETF industry will be bigger, as the ETF is just a superior way to get exposure for systematic strategies.

I don’t think the composition of strategies changes overnight away from straight beta strategies. But I do think the growth trajectory of multifactor strategies will continue to exceed that of pure cap-weighted strategies for all the reasons I mentioned; investors need something beyond plain-vanilla exposure given the return and risk challenges we’re facing in the years to come.


Matt Hougan is the CEO of Inside ETFs. Inside ETFs and are both owned by Informa, PLC.

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