ETFs: Building Individual Portfolios Like An LDI

by: ValueWalk

By Michael Ide

Exchange traded funds (ETFs) have grown so popular that they are expected to surpass the hedge fund industry in total AUM in the next year or two, putting many asset managers on the defensive, as they either struggle to justify high rates or launch active ETFs that offer a compromise between passive index tracking and expensive traditional portfolio management. In pursuing an under serviced segment of the pension market, Sage Advisory Services has found a different approach that it believes individual investors can put to good use.

Fixed income ETFs, a more efficient technology

Pension plans are unique in that they can't just try to maximize their risk/return, they have payments down the road that have to be met. To accomplish that they follow liability-driven investment strategies which are meant to match future income on side of the balance sheet with future liabilities on the other, typically using bonds to hedge against interest rate risk. Said Sage Advisory Services CIO Robert Smith in an interview with ValueWalk:

Most activity has been focused on the large plans well north of $100 million, into the billions… whether you're a big plan a medium plan or a small plan, you're all faced with the same fiduciary responsibilities. They all seem to have the same trends in terms of what going on in risk management.

The reason for this is obvious, managing a $100 million plan is more profitable than a $1 million plan, but the universe of small single employer pension plans is enormous and Sage wanted to find a cost efficient way to tap into it. The answer was to build LDI strategies using a small number of well-researched fixed income ETFs that can be rebalanced without much additional overhead.

Says Smith:

The problem is that the smaller you become the harder it is for you to aggregate individual securities, smaller lots, at institutional prices and institutional spreads in terms of dealer costs. Second, you can't always find them in tiny lots. I might be willing to give you half a million or a million bonds, but I'm not going to give you twenty or thirty bonds and break up my lot.

He explains that ETFs are a 'more efficient technology' for portfolio management because they scale better. Anyone can have access to institutional spreads, slightly offset by the ETF management fees, and he says that he can and has recommended their use to individuals thinking about their own investments.

Treating individual portfolios like a pension plan

Sage has shown that it can track an underlying index with monthly rebalancing with very low tracking error (they do this for 40 basis points per year plus the fixed income ETF fees, compared to an average 0.84% expense ratio for actively managed ETFs). They use the discount curve published monthly by the IRS and a handful of different fixed income ETFs, which seems like it should be a feasible strategy for capable individual investors as long as they're willing to think seriously about their future expenses.

Says Smith:

What drives this process is the fact that there's an actuary who actually sat down and said ok, let take all of your future promises to pay yourself and let's see what those are valued at and discount them back to present value. Most individuals don't do that, but I think we're coming to a point where they're going to start.

Disclosure: None