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U.S. Equity Strategies

Tactical strategies dominate investor interest right now.

Andy Gogerty, 02/06/2013

ETF managed portfolios are investment strategies that typically invest more than 50% of portfolio assets in exchange-traded funds. Primarily available as separate accounts, they represent one of the fastest-growing segments of the managed account universe. Morningstar has developed a proprietary classification system for ETF managed portfolios that identifies the investments’ portfolio attributes. The new structure consists of four main attributes: universe, asset breadth, portfolio implementation, and primary ETF exposure type. This system helps investors better understand the philosophies underlying these investment strategies. The latest Morningstar ETF Managed Portfolio Landscape Report (which can be accessed here) is a comprehensive industry review of strategies that report information to Morningstar’s separate account database.

In this series we’re taking an inside look at the industry using the combination of universe and asset breadth attributes as a starting filter. This commentary is focused on United States (universe) equity (asset breadth) strategies, and upcoming commentaries will discuss other attribute combinations.

A Twist on SPY and VTI

U.S. equity strategies benefit from one of the deepest, oldest sets of ETFs available. Many of the early ETFs brought to market were focused on different facets of the U.S.- equity universe, and strategists can slice the market in almost any direction, including sector, niche industry, market-cap, and style. The newer crop of ETFs has focused on non-market cap weightings such as equal- and fundamentally-weighted indexes and volatility-based screens. When viewed as a technology rather than an investment, the ETF has given tactical and strategic managers alike a cost-effective way to express a more-elegant view on the equity market. 

This expanded tool set, combined with a resurgent U.S. equity stock market and continued popularity of ETFs, has pushed significant assets into U.S. equity ETF managed portfolio strategies. These strategies account for a material share of total industry assets, as many advisors and asset allocators look to equities as a primary portfolio building block and likely remain biased toward their home-country market. When comparing ETF managed portfolios by Morningstar’s universe and asset breadth classifications, U.S. equity strategies rank second by size as of Sept. 30, 2012.

Collectively, equity strategies have kept pace with the industry’s growth, holding steady at approximately 42% of assets. But, as we noted in the most recent landscape report, U.S. strategies have been a focal point of interest, with assets up 61% in the first nine months of 2012 and now accounting for the largest portion of assets in equity strategies.  

Top-Heavy and Tactical

The growth in U.S. equity strategies has been dominated by the industry’s top players, keeping assets concentrated. Multiple strategies from F-Squared Investments (in both the U.S. equity and the global-all asset groups) have seen material asset growth. F-Squared’s weekly and monthly sector-rotation models are in demand from not only other advisors for implementation in separate accounts, but also from multiple Virtus mutual funds that include these strategies in their holdings. The firm’s models driven off the SPDR Select Sector ETFs are most popular, but new strategies also are available using First Trust’s AlphaDEX series of sector ETFs. 

Chicago-based Good Harbor Financial remains the group’s darling, with its U.S. Tactical Core strategy growing nearly $2.4 billion in the first nine months of 2012. The strategy’s model uses three states: 100% equity, 50/50 stocks and bonds, and 100% bonds. The portfolio uses leveraged ETFs, and the strategy reallocates among the states as often as monthly should the model indicate a change is necessary. The strategy employs primarily broad market equity and U.S. Treasury ETFs. 

Innealta’s Core sector-rotation strategy, like F-Squared’s, uses SPDR Select Sector ETFs to tactically position the portfolio. When its models don’t like a sector, that portion of the portfolio is allocated to a fixed-income sleeve. The Opportunity strategy uses the same model but uses levered sector ETFs to gain exposure. Investors have preferred the unlevered version, but both strategies rank in the top 10 in terms of size of all U.S. equity strategies.

Among all ETF managed portfolios, the strategies are approximately split 45% hybrid/45% tactical/10% strategic. Within the U.S. equity group, however, the asset breakdown leans toward tactical with a 12%/87%/1% split as of September 2012. 

Know What You Own

Like the broader ETF managed portfolio universe, U.S. equity strategies typically employ a combination of technical and quantitative factors. Statistics such as momentum, moving average, relative value, relative volatility, and various yield-curve scenarios often form the basis of model inputs. Strategists use factors such as these to gain insight into pockets of investment opportunity within the broader U.S. stock market. Other factors such as mean reversion or mean variance optimization can also play a role in determining portfolio holding weightings.

Understanding the strategy’s scope and objective is crucial to using it correctly within a broader portfolio. Decision-makers must have a clear view of the importance of factors such as upside participation, downside-capture, and correlation. A strategy’s portfolio may quickly and extremely move in and out of sectors, industries, or equities, while other products have concentration limits. When investors clearly understands these aspects, they’re able to picture what a strategy actually does (rotates into better pockets or offers a degree of downside protection, for example) as well as what is unusual or atypical compared with peers (slight or extreme tactical changes, or leveraged or inverse ETF holdings, for instance). 

Defining “Cash”

Finally, it’s important to understand which securities the “cash” or “out of the market” sleeve owns, if applicable. When tactically rotating out of sectors or other strata of the equity market, know where a strategy typically parks those assets. Some strategies hold U.S. Treasury ETFs, while others prefer short duration credit, such as PIMCO Enhanced Short Maturity MINT. Some strategies employ a tactical fixed-income model to manage the non-equity portion of the portfolio. Each of these approaches can have a different impact on the strategy’s total risk profile.

Under The Hood

At a quick glance, SPDR Select Sector ETFs are the lineup of choice for sector exposures in U.S. equity strategies. A few venture outside of the SPDRs, but the assets in these ETFs are small. F-Squared’s AlphaDex lineup and SignalPoint’s Signal 10 strategy, which uses PowerShares’ Dynamic sector lineup, are the most notable. Broad market exposure shows the cast of top ETF providers (SPDR, Vanguard, and iShares) are common top holdings, while SPDR and Vanguard are the firms of choice for REIT ETF exposure. 

Alternatives and volatility-linked ETFs don’t represent big portions of U.S. equity strategies, though we are seeing some increased use. Longview Capital Management’s Dynamic Large Cap Strategy, for example, had a 45% allocation to the PowerShares S&P 500 Low Volatility SPLV and a 10% combined weighting to various volatility products in its most recently disclosed portfolio.

How They Can Be Used

U.S. equity strategies can be used in a variety of ways—especially if decision makers consider the characteristics of the return stream rather than the portfolio holdings. Most commonly, advisors will invest the core portion of clients’ portfolios in these strategies. Institutions and other large investors can also consider them for an alpha satellite holding or risk-diversifying allocation, depending on their drawn-down and volatility-consistency goals. Below we highlight the top strategies based on risk-adjusted return, core/alpha characteristics, and diversification.  

The correlation statistics were calculated against Vanguard Total Stock Market ETF VTI.

The Near-Term Prospects

U.S equity strategies are likely to keep pace with the general growth of the broader ETF managed portfolio universe. We don’t expect many changes in the way they’re used in portfolios—mostly as a core building block for portfolios combined, given a home-country bias. The rate of growth will likely hinge on the performance of U.S. stocks, especially relative to global and regional equities.

As new products gain longer and more-established track records, we wouldn’t be surprised to see more strategies tap leverage and volatility-linked ETFs and ETNs. Strategists remain focused on managing risk, and these products may be cost-effective tools to that end. We also expect strategists to tactically or strategically adopt ETFs that cut the market by a specific factor, such as PowerShares S&P 500 Low Volatility SPLV, to add to returns or diversify the portfolios return steam. 

Andy Gogerty

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