The concept of a “wrap program” has been around for years and the idea is quite simple. The novice investor hands over one of the more fundamental components of the portfolio construction process, namely the asset mix decision, to a professional. Of course, this service should also include the ongoing rebalancing required for the portfolio. If asset allocation is the main driver of portfolio returns (actually, the 1986 Brinson/Hood/Beebower study says it’s the key determinant of the variability of portfolio returns), then it makes sense that novice investors should get advice from professionals for this key function as much as they do for securities selection.
Of course,this service comes at a cost so one of the primary downsides for such programs is the added layer of fees. For a portfolio of mutual funds, however, the risk is that the overall portfolio provides little beyond market returns at a high price. Despite this, the concept exists not only with mutual fund wrap programs but beyond. Another example is the “fund of hedge funds” (more commonly known as simply a “fund of funds”). In this case, the fund of funds manager must consider the mix of hedge fund strategies which is altogether a different sport from the mutual fund wrap program. In either case, the overseeing manager is a “manager of managers” and will likely assert in their marketing material that they have skills in selecting managers. Of course, just like no one wins in a sport all the time, managers can’t be top decile for long which is why I’ve labeled the manager selection process earlier as “sport”. Ali, Pele, Jordan, Schumacher, Tiger Woods, Federer … there are countless examples of sporting figures who did or are doing more than simply excel beyond the competition. Dominate would be a better term. But just like Peter Lynch, Bill Miller or Warren Buffett, winning streaks don’t last forever. Dynasties like those from the Chicago Bulls or the New York Islanders are rare but I think are rarer still in the fund management space. Thus, the idea of picking winning managers is truly a tough sport.
So, how about an “ETF of ETFs”? It’s still tough but at least you’re taking the active management component away from the process … or are we? The way the ETF industry is moving, active management will soon be as common to ETFs as it is in the rest of the fund universe. Whoa, I suppose there’s a case for a wrap program of ETFs or some “fund of ETFs” or “ETF of ETFs”? Well, based on what I’ve just said about selecting managers, maybe not a case for the investor but maybe one for the product provider. Oh, they’re coming.
Here’s news of a fund company that will build a series of mutual funds holding only ETFs to track the Lipper ETF Indexes which David Hoffman of InvestmentNews has recently covered. As a quick review, Lipper has essentially created a family of “target risk benchmarks” made up entirely of ETFs (which I don’t think have been made public and I wonder if they will be?!). The five indexes are:
Lipper Optimal Aggressive Growth Index Lipper Optimal Growth Index Lipper Optimal Moderate Index Lipper Optimal Conservative Index Lipper Optimal Very Conservative Index
Sounds like a typical family of wrap programs … the one that you get slotted into after filling out a form with a couple dozen standard questions. I’m not sure if other such target benchmarks exist, but this could be a place to start for investors who have built a portfolio consisting primarily, or exclusively, of ETFs. I’ve said this before but I think it’s worth repeating … why someone would limit themselves to just using ETFs is beyond me. ETFs are great and have many worthy benefits but to put such constraints on oneself is rather pointless. ETFs are ideal but not for every investor in every situation … there are areas of the capital markets where an ETF is simply not the best choice for you. As much as I may like any financial instrument, I wouldn’t want to be handcuffed to them exclusively.
Still, for those who have built a portfolio with extensive use of ETFs, these Lipper benchmarks provide a gauge for comparison. A good or bad gauge, I just don’t know because, again, I don’t know what are the ingredients nor the recipe.
I started this post talking about the asset mix decision. But is this the case for a fund of ETFs? In a way, it’s still about the asset mix but talk to any advisor who uses ETFs in their client portfolios, or in fact any ETF focused investor, and they’ll likely tell you that the selection process is as important. With all the ETFs out there, is that a surprise? And with the exponential growth in terms of the number of new offerings, perhaps asset allocation will take a back seat to securities selection. Right away it makes me wonder if that’s a good thing. Although it’s not manager specific selection (or at least, until more actively managed ETFs are introduced to act as components within a “fund of ETFs”), it’s still moving towards the sport of chasing returns. So, one area of inquiry into these new wrap products (that’s essentially what they are, right?), as well as existing services at financial advisory firms that focus on managing ETF based portfolios, is the extent to which active management is applied to these programs. Questions could include:
What is the overall portfolio’s turnover? Is rebalancing based on fixed periods (semi-annually, annually, etc.), based on volatility (for example, if a position moves X% from its initial allocation then it moves back to X%) or some other rule? What is the average holding time for core and non-core positions? What are the total number of holdings at any given time and is there a minimum or maximum number of holdings? What is the universe in which the manager can select funds from? How does the manager deal with new ETFs that get introduced into the market and what determines if it becomes part of the opportunity set? What would make one holding be deemed more appropriate than another holding? For example, would VWO ever be considered a full replacement for existing EEM positions.
Active management will always be a part of the investment industry and that’s no surprise for many obvious reasons. Furthermore, the use of ETFs in organized portfolio is not new. Many financial advisors in North America have built a practice around the use of indexed instruments (index funds, ETFs, etc.) but no matter how much they believe in efficient markets, there’s some degree of active management in what they do. There are many planners who focus their practice on the exclusive use of a certain family or families of funds usually with names such as Vanguard and Dimensional Fund Advisors. Like ETFs in general I don’t like absolutes and exclusivity, but these two firms in particular are cult-like in their focus on disciplined asset class investing with a minimal use of active management. It is the advisor who listens to such advice who I believe is doing the greatest service to their clients.
These are services but what about products? The next logical step is for fund companies to get into the action with funds of funds. In addition to the news mentioned above, through my contacts and with some poking around I know that there are more similar products on the way. It’s only a matter of time before we see ETFs of ETFs. Again, it’s about the movement towards greater active management in the ETF space. The real question is what degree of active management will be applied to such products and will investors in these products receive the benefits that ETF promoters have long suggested make them an asset rather than a liability versus more traditional actively managed products such as mutual funds.
What would be the worst thing for the ETF focused investor who gets into a managed program such as an “ETF of ETFs”? Some may think that it would be the decision to go with a manager who trades opportunistically and, like some well publicized hedge funds, shoots its lights out. There are mandates like this and the managers are not afraid to call them hedge funds nor are they shy about their performance fees. I’m talking about a totally different animal … the more traditional mandate. To me, the real risk is that the overall portfolio provides little beyond market returns at a high price. In that case, the whole point of using ETFs has been lost.