ETF Managed Portfolios Require a Dose of Caution

Question: A friend mentioned that his financial advisor has him in ETF managed portfolios. What are these and how do I know if they're right for me?

Answer: ETF managed portfolios have become a hot topic in the financial advisor world and are often billed as a way for advisors to accomplish specific asset-allocation goals for their clients while lowering investment costs. Whether they actually end up saving investors money is open to debate, however.

ETF managed portfolios typically are accessed through financial advisors. You may also be able to purchase them directly from the firms running the portfolios or on other platforms, although high minimum investments may be prohibitive for some investors. 

Sophisticated Allocation Strategies for the Mass Market
In a sense, the idea of ETF managed portfolios is nothing new. The financial industry has long offered products designed to achieve investors' allocation goals, such as balanced funds that own both stocks and bonds or funds of funds that hold multiple mutual funds in different allocations in order to achieve a desired mix. ETF managed portfolios are designed similarly but are built using exchange-traded funds, typically index-based ones. In a sense, this structure de-emphasizes security selection--the choices active fund managers make to buy and sell specific stocks and bonds--and puts greater emphasis on allocation decisions. It's also a way for financial advisors to outsource the portfolio management part of their job, freeing them up to focus on other areas such as tax management, insurance, or estate planning if they believe they can add more value that way.

ETF managed portfolios may be used independently or combined with other ETF managed portfolios or other investments to arrive at an overall allocation that makes sense for the investor. For example, an advisor whose client wants to capture market-level returns but devote some of his or her portfolio to move in and out of the market to take advantage of market dips and spikes might put the majority of the client's assets in a broad-market-ETF portfolio and a small portion in a tactical-ETF portfolio that moves assets into and out of stocks depending on market conditions.

While ETF managed portfolios have been around for more than a decade, their growth accelerated following the 2008 financial crisis as investors and advisors increasingly looked for ways to lower costs while providing more targeted investment options. These included low-volatility strategies as well as tactical ones that give the portfolio manager free range to reallocate assets within or across asset classes to take advantage of market opportunities or to guard against the risk of losses.

As of June 30, Morningstar tracked 667 ETF managed portfolio strategies (another name for each of these products) with assets of $102 billion, up from 530 strategies and assets of $63 billion at the end of 2012 (although part of this increase in assets is undoubtedly due to the market's strong performance over that time period). Half of all ETF managed portfolio assets were invested in equity-only portfolios and nearly 30% were invested in all-asset portfolios that may include stocks, bonds, and other asset types. A little more than half of all assets were invested in global portfolios consisting of U.S. and foreign securities while most of the remainder hold U.S. securities only. For more information, you can read the latest Morningstar landscape report on ETF Managed Portfolios by clicking here. 

Although the ETFs used in these managed portfolios often come from well-known ETF providers such as iShares and Vanguard, firms that run the portfolios are often less well known outside financial advisor circles. The top ETF managed portfolio provider by assets is F-Squared Investments ($25.6 billion in assets in 25 strategies), followed by Windhaven Investment Management ($19 billion in 3 strategies), and Good Harbor Financial ($9.6 billion in 2 strategies). Morningstar also provides ETF managed portfolios through its Morningstar Investment Management arm.

Criticism of ETF Managed Portfolios
Among the criticisms of ETF managed portfolios is that, despite using ETFs that typically cost less than traditional mutual funds to own, they layer on additional fees for management of the portfolios. Any time another party is involved in managing your investments, that party needs to be paid. If you were to own ETF managed portfolios through your financial advisor, not only would you be paying him or her a fee, you'd also be paying a fee for the company that manages the ETFs--plus another fee to the company that manages the portfolio allocation. This has the potential to get rather expensive, even when using low-cost ETFs as the basis of the investment.

Among the ETF managed portfolios tracked by Morningstar, the median management fee at the lowest asset level (less than $1 million) is 55 basis points (0.55%), which does not include the advisor's fee or those charged by the underlying ETFs. But some ETF managed portfolios cost two or three times that amount--one multisector-bond ETF managed portfolio charges 3%. Such charges represent a substantial drag on portfolio performance.

Fees generally are lower the higher amount of assets invested and vary from platform to platform. But, as an example, if your advisor charges a 1% annual fee for his or her services and invests your assets in an ETF managed portfolios charging 0.55% and that uses ETFs that charge 0.25% in fees on average you are essentially paying 1.8% to have your money managed. If your advisor is offering additional service as well, such as providing investing advice that you value as well as helping you manage other financial matters, you may well consider his or fee worth the money. And 1.8% in fees is still lower than you might pay if your advisor had you invested in actively managed mutual funds. But keep in mind that those are fees you pay year after year regardless of market performance, and that keeping costs low is one of the most effective ways to improve the long-term performance of your portfolio.

Critics also point out that, despite being built around index ETFs, these are not passively managed products. Given that the portfolios often base their allocations to various ETFs on a criteria other than a simple market-cap weighting, used by traditional index funds, some argue that what they do is actually active management using index ETFs. Tactical use of ETFs--trying to time moves in and out of the market based on market conditions--adds to this perception.

Speaking of tactical use of ETFs in managed portfolios, another potential problems is that they can increase investors' tax bills when held in taxable accounts. That's because short-term capital gains--the kind one would expect from tactically moving in and out of stocks--are taxed as ordinary income rather than at the lower rates that apply to long-term capital gains. Unless an ETF managed portfolio specifically bills itself as being tax-efficient, those portfolio changes could negate the generally low tax costs of broad-market ETFs themselves.

Finally, benchmarking ETF managed portfolios can be tricky, in part, because of a lack of standardization in the way the portfolios are built and operate. This makes apples-to-apples comparisons of ETF managed portfolios difficult to do in many cases and makes it more challenging for investors (and advisors) to determine whether an ETF managed portfolio is worth the cost.

Questions to Ask
Before investing in ETF managed portfolios, take the time to ask some questions of your financial advisor.

Morningstar fund analyst Ling-Wei Hew, who tracks ETF managed portfolios, recommends that investors "question the advisor about why he or she wants to use them and what role the strategy will play within the broader portfolio." Make sure you understand the advisor's reason for using an ETF managed portfolio for your account.

Also, make sure you understand how much the ETF managed portfolio will cost you. Ask for a breakdown not only as a percentage of your assets but in dollars and cents as well so you know exactly what it will cost you, as well as whether you'll incur any tax or transaction costs in making the switch from your current portfolio to the managed ETF portfolio. If the ETF managed portfolio is adding 1% or more to your total investing costs (above and beyond what the advisor charges), you may want to ask your advisor if less expensive options are available, including building a less-complicated portfolio using ETFs directly rather than via a managed portfolio.

Hew also suggests asking the advisor to consider lowering his fees if portfolio management is a major component of the services he is providing and it is being done specifically through ETF managed portfolios. After all, what's the sense of paying full price if the job has been outsourced to someone else?

Also, be sure your advisor chooses a reputable firm to manage the ETF portfolio. Hew suggests asking whether the firm has a long-term plan for its growth and how that growth might affect the firm's investment style or styles. Also, ask whether the firm offers incentives likely to help it retain talented employees.

All this isn't to say that ETF managed portfolios are a bad idea. In fact, they can provide rather sophisticated portfolio-allocation tools to advisors and their clients at a reasonable cost. But as with any investing product--especially those with multiple layers of fees and complexity--due diligence is required.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.