Streamline your practice with strategic model portfolios

November 12, 2018

 
Elisabeth Kashner

Elisabeth Kashner
Director of ETF Research at FactSet

Elisabeth Kashner, the director of ETF Research at FactSet and founding cohead of the San Francisco chapter of Women in ETFs, has one of the keenest minds in ETFs. Kashner began her career 25 years ago as a bilingual fourth-grade teacher. But she gave that up to pursue a career in finance that began on the floor of the now-closed Pacific Exchange in San Francisco, where she was a derivatives trader. She had three children and spent half a decade focusing on her family. Then she earned a master's degree in financial analysis and became a CFA® charterholder.

Later, as an investment strategist at a wealth management firm that used active mutual funds, she found herself sifting through client portfolios after the 2008 market crash, struggling to understand exactly what securities were in those opaque funds. The allure of transparent ETFs loomed large, and so it was that she joined ETF.com in 2010 to help create an ETF analytics and classification platform. That tool is now owned by FactSet; its output is licensed to ETF.com. Kashner, a believer in broad-market passive investments for most investors, helped us analyze the growing phenomenon of model portfolios. She argued that buy, hold, and rebalance strategic model portfolios can be an efficient way for advisors to provide clients with passive strategies, but she stressed that model portfolios can go only so far, especially for clients whose financial challenges are quite complex.

Vanguard: Where did model portfolios come from, and where is this phenomenon heading?

Elisabeth Kashner: The idea of creating something standard and deploying it across scale is an old idea. You have to look at the target-date funds and their kissing cousins, the target-risk funds, which have been out in the market for a long time. Target-date funds, in particular, have the additional feature of not having a single target asset allocation but, rather, a dynamic one that shifts over time as the portfolio holder ages and aims to de-risk the portfolio as retirement approaches.

The advantage of target-date funds, and now model portfolios, is that they simplify the investment process for both advisors and clients. That's pretty great. Models also have the beneficial feature of automatically rebalancing when market activity moves the portfolio allocation outside a certain band—whether it's done on a periodic basis or on a threshold basis. That's a useful feature for ordinary people who don't want to do things like periodically rebalance their investment portfolios.

So what are other examples of model portfolios?

EK: Well, there are ETF strategists who put together ETF-based portfolios, but they're more like the next generation of the active fund manager, and I would not lump them with strategic model portfolios. The ETF strategist has given up on securities selection and has doubled down on making specific macroeconomic-type bets, whether they are on interest rates or countries or sectors. There are examples where that has worked out spiffily, but the results from the S&P Indices Versus Active (SPIVA) reports keep telling you quite consistently that active management has turned out to be a losing bet.1

But regarding other strategic model portfolios—robo-portfolios are generally an example, and some of the hybrid models are also an example—these are all strategic. They're trying to keep overall allocations either relatively static based on an investor's risk level or informed by an investor's age and glide path.

They're not involved in picking and choosing in the capital markets but are instead trying to hew to a strategic allocation. There are now many, many models to choose from, and so the question for advisors becomes, "How do you choose?" What advisors may find over time is that, like so much of the asset management world, selling needless complexity is becoming harder to do.

Advisor portfolio construction process

Advisor portfolio construction process

Source: Cerulli Associates, 2018. The Cerulli Report—U.S. Intermediary Distribution 2018. A Holistic Approach to Wholesaling. Boston, Mass.: Cerulli Associates.

Do you view the ETF as absolutely essential to the whole model portfolio phenomenon?

EK: Yes and no. The yes answer is that ETFs in many ways have birthed the model portfolio as we know it. But that doesn't preclude this type of tactical model portfolio from also working in a mutual fund format.

The tactical model portfolio works well with ETFs because of the ease of intraday trading—the ability to put on and take off positions when you want—and the relative predictability of a passive investment. Once an ETF strategist selects a fund—whether the strategist chooses quite a plain-vanilla approach to a specific sector, industry, country, slice of the bond market, commodity, or what have you—the strategist knows what he or she is going to get. And the proliferation of ETFs has made getting very narrow, targeted exposure across geographies and asset classes far more possible than it was in the mutual fund world. So for the tactical manager, ETFs are really a godsend.

Now the tactical manager has to deal with all the trading issues. And any manager has to deal with tax consequences—if you turn the portfolio over too much, you're going to hit your clients with capital gains. That would be true in a mutual fund format as well. The ETF, of course, seldom passes along capital gains to the fund holders, so that's at least one thing the strategist doesn't have to worry about.

But in the strategic world that hews to long-term asset allocations, it's more of an open question whether mutual funds or ETFs are better. Depending on the simplicity or complexity of the portfolio you want to build, there's a very good argument that mutual funds are still the better vehicle. It's become clear that Vanguard often takes that approach. Vanguard uses its mutual funds pretty extensively in the target-date and target-risk funds.

What kind of advisors are best suited to take the deep dive on model portfolios?

EK: From an advisor's point of view, you have to think about what sort of a business you have and how an ETF portfolio would fit into that. If you're trying to attract clients by being the smartest guy in the room, you're going to want a tactical portfolio that sometimes includes some pretty specific holdings and, of course, sometimes excludes a lot of pretty specific holdings as well to come up with a portfolio that's very different from a benchmark portfolio.

But if you're trying to streamline your practice so that you can really add value in other areas of financial services—such as planning, insurance, tax management, and hand-holding—then a simpler strategic model portfolio is appealing and in line with the message that you're trying to state.

Equity ETF flows favor broad, plain-vanilla strategies

The table below shows the percentage of net 2017 flows captured to market share as of December 31, 2016, along with the asset-weighted expense ratio as of December 29, 2017.

 Net flows ($ billions)Flows/2016 AUMExpense ratio
Core259.41.4%0.12%
Tactical155.20.8%0.39%
Style box52.80.6%0.16%
Cash10.14.1%0.23%

Source: FactSet.

What kind of clients are best suited for the use of model portfolios?

EK: On the one hand, the answer is anybody who doesn't want to build his or her own portfolio from the bottom up and manage it on an ongoing basis. And to a certain extent, that's almost everybody. The more strategic kinds of model portfolios can be suited to many kinds of investors because, generally, a lot of thought has gone into them. Many shops provide them with varying degrees of complexity. On the other hand, an investor who likes to go for outperformance and likes to have a story behind it might prefer a tactical ETF strategist.

But I think clients are well advised to think long and hard about whether complexity serves their needs. It's good to ask if your investment portfolio is serving an emotional need. How much are you willing to pay for that in fees and in risk? I know that active management is not dead—a huge percentage of investor dollars is still tied to active managers rather than passive. But the argument for bottom-up security-level active management is one that has been losing ground tremendously in the marketplace over the decade since the financial crisis.

What are the limits to the simple strategic model portfolio approach?

EK: There are clients and situations where models don't quite fit. I will quote my good friend Allan Roth here, "I've always said investing is simple but taxes aren't."2 I think Allan makes a good point.

Here's an example from my own family. We transitioned from a complex to a simple portfolio, but certain assets couldn’t transition right away because they were privately held and also had a lockup period. Some distributed cash after a while. So we might have had a situation where something made a great cash payout that needed to be reinvested and, therefore, the portfolio needed to be rebalanced around this cash flow. I can tell you that everything is a moving part.

I solved the problem myself using spreadsheets, and it wasn't all that easy. I really had to think in several dimensions about how this affected the asset allocation overall; how it affected the balance between taxable and tax-deferred; and if reinvestment was required, which of the accounts it should go into, given multiple beneficiaries. So the freeing up of cash allowed me to increase the simplicity of the portfolio overall, but it took a lot of complex maneuvering to make happen.

There's also the issue of asset location. Most advisors recommend placing fixed income in your tax-deferred account and equity in your taxable account. However, if you have a large allocation to fixed income, then you have to fit some of it outside your tax-deferred accounts, and you're going to have to really look at the tax consequences of that. There might be instances where it's useful to go into muni funds, so then you have to start thinking about whether state-specific muni funds are worthwhile. State-specific muni bonds is one rare area that is not yet served by ETFs.

How do you go about evaluating a model portfolio series or family?

EK: In the absence of the kinds of complex circumstances that I just described, where you have holdings you can't sell for tax reasons or you need to shelter things at a state level or you really need to think about holding bonds in a taxable account, I think the end goal is simplicity. The broader and more inclusive the portfolio, the better.

In terms of equities, that means looking to include every geography possible. And it's not just large-caps and mid-caps but small-caps and even micros to the extent that they're feasible. Also, neither overweighting nor underweighting relative to the global market cap makes sense.

Where things get a lot more complicated, frankly, is on the bond side. I'm not as convinced of the necessity for diversification in the fixed income space as I am in the equities space, especially for U.S. investors, because the U.S. dollar is still the world's dominant currency.

When you think about it, in fixed income, you really have two major risks: interest rate risk and credit risk. You don't necessarily need to diversify to control your interest rate risk. Understand how much interest rate risk you want and target that duration exposure. It can be managed with a portfolio of U.S. Treasuries, but it's managed by constraining your holdings.

So pick a given duration that's appropriate to your age and risk appetite and stick with it?

EK: Yes. To put it more simply, if you have a portfolio of T-bills and you diversify by adding the long bond to it, you increase your interest rate risk.

And what about credit risk?

EK: Credit risk is another matter. With credit risk, it is absolutely true that you don't want all your eggs in one basket. So I think there are some real reasons you might want to diversify in the credit realm of the fixed income space.

Are you saying that investors can target credit and duration risk as they see fit?

EK: Yes, you don't necessarily need to have a broad-based bond exposure, and you can target it more. However, I want to be clear, that there are trade-offs between owning individual bonds and owning a bond fund, and it's not a slam dunk either way. In general, for most investors, the economies of scale that are afforded by a bond fund make it worth taking on the volatility. You get the added benefit of washing your hands of all the portfolio management tasks and the trading expenses of a bond ladder.

Is there such a thing as too much complexity?

EK: Clients are starting to really question the value-add all along the financial services chain. I said earlier that sometimes the value is in a story rather than in something that's otherwise measurable economically. So if you're an advisor and you want to attract clients by saying to them you're going to do better than what they could do themselves in something very straightforward and easy to manage, you are inevitably selling complexity. But you're not necessarily selling complexity that's going to deliver risk-adjusted outperformance.

In the end, the market is really speaking. And what the market is saying pretty relentlessly is dirt cheap, broad-based, and simple are winning. When I look at where flows are going in the ETF marketplace, that's where the market is going. There are people who are trying to adapt their existing businesses to the current market conditions, and some of them will be successful for some period of time. But if things keep going the way they are, selling complexity will be increasingly difficult. Between the technology of the ETF and the overwhelming evidence about the value of passive investing, selling complexity is just an increasingly difficult argument to make.

Download the complete Fall 2018 issue of ETF Perspectives

1 Elisabeth Kashner, 2017. ETF due diligence: Chasing quality, not performance. Accessed on September 19, 2018, at https://insight.factset.com/etf-due-diligence-chasing-quality-not-performance.

2 Harry Sit, 2017. Advice-Only in action: An interview with Allan Roth. Accessed September 13, 2018, at https://adviceonlyfinancial.com/advice-action-interview-allan-roth. (Blog.)

Notes:

  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • All investing is subject to risk, including possible loss of principal.
  • Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the work force. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target date funds is not guaranteed at any time, including on or after the target date.

 

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