Strategies are a welcome innovation, but like all managed products, investors must approach them with care.
This article originally appeared in the December/January 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Managed exchange-traded-fund portfolios, which are professionally-managed, diversified strategies that invest primarily in ETFs, have been one of the fastest-growing segments of the investment-management business in recent years. Morningstar estimates that such portfolios had $50 billion in assets under management as of June, up 30% year to date and 48% since September 2011, when Morningstar began tracking them.
What’s all the fuss about? In this commentary, we try to place managed ETF portfolios in a broader industry and historical context, attempt to explain why they’ve caught on with so many advisors, and take a stab at assessing the merits of managed ETF portfolios, including tactical strategies. (Note: We approach this topic not as totally passive observers, but as participants— Morningstar Investment Services has been managing ETF portfolios for clients since 2007.)
The New ‘New Thing’
Viewed in a certain light, managed ETF portfolios might seem radical. After all, here are portfolios that eschew the usual trappings of the investment-management business— active management, “building block” products, etc.—in taking a more-minimalist tack. With a managed ETF portfolio, it’s a manager, some index funds, and a model that brings them together in expressing a certain point of view on the markets. Where in the past the investor assembled the portfolio brick by brick, here the managed ETF strategist takes care of the whole thing.
Managed ETF portfolios also seem to break with tradition in another respect—they’re inexpensive. Whereas a typical U.S. stock mutual fund might set an investor back around 1% in annual expenses, a managed ETF portfolio might not cost more than 40 or 50 basis points in underlying fund fees, if that.
Evolution, Not Revolution
Yet, the rise of managed ETF portfolios isn’t really a signal event, but rather another fold in investment management’s evolution. Indeed, the advent of fee-based advisory, and the resulting higher demand for products like no-load funds and ETFs, came about amid a desire to separate the costs of advice, distribution, and investing itself. Thus, advisors ditched load funds and began charging a separate percentage fee for their services. Seen in that light, the move to managed ETF portfolios is just unbundling of a different sort, in this case reflecting the desire to peel the cost of pure market exposure (or beta) away from that of active management.
It also reflects the increasing primacy of asset allocation and fees. Investors singed by repeated downturns and dismayed by active managers’ inability to protect their capital have become less willing to cast their lot with a single asset class. For age and demographic reasons, many can’t afford to roll the dice and so are increasingly seeking packaged solutions that deliver exposure to many asset classes in one fell swoop, as many managed ETF portfolios do. They’re also confronting a return-constrained world in which costs loom larger, explaining the bid to wring out expenses via low-fee investment solutions.
Dollars and Sense
Managed ETF portfolios also have risen to the fore for more humdrum, though no less significant, reasons. For example, advisors who are reluctant to cut their fees have sought other ways to remove costs from the client’s experience to remain competitive; given their low associated costs, ETFs and managed ETF portfolios are a surefire way to achieve this goal.
In addition, advisors understandably want to minimize the chance of looking bad in front of their clients, as can happen when an investment they recommend generates disappointing results. A managed ETF portfolio is no silver bullet in that regard—it can flounder like any other product, after all. But at least it isn’t saddled with the higher fees of actively managed funds that bake-in the costs of distribution and advice. These pricier funds are almost bound to lag, raising clients’ ire in the process.
Whether costs are bundled or unbundled, clients must still pay for distribution, advice, and investment management itself. Thus, the skeptic in us might argue that where managed ETF portfolios triumph is in the packaging—they conjure the appearance of giving clients the same services and benefits as before, but at a markedly reduced cost. In fact, when one takes together the financial advisor’s fee (often around 1%), the portfolio strategist’s fee (varies, but 25 to 75 basis points seem to be the norm), and the cost of the underlying investments and transaction costs (again varies, but 20 to 80 basis points is a decent estimate), the final price tag can resemble that of a C share mutual fund.
Worth Their Salt?
Is it worth investing in a managed ETF portfolio? The short answer is—it depends.
Reducing client expenses is a worthwhile pursuit, whatever the context or motivation. In that sense, managed ETF portfolios are a laudable innovation, as they can economize the process of investing in a diversified portfolio by unpacking the cost of pure market exposure and active management. This ought to appeal to clients who are increasingly attentive to the fees they pay for their investments.
Managed ETF portfolios also make it easier to implement a simple, strategic asset allocation. Indeed, with hundreds of low-cost options to choose from, managed ETF portfolio strategists can construct widely diversified portfolios with near-surgical precision. This represents an advance for the simple reason that cheap index funds have not abounded on no-transaction-fee brokerage platform menus, explaining why it’s been difficult in the past for advisors to build low-cost, widely diversified models.
For investors in these sorts of no-frills managed ETF portfolios, a few caveats apply. First, ETFs aren’t always the best choice, especially in less-liquid realms where an investor might prefer to own a mutual fund or an individual security such as a stock or bond. Second, a high strategist fee can dull the luster of these portfolios, so it pays to sweat the details to understand what it costs to actually implement the strategy. For a simple, buy-andrebalance allocation strategy, a strategist fee over 0.2% (not including transaction costs) seems questionable. Finally, investors in smaller accounts might not be ideal candidates for strategic ETF portfolios given the potential for heavy transaction costs, even allowing for their typically low turnover and lower brokerage commissions.
A Special Case: Tactical Portfolios But what about the burgeoning crop of “tactical” managed ETF portfolios that have burst onto the scene? To review, tactical strategists typically forgo traditional approaches to portfolio management. They dynamically allocate assets to and fro based on their reading of macroeconomic currents or other factors.
Given their shape-shifting nature, it can be challenging to assess the performance of tactical ETF portfolios. However, Morningstar recently began compiling data on all managed ETF providers that have submitted their model portfolios into the company’s separately managed account database. To facilitate comparison, Morningstar also devised a classification scheme, which categorizes managed ETF portfolios into one of three “portfolio implementation” groupings—strategic, tactical, and hybrid—based on their objectives and attributes. (See also “ETF Managed Portfolios on the Rise,”)
As of June 30, there were 194 tactical managed ETF portfolios in Morningstar’s database. It is worth noting that this is an incomplete tally of such portfolios; submission of these models to Morningstar’s database is voluntary. It’s also worth noting that many of the tactical ETF portfolios that Morningstar is tracking are new: 119 of the 194 had been launched in the past five years. Nevertheless, Morningstar’s database represents a useful starting point from which to assess the risks and rewards of tactical managed ETF portfolios. (Morningstar Investment Services’ ETF portfolios are included in the database. These portfolios are classified as hybrid.)
Taking Their Measure To conduct that assessment, we compiled the since-inception monthly returns of all tactical managed ETF portfolios whose data was current through June 30 and had at least a one-year track record as of that date. Excluding mothballed portfolios, portfolios lacking current data, portfolios less than a year old, as well as difficult-to-benchmark portfolios left us with 155 models. We then compared these portfolios to the performance of a set of blended benchmarks, the composition of which depended on the portfolios’ Morningstar classification.
What did we find? At first blush, it appears these tactical portfolios fared well. In many cases, they generated better since-inception returns or experienced less volatility than their benchmarks, resulting in higher Sharpe ratios. Though many tactical portfolios have lagged in recent years, a remarkable number appear to have beaten their benchmarks over longer periods, as evidenced by the impressive since-inception figures.
Nevertheless, there are a number of issues that cast uncertainty over these results. These can be instructive to investors considering tactical managed ETF portfolios.
As is typical with separately managed accounts, the results shown are gross, not net, of the fees that the portfolio strategist levies. To approximate the returns an investor might have actually earned, one would need to give a haircut to the results shown in Morningstar’s database. This would significantly diminish, if not erase, the advantage many of these portfolios have enjoyed. In fact, when we subtracted a hypothetical 1% in annual expenses from the since-inception gross returns of the tactical portfolios we examined, roughly four in 10 portfolios underperformed their assigned indexes.
Because inclusion in Morningstar’s database is voluntary, strategists can essentially pick and choose which models to submit and which to withhold. For this reason, it’s conceivable that Morningstar’s database exhibits self-selection bias, which can tell an overly rosy story of how well tactical ETF model portfolio strategists have represented themselves as a group. Investors should take the results with a grain of salt.
Tactical models are especially challenging to categorize for the very reason that their underlying holdings, and thus risk profile, can change dramatically even over shorter time spans. This can create comparability issues that make them more difficult to reliably classify and benchmark.
While questionable data, such as simulated performance, does not appear to be a prevalent issue in Morningstar’s dataset, investors ought to read the fine print anyway when evaluating managed ETF strategies. True, many managed ETF portfolio strategists can claim compliance with the CFA Institute’s exacting Global Investment Performance Standards. Yet, we find it is still worth drilling down to assess a strategist’s track record in granular detail.
For example, we examined the monthly returns of one managed ETF portfolio that boasted the second-best since-inception risk-adjusted returns in the Global Equity category as of June 30. The portfolio’s composite was created on May 1, 2007, which was also its inception date for the GIPS-verification purposes; however, Morningstar’s database lists a Sept. 30, 2005, inception date. Why the discrepancy? As explained in footnotes to the model’s marketing materials, before May 2007 the composite “consisted of one account that is related to one of the firm’s principals whose investment objectives and philosophy were similar.” (The footnotes also advise that the portfolio’s pre-May 2007 net returns were not subject to a management fee, likely because it wasn’t being managed for clients at the time.)
What especially stood out was the pattern of the portfolio’s monthly returns. The portfolio generally struck a mild profile, with monthly gross returns ranging from 0% to 2%, with the occasional small drawdown, a far cry from the more-volatile MSCI World Index. But then, in March 2010, the portfolio suddenly shot to an 18.5% one-month gain, an advance that more than tripled its best monthly showing to that point and dwarfed the MSCI index’s return that month. (It represented the second-best return of the 5,874 separate accounts that Morningstar tracked that month.)
While this outlier doesn’t necessarily call the portfolio’s entire track record into doubt, it raises questions about the nature and consistency of the strategy on which it was built. How did the management team build its record? What sort of risks did it court in doing so? How repeatable are those accomplishments? Answers are likely to be forthcoming only when investors go beyond a cursory examination of a fund’s historical risk and return figures, a point this particular example underscores.
Another Step Along the Path
Managed ETF portfolios are a welcome innovation, as they help investors further simplify and economize the process of investing. But, viewed in context, they’re really just another step along the path of unbundling investment-management services, an evolution that has been underway for some time amid the migration to fee-based advisory. Given this, investors ought to evaluate managed ETF portfolios as they would any other managed product. This means assessing the portfolio’s portfolio-construction and investment decision-making approach, with special care taken to measure and properly benchmark performance of tactical portfolios; it also means evaluating the competitiveness of the strategist’s fee, the all-in cost of the solution (which includes the financial advisor’s fee and transaction costs), and granular details like category-fit and the integrity of the underlying data.
Note: The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar Investment Services shall not be responsible for any trading decisions, damages, or other loses resulting from, or related to, the information data, analyses or opinions or their use.
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