We recently had an opportunity to talk again with Vern Sumnicht, the CEO and founder of iSectors, about the rise of ETF managed portfolios. In addition to discussing the rise of ETFs and their importance in managed accounts, we also delved into some of the most important factors to consider for anyone who’s evaluating ETF strategists [see also Investing Insights: How iSectors Utilizes ETFs].
ETF Database (ETFdb): Why do you think many financial advisors have generally been slow to embrace exchange-traded funds in their practice?
Vern Sumnicht (VS): Financial planners/registered investment advisors (RIAs) are fiduciaries; they are required, by law, to act prudently when providing investment advice to clients. Advisors put a lot of time and money into developing systems and procedures for advising and managing client assets. Many of these systems are built around the advisors’ conviction that they can select the best performing (managed) mutual funds for their clients’ portfolios.
These systems and convictions have served their clients well for many years (if it isn’t broke, why fix it), while wide availability of ETFs is a relatively recent phenomenon. In addition, because advisors generally work with managed mutual funds, they have been slow to move into index funds, the traditional form of ETFs, even though the facts weigh heavily in favor of indexes. Research has indicated unequivocally that index-based investments and allocated portfolios using indexes have consistently outperformed professional, active money managers.
There are indicators signaling advisor acceptance of ETFs is growing. For example, assets in ETFs have grown by $1 trillion in the last two years and Morningstar indicates advisors have outsourced $102 billion as of June 30, 2014 to ETF investment strategists.
ETFdb: Why should an advisor consider outsourcing some or all of their investment management to an ETF investment strategist’s model portfolios?
VS: Advisors need to outsource some or all of their investment management services to be competitively priced. The ETF approach offers a leg-up with lower transaction costs and lower management fees. If approximately 50% of advisors are now outsourcing investment management combined with ETFs growing by a rate of 40% each year, it stands to reason an advisor conducting his investment management solely in-house still picking individual mutual funds will not be competitive in growing their business. Advisors of this breed will simply not have the amount of time as their competition that chooses to outsource to develop or maintain relationships with clients.
ETF managed portfolios have shown better performance on a risk-adjusted basis due in part by lower fees and because the indexes outperform the managed portfolios [see also The Cheapest ETF for Every Investment Objective].
ETFdb: What issues or trends in the industry are pushing the growth in ETF managed portfolios?
VS: CEG Worldwide, a consulting firm for advisors, has identified a shift (between 2001 and 2012) in advisors’ emphasis on client relationships as opposed to the historical advisor emphasis on investment management. The study found advisors who develop stronger relationships with clients have a deeper understanding of their clients’ financial needs and concerns. This deeper understanding and relationship leads to additional assets under management and referrals from clients.
A study conducted by Cerulli Associates showed smaller advisors (less than $100 million in AUM) spend only 48.4% of their time with clients. The larger RIA firms (over $1.0 billion in AUM) spend 92.5% of their time with clients. In addition, smaller RIA firms spend over 20% of their time on investment management while larger RIAs spend less than 4%.
This trend towards focusing on client relationships rather than investment management has led to the growth in ETF-managed portfolios. CEG Worldwide’s survey of financial advisors indicated several benefits from outsourcing to ETF investment strategists including more time to spend with their current clients maintaining and building relationships and for prospecting and relationship development of potential new clients.
Another benefit is investors’ ability to access experts in investment analysis, portfolio construction, asset allocation, tax implications, etc. Finally, the outsourcing to ETF investment strategists allowed for an increase in the scalability of their investment advisory practice allowing greater long-term growth.
As time goes on, more and more advisors are going to realize achieving reasonable risk-adjusted returns for their clients is simply too costly and time consuming. Advisors will need to outsource investment management to be competitive with other advisors who are outsourcing.
ETFdb: What factors should you evaluate when choosing an ETF strategist?
VS: When an advisor is looking for an ETF strategist, they should conduct the same due diligence they would for any other type of money manager or mutual fund, but there are three areas to focus on when evaluating ETF strategists.
First, have the strategies offered accumulated a live track record through a complete market cycle? The emphasis on live track record is because those who do not have them seem to have backtests showing their methodology outperforming during 2007 to 2009 (and beyond). Don’t be one of the many advisors that has been fooled and suffered client losses by relying on backtested data [see also 25 Things Every Financial Advisor Should Know About ETFs].
If the methodology of a seasoned strategy is utilized for a new, more conservative investment option, it may be worth considering. But for our purposes, let’s only consider seasoned strategies.
For the top performers (the ones that may show skill), advisors will want to click on the names of the top 10 to 15 strategies to look at the Morningstar Quicktake reports for the investments. Look for one or more of these three warning signs:
- A “Composite Inception Date” (in the right column) later than 10/31/2007.
- A “Rebalance/Allocation Frequency” (in the right column) of Daily or Weekly. This is a sign of potential excess trading costs and, if the strategy earns gains, large amounts of it will be taxable, short-term capital gains.
- Small number (under five) of factors that are used as inputs in the investment process. You can usually find this information in the “Investment Strategy” or “Investment Decision Making Process” section in the left column. You do not want to expose your clients to strategies that have a limited number of inputs. If the data for one or two of these inputs go awry, the strategy may veer off course and earn detrimental returns.
Third, you should contact the investment firms managing the remaining strategies on your list to receive their marketing material, especially their fact sheets. Information on these sheets on which you should focus includes manager fees, risk, relative Sharpe ratios and performance in low return years other than 2008.
ETFdb: What should advisors expect from their relationship with an ETF strategist?
VS: Assuming the ETF investment strategist meets the advisor’s due diligence expectations, the advisor might also consider how else the strategist can support them.
If you are relying on a third party for investment management, you should expect assistance with communicating the investment strategy to clients. The strategist should be available to help you create presentations about the strategy for client meetings and business development seminars.
Similar to an advisor-client relationship an ETF strategist should be generally available to the advisors using their strategies to answer questions about the allocations and best practices for implementing them as part of a client’s portfolio. An engaged ETF strategist should care about the success of the individual advisor and his clients.
The Bottom Line
The rise of ETFs in the managed-accounts industry serves as a testament to the inherent cost-efficiency benefits, among others, associated with the exchange-traded vehicle. For advisors especially, utilizing ETFs may offer tremendous advantages in terms of freeing up their resources to focus on other vital aspects of their business. As always, be sure to do your homework and take a good look under the hood of any one product or managed portfolio before allocating capital; it’s always better to uncover any blemishes before you’ve pulled the trigger.