ETF managed portfolios are among the fastest growing segments of the investment marketplace, reaching $100 billion of assets after growth of 40% in 2013. The category, as defined by Morningstar, includes more than 600 strategies managed by 150 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.
- Hybrid asset allocators that combine strategic and tactical elements.
The focus of this column is on tactical asset allocators, as they have had the most success gathering assets and offer a compelling but controversial value proposition.
The leading tactical asset allocators offer the potential for upside participation while protecting against downside risk, a tempting offer for advisors and retail investors scarred by two brutal bear markets since 2000.
Windhaven Investments (formerly Windward Investment Management), purchased by Schwab in 2010, is one of the biggest success stories with $18 billion under management. Good Harbor Financial, which manages approximately $10 billion, originated as a part time venture to manage the founder's retirement account. Another category leader is F squared, which manages approximately $15 billion.
Quantitative techniques are at the core of their 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 having to make changes to their materials in response to ongoing scrutiny from SEC examiners.
Selecting an ETF Strategist
We encourage advisors to go beyond flashy short-term performance results when thinking about investing with an ETF Strategist that offers a tactical asset allocation strategy. There are critical questions to ask 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 advisors 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 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 utilize 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 the judgment apply? 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%, potentially an unpleasant surprise for the taxable investor.
