- The failure of traditional asset allocation will force wealth management firms to embrace tactical asset allocation.
- The proliferation of ETFs also puts a premium on tactical advice, rather than manager seleciton.
- These trends are bearish for Citigroup (NYSE:C), JP Morgan (NYSE:JPM), Wells Fargo (NYSE:WFC), US Bancorp (NYSE:USB), Fifth Third (NASDAQ:FITB) and Bank of America (NYSE:BAC).
- These trends are bullish for E*TRADE (NASDAQ:ETFC), Charles Schwab (NYSE:SCHW), and TD Ameritrade (NASDAQ:AMTD).
"Better to meet a bear robbed of her cubs than a fool in his folly." (Proverbs 17:22)
On July 10, the Wall Street Journal had a front-page article about the failure of asset allocation in 2008. The bear market devastated portfolios, and diversification didn't help: All asset classes become correlated except cash and Treasurys. Consequently, investors are now demanding tactical advice from their investment advisors.
Simple Questions Challenge the Status Quo
This failure of traditional asset allocation is a huge challenge for fiduciaries in the investment management business. This includes the trust and asset management divisions at JPM Chase, Bank of America, Wells Fargo Corp., Citigroup, U.S. Bancorp, and Fifth Third Bancorp. Why? High-net-worth investors are asking some very simple questions:
- If buy-and-hold is best, why can't I just buy some ETFs from a discount broker?
- Since asset allocation determines over 90% of returns, why does tactical asset allocation get so little attention and fund selection get so much attention?
- Why is cash neglected as an asset class?
A Bear Robbed of Her Cubs
A financial advisor would rather face a bear robbed of her cubs than to answer questions like these. Candid answers require an admission of how a firm's business model affects its investment recommendations.
Consequently, these discussions rarely happen. The industry has a vested interest in the current system, despite its obvious shortfalls during bear markets. After all, large banks and brokerages are asset-gathering machines, so it's best to stick with conventional asset allocation and consensus thinking.
Clients Want Tactical Asset Allocation
Bear markets put a premium on firms that adapt and customize asset allocation. Ideally, portfolio construction not only reflects client goals, but also the current market outlook. This would help protect investors from threats that are specific to their investment horizon (i.e., retirement during a period of rising inflation). This requires tactical advice and ongoing customization, which clients fully embrace.
Alas, change is slow in coming. The asset management business reflexively dismisses tactical asset allocation as a pipe dream, unworthy of serious research and attention. And even though more than 90% of investment returns come from asset allocation, attempts to add value via tactical asset allocation are derided as "market-timing," and dismissed as impossible in principle.
Vested Interests in the Status Quo
Why the hostility? The largest firms serving retail and high-net-worth customers have a vested interest in the status quo. Their goal is asset gathering, which encourages the big firms to recommend standard asset mixes, diversified by asset class, and outsourced to "best-of-breed" third-party managers. Fee-based compensation encourages conformity, and standardization of client portfolios is the key to scalability and high margins. This business model allows firms to spend less money on investment research, and more money on sales and asset gathering. Conformity also means that investment performance will rarely differ from peers, so client complaints are less frequent, and easier to address.
While this is a sound business strategy during most markets, its assumptions fall apart under stress. Clients find that alternative assets and pooled vehicles become illiquid, and that their investment advisors are unprepared to adjust their asset allocation in a bear market. Managers are especially reluctant to raise cash, since cash generates no fees.
Consequently, the largest players have vested interests in:
- Simplistic risk buckets (aggressive, conservative, etc.)
- A long-term approach to asset allocation
- A focus on adding value via manager selection
- Standardization of client portfolios
- Neglect of cash as an asset class
Simplistic Risk Buckets
Simplistic risk buckets spit out a mix of stocks and bonds for "aggressive" investors, "conservative" investors, and everyone in between. This approach now reflexively puts conservative investors into long-term U.S. government bonds. Unfortunately, long-term bonds are now very risky since inflation relief won't last. Meanwhile, cash continues to get neglected, despite perfect liquidity, near-zero credit and duration risk, and its excellent track record as an inflation hedge.
But who gets paid to recommend cash?
Outsourcing the Core Business
It wasn't always this way. Early in my career, from 1985 to 1995, most asset managers had a "do-it-yourself" approach to security selection and portfolio construction. Since wealth managers did everything in-house, we were completely responsible for investment performance. Over time, firms outsourced peripheral asset classes to broaden their product mix. Eventually, firms outsourced all asset classes as the industry fully embraced "best of breed" manager selection. The wealth manager selects the best manager in each asset class, and allocates them accordingly.
Thus, we now have the bizarre situation where many firms have successfully outsourced their core business, investment management. They just assign each client to a simplistic risk bucket and fill the portfolio with the "best of breed" for each asset class. This eliminates the risk of underperformance: If an outside manager fails to deliver, the client just gets a new fund.
Portfolio Construction the Easy Way
The future, however, belongs to tactical, customized ETF Portfolios like this:
· 50% SPY (S&P 500)
· 20% AGG (U.S. investment-grade bonds)
· 10% TIP (Treasury Inflation Protected Securities)
· 5% USO (West Texas intermediate crude oil, spot price)
· 5% GLD (Gold bullion)
· 5% EEM (Emerging market stocks)
· 5% GARTX (Goldman Sachs ART hedge-fund index)
Viola! A diversified global portfolio of stocks, bonds, commodities, and alternative assets. As prices move and the outlook changes, it is easy and cost-effective to rebalance the portfolio. (Mutual funds and alternative assets, on the other hand, have tax and liquidity constraints that make tactical moves impractical.) Thus, the proliferation of ETFs puts a premium on tactical advice rather than manager selection.
This trend is bullish for discount brokers who help investors build customized ETF portfolios: TD Ameritrade, Charles Schwab Corp., and E*TRADE Financial Corp. This trend is also bullish for independent financial advisors such as David Fry who provide tactical ETF recommendations.
The shift to tactical asset allocation is a huge challenge for current wealth management business models, and ETFs now make the issue impossible to ignore. Firms that adapt will gain share, and firms that don't adapt will get a smaller piece of the pie.
Disclosure: Long SPY, TIP, GLD, USO