Download ETF Strategists: The Next Generation of Asset Allocation

Trends in Investing
COVER STORY
ETF Strategists: The Next
Generation of Asset Allocation
by Daniel Kern, CFA
E
TF managed portfolios
exploded in popularity in
recent years, boasting more
than $90 billion of assets at the end of
2014. The category, as defined by Morningstar, includes nearly 700 strategies
managed by 150 ETF strategist firms.
Morningstar divides the ETF managed
portfolio universe into three distinct
sub-categories based on investment
approach: strategic asset allocators that
establish a long-term asset allocation
and allow for limited deviation from
that asset allocation; tactical asset
allocators that rotate asset classes more
frequently and to a larger degree; and
hybrid asset allocators that combine
strategic and tactical elements.
Tactical Asset Allocators
The focus of this article is on tactical
asset allocators, as they have had the
most success gathering assets but have
also had some high-profile cautionary tales. The leading tactical asset
allocators market a compelling but
controversial value proposition, offering
the potential for upside participation
while protecting against downside risk,
undeniably tempting for advisers and
retail investors scarred by two brutal
bear markets since 2000.
The three market leaders at the
beginning of 2014 each faced challenges
during the year. F-Squared Investments
experienced the largest fall from grace
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in the aftermath of SEC sanctions and
the departure of its embattled CEO.
F-Squared saw its assets decline by more
than $3 billion in the fourth quarter of
2014, and recently cut 25 percent of its
staff. Schwab’s Windhaven Investments
continues to be a major success story,
though it also lost assets in the second
half of 2014 after the departure of
founder Steve Cucchiaro. Good Harbor
Financial also faced challenges, with its
flagship product delivering a return of
negative 20 percent the year in which
the S&P 500 was up nearly 14 percent.
Despite the challenges faced by the
market leaders, a growing roster of innovative firms provide ETF managed portfolios
that meet a wide range of investor needs.
ETF strategists, like robo-advisers, are
drawing some of the brightest financial
and quantitative minds to their efforts and
offering a compelling career alternative
to professionals who previously would be
drawn to traditional jobs with large asset
managers and hedge funds.
Quantitative techniques are at the
core of the investment process for
most tactical asset allocators, driving
decisions to rotate between different
investments, and in many cases, into
or out of the market. As is so often the
case, the most successful firms have
gathered assets by delivering strong
returns during a critical period for the
markets. Windhaven delivered outstanding relative returns by preserving capital
in the aftermath of the tech bubble in
2002, as well as during the heart of the
financial crisis in 2008. Good Harbor
also made its reputation in weathering the market downturn, providing
significant outperformance in 2008,
then calling the market turnaround correctly in 2009. F-Squared has a slightly
different story, demonstrating strong
simulated performance in marketing
materials before making major changes
in response to the SEC investigation and
subsequent sanctions.
Selecting an ETF Strategist
We encourage advisers to go beyond
flashy short-term performance results
when thinking about investing with an
ETF strategist that offers a tactical asset
allocation strategy. Critical questions
should be asked before investing:
1. What role will the strategy play in
your client’s portfolio? Will it be used for
return enhancement, diversification, or
risk management? Some advisers use tactical asset allocators to supplement a core
portfolio, while others use them as a core
holding. Having a clear purpose simplifies
the decision-making process and informs
the evaluation process post-purchase.
2. What is the strategist’s investment “edge” and is that edge
sustainable? The most successful ETF
strategists make extensive use of quantitative metrics, leveraging technology in
their investment process. Windhaven’s
June 2015 | Journal of Financial Planning
25
COVER STORY
Trends in Investing
Actual Annual Returns for Three Popular ETF Strategists Compared
to the S&P 500
50
40
30
S & P 500
20
Good Harbor Tactical Core US
10
0
Windhaven Diversified Growth
–10
F-2 Premium AlphaSector Index
–20
–30
2014
2013
2012
2011
2010
2009
2008
–40
Source: Morningstar data
approach relies on a proprietary model
of key economic, fundamental, and
behavioral relationships; Good Harbor
focuses on momentum, economic data,
and yield curve analysis; and F-Squared
has a sector-centric focus driven by
volatility and trends in total returns. The
strategist should be able to articulate
their advantage and explain why that
advantage is sustainable over time.
3. How does the firm use the technical inputs? Does the strategist follow
the model inputs without intervention,
or is there a judgmental overlay applied
by an individual or committee? If there
is a judgmental overlay, under what
circumstances does judgment apply
and how successful has the judgmental
component of the process been relative
to the quantitative component?
4. How is the strategy implemented? What investment instruments are used, and how much does
the portfolio change over time? For
example, can the portfolio go from being
fully invested to all cash, or are moves
more measured in approach? Portfolio
turnover is also an important strategy
question, particularly for taxable investors. One of the strategies we examined
had turnover of more than 400 percent,
26
potentially an unpleasant surprise for
the taxable investor.
5. How did the strategist perform
in different market environments?
Looking beyond three- or five-year
performance numbers is a must. Some
asset allocators built their track record
on the basis of one or two great years of
performance around the financial crisis,
but have delivered less inspiring returns
since (see the bar graph above). Also,
size is often the enemy of investment
performance, and many stellar track
records were built on a small asset base.
We think that it’s tougher to sustain
success when assets under management
grow rapidly. We also caution advisers
about the use of simulated, back-tested
performance results. Although backtested results can provide useful insight
into how a strategy will work over long
periods of time, there is a big difference
between simulated and actual results.
Closing Thoughts
History is filled with investors who
became famous on the basis of one or
two high-profile market calls that went
right. Far fewer investors have been
able to sustain that kind of success
over a long period of time. Michael
Journal of Financial Planning | June 2015
Mauboussin, in his book The Success
Equation, discusses the role of luck in
success. Mauboussin cites the tendency
of people to derive more meaning from
small samples than is warranted by the
data. Assuming that a manager who
performed well during the last financial
crisis will also perform well during the
next crisis may not be justified by the
data. Investors expecting asset allocators
to anticipate all market downturns may
have been disappointed during last
year’s “taper tantrum,” as most of the
leading strategies followed the market
downward during that brief but painful
correction. So it’s important to do the
homework to distinguish whether
a tactical asset allocator is a one-hit
wonder or has the right stuff necessary
to sustain success over time.
As Mauboussin also points out, the
markets are a marvelously adaptive
environment with market participants
adjusting their behavior in response to
market activity and other trends. The
adaptive environment can include traders
that try to trade ahead in anticipation of
repositioning by large asset allocators, or
“copycats” who crowd into positions held
by the large asset allocators.
The “quant quake” of 2007 illustrated
how too much of a good thing can
end up being a bad thing. Many bright
quantitative investors used similar
models drawing upon similar investment factors to crowd into many of
the same stocks. When the models
indicated that it might be time to sell,
the resulting deluge of selling reversed
several years of excellent performance
by quantitatively oriented strategies.
So even the best of asset allocators may
have their advantage eroded by such
adaptive markets.
Daniel Kern, CFA, is president and CIO of Advisor
Partners. He is the former managing director and
portfolio manager for Charles Schwab Investment
Management. He managed asset allocation funds,
including target funds, from October 2008 to July 2011.
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