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Breakout Session: Portfolio Construction Best Practices from the Pros
Bob Goldsborough, an ETF analyst with Morningstar, introduced the three panelists; Michael Iachini, who runs Charles Schwab's ETF wrap program; Hal Ratner, Asset Allocation Strategist with Morningstar Associates; and Rick Ferri, CEO of Portfolio Solutions. The first item on the agenda was for the panelists to explain their approaches to portfolio construction. Iachini's Schwab Managed Portfolio's approach is pretty simple: diversification across asset classes. With the all-mutual-fund portfolios, they concentrate on picking good managers. With the all-ETF portfolios, they concentrate mostly on basic strategic allocation, but with the addition of a tactical overlay within asset classes. Ratner uses ETFs with client portfolios at Morningstar Associates to implement a specific asset-allocation strategy. He finds this approach useful in limiting risk. Ferri also looks at a particular client's needs in order to inform his strategic asset-allocation approach. Once you choose an asset class weighting, the next step is to find the right investment, be it an ETF, open-end index fund, or actively managed mutual fund. Then it's simply buy, hold, and rebalance.

The next question concerned what types of ETFs they use in their portfolios. Iachini uses domestic and international equity, sector equity, commodity, and real estate ETFs, but no currency, leveraged, or actively managed ETFs. Ratner uses mostly plain-vanilla index ETFs, but he wishes there were more fixed-income ETFs, particularly international. Ferri eschews fixed-income ETFs and doesn't invest in commodities at all.

While the panelists all use strategic asset allocation, there are some unique approaches. According to Ferri, years ago, 90% of advisors were strategic; now it's between 30% and 40% strategic, 60% and 70% tactical. Ratner doesn't use a fixed beta, because correlations can change over time. When they do, he responds by shifting allocations so the overall portfolio risk level remains in line with client expectations. Iachini calls his approach "the enhanced index approach"; allocations are pretty much fixed, but there is movement within the asset class.

Next, they discussed problems in building a portfolio. Ratner stated that liquidity can be an issue with large clients. Ferri sometimes had problems when rebalancing between mutual funds and ETFs because the products have different settlement dates and, depending on the custodian, clients could be charged for margin while the transactions settle.

Some advice the panelists shared for financial advisors is that the first step in understanding a particular ETF is understanding the index that the ETF tracks. Iachini also preached understanding the clients and what they each want--buy and hold or more active management.

Tracking error was another interesting topic. According to Iachini, measurement is important. His firm uses market price returns to measure ETF tracking error, which introduces the need to adjust for serial correlation. For example, with international ETFs where the underlying components trade in a different time zone, the ETF can trade away from the components during the hours where the domestic exchange is closed, until the following day when it reopens. Ferri reminded the audience that tracking error isn't exclusive to ETFs, but open-end funds can also suffer from it.

The panelists agreed that they aren't doing much in anticipation of tax changes coming out of Washington, but Ferri did mention that he is harvesting tax losses in case long-term capital gains taxes go up. None of them were fans of equal-weighted indexes, because they basically are just disguised mid-cap indexes. If a client wants that exposure, they would rather use an ETF that tracks a mid- or small-cap index that has a lower cost. They also suggested that two areas where they would rather use active managers than passive, cap-weighted ETFs would be with high-yield debt (because a cap-weighted index overweighs the riskiest debt) and commodities (because of the negative roll yield in the futures market due to contango).

-- Alan Rambaldini

Panel: Alternative ETFs in the Portfolio
The session started with an introduction to the alternatives sector by Morningstar's own Nadia Papagiannis. The past decade has seen a flood of new alternative investment vehicles, both in mutual funds and ETFs. Currently, Morningstar tracks 420 total alternative funds, 182 mutual funds, and 238 ETFs. Flows are also growing rapidly, with a marked increase in interest in the sector in 2009. Alternatives can include many different investment strategies, including commodities, bear market (inverse funds), currencies, long-short funds, and others like hedge fund replication and alternative asset allocation.

Papagiannis then moderated a panel that included Adam Patti, CEO and founder of IndexIQ, George O'Connor, director and manager of BlackRock's global client group responsible for iShares product development and research, and Peng Chen, president of Ibbotson Associates, an RIA and subsidiary of Morningstar. The first topic of discussion was the broad democratization of alternatives, from hedge funds, which are the near-exclusive domain of high-net worth and institutional investors, to ETFs available to the retail investor.

According to Patti, in 1984 there were 84 hedge funds. Today, hedge funds number about 10,000. A study by Ken French showed that the typical 2+20 (2% of assets, 20% of returns) hedge fund fee takes about 4.5% off the top, a high hurdle for managers to create alpha. With the competition increasing over the past 25 years, hedge fund managers have more difficulty in justifying these fees. Studies show that about 75%-85% of actively managed mutual funds underperform their benchmarks after fees, with similar numbers for hedge funds. Other studies show that the majority of hedge fund returns can be explained as a form of 'alternative' beta, or a series of risk premia across different asset classes.

So why should investors pay 2+20 for underperformance if they can replicate those returns using commonly available asset classes? Patti's firm, IndexIQ, launched a series of representative indexes in 2007 to demonstrate the capability of using investable products like ETFs to mimic hedge fund returns. Their QAI ETF charges only 0.75%, plus about 0.30% for underlying fees, and has a good track record, especially considering that hedge fund indexes typically overstate the industry's returns--as only the hedge funds that have done well tend to report their results.

O'Connor indicated that there is no standard definition for "alternatives." He suggested investors should look at it based on the desired outcome, an addition to a typical equity and fixed-income portfolio that has low correlation, positive returns, and hopefully low volatility as well. How can investors gain access to alternatives? Hedge funds are one tool, but they can't be all lumped together as some deliver diversification, and others strive for alpha. These different objectives should have different price points. ETFs are a better alternatives tool for delivering diversification, because they are more liquid, more transparent, and have lower fees and better tax consequences than hedge funds.

Patti chimed in that he believes alpha is elusive, so portfolios should be constructed primarily with diversification in mind.

Chen explained that there are three components to hedge fund returns: alpha, beta, and fees. A historical study showed that 60%-65% of hedge fund returns can be explained by some form of beta, while 20%-25% was fees. The remainder was alpha or undiscovered beta.

The next topic was allocation to alternatives. Chen said that the first decision investors must make is deciding where they want returns to come from, beta or alpha. He agreed with Patti that the average investor is better off using beta, because it has lower fees and is more diversified. In a typical portfolio composed of 60% equities and 40% fixed income, a rough estimate of the desired allocation to alternatives is 20%. O'Connor estimated the range of allocation to alternatives to be anywhere from 2%-30%, again depending on the definition of alternatives. Patti estimated the range to be 10%-30%.

-- Alan Rambaldini

ETFs and the Tax Man
Tim Strauts moderated Friday's panel discussing tax implications in the exchange-traded fund space. The panel included:

* Mark Balasa, CPE, CFP, principal, co-president and chief investment officer of Balasa, Dinverno & Foltz LLC.

* Edwin Baldrige III, CFP, president of Baldrige Asset Management

* Tom Driscoll, tax partner in Deloitte Tax LLP’s Chicago office

Tim opened, making quick note of the tax efficiency and advantageous fees of ETFs, but the conversation quickly moved to forward-looking tax implications. Driscoll noted that under a passive political framework, where standing tax legislation remains unchanged, tax rates on individual income, capital gains, and dividends will substantially increase. Deloitte expects no related legislative action before the election.

Baldrige posited that the proactively minded may be able to maneuver around such rate increases in the same short term. He noted that while it may disrupt a portfolio strategy, realizing capital losses can absolve investors of the need to pay increased capital gains rates in the future.

While not the main drive of an investment strategy, taxes should garner significant investor consideration. Rebalancing and actively harvesting losses can add material value to a portfolio, according to Balasa.

The panel shifted discussion toward taxable versus tax-deferred accounts. Baldrige noted that REITs and TIPS should generally be relegated to IRAs and foreign positions held in taxable accounts to collect the tax credit. The consensus, however, seemed to be that allocations generally need to be made based on client-specific needs.

While ETNs are treated as prepaid contracts and realize long-term capital gains rates, Driscoll noted that the IRS could change ETN tax treatment, and the outlook is still uncertain.

He went on to discuss MLP tax implications, noting that while they maintain flow-through status and see no entity-level taxation, the mass of K-1 filings required for reporting can be burdensome. Driscoll warranted caution when approaching MLPs in the ETF space, as ETFs and ETNs see very different tax treatment.

As the session came to a close, panelists noted that while fee and portfolio construction issues may lead to investment in an ETF over a mutual fund, or vice versa, tax implications can detract or add to returns and should not be discounted.

--Abraham S. H. Bailin

Source: ETF Portfolio Construction, Alternatives and Taxation: Notes From Morningstar's ETF Conference