3 Methods of Evaluating ETFs

Andrew Gogerty: Good afternoon. This is Andrew Gogerty from Morningstar, and we're coming to you from the 2012 Morningstar Investment Conference. ETF managed portfolios represent one of the fastest-growing areas of the managed account space, and joining me today for perspective on this growing trend is Eric Biegeleisen, the director of research for Windhaven Investments.

Eric, thank you for joining me.

Eric Biegeleisen: Thank you for having me.

Gogerty: So, Morningstar is defining managed portfolios as investment strategies with more than 50% in ETFs. Windhaven is 100% ETFs; that's all you use in your strategies. This trend in assets and demand from advisors has really picked up in recent years. As one of the biggest players in this space, what's kind of your perspective or what do you think is driving kind of this change in advisor demand over the last few years? What are they looking at that Windhaven and your competitors are offering that's becoming attractive?

Biegeleisen: Sure. I think, a large part of it has to do with just the growth of ETFs. They're easy to use, they are efficient, and they provide cheap access to a wide variety of asset classes making portfolio construction easier than ever. A lot of people view ETFs, including ourselves, as building blocks, rather than portfolio solutions.

Whereas mutual funds can maybe play both roles, ETFs really focused in on being tools to build up asset class exposures and combining an entire portfolio construct. Within that we're able to provide both a core or strategic asset allocation, in addition to a tactical asset allocation. When we combine both of these, we get our entire portfolio.

Gogerty: So you had mentioned the core and satellite part of Windhaven's process. Let's delve into that a little bit. You have three strategies with different levels of perceived risk in the name aggressive, moderate, and conservative. How does a core, and maybe a more tactical sleeve mesh together here? What are you trying to accomplish by having two inside a portfolio, but you like putting them together in one solution?

Biegeleisen: We offer three globally diversified asset-allocation portfolios. They are called diversified conservative, diversified growth, and diversified aggressive. Each is provided in separately managed account format. We don't utilize any inverse or leveraged products doing this.

Each has an element of equities, fixed income, hard assets, including commodities, gold, real estate, and currencies across the U.S., international developed, as well as emerging markets. This wide variety of asset classes provides us the ability to not only participate in economic prosperous times, were equities outperform, but also protect against downside risks such as those like say a credit contraction or a debt deflation or a geopolitical uncertainty.

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Gogerty: Or basically whatever happens tomorrow.

Biegeleisen: Exactly. These three strategies each have those wide varieties of asset-class exposures. Within the conservative, it's more suited towards a lower-risk-tolerance-type investor with a shorter time horizon. Largely fixed-income based. Within the growth portfolio, it's more of a moderate risk profile with a five-year-plus time horizon. And in the aggressive portfolio, which is more equity-based, it's typically a 10-year to 15-year investment horizon and has the ability to take on a higher level of risk.

Gogerty: You provide a lot of commentary both to users and even prospective users, and going back to the first quarter your firm touched on an overweight to U.S. versus international equities, and also positions in TIPS and in gold. Looking at the ETF as a technology, how does that structure allow you to invest and analyze multiple asset classes which historically would have taken an army of specialized analysts?

Biegeleisen: Well, we don't like to think of ourselves as an ETF firm per se. We're sitting down to model each of these indices across the globe, and we're attempting to derive the true cause-and-effect relationships that drive each one of the asset classes looking at fundamental, economic, and investor behavioral factors within each one of the asset classes that we model.

Second to that is the ETF-selection process, and it does in some respects take an army of people to look at it. Thankfully we have great tools at our disposal through a wide variety of people such as Morningstar that provide excellent tools for analyzing these types of products. You really need to strip off that ETF wrapper and look under the hood. There are three main areas that we look at when evaluating ETFs, maybe I would summarize as being sort of tracking, trading, and structural.

And just to highlight some of the things we're looking at within each, within the tracking, we're sort of looking at the performance of the ETF versus its underlying net asset value, versus its underlying index, versus its iNAV, which is the intraday net asset value. Sometimes that's a useful number and really does correspond to how the price of the ETF should move and sometimes it's not. But it's priced every 15 seconds, and so there it's at least a data point to look at. When it comes to really this tracking, in general, you really want to focus in on index-construction methodology, that's at the heart of the whole tracking concept. What is it that you're really getting when you buy this ETF? Why is each stock or bond or whatever is in this ETF why is it there and why is it in that proportional wedge size? That's really what we need to understand.

Within trading, we want to understand not just the expense ratio of the fund to make a decision, but also the total round-trip cost for entry and exit. We build our own fair value models to determine what we think we should be paying for different size lots of the ETF. Since oftentimes with the vast majority of ETFs you are unable to get a good depth of market on most of them. So we work with authorized participants, as well as market makers in a negotiation process really to arrive at an agreed-upon sort of fair value for that ETF.

Within structural, what we're looking at is a hodgepodge of different things to help define other areas that we should be focused on when performing ETF selection. For example, the business viability of the issuer. You wouldn't like to enter an ETF and then a month later the ETF shop closes down. You'll probably be ring-fenced, if it's a 40 Act type structure. Your assets are still there, but it doesn't look so good that you just put a client into this particular fund and the company just shut down.

Second to that might be looking at the actual structure. Is it a 33 Act structure? Is it a 40 Act structure? What kind of investor protections do you have? What are the tax implications of investing in something like that? In addition, you might want to look at whether there are ADRs versus locals. If there are futures contracts, you might want to know if you are in a contango or backwardation situation. So, these are the types of things we're looking at. We'll also focus on the availability of proxy hedge vehicles, which dovetails into the trading aspect. And how efficiently you can enter and exit that type of ETF.

Gogerty: So it seems like that's an interesting dynamic, all of those levels, because a lot of people might think, well, if you're doing ETFs you're really just doing top-down asset allocation, but it seems that at the core you still having to do some type of bottom-up analysis where you're not looking at the individual stocks, but there are a lot of steps to get up from the base of an ETF to what it owns to how it performs. One of the things in the panel that we did [at the conference], you talked about a dozen financial ETFs and depending on the structure and what they own, you can have a yearly return outcome that could be very spread out.

I think that's something that maybe people don't recognize, but it's evident that it's a crucial part of this. But at the end of the day it's interesting, people are still going to look to you for asset allocation and they're going to look to you for that tactical piece. I imagine that's one of the biggest parts of education you're having right now is explaining to people why you do tactical, probably right after you explain to them why you decided to do it with ETFs, is that accurate?

Biegeleisen: Yeah, I think that's right. I think, first we have to explain our process in general. There's sort of a premise and belief at the firm that securities, stocks in general, are sort of micro-efficient, in that there's so many analysts that are trained to focus on equities and industries and fixed-income analysts, but fewer people are trying to be opportunistic across asset classes.

And the asset-allocation studies we see, the Brinson Asset Allocation Study we see shows that over 90% of return variability comes from asset allocation with the remainder being selection. So it just goes to show that one should be really focused on what asset class to be in as opposed to whether or not they can eke out a few basis points over a given benchmark or index. So we have to explain that story. And then it's really breaking apart the core and the tactical story that we have this diversified core strategic asset allocation there to weather economic uncertainty, to weather exogenous events that may occur or long-term capital market expectations that we may have. And then you sleep well at night knowing that all of these diversified asset classes over the long run will provide a positive real return over and above CPI. They'll help dampen volatility; they'll help dampen portfolio maximum drawdown.

And then tactically you have the chance to be opportunistic. We might not be right all the time; no model is. But it's our attempt through these cause-and-effect relationships that we are identifying opportunities to invest in.

Gogerty: Great. Thank you for perspective both on ETFs and construction. It's a very fast-growing part of the market. I appreciate the time you've carved out today. This is Andrew Gogerty at the 2012 Morningstar Investment Conference with Eric Biegeleisen from Windhaven Investments. Thank you for joining us.