Defining the needs of a client portfolio is crucial to selecting an appropriate strategy.
The growth of assets in ETF managed portfolios and the number of strategies reporting to Morningstar's separate-account database is creating a small frenzy in the managed account industry. Multiple platforms are devoting additional resources to cover these strategies. They aim to provide advisors and RIAs with better tools for understanding and adopting these strategies. Regardless of momentum, advisors' key consideration remains the same: identifying and meeting a specific need for a client portfolio. Once an advisor has identified the allocation goal, whether they're building a new portfolio or reallocating an existing one, they've created a roadmap for selecting an ETF managed-portfolio strategy.
To select a strategy and use it appropriately in a portfolio, start by answering two main questions: "What does the strategy practically do?" and "What is its potential role in a portfolio?" The answers to these questions will help advisors fit the strategy (or strategies) into a portfolio and determine the strategy's potential impact on the whole portfolio and the client's financial goals.
What Does the Strategy Practically Do?
Get down to brass tacks. Because many of the ETFs provide exposure to a basket of securities, your analysis will be more technical in nature. Look past any rhetoric (hopefully it is kept to a minimum) and identify what technical inputs are used to analyze asset classes and to select and rotate ETFs in the strategy. Many strategies look to factors such as momentum, relative value, moving average, relative volatility, mean reversion, and changes in the yield curve. Determine which levers the strategy pulls, why, and in what weight. And find out how the inputs individually add value. If the investment manager employs macro inputs, or qualitative discussion from an investment committee, learn how these aspects interact with the technical levers. Understanding the strategy from this perspective will (one hopes) confirm its stated philosophy and how the portfolio exposures are determined.
Advisors should also be clear on the strategy's tactical ability to make large reallocation moves within and between asset classes. Going in and out of asset classes and cash or staying fully invested but with large potential swings between investments doesn't change an analysis. Rather, it defines what produces the characteristics of the strategy's return stream.
Potential Role in the Portfolio = Impact on Asset Allocation
A strategy's role in a client's overall portfolio depends on three key assessments: use, purpose, and value proposition. The first two admittedly look the same, but they are materially different. Value proposition is where you press the investment manager and look for definable, quantitative support of its benefit to your client. Here is the roadmap for these considerations.
Use -- Identify the potential use of a strategy in a client portfolio. Will the strategy serve as part of the core, or will it be utilized as an alpha-generating allocation? Many global all-asset or global balanced strategies (as defined by Morningstar's ETF Managed Portfolio Attributes) are designed as a whole-portfolio solution, or an outsourced CIO offering, where the advisor allocates to a strategy and effectively removes him or herself from the asset-allocation decision-making.
Purpose -- The purpose of the strategy is to meet a return-based or holistic goal within the client's current portfolio. Here, the entire portfolio--sans the strategy under consideration--is viewed as a single entity and the new strategy is labeled by what returns or statistical metrics it can change. Will the strategy improve the entire portfolio's downside protection? Does the strategy diversify the portfolio's return stream? Improve the Sharpe or Information ratio? Dampen overall volatility? Clarity of both use and purpose give an advisor confidence on how to analyze and frame the discussion around the strategy's value proposition in a specific portfolio.
Value proposition -- One of the most-used phrases that long-only stock managers use to describe their strategies is a combination of "bottom-up, proprietary, stock-specific research," making it tough to know what sets one strategy apart from peers. Many ETF managed-portfolio presentations fall into the same trap, just using different labels. Here the tag lines are "propriety model," "mix of multiple technical factors," and "systematic macroeconomic analysis."
It's important to get beyond these labels. Everyone's model is proprietary. We haven't yet come across a firm representing that they focus on re-engineering and copying another firm's model.
We doubt that few, if any, strategies would be allocated to a client portfolio after the initial presentation, so press the asset manager for detailed analytical data in subsequent conversations. For example, if the strategy's stated value proposition is alpha, or downside capture, press the firm to provide analytical data to support their conclusions. This exercise provides a practical check on the investment team's approach, indicates their understanding of the investment product and benefits, and provides insight into their operational record-keeping ability to present the strategy from multiple angles. Below is a rough, hypothetical example of the type of supporting data the manager should be able to readily produce and discuss with an advisor.
Here, an equity portfolio is approximated by SPDR S&P 500 ETF SPY. From there, the asset manager can demonstrate the impact of adding its strategy to an overall portfolio. True, not everyone uses a 60/40 portfolio, but showing how the portfolio metrics change when adding a new strategy gives insight into its potential use and benefit. The advisor can also tailor the metrics used based on the previously determined purpose or goal of the strategy in the portfolio.
The Multilens Approach
The above table is just one example of the type of analysis used to determine how a strategy's purpose and use could have an impact on a portfolio's performance. Consider multiple scenarios to ensure that a strategy fits properly in a portfolio. Without going off on a benchmarking tangent (that subject will get its own commentary), it can be revealing to compare the client's proposed portfolio to passive or naïve portfolios that are rebalanced periodically (and that could be done by the advisor). Compare correlation and capture statistics, as well as risk-based reviews to ensure that a potential strategy is fully vetted for use in an overall portfolio plan.
Focus on the Outcome
The focus of any portfolio change should be on the return stream. How a portfolio is allocated at one point in time is just that--a data point. The characteristics of the return stream determine how and where a strategy fits into a client's overall portfolio. To be fair, if an advisor can't communicate or agree on a tactical strategy with a client, then there's no point in continuing their research. But in the end the client's entire portfolio is a solution, constructed to meet a goal. How do you evaluate the client's entire portfolio? What does replacing a current allocation with a potential ETF managed-portfolio strategy do to that analysis and the probability of the client meeting their financial goals? The same philosophy should be used to evaluate a multifaceted or multiasset strategy.