A Q&A with Nate Geraci: The best portfolio is the one your clients stick to

February 19, 2019

 
Nate Geraci

Nate Geraci
President
The ETF Store, Inc.

A registered investment advisor and ETF educator, Nate Geraci evangelizes about the power of ETFs at his Overland Park, Kansas-based RIA and on the radio show ETF Prime.

ETFs have made significant inroads since Nate Geraci helped launch The ETF Store ten years ago. They have undermined a pricey, commission-based approach to money management and have also expedited the ushering in of a new order of low-cost products with an emphasis on asset allocation.

But in a low-cost ETF ecosystem, where price differences among competing ETFs are often negligible, advisors must raise their game when choosing appropriate ETFs for their clients, Geraci said. Moreover, he said investment management has become commoditized.

Therefore, the winners of the next generation of advice will be those who are ready to guide clients through all kinds of market cycles and financial challenges and can make sure their clients own the portfolios they will stick with for the long haul.

Vanguard: Walk me through that moment when you first saw something new and different and full of unexplored potential in ETFs.

Nate Geraci: The real aha moment for me was in late 2007 to early 2008, when I was using ETFs in my own account. I think I started to understand the potential cost advantages of the ETF structure, along with the ability to trade intraday and build a diversified portfolio with them. With all these benefits, it just struck me as extremely compelling, especially in contrast to the old way of doing things. Again, there was a lot of commission-based product still being offered—even in 2007 and 2008. From an innovative standpoint, the ETF struck me as a disruptive technology.

When did the dream of building a diversified, all-ETF portfolio become a reality?

NG: I think there was critical mass in 2007–2008. The challenge was that very few people were aware that ETFs existed. If you look at the products going back even to the early 2000s, you had broad-based equity ETFs available, you had broad-based bond ETFs available, and you had a gold product launch in 2004. So by 2007, you had the ability to build a diversified portfolio. Of course, since that time, it's only become easier. You can slice and dice the market in a million different ways now with ETFs, for better or worse.

What do you think about the ETF education challenge?

NG: It's a difficult challenge because there's a lot of noise in the market. There are a lot of different investment products available to individual investors and advisors. It's not just product proliferation on the ETF side—it's in the entire investment landscape. One of the things we have done is stayed persistent with ETF education, continuing to inform individual investors and the public on the different products that exist, how to use them in a portfolio, and their potential benefits. I don't know that we have a magic formula for it; it's just the consistency and persistency of our message.

Are investors catching on?

NG: We have seen phenomenal growth across the ETF industry, but I think we're just getting started. It's often said that ETFs have democratized investing. I think that's exactly what ETFs have done. They've taken strategies that investors could not have dreamed of accessing even 15 years ago and made them readily available at a very low cost. Investors can construct a portfolio in a multitude of ways. They can also inflict damage on their portfolios in a multitude of ways. And this brings us back to the ETF education piece.

How do you see the future unfolding?

NG: I think we'll continue to see product innovation, and we'll continue to see ETFs take market share from other investment vehicles. And the more the public is educated on the potential benefits of ETFs, the more adoption you're going to see.

Low cost is great, but it isn't everything, is it?

NG: I like this particular topic. There aren't too many things that we know for sure in investing. We don't know what the markets are going to do tomorrow, we don't know what they're going to do next year, and we don't know what's going to happen with the political landscape or the economic landscape. But when we look into an investment portfolio, we know one thing for sure: Investment costs matter. And we know that lower costs are better than higher costs. So it's imperative for every investor to pay attention to investment costs.

That said, as fees have continued to come down, they have become less important. What I mean by that is that as ETF fees become a few basis points, and potentially zero at some point in the future, a few basis points difference in cost isn't going to matter if an investor has the exposure wrong. We're now at a point where it's almost as if investors have won on the fee side. So now the critical area to focus on is due diligence in portfolio construction.

Growth of ETF assets vs. index mutual funds (in trillions)

Growth of ETF assets vs. index mutual funds (in trillions)

Source: Morningstar Direct.

1 Includes active and passive products.

Let's talk about due diligence.

NG: The most important decisions are asset-class exposures and how you are gaining access to those asset classes. So if you're not starting there, you're doing it wrong. But there are other factors to look at too, such as the liquidity of the ETF. Or how is the ETF taxed? Does it trade commission-free? So cost is just one area to look at in the entire due diligence process.

An advisor's ETF due diligence checklist

  • Is the ETF low cost?
  • What is the ETF's asset-class exposure?
  • How does the ETF achieve its exposure?
  • Is the ETF highly liquid?
  • Is the ETF tax-efficient?
  • Does the ETF trade commission-free?

So how do you discuss asset allocation with a prospect or a client?

NG: We take a longer-term view of the markets—we are strategic asset allocators. We believe it's important to build a globally diversified portfolio of stocks and bonds and potentially include some alternative areas, such as real estate. In terms of our portfolios, we have "very conservative" all the way to "very aggressive." So in our conversations with the client, we're going to determine the best fit. But it's my belief that investment management is now, in many ways, commoditized, and if you're a fiduciary advisor and you're truly trying to do the right thing for the client, a portfolio should look relatively similar across different advisors.

From there, it gets into investor behavior and how to get investors to stick to their plans. The best portfolio for individual clients is the one they can stick to. If you're in index-based strategies or in factor-based strategies or in active strategies—whatever the case may be—it's only going to work if the investor sticks with it. We construct globally diversified portfolios because our experience has been that they provide the best path toward good investor behavior. If you start trying to tinker with the portfolio and get into esoteric asset classes and trying to get too cute, then you're bringing in risk that the investor may not have the wherewithal to stomach over the long term.

Are some advisors unprepared for the future?

NG: First, advisor value propositions are becoming important. There's been a lot of focus on fund fees and ETF fees. But the spotlight is starting to shift to advisor fees and to what value investment advisors provide.* For advisors, if all they're offering is the investment management piece, I think it's going to be a very difficult environment for them moving forward. Advisors that are not offering full financial planning and not doing all the things on the investment management side—the tax-loss harvesting, the disciplined rebalancing, everything that goes into portfolio management—I think it's going to be a really difficult slog going forward.

Most advisors expect downward pressure on their fees

Most advisors expect downward pressure on their fees

Source: Cerulli Associates, 2018. U.S. advisor metrics 2018: Reinventing the client experience. Boston, Mass.: Cerulli Associates. (Cerulli Reports.)

Note: Cerulli Associates collected data in partnership with the Investments & Wealth Institute (formerly IMCA) and The Financial Planning Association. Data represent survey responses from all advisors. The data and analysis cover financial advisors operating across all channels, including wire house, national/regional broker/dealer (B/D), independent B/D, hybrid registered investment advisor (RIA), independent RIA, insurance B/D, and retail bank B/D.

Let's turn to the active-versus-passive debate. What do you think about the future of active management?

NG: I think the active-versus-passive debate is a tired debate. If you look at the past ten years or so, the predominant trend has been from high cost to low cost. It's not necessarily active to passive. It's been investors seeking lower costs. And, ultimately, any decision an investor makes about a portfolio is active. You decide what allocation you want to U.S. stocks; you decide what allocation you want to international stocks and to bonds. All of those are active decisions.

That means that even rebalancing is an active decision?

NG: Exactly. Everything you do as an investor is ultimately active, and that has to be the starting point when you start talking about this debate.

The zero-sum game and the impact of costs

The zero-sum game and the impact of costs

Source: Vanguard.

We know from the data that outperforming a market-cap-weighted strategy in a particular asset class is a difficult proposition for active managers. We also know, regarding active management, that costs matter. So the lower the fee hurdle for active managers, the more they're going to have the opportunity to provide outperformance.

And, again, whether you're talking market-cap-weighted index strategies, factor-based strategies, or traditional active management, the best strategy for investors is the one they can stick to. So if you're an investor in a market-cap equity strategy, you're potentially going to get the returns of the market no matter what, and you have to be comfortable with that.

Another thing I'll say is, the biggest advantage of the rise of passive investing is that it's weeding out high-cost closet index funds—active managers that are just effectively replicating benchmark indexes and charging a high fee for it. That's been a huge service to investors.

What else is worth emphasizing when we talk about active?

NG: If you're going to invest in traditional active management and factor-based strategies, you have to have a lot of patience regarding underperformance. There could potentially be long periods of underperformance. You have to give them time to work. If you believe an active manager can outperform in the long run, you have to give that manager the time. If you believe a value strategy is going to have a premium over time and you want to overweight that factor, you have to believe that will work over the long term. The point here is that it's a fool's errand to try to time factors or active managers.

What is your view on factor-based investing?

NG: Value, momentum, quality, low volatility have proved to be academically robust factors, with strong research underpinning each. I think as an investor, if you're evaluating different factor ETFs, I think you need to think of them in terms of a spectrum. There are ETFs out there that will offer you just a slight tilt toward, say, the value factor, or ETFs that will go all in on the value factor. As an investor, you have to decide how much of a tilt you're willing to make and—surprise, surprise—it gets back to the pain of what you can stomach in terms of tracking error. What can you stick with? So if you believe in the value factor and you believe it can offer a premium long term, how much tracking error can you stomach to take advantage of it?

I know I sound like a broken record, but the right strategy is the one the investor can stick to.

* Donald G. Bennyhoff, Francis M. Kinniry Jr., and Michael A. DiJoseph, 2018. The evolution of Vanguard Advisor's Alpha®: From portfolios to people. Valley Forge, Pa.: The Vanguard Group.

Note: Nate Geraci is not affiliated with Vanguard, and Vanguard does not make any representation regarding his views.

Check out the next article in the winter 2019 issue of ETF Perspectives.

Rich Powers

Understanding the growth and acceptance of bond ETFs

Rich Powers, Head of Vanguard ETF Product Management, shares his insights on how bond ETFs have come of age.

Notes:

  • All investing is subject to risk, including possible loss of principal.
  • Diversification does not ensure a profit or protect against a loss.
  • There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
  • Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
  • Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from the stock market. Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.
  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
  • Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could perform worse than the original investment, and that transaction costs could offset the tax benefit. There may also be unintended tax implications. We recommend that you consult a tax advisor before taking action.

 

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