The following is an edited transcript of the Nov. 27 webcast, “Beyond the Basics: Building a Growth Portfolio using ETFs,” moderated by InvestmentNews deputy editor Gregory Crawford and reporter Jason Kephart.
InvestmentNews: Let's take a quick look at the macro environment. The election is over, but now we're looking at the fiscal cliff and tax uncertainty. Tim and Scott, could you each tell us a bit about yourself and your firm?
Mr. Clift: Envestnet is an investment and technology platform geared toward fee-based financial advisers. My focus is within the investment strategy and portfolio consulting teams.
As far as what's informing our investment strategy, the headline news is the fiscal cliff, and it's clearly a driver in the markets. We are focusing a lot of our efforts on helping advisers manage downside risk. That's the biggest concentration — how to create a growth portfolio with downside protection.
There are head winds in the equity and in fixed-income markets, with low interest rates and nowhere to go. The question becomes how to build the growth elements into a portfolio without just turning on risks. We look at alternative investments. We look at tactical strategies; a lot of them are using exchange-traded funds, one of the fastest-growing strategies on our platform.
InvestmentNews: Scott, does that resonate with your view?
Mr. Kubie: Definitely. About CLS: We are a professional manager. We've been managing ETFs since the "90s, and we've been doing ETF-only portfolios for over 10 years.
Beyond the short term, I would hit a couple of points. One is that we're looking for countries that are taking steps to improve their capacity for growth by getting their tax and debt situation under control, and by doing things on the supply side that will allow greater flexibility.
Second, we're looking at if the continuously strong growth that we've seen out of the Great Recession will continue, moderate or slow, and whether areas like China and Europe might start catch-up in earnings growth relative to the U.S.
InvestmentNews: Have exchange-traded funds changed the way that advisers build portfolios in terms of asset allocation and taxable-allocation choices? Scott, what is your sense of that?
Mr. Kubie: First, they've lowered the cost. That's been a big driver and a big change.
They also bring a different focus, a different way of putting portfolios together. Think back to the days when there were mostly open-end mutual funds. There weren't many country funds. There were sector funds, but not nearly as many and not as defined and well-understood, because the portfolios weren't available online all the time.
You have an ability to target asset classes and control the allocation in ways that were impossible before. It wasn't very easy for most advisers to purchase a group of English stocks and a group of German stocks, and a group of South African and Japanese and Chinese stocks. But all of a sudden, that's become much more accessible, and that makes it very, very powerful. You can combine and put those items together in ways that weren't easy for an individual adviser. That's a huge opportunity.
Cost and the ability to see allocations differently are huge transitions that ETFs have made and will continue to make.
InvestmentNews: Mike, what can you tell us about the cost of a typical growth portfolio, looking at mutual funds versus ETFs?
Mr. Rawson: Again, ETFs are generally cheaper than mutual funds, but there's no substantial difference between growth and value ETF expense ratios, or growth and value mutual fund expense ratios. The real story is that there are a lot more value ETF strategies available. When you go to mutual funds, more growth strategies and certainly more growth assets are available. For whatever reason, the asset number isn't showing up there for ETFs.
It's much easier to build an index based on value stocks and strategies than it is growth strategies. I can put together a simple screen that sorts stocks based on [price-earnings ratios]. I can buy the cheapest stocks, and that index will probably do OK. I can build a screen to rank growth stocks, but that index probably isn't going to perform very well — just, again, because of that value stock premium.
The average expense ratio I found in growth mutual funds was about 83 basis points. In the value ETF, you can get that for about 24 basis points. It just shows how difficult growth is — that you can't blindly construct a rules-based index to generate growth. You need active input, either at the portfolio or stock-picking level.
"KEY CONTINUUMS'
InvestmentNews: Scott, when you are building a portfolio, do large-cap-growth ETFs play a role?
Mr. Kubie: They can represent a good core solution. But as a tactical manager, we would want either the overweight growth or overweight value as one of the seven key continuums that we add value along. Right now, we're relatively neutral. Maybe growth and value are fairly neutral after growth did very well in recent years, and handled the downturn and rallied better.
We're more focused on different continuums, low volatility, as well as large-caps relative to small-caps, as more attractive and a better place to allocate that risk budget.
As we get into the ETF space, it's important to take advantage of the opportunities, like country and sector funds, and asset classes that can supplement a traditional equity portfolio and grow but also have a fixed-income component.
InvestmentNews: Mike was talking about active versus passive. And Tim mentioned that it plays a key role. Could you discuss this a bit more?
Mr. Rawson: It's interesting to see how ETFs have been implemented here. In some cases, they're used where it may be hard for advisers and investors to access markets, so they're better off benchmarking those and putting active in the core. Then I've seen just the opposite, where they're putting ETFs in the core piece, which is maybe more efficient and where active managers have a tougher time being benchmarked, and doing more active management in the peripheral.
We do a study every year on active and passive investing, and they both have weaknesses and strengths. If you look at it by category, you can figure out which have been handled better by active and passive managers.
InvestmentNews: So even though you are using passive ETFs, the portfolios are actively managed?
Mr. Clift: You can still make tactical biases. You can still overweight or underweight growth or value, or have all those different components. That almost gets into questions about building a portfolio using traditional asset classes and ETFs or looking into tactical strategies. There are lots of different ways to employ ETFs within portfolios, not just at the asset class level but from a portfolio [management] and active-management standpoint.
InvestmentNews: Scott, how active are you between asset classes?
Mr. Kubie: We have a turnover of about 30% on average, which means that our average holding is about three years. And our overweight positions tend to hold for about that time, depending on the asset class and the market. But one aspect for Envestnet and other types of platforms is a greater opportunity to use more active strategy. We're working on strategies designed to give the adviser more control over what choices are in the asset allocation.
We also want to ensure that there's the flexibility that the ETFs bring to impact the allocation through tactical levels. With the innovation of the ETF and the platform, we see an opportunity to bring value to advisers who may be doing their own allocations but want a strategist to look at a particular segment of the market.ALTERNATIVES
InvestmentNews: A question from the audience: How do you define alternative fixed income?
Mr. Clift: I'll define alternatives and then push into the fixed-income segment. Anything that can short, or can use leverage or derivative, we define as an alternative. Morningstar has about 30 categories that have products with one of those three criteria. That gives us about 1,000 mutual funds in that universe.
Fixed income is fairly narrow. We've identified about eight categories within the alternative space. We have one for fixed-income, and we call that strategic income. You'd find long-short bond, unconstrained bond, convertible arbitrage. Those are the types of strategies that we fit into the alternative box on the fixed-income side. As we see more participants in that box, we'll be able to split it out more.
Mr. Rawson: Anything that's not high-quality government bond is alternative. It's kind of a binary definition. You're either a Treasury bond or you're not.
And if you look at fund flows over the past few years, we've all heard about how fixed income is attracting tremendous flows, people are abandoning equities. The assumption would be: If flows are going into fixed income, people are risk-averse. But that's not the case. When you magnify down, the flows are not going into Treasuries. They're going into high-yield-bond, emerging-market-bond, nontraditional- or multisector-bond funds. The government-bond funds are attracting very little.
Though investors are avoiding equity risk, they're taking on a lot of risk in fixed income. Maybe what people are losing sight of when they transition their fixed-income portfolio into these nontraditional-bond funds is that most of the reason you own fixed income is downside protection when the equity markets implode. The risk here is that high-yield bonds in particular are more highly correlated to equities than they are to fixed income; they behave more like stocks than like government bonds.
When you look outside the traditional bond portfolio for sources of income and yields, you have to be aware of the impact on your overall risk.
InvestmentNews: Scott, could you talk about your methodology if you're looking at a growth portfolio built on ETFs, versus one built on mutual funds or stocks?
Mr. Kubie: One of the reasons we focus on ETFs is our desire to manage risk. One of our experiences in the 2008 downturn is that it's harder to know what's going on inside an actively managed mutual fund than an exchange-traded fund. That's an advantage to using ETFs as the primary vehicle and bringing active management, because there are so many more choices.
It seems that number ought to be going down rather than up, but providers continue to find interesting and creative ways to bring ETFs that fit the way we want to do asset allocations for our investors. As new strategies come up, like low- and minimum-volatility ETFs — it has been a big boost to the overall opportunity that we have and makes ETFs more attractive to us than open-end mutual funds. We pick up some cost advantage.
Another big advantage of ETFs is the ability to move in and out, and to adjust without impacting other shareholders.
InvestmentNews: If you've got a growth portfolio that's built with mutual funds, and you want to transition to one built more on ETFs, what key points do advisers need to keep in mind?
Mr. Clift: The rule of thumb is, the more efficient the asset class — and that just means the more researched — the easier it is to go passive or buy an ETF, because you don't tend to have as much variation in returns, and you may just want to capture beta.
You can also think about using ETFs where you have difficulty getting exposure. There may not be a mutual fund, or you don't want to research the individual securities in a country you're not familiar with. You can just look at the portfolio and say, “Well, by switching to an ETF from this large-cap-growth fund, I can save 100 basis points on that allocation or that piece of the portfolio.” Those are the kind of trade-offs you look for.
Mr. Kubie: If I were an adviser, I'd ask two basic questions. One is, “Do I feel comfortable representing this portfolio as a transition from funds to ETFs?” Because every portfolio underperforms at some point, and you've got to be OK with the reasons it underperformed. The other is, “Do I feel comfortable doing that portfolio?”
InvestmentNews: What other major asset classes should advisers think about if they are building a growth portfolio out of whole cloth?
Mr. Kubie: Advisers should look at commodities or managers using commodities in their strategies when those are attractive — when interest rates are really low and we see higher inflation.
InvestmentNews: That is a great point to end our discussion on. Thank you.
