Innovation is a constant in the world of investing. New spins on old ideas are forever being dreamt up by product departments — most of them are meant to make lots of money for the people who sell them and the investors who buy them. Not all of them succeed at both. ETF managed portfolios — separately managed accounts with over half of their assets in ETFs — are among the latest hot products everyone is talking about. At least 100 new portfolios have been launched within the past three years, while assets in the strategies soared 43 percent to between $40 billion and $100 billion in the 12 months prior to September of last year, according to Morningstar, which just began tracking the investments a few months ago. (Morningstar only follows a portion of the universe — 370 portfolios with $27 billion in assets.) Advisors are piling in — both Charles Schwab and TD Ameritrade reported big bumps in RIA assets dedicated to the strategy last year.
So what's the appeal? Ken Courtney, senior manager of the managed accounts solutions group at TD Ameritrade, says the firm added ETF managed portfolios to its platform due to demand from RIAs, who wanted to round out their portfolios with tactical strategies to generate more alpha. Advisors also like them because they offer a highly liquid, low-cost and tax-efficient way to get broad exposure to many asset classes, says Morningstar. The bulk of the growth has been in global all-asset portfolios — which hold more than 10 percent in ‘other’ assets in addition to stocks and bonds and can add exposure to any market across the globe — according to Andrew Gogerty, ETF managed portfolios strategist at Morningstar. Buying and selling different asset classes is more cost-efficient with ETFs than stocks and bonds, he says.
But as is often the case with hot new investments, there are many questions about the relatively untested portfolios. Because so many of the managers have fewer than three years under their belts, there is little reliable performance data, which makes it difficult to compare them or to determine whether they generate total returns after fees over the long haul. Some critics say advisors just want to profit from the shift toward low-cost ETFs and need a new story to tell clients in today's volatile markets. Others ask whether actively managed ETF portfolios don't defeat the very purpose of ETFs — passive management at a low cost.
As is true with most investments, the key seems to be good due diligence. James Shelton, CIO of Houston-based wealth management firm Kanaly Trust, uses all-equity and moderate growth ETF managed portfolios from Sage Advisory Services, which has a 10-year track record. He says the investments are a good way to satisfy clients' demand for ETF-only portfolios. That said, Shelton acknowledges that many of these strategies are very new and that fees can be similar to those on traditional SMAs. As an advisor, you have to do the same due diligence and research you would on an actively managed mutual fund, taking a close look at fees, the management team, and their discipline for buying and selling ETFs, Shelton says.
“It's what the new financial advisor needs in the absence of having a massive research department of people covering everything under the sun,” says Joshua Brown, New York City-based advisor at Fusion Analytics, who uses an ETF managed portfolio strategy with a nine-year track record. You have to be selective, he agrees. There are some strategies that work and some that don't. You've got to vet the manager's performance in a variety of market environments, the costs of implementing it, and how the investment strategy fits into the larger scheme of a client's portfolio. The manager he's using is performing well, sticking to his strategy and justifying the cost of running it, he says.
Morningstar started tracking the new ETF portfolios because of rapid growth in the space, but also to keep the managers honest. “Whenever you think you can have it all, there's going to be abuses in a situation like that, and I think that's what happened with ETF managed portfolios, and that's why Morningstar's monitoring it,” says Christian Magoon, CEO of Magoon Capital, an asset management consulting firm.
Jury's Out on Performance
One of those abuses, Magoon says, is that some managers rely on survivorship bias to boost reported returns. “What's happened a little bit here, and what Morningstar has found out in its analysis, is that there have been groups that have put out 40 model portfolios over the course of three years,” Magoon says. Then, typically the manager will push the performance of the five model portfolios that have survived and outperformed, neglecting to mention the other 35 portfolios that were shut down. By overstating the contribution of the better-performing strategies, they generate artificially-inflated numbers, Magoon says.
But Adam Patti, CEO of ETF provider IndexIQ, says a performance reporting bias is not uncommon in the world of asset management. Actively managed mutual fund families also report their performance history based on surviving funds and exclude the poor performers that have shut down.
And yet, even when managers aren't actively relying on survivorship bias to boost returns, it's hard to judge performance because the strategies are so new. At least a third of the 370 strategies Morningstar tracks are less than three years old, and another two-thirds were launched after 2004. “Two guys in a garage are pulling together an ETF model and all of a sudden, they're asset managers now,” Patti says.
Further, some of the managers in the space rely on back-tested, or simulated, performance in their reporting. “Because they use ETFs, there's a big quantitative component to them,” Gogerty says. “It's very easy to run a model as a simulation if you have access to long historical periods of data.” (Morningstar's performance data is based on funded composites, however, meaning real returns, says the firm.)
Measuring performance and comparing managers can also get complicated with these strategies due to the way they're benchmarked. Because many of them include a mix of different asset classes, managers often create blended benchmarks, and they're going to choose the benchmark that makes their performance look best, Patti says. With so many different custom benchmarks floating around, comparing strategies across the space is very difficult, Morningstar says.
Advisors need to do their own due diligence to determine whether the benchmark provided by the manager is an appropriate benchmark for that particular strategy, says David Lindenbaum, vice president, managed accounts and alternative investments, Charles Schwab & Co.
Another Story to Tell?
ETF managed portfolios present an easy and attractive story for advisors to tell clients. An advisor who does not have specific expertise on particular sectors or countries, or on the thousands of ETFs out there, can outsource ETF selection to a third-party manager. The advisor gets paid the same fee, and clients get the liquidity, transparency, tax-efficiency and vehicle benefits that come with ETFs. The strategies also offer broad exposure to multiple asset classes in one structure.
But is it just another marketing tool advisors can use to appease clients in these markets — to justify their fees?
“I have my own beliefs about why advisors are using subadvisors like this; it's because they're charging a lot of money and they feel they need to deliver alpha,” says Rick Ferri, founder of Portfolio Solutions and author of The Power of Passive Investing. “You've got to go out there and try to beat the market. If you just do buy-and-hold, that's the best thing for the client, but it's the worst thing for you as a broker.”
Many advisors don't want to add alpha themselves, however, says Ferri. If something goes wrong, they don't want to take the blame. “If I go out and I pick the ETFs and I screw up, I'm stupid,” Ferri says. “But if I hired a money manager and the money manager screwed up, I blame the money manager.”
Larry Swedroe, principal and director of research at Buckingham Asset Management in St. Louis, believes it's a way for advisors to profit from the shift towards passive vehicles. “It's a way to change the framing of the story,” Swedroe says. “‘We can give you a low-cost ETF,’ while still using active management because they generate the fees from that strategy. They don't want to compete in the world of passive management, where fees tend to be lower.”
Defeating the Purpose?
ETF managed portfolios do present a paradox. When you think ETFs, you think low cost and passive. How does the phrase go? The Holy Roman Empire was neither holy, nor Roman. ETF managed portfolios are neither low cost, nor passively managed.
According to Gogerty, the management fees on these ETF managed portfolios can range from 40 to 125 basis points. That's similar to what you would see in the SMA space, he adds. Fees on more esoteric, alternative managed ETF strategies can go as high as 2 percent, Lindenbaum says. So far, he hasn't seen much traction with these pricier investments among Schwab's RIAs.
“They (the RIAs) could just go out and buy ETFs for their clients, right? They're going to have to justify in their minds why they're going to bring this other party in who's going to get paid between 50 and 100 basis points.”
Layer on top of that the fee the client pays to the financial advisor and the underlying expense ratios of the ETFs in the portfolio, and the client could end up paying over 2 percent, says Ferri. (All in, the cost of one of the more expensive alternative ETF managed portfolios could get up to 3 percent.) By comparison, the average hybrid mutual fund, a mix of stocks and bonds, charges 1.27 percent, according to the Investment Company Institute.
“To say, ‘OK, we're going to use a cheap asset, but we're going to throw a management fee on top of that,’ sort of defeats the purpose,” says Aaron Katsman, an advisor based in Jerusalem, Israel. He works with clients around the world. “The whole point (of ETFs) is to try to cut down your costs.”
Getting Active with Passive Instruments
Meanwhile, ETFs are passively managed for a reason — they're designed to track an index, not to beat the market. But many of the ETF managed portfolios are tactically managed — managers shift assets around based on market conditions. And active management is hard to do; much of the evidence shows that on average, active managers can't beat the markets. (See Registered Rep.'s December 2011 cover story.)
“There's no evidence that anyone has ever figured out how to find the managers who are going to beat the market in the future,” says Swedroe. “It's easy to identify the ones that did so in the past, but all the studies done show that no one yet has really figured out how to identify the future winners because you can't separate skill from luck.”
But Fusion Analytics' Brown says the active versus passive argument is a philosophical question; there are instances where an active strategy makes sense and instances where passive is the way to go. For example, you wouldn't want to have passive exposure to commodities because they are futures contracts that expire and have to be rolled over.
“Anyone who says every dollar should be passively or every dollar should be actively managed is an ideologue,” Brown says. “I feel bad for the client whose advisor is so doctrinaire that they won't even consider one or the other.”