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Under the Hood of ETF Managed Portfolios

Jason Stipp
Andrew Gogerty

Jason Stipp: I’m Jason Stipp for Morningstar.

ETF managed portfolios are seeing tremendous traction as solutions for advisors and institutions.

Morningstar is now digging into these investment offerings with data and research, and joining me today is our ETF managed portfolios strategist, Andy Gogerty, to give us an overview of the ETF managed portfolio space.

Thanks for being here, Andy.

Andrew Gogerty: Thank you for having me.

Stipp: ETF managed portfolio: I get the ETF part, we are familiar with the ETFs, we have been covering them at Morningstar for a long time.

What is this solution here? What is the "managed portfolio" part of this? If you had to describe, define, an ETF managed portfolio, what would say it is?

Gogerty: Morningstar is defining managed portfolios as investment strategies where more than 50% of the assets are invested in ETFs. So, think of it as your typical mutual fund wrap, where in one account you have multiple underlying mutual funds with different objectives. Same parallel here, except the underlying investments in the portfolio are ETFs.

Stipp: So, who is managing these products? Obviously, advisors would use these. They could put their client assets into them. Who is doing the management of the managed portfolio?

Gogerty: Most of the asset managers are other RIAs. Think of them as boutique separate account managers. They tend to be smaller shops; you are not going to get the big industry heavy weights here, but that’s not to say that assets still aren't substantial. One of the biggest firms, Windhaven, for example, one of the wholly owned subsidiaries of Schwab, they have three strategies and $10 billion all inside of ETF separate accounts.

Stipp: So, why are we not seeing like a Vanguard or Fidelity of the world doing ETF managed portfolios as solutions for advisors? Why is it these smaller shops that are in this business?

Gogerty: Well, I think because a lot of these smaller shops started as RIAs and so what they are looking for is fee-based, broad diversification, low-cost portfolios that initially they were building for their own clients and then over time what has happened is, some RIAs have said, "I’m very good at managing my current clients and gaining new clients, but with all the other things I have to do, picking investments is not in my wheelhouse; I’m comfortable outsourcing that."

And so, that’s really how this space has grown, but to go back to your point about the industry heavyweights, it’s my opinion that it is only going to be a matter of time. As the fiduciary standard moves forward, low-cost, broad-based, focus on asset allocation is really going to be the standard for managing client money. And as the flows have shown, ETFs are definitely gaining traction, are here to stay, and I think as more and more advisors want these types of portfolios, the heavyweights are going to have to get into to have a presence.

Stipp: You kind of mentioned this with the answers you had there, but the primary clients for these solutions, then, are advisors or institutions that want to focus on the planning aspects and managing their own clients, and they want to outsource the investment decisions then to these managed portfolios. Is that the primary use case for these?

Gogerty: Yes, you are not seeing individual investors walking into an advisor's office and saying, "I want to write a check and be in one of these portfolios." What it is, is you have clients that are using a financial advisor or you have smaller institutions that say, we would like to gain access to one of these portfolios. Let’s go to a separate account platform, or if we are a small endowment or institution, let’s go directly to this asset manager. And [they] basically allocate a portion of their portfolio to them.

Stipp: So, assuming that you are an advisor and you are you are looking at these, you are going to have different objectives for your clients. What different flavors of managed portfolios might be available to me?

Gogerty: That’s something that’s very interesting, and this gets at the heart of what ETFs provide. Because ETFs are traded on exchanges, there is no really limitation as to what an advisor can offer. So you may have, for example, a portfolio that can invest across the globe and across asset classes, kind of global all-asset, and that’s because ETFs provide a very cost-efficient way for advisors to move between asset classes. You are also going to get more broad-in-scope portfolios. You are not going to see a large-cap ETF strategy. What you are going to see more often is a tactical U.S. equity strategy, where they are trying to beat broad U.S. benchmarks by moving around from underlying ETF portfolios.

Stipp: So, the growth in ETF managed portfolios has been pretty tremendous. Can you give us a picture of that and why you think these have grown so much and why you expect them to continue to grow?

Gogerty: In September when we first launched our landscape report, we are tracking approximately $27 billion, 43% asset growth. As of the end of Q1 of this year, our database is going to grow to approximately $43 billion, representing approximately a 25% asset growth.

And I think there are a few main reasons, one which we touched on, and a few that are new. One, the fiduciary standard is marching forward as a way to manage client money. It's here to stay--it’s not mandated by law yet--but it is going to become the industry standard, in my opinion.

Second, ETFs provide a way to access low-cost, broad-based investments, and they give you more choices than historically you’ve gotten in other investment vehicles.

Finally, because of that, and because of technology, advisors can now access institutional-type portfolios from these asset managers still at a very reasonable cost. You don't have hedge fund lockups, and you don't have $100 million minimums like you had in traditional institutional portfolios in the past. So, it gives advisors access to top-quality asset allocation, very many flavors of tactical--fast-moving, slow-moving--portfolios at a reasonable price, and with ETFs and the fact that it's in a separate account, you get daily liquidity and you get complete control of your holdings.

Stipp: Morningstar is famous for looking at investment types, categorizing them, and figuring out how to compare them against each other. It sounds like this investments type wouldn't fit very easily into our mutual fund categorization, for example.

Gogerty: Correct.

Stipp: So, you have come up with a new way of categorizing and classifying ETF managed portfolios. What factors are you looking at and what groupings are you seeing as you do that?

Gogerty: What we took a look at and you hit on it with the mutual fund categories. Mutual fund categories are very effective for long-only managers who kind of stick to one type of investment.

The problem is, with these managers they can go from stocks to bonds to gold, and because of periodic holding disclosures, a lot of things might look like moderate allocation, for example. Well, one moderate allocation strategy might be 60% stocks, 40% bonds; another one might be a tactical equity strategy where they go to fixed income in times of market stress or downturn or volatility. Well, that’s two very different investment profiles, both being in moderate allocation.

So, what we have done is, we've created a portfolio attribute system: universe, asset breadth, portfolio implementation, and ETF Type. And what that does, it gives advisors a better understanding of what a strategy does. A strategy may be, for example, in moderate allocation, but if I tell you it’s a U.S. equity strategy that’s very tactical, I have now given you a tremendous amount more of information than you would’ve gotten from a purely holdings-based disclosure.

Now, one of the things that has changed is these attributes are based not only a review of the holdings of the portfolio in the Morningstar database, but also our assessment of the strategy’s philosophy and positioning. So, there is definitely a qualitative component, which is a departure from the Morningstar category system that people know from mutual funds. But times have definitely changed, and these portfolios are evolving forward, and the ETF as a technology has provided that.

And so, what we've done is, we've come up with these attributes. There are a few options in each, and what it also allows is, it allows an advisor to customize their research. Because the four attributes are independent of each other, it allows an advisor to customize their research.

Some may want global equity, but they don't care how the manager gets the exposure. Some managers may want global equity, but they only want the advisor to use single country ETFs, like a Canada or an Asia or a China or a Sweden ETF. Well, they are still global equity, but how they get it may or may not depend for the advisor. So that's important, and I think it allows flexibility for both the advisor and even the institution to customize their research.

Stipp: So looking at all these classifications, advisors can find the ones that are executing the way they want it to be executed and getting the exposure that they are looking to get.

Gogerty: Absolutely.

Stipp: So last question, then, for you Andy: You mentioned that a lot of these portfolios are using tactical strategies. Obviously, it’s very important, execution, to get these strategies right, and we’ve seen that it can be difficult to make the tactical moves correctly unless you really know what you are doing.

Gogerty: Absolutely.

Stipp: So, as an analyst, Andy, and you are looking at the managers of these ETF managed portfolios, what do you look at to get a sense of whether the success that a managed portfolio ETF solution has had will continue in the future? What are the hallmarks?

Gogerty: Well, I think some of the hallmarks are understanding the philosophy, and I think this is going to be very important for advisors selecting these strategies. It still goes back to, what are you allocating to the manager for? Are you allocating to them for downside protection? Are you allocating to them for lower correlation to what you have in your portfolio now? So, it’s an assessment of, is the philosophy bearing it out. If you have a strategic strategy that doesn't move around very much, you would expect them to kind of track the market of the securities that they are in.

If you have a tactical manager that's focused on downside protection, well, Morningstar has a tremendous amount of data. We can go in and analyze, how have they held up in downmarket months. Are they truly protecting capital? If there is a manager that says, we can outperform the index in all markets, well, we better see capture ratios pretty high both in up and down markets.

Now, how they gain that? It could be a variety of reasons. They could move in and out of cash. Some managers actually use the lighter flavor of levered ETFs, all of which present their own risks, but none of which in a vacuum are necessarily a bad thing. Going to cash is not a bad thing if you do it well. Using a levered ETF in these strategies can be very attractive, if it's executed well. So, what we are looking for is execution, and we are looking for return streams that kind of match the expectation of the philosophy.

Stipp: So it sounds like lot of for advisors to size up, but certainly the tools that you are providing, the classification that we are providing on, will give advisors a good leg up in getting a sense for this investment vehicle and how to analyze them. Thanks for joining me today with all information, Andy.

Gogerty: Thank you.

Stipp: For Morningstar, I’m Jason Stipp. Thanks for watching.