An emerging market of strategies takes advantage of advisors’ growing interest in funds of funds.
This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
While the popularity of exchange-traded funds among financial advisors and other institutional users is no longer a new story, the emerging story of ETF managed portfolios has been little discussed. Their growth illustrates the massive appeal that funds of funds have for advisors in today’s investing environment. Primarily structured as separate accounts, these strategies typically have more than 50% of portfolio assets invested in ETFs and represent one of the fastest-growing segments of the managed-account universe.
Professional money managers are packaging portfolios of ETFs into investment strategies to meet a wide array of investor demands. The influx of new individual ETFs provides access to stand-alone investment strategies and one-stop, complete-solution offerings.
Morningstar tracks nearly 490 strategies from 120 firms with assets of $50 billion as of June. Assets in this space grew 30% in the first six months of 2012 and 48% since September 2011. These numbers mark a significant increase from the 370 strategies offered by 95 firms that contributed to Morningstar’s database a year earlier. Demand for access to and information on ETF managed portfolios is on the rise, coming from both the firms managing these portfolios and the institutional decision-makers responsible for including them on advisors’ distribution platforms.
An Evolution of Money Management
The market for ETF managed portfolios is growing for several reasons. Morningstar and academic research have shown that asset allocation is as important as security selection in determining a portfolio’s total return. A prudently constructed portfolio of ETFs provides wide asset-allocation options and low-cost diversification. ETFs provide transparency, intraday liquidity, and portfolio consistency to strategists allocating among various asset classes and subclasses.
The fiduciary standard continues to move forward as the baseline philosophy for managing client portfolios. As a result, more fee-based advisors are tilting clients’ portfolios toward lower-cost, broad-based investments, with a focus on asset allocation. In addition, the ETF as a technology platform allows third-party ETF strategists to deliver to advisors institutional-type diversification and portfolio management, allowing advisors to focus on gathering and retaining client assets and managing clients’ overall financial profiles.
The New Crop of Asset Managers
The growing use of ETF managed portfolios has led to changes in how ETF strategist firms are organized and perceived by advisors and institutional decision-makers. Many of these firms were started by financial advisors who broke away from wirehouse operations or other regional broker/dealers. As is the case with many startup ventures, these entrepreneurs were likely lured by the possibility of greater autonomy, a wider potential client base, and the ability to build a distinct brand.
Initially, these firms were serving their own clients, but many firms began seeing a growing interest in their investment and asset-allocation strategies from other financial advisors and investment consultants. As a result, firms evolved—and continue evolving— from a client advisory practice toward the small, boutique money-manager model commonly seen in the traditional separate account industry.
A Reference Guide
So what makes ETF managed portfolios hum? ETFs trade intraday so managers can quickly and cost-effectively change, sometimes in dramatic fashion, the profile of a portfolio. For example, a manager can swap U.S. large-cap stock exposure for dividend-paying, emerging-markets small-cap equities by trading one position in SPDR S&P 500 SPY for another in WisdomTree Emerging Markets SmallCap Dividend DGS. Meanwhile, a traditional equity portfolio would go through potentially hundreds of individual stock trades to replicate the same exposures.
Because it’s so easy for an ETF managed portfolio strategist to do a tactical about-face, advisors need additional information on these strategies beyond the typical holdingsbased analysis. In January 2012, Morningstar introduced a new classification system that shows investors what philosophies and objectives drive this growing crop of investment strategies. Our classification system relies on our analysis of the investment strategy as well as a review of these firms’ historical portfolios. Some strategies invest solely in equities or fixed income but provide broad exposure across the Morningstar Style Box; others are built around a total portfolio concept, emphasizing risk or global diversification with some alternatives blended in. To determine a portfolio’s classification, we start with its investment universe, move on to the type of assets in which it invests and the process it uses to implement its strategy, and finish with the type of ETFs the strategy uses. We dive deeper into each attribute below.
The first attribute describes where a strategy intends to invest. We assign the strategy to a universe based on where the ETF is investing, not the domicile of the ETF itself.
Global: These strategies have the opportunity to add exposure to any market across the globe and have historically used such flexibility.
International: International portfolios primarily use ETFs providing exposure to non-U.S. equity and fixed-income securities.
United States: U.S. portfolios primarily use ETFs providing exposure to U.S. equity and fixed-income securities.
The classifications within this attribute indicate a strategy’s primary asset-class exposure or returns driver. These selections don’t indicate that the whole portfolio is, for example, invested in equities or bonds, but rather which of these asset classes will primarily drive returns. To classify strategies within this attribute, we analyze historical portfolio asset allocations and review, if available, a strategy’s investment policy benchmark or starting portfolio.
All-Asset: These strategies typically have the widest and most flexible mandate when investing in ETFs across asset classes. In reviewing the portfolios, we designate this attribute to strategies that consistently held more than 10% in assets other than cash, equity, and fixed-income securities.
Alternative: Alternative strategies typically seek returns uncorrelated to traditional equity and fixed-income markets by attempting to remove one or more asset betas or return drivers. Strategies with this attribute designa- tion include long/short or other alternative strategies, including currencies.
Balanced: The return drivers for these strategies are a combination of equity and fixed-income exposure on a dedicated, ongoing basis. These strategies typically have a 30% to 70% allocation to equities.
Equity: These strategies primarily feature long or beta-type exposure to equity securities. We ignore whether the underlying ETFs use leverage. These strategies typically have at least a 70% allocation to equities.
Fixed Income: Bonds, either long or beta-type exposure, drive returns at these strategies. As is the case with the Equity classification, we disregard leverage. These strategies typically have less than a 30% allocation to equities.
This attribute gives insight into the investment manager’s process for implementing a portfolio’s investment strategy. To classify the strategies, we review the degree of changes both within and among asset classes in a portfolio. As a result, we consider changes to broad asset allocation (cash, equity, fixed income, and other), as well as to a portfolio’s U.S./non-U.S. exposure.
Hybrid: These portfolios combine tactical and strategic asset allocation. Hybrid portfolios, for example, start with a stated investment policy benchmark or asset allocation but allow for significant deviations of exposure within and between allocations, similar to “core and satellite” or “hub and spoke” operating models. Portfolio strategies that make significant use of options also receive this classification.
Strategic: These strategies establish and maintain a long-term allocation plan across either asset classes, sectors, or a combination. These portfolios may deviate from the plan in short-term periods but typically to a smaller degree compared with tactical strategies. Strategies for which few historic portfolios have been provided to Morningstar’s database initially default to this classification.
Tactical: Tactical strategies engage in short-term and potentially large changes in the asset mix of a portfolio to capitalize on identified investment opportunities. These changes are often reversed or removed.
Primary ETF Exposure Type
The last attribute identifies the type of ETF the strategy typically uses to gain the exposures reflected in the Universe and Asset Breadth attributes. To determine this attribute, we look again at past portfolios and information regarding a strategy’s starting universe or list of potential investments.
Broad Market: These strategies own broad- based ETFs that track diversified indexes such as the Russell 2000, S&P 500, or Barclays Aggregate Bond.
Sector: These primarily employ individual equity-sector ETFs, such as those focusing on financials, or more narrowly focused fixed- income ETFs to gain exposure within the Asset Breadth attribute. A sector fixed-income strategy is typically one focused on a single sector, such as municipals or Treasury ETFs.
Country/Region: Similar to the Sector option, these strategies use single-country, regional, or currency ETFs focused on a geographical area and are typically found in the International or Global Universe attribute.
All-Inclusive: All ETFs meeting the Universe and Asset Breadth criteria for a strategy are potential investments.
Hello, U.S. Equities
Now that we can categorize ETF managed portfolios, we can dive deeper into the attributes of these strategies to discuss developments and trends in this growing space. U.S. equity strategies saw a surge in advisor and institutional demand in the first half of 2012. Of course, it certainly didn’t hurt matters that the S&P 500 Index was up in four of the first six months of the year. Among all-equity funds, U.S.-focused strategies saw the largest growth in 2012 and now control $12.5 billion in assets, more than 50% of the $20.6 billion invested in equity strategies.
More strategies have begun disclosing information to Morningstar, and global strategies continue to garner a majority of assets. As of June, these strategies collectively held more than $30 billion in assets, or 61% of the total assets invested in ETF managed portfolios. Inside the Global universe, All-Asset strategies have $17 billion in assets. In addition to traditional equity and fixed-income allocations, many strategies in this space allocate assets to gold, silver, and broad-based commodity indexes.
Assets in the Global All-Asset space are highly concentrated. Windhaven Investment Management’s three strategies continue to see significant traction within the Schwab network, growing $2.6 billion collectively through the first six months of 2012 and holding a combined $11 billion, making the firm the largest in the entire ETF managed portfolio space. Quantitative Advantage’s Tactical All Market strategy and Cougar Global Investments’ multiple MAR (Minimal Accept-able Rate of Return) strategies have also seen significant growth and rank among the largest strategies in this universe.
Give Me Some Action!
Driven by growth in both the Global All-Asset and U.S. Equity space, total assets in pure tactical strategies have inched past those in hybrid offerings through midyear. Overall, though, the Portfolio Implementation profile of the ETF-managed-portfolios space has remained relatively stable, with Hybrid and Tactical strategies each controlling approximately 45% of assets—with the remaining 10% in Strategic offerings. In fact, Tactical strategies have been the primary beneficiaries of investors’ appetites in the U.S. equity space. Strategies from Good Harbor, F-Squared, and Innealta have enjoyed the lion’s share of the growth in the domestic-equity segment and also rank among the fastest-growing of all strategies in the space.
This makes sense, as the value proposition of many strategies includes the promise of a “better mouse trap” for allocating assets among sectors or asset classes. Hybrid strategies often include a combination of tactical and strategic elements in asset allocation. Hybrid portfolios, for example, start with a stated investment policy benchmark or asset allocation but allow for significant deviations of exposure within and between allocations, similar to a “core and satellite” or “hub and spoke” operating model.
Promise of Technology
Perhaps the biggest trend in ETF managed portfolios is the promise of technology.
Technology will continue to redefine the money-management industry. We see that in ETFs now. They’re technology solutions, not funds. Not only do ETFs provide global access to investment opportunities, but their on-exchange structure democratizes investing; the conflicts present in other investment vehicles don’t exist here.
Advances in technology—whether it is the UMA structure, portfolio overlay services, or simple outsourcing of investment management duties to ETF strategists— will allow advisors to focus on the core of their business and clarify their value proposition to clients. If advisors have access to technology that allows them to provide better, more efficient portfolios to clients, they have the power to redefine their client-relationship role.