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ETFs: What's the Right Beta Strategy?
Experts from Schwab, Deutsche Asset & Wealth, State Street and WisdomTree discuss where active, passive and smart beta strategies fit in current portfolios
Anthony Davidow, Vice President and Alternative Beta and Asset Allocation Strategist at the Schwab Center for Financial Research
David Mazza, Head of Research for SPDR ETFs and SSgA Funds at State Street Global Advisors
Dodd Kittsley, Head of ETF National Accounts & Strategy at Deutsche Asset & Wealth Management
Luciano Siracusano, Chief Investment Strategist and Head of Sales at WisdomTree
Duration:
00:51:21
Transcript:
ETF MasterClass (8/6/14)
Active? Passive? What’s the Right Mix?
Evan Cooper: Welcome. I’m Evan Cooper and in today’s Masterclass we’ll be discussing the role of exchange-traded funds in portfolio construction. Today’s advisors understand the value of passive investing and want to know how to blend the best of passive and active approaches. We’ll find out from our panel of experts:
Anthony Davidow, Vice President and Alternative Beta and Asset Allocation Strategist at the Schwab Center for Financial Research; Dodd Kittsley, Head of ETF National Accounts & Strategy at Deutsche Asset & Wealth Management; David Mazza, Head of Research for SPDR ETFs and SSgA Funds at State Street Global Advisors; and Luciano Siracusano, Chief Investment Strategist and Head of Sales at WisdomTree.
Welcome, gentlemen.
We can all agree that passive investing has come a long way. It’s now an active part of the discussion at the asset allocation table. The question isn’t, “Should it be passive?” It’s now passive and active, where each fits. We’re going to discuss that today.
Dodd, let’s start with you. Give us your overview of where the active passive issue is and where we stand.
[Overview]
Dodd Kittsley: We’ve come a long way. This is certainly a very important current topic right now — application. To your point, active and passive, active and index have really expanded the investor’s toolkit. It’s enabled investors to be able to leverage the strengths that both bring to the table.
We get into portfolio construction and we get into application. I think that’s why we’re here today and excited about being able to discuss it with these gentlemen.
Evan: David?
David Mazza: I’ll pick up on what Dodd said because what’s interesting about active and passive management is that the toolkit for both has really expanded. We often thought about the ability to access certain markets in just an active fashion, and now we know the benefits of passive management, both theoretically and then with its practical implications, in many cases, showing its resiliency and its ability to actually outperform its active peers, in many ways. But now there’s of course a third leg of the active versus passive debate with advanced beta. This again is in some ways muddying the waters, but actually in our opinion it opens up the toolkit even further for investors to think about that spectrum — all the way from low cost, passive exposures and, in many cases, efficient asset classes, towards advanced beta approaches in certain asset classes which are well known and liquid. Then all the way up to more sophisticated type active management, which is looking to, of course, outperform certain benchmarks.
Evan: Tony?
Anthony Davidow: Hopefully, we’ve evolved past active versus a passive to really get into active and passive. I think to pick up on Dodd and David’s point. Hopefully, we’re at a point in time where advisors, practitioners now have a much more robust toolkit where they can select among the traditional passive strategies.
Advanced beta, strategic beta, smart beta or whatever you want to call it. These more evolved strategies, and active, and a lot of the active management shifts to the advisor and their ability to use those in various market environments. Our view is each is a complement of the other, but certainly certain market environments and certain segments of the market are going to reward one more than the other.
Evan: Luciano.
Luciano Siracusano: I would just follow up on what Tony said, which is that in different market environments, you may view the question differently. We’re in a market environment now with historically low interest rates. If interest rates go back up, traditional index based approaches to fixed income may not be the optimal way to think about your fixed income allocations, in which case there might be a very different role for the active manager in that kind of market environment.
Evan: Let’s go back to the point David and Anthony made too, and everybody’s made this, about smart beta, alternative beta, where it fits, because there’s like this...on the continuum of active and passive, it’s somewhere in the middle someplace. Let’s first describe what that is, and also by whatever name we want to call it, and then say where it fits. Dodd, let’s start with you. What is it? What is alternative beta?
[Alternative beta]
Dodd: Smart beta, alternative beta, strategic beta, it’s really an umbrella term for anything that’s not market cap weighted. It can have a very simple type of exposure, for example, high dividend paying stocks. It could be multiple factors combined together in an effort to actually add alpha and outperform standard market capitalization type indexes.
We also look at that category as being those that have strategies embedded with them, so currency hedge types of investments, for example, while market cap weighted is controlling for a risk that previously investors never were able to. It’s a broad category. I think we need to be specific about what we’re talking about when we get into it, but it really has made indexing, and ETFs in particular, much more applicable to a broader investor set.
Evan: David.
David: What’s most interesting, in my opinion, is that it’s, in many cases, taking the benefits that active management have brought for multiple time periods into a low cost, cost effective fashion, and oftentimes it’s manifested in the course of an ETF. An investor can get access to premiums and factors that have the ability to outperform both in the equity market and is really beginning to see a lot of cross currency in the fixed income market being made here, of course commodities and currencies, but again do so in a way which is low cost, transparent, and rules based in most approaches.
For investors looking to have that toolkit approach that we discussed, knowing that their exposures are going to adapt depending upon what that rule will be is the real benefit there, so it’s going back to knowing what you own.
To Dodd’s point, I think which we can explore in today’s discussion a little bit further, then if we have all of these multiple approaches all the way from high dividends to low volatility to the multi factor, what role should they play? Are they core-type approaches or just tactical in nature? That’s really what one of the big question marks is.
Evan: Anthony, you do a lot of work in this area. Tell us...
Anthony: We have, and I think I’ll start with, yes, we view them on a continuum, and I think ideally they are capturing positive attributes of both traditional market cap and active strategies. I think Morningstar has actually started to do a very good job in thinking about them. They call them strategic beta, and they describe, I think as Dodd start to, some of those, or as naive is just having certain tilts built into the portfolios. Then you start to look at strategies like fundamental, equal weight, low volatility. Whatever the master is on that, I think it’s fine. As an industry we should probably come to one consensus and call them all the same. What’s important for advisors, though, is they need to peel back the onion and understand the differences of those strategies.
The term “smart beta” implies that these are better than the traditional beta. Certainly the work that we’ve done, fundamental strategies have delivered alpha over extended periods of time. Low volatility strategies, or many of the low volatility strategies, are really designed to dampen the volatility. They’re not really designed to give you the excess return. To group them all together I think often confuses the advisors, so I think all of us here, and hopefully the industry as a whole, need to do a better job describing to advisors what sort of environment will they perform well, perform poorly, and how are they constructed. Anything that’s non cap weighted is easy to throw in this bucket, but they’re not all created equally, and the more that we can educate advisors, I think the better experience they’ll have and the better experience their clients will have.
Evan: Luciano.
Luciano: WisdomTree invented some of the early smart beta indexes, and I think you need to draw an important distinction between a factor and a return premium. For example, a lot of research says over time there’s a value premium in the market, and the question is how do you access the value premium? You can do it by screening for companies that are cheap based on book value, maybe based on PE, maybe that have high dividend yields, and they all give you access to this value premium.
There are other premiums you can tap into. Value is one. Another one is size. Another one is what they call momentum, price movement, quality, which more and more people think is related to profitability, and, more recently, low volatility. They’ve been able to demonstrate over time that the lower volatility stocks historically have outperformed the high volatility stocks, and when you adjust for risk, the returns are pretty impressive.
These are basically return premium that are underneath the market that you can tap into, and the question is, “Can you tap into them more efficiently than a cap weighted index can?” The cap weighted index, remember, never rebalances, it just owns the market, so left to its own devices, it’ll probably tilt towards large cap companies over small, towards growth stocks over value, and at the top of a bubble, towards the junk companies, the more speculative ones, rather than the high quality. There might be a built in bias to the actual weighting mechanism of cap weighted that dilutes the potential return premium, so what WisdomTree, and now some of the other up comers to the party, are trying to do is capture those return premium in more efficient indexes that either select stocks based on these premium, or weight them, or both to try to get you a better risk adjusted return over time or possibly just higher returns over time.
[Why measure differently]
Evan: I’ll ask sort of a naive question maybe that an investor might ask. Theoretically, the index is supposed to represent a market, so if somebody wants to invest, they’d say, “I’ll invest in index because that’s the market, so how do I compare to the market? The index is the market, right?”
Dodd: Yes, and I think Luciano did a great job describing some of these factors, but I think we maybe just need to pull it back a little because, you’re right, a lot of people naively buy a market proxy assuming they’re getting a market experience. Sometimes that’s good, sometimes it’s bad, but a lot of academic research has shown, as Luciano has pointed out, that there are factors persistent in the market that give you excess return over extended periods of time.
If we just back up a little bit, a market-cap portfolio, the traditional way that you buy in index, you’re over weighting the overvalued stocks. It’s a kind of naive way of getting market exposure where the largest companies have the largest weight. Some periods of time you’re going to be rewarded for that. Some periods of time you’re not.
I think most of the academic research has shown that these smart beta strategies have delivered excess return over time essentially because you’re breaking the length of the price. You’re actually weighting based on metrics that have shown to be durable and persistent over time, and as Luciano points out, the rebalancing actually allows you to capture what happens in the market over an extended period of time. Those strategies have delivered the excess return, and frankly, the fact that we’re up here talking about it is a very good thing because we’re giving better tools to advisors so they can have the ability to select amongst the options available in the marketplace.
Evan: There’s a broad question for everybody. If you do that kind of thing with a specialized index that’s trying to capture different kinds of measures, in a way it’s no longer passive, because you’re imposing a value judgment that’s sort of an active judgment saying, “These are certain factors that you want to create a benchmark for.”
Luciano: I would just say that for people who’ve been doing for 30 years, it’s nothing new. If you wanted to buy the market, you would just buy all the stocks cap weighted. But people don’t do that. They break it out. They say, “I want to buy the S&P 500 to get the US,” or, “I want to buy the Russell 2000 to get the US small-cap segment.” They’ve already been accessing the market in subsets. The question is, is there a more efficient way to get your small-cap exposure? Is there a more efficient way to get your value exposure? If growth is not really a return premium, is there a more efficient way to get quality or momentum, which may be driving excess returns in growth indexes for some periods of time.
Evan: Dodd is itching to say something, so let him say something.
Dodd: I agree. It’s been a great discussion thus far. It allows investors this strategic beta, and we’re staying mostly in the middle here, right? Do you want to have a discussion on index and pure active, which we define as manager discretion too. I think there’s a place there. But the sweet spot in the ETF industry clearly has been this strategic beta area, and to me, to be able to deliver transparent exposure to allow people to be able to capitalize on a particular factor or a particular characteristic of the marker in a diversified, packaged, efficient way really has been a breakthrough, right? It’s democratized investing. Whereas for 30 years, certainly the largest institutions in the world have been able to say, “I want to take a tilt towards the low volatility stocks.” For an individual investor, that was very hard to be able to do until the advent of that. I think a lot of value has been brought into that. It really has been the future and driving growth. We saw 26 percent of flow last year into non traditional market cap weighted, non market cap weighted product.
David: It’s really about getting exposure. That’s what we have to think about. We often think about just the index, and the index is actually somewhat of a construct. It wasn’t really investible until the early 1970s. Now we’re seeing an evolution of indexing being played out in the ETF industry.
What we’re now talking about is saying, “Obviously everyone wants a certain return stream.” They are willing to take a level of risk to get there, and it’s going to come with a certain cost. But if we can do so in a way which provides a more efficient return stream to meet my needs, maybe my needs is I need persistently low volatility. I’m willing to accept in up markets I may underperform. But over the long run, I want a smoother return path. I want to remove out those bumps, so that’s great for those type of investors.
Other people need a different sort of tilt or a different kind of exposure, and that’s really what it comes down to is that we can break out the landscape. Certainly think about indexing broadly, whether or not it’s globally, or picking your parts geographically. But it’s another dimension to think about in regards to portfolio construction, not just simply, where is the company located and what sector would you define it as?
[Portfolio construction]
Evan: Let’s get to the portfolio construction part, which is obviously crucial. Rather than just active passive, which are two ends of the barbell, you now have the whole middle that you can work with. All right, so how does it all fit? How do you decide which pieces gets what and how much goes to the new kinds of beta strategies? Where does that fit and where does passive and active fit?
Anthony: Traditionally, people would use indexing in the most efficient part of the market. They would typically use the active manager for the less efficient part. When you look at US small cap and US mid cap, what’s interesting is you can look at the S&P 400, which is a mid cap index, and over the last 10 years, that index has beaten 90 percent of all of the actively managed mid-cap managers, according to Morningstar. It gives you some indication of how hard it is to beat that index. Some of the smart beta mid-cap indexes now are beating 95 percent of the active managers over five years. I think it’s raising the bar for the active managers. It’s making it harder now for the active managers to compete with the indexes. But I would say typically people will start in a less efficient part of the market and then they’ll build out from there.
In terms of where are they using smart beta, I would say that in this environment probably the best place to use them right now would be emerging markets. Because there is such a differential in the dynamics and what’s going on at the country level that if you’re going to add excess return in emerging markets, you’re typically doing it through the country level. If you have a very good active manager who has the ability to analyze that, both on the equity side and the bond side, you probably have the potential to actually add excess return there, because some of the broader indexes are disproportionately over-weighted towards the largest countries in emerging markets.
Dodd: We have a point of view that there’s a role for a market-cap active and fundamental, but we do think each one plays a role in the portfolio and it’s important to define that role. We would argue that market cap provides cheap beta exposure to virtually every market. It’s an access play.
We would argue that in active management, and Luciano cited some of the numbers, there’s a tremendous amount of research that’s been done that shows the difficulty of active managers to consistently outperform. I would just cite the SPIVA [S&P Indices Versus Active] persistent scorecard where over the last five year period that they had looked at, three percent of the managers were able to be in the top half of the class persistently. We know that it’s very difficult for the active managers to outperform.
However, we would argue a lot of the value of an active manager is the ability to play defense and really adjust when the markets get choppy, as they are today. We’d argue that active managers do have a critical role in the portfolio. It’s primarily to play defense. If you can find a good manager but somebody who could do a much better job protecting on the downside, that’s of great value to clients’ portfolios.
Frankly we view fundamental strategies as an alpha play, a way of getting excess return over time. If you think of the role of those three, then you can think about across the various markets how to deploy them. In the most efficient markets, we’d have a higher allocation to fundamental strategies. We don’t see a lot of scale to be had, so we’d have a 50 percent allocation in the large-cap space, 50 percent allocation of fundamental, a lesser allocation to market cap, and then a smaller allocation even yet to active managers.
In the emerging market, a very inefficient market where there’s a lot of noise and the ability to pick the right companies and avoid the wrong countries, we think is of great value. We’d actually have the highest allocation, a 50 percent allocation to active managers, a lesser allocation of fundamental, and the least allocation would be to market-cap portfolios.
We’ve developed a framework, and we also think that by developing that framework and understanding the role that each of these play, the individual advisor can customize that based on their forward looking view of the markets, or where they may be allocating capital.
Evan: David?
David: One of the interesting points that was brought up is that there are a multitude of studies that measure whether or not active managers have persistence of have had the ability to outperform over 1 , 3 , 5 , 10 year periods. The numbers aren’t too exciting in many cases for active managers, frankly. But one of the other elements to consider is what is the forward looking outlook for that? We know there are certain areas where it’s very difficult, but oftentimes as investors, we get stuck in our historical mindsets.
US small-cap, super inefficient, that’s got to be a place where active managers do well. High yield, again, super inefficient. Active’s going to do well. Interestingly enough, within fixed income, high yield is harder to beat historically than investment grade, and that raises a few questions. Theoretically, we could debate why that is. Oftentimes we think about that, you’re really picking credits in high yield and investment grade corporates. We have credit and interest rates that play a role, so maybe that has a part to do with it.
But what’s challenging today is that there are a lot of counterforces that are occurring. Is that maybe the outlook for high yields is a little bit better for active managers, theoretically, because spreads are as depressed as they are. Questions about the Federal Reserve’s policies and tapering and rising rates may do. Maybe someone who’s steering the ship and can avoid some of the potential stresses in the CCC part of the market with all these covenant lights may be able to do better going forward. It’s not a guarantee, but it’s something to consider.
We want to take look at what historical returns have told us, but really look out ahead to the future and say, “What role could active play there?” Then balance that to say, “Well, I need some low cost exposures, and maybe there’s something unique that I can get with the advanced and strategic beta type plays.’’
Evan: Dodd, you’ve done some research in this area, right?
Dodd: We have, and I couldn’t agree more with what David said. Forward looking is so important. To frame how to look at active versus index versus your choices in the middle, to me it all boils down to your level of conviction and your level of conviction on a go forward basis. There are a lot of great active managers out there. As hard as it is to outperform the index and these numbers don’t lie. Most managers don’t outperform their benchmark index after fees and taxes. It’s just a pure mathematics.
Moreover, most active managers don’t outperform, regardless of what market segment you’re talking about. Whether it’s super efficient like US large cap, or whether it’s some uber inefficient like frontier markets, the probability of outperformance, the distribution of performance of active managers, it’s eerie, but it’s almost the same in almost every category.
Our viewpoint is, really, it’s the level of conviction and manager to deliver alpha, to be able to outperform whatever benchmark you’re looking at. The point here for investors is that they have choices now. They’ve got choices to do a market cap weighted index. They’ve got choices to take a tilt, whether it’s a single factor, whether it’s a bundle of factors together. That’s a beautiful thing. Again, I think the most important thing for investors is the asset allocation decision. They make that, and then within each one of these sleeves it’s a level of conviction on active first, and then after that you have other tools in which you can’t. The world has changed, the way you manage money has changed, and we’re seeing a lot of clients using ETFs, using active managers, using strategic beta ETFs in a very holistic approach. That to us really is the opportunity set.
[Market-timing]
Evan: Let’s say you’re an advisor and you think, as many of the prognosticators and strategists are saying, there might be a correction coming this year or soon. We’ve seen a couple days where we’ve had corrections, mini corrections.
Assume that that’s going to happen. What would you do with an active passive mix? Would you switch and become a more active? Would you tone down? What could you do so that you’re not market timing, but still not standing there and saying, “Well, whatever happens I’m just going to go in it for the long run.” What do you do?
Luciano: The first question, is it a correction in the stock market or a correction in the bond market?
Evan: Let’s do stocks first.
Luciano: Let me try the bonds first. The point about bonds is interesting because the point David made earlier was excellent, which is that over a long period of time in a bull market, you can benefit from these index based approach.
But what happens when rates rise and all of these ETFs that have tremendous assets in them need to start unloading some of these high yield and investment grade credits all at once? Is that an opportunity for an active manager who might have a smaller portfolio to manage and look at the individual credits to actually be nimble and take advantage of that environment.
Evan: And it happened a little bit with the muni bonds...
Luciano: It happened a little bit, and we get little instances of what may come. Because we haven’t really experienced a real big run up in rates with the asset levels at this level. All I would say is there probably is room for an active manager, particularly on the credit front, to look at the credits in emerging markets and to look at the credits in investment grade in the US.
People who buy a US ETF that’s investment grade or high yield, they see US and think they’re US invested. They don’t realize that 20 to 25 percent of the securities are outside the United States, and companies all over the world are issuing debt like crazy these days because the rates are so low, which means their rates may be going up, and you may have much more international credit exposure than you’d have thought because you thought this was a US based ETF. That’s really I think where you could use the global credit manager, actually looking around and evaluating these companies. I would say that to me would be the number one place to start thinking about using an active manager for the three to five years ahead of us.
[Fixed income ETFs]
Evan: Let’s stay on fixed income for a while. Would everybody else agree with that assessment — to turn up the active part of fixed income management?
Anthony: I would just say that I think most fixed income ETFs have a degree of active in them. I am very concerned, as you are, on the unwind of it, but there’s some degree of active in it, because there’s some selection. Nobody’s buying the Barclays Agg. People are making determinations out there. But I do worry about the unwind of that. I do worry about, as people bought high yield without really understanding the risk of the high yield, they were just chasing the yield, then you could have repercussions and it could ripple throughout the whole industry. But when I think of fixed income, I think almost all fixed income ETF have an element of active because you’re selecting which securities and which credits go in the portfolio.
David: The fixed income portfolio management in ETFs is very much an active process, even if you’re attempting to passively replicate the performance, the yield and capital appreciation of an index, because, as you allude to, there are some indices in fixed income that have 30,000 issues in them. Frankly, you’re just not going to be able to cost effectively own them, and forget about cost, ever get access to some of those bonds.
But really, this is where the portfolio construction component plays an important element in regards to what the portfolio managers are doing on a daily basis to balance liquidity from the ETF perspective, and the tracking error.
I would caution investors who...Some folks are scared of fixed income ETFs because of that, but there still is a lot of benefits that they can bring. Because what you can do is that oftentimes they’re providing price discovery to the market. They are trading intraday. Giving you the ability to get in and out of the market should you need to do. This is why what we’re beginning to see is really the pairing of folks taking advantage of many of the growth of these multi sector, go anywhere type fixed income products, which have some great utility. Pairing them with the low cost ETFs around them to meet a particular need, to seek a yield, to seek a duration balance in their portfolio and, thinking about everything, to Dodd’s point earlier, more holistically. Not just necessarily saying, “I need to go completely active here or completely passive here.” Because even intra asset class, that’s where the beauty of blending passive and active together can really play a lot of benefits.
Evan: Dodd, finish off the fixed income discussion before we go to equities.
Dodd: Fixed income, I think ETFs have delivered enormous value in the fixed income market by porting an over the counter market that’s been opaque and inefficient to say the least into something that’s competitive and transparent. It’s really compressed spreads. To David’s point, it’s allowed people to be able to do price discovery, to be able to very efficiently reflect their view and be able to get in and out in a market that is traditionally more buy and hold long term.
It also has enabled people to take a top down, macro approach, because initially when people think about fixed income, they either outsource it to an active manager, or they bought individual bonds. Today we’re seeing many investors either outsourcing it to ETF strategists or doing it themselves, of being able to position for an environment such as you describe. Whether it’s a sell off in the bond market, a credit event. There are a lot of choices out there for investors to be able to rotate within fixed income.
We saw that last year. It was a complete year of duration rotation into short duration floating rate and bank loans. This year we’re seeing a much more balanced flow to reflect more of a barbell approach that investors are going at. It depends on your perspective as an investor of how you’re going to use ETFs and how you’re going to use ETFs in the fixed income market.
[Equity ETFs]
Evan: Let’s go to equities now and picking up on the idea also that there might be a correction. How do you change the dial, the active passive mix?
Luciano: On the passive side you may want to tilt towards the more defensive indexes. Some of the indexes have lower betas, lower volatility. Some of them that are dividend weighted may have higher yields that help limit the downside. But that’s when the active manager needs to make his money. He needs to earn you back in down markets what he loses you by not participating 100 percent in the up market. It’s very hard for the active manager to get 100 percent of the upside over five years, because he’s got to know what to buy, when to buy it, when to sell it, and then he’s got to keep cash on hand to meet redemptions. If you have any kind of a cash drag in a market that compounds 20 percent for five years, there’s a good chance you’re going to underperform the index. They have to do it on the downside.
A lot of them didn’t get it done in 2008. They were buying stocks at the wrong part of the downside, and a lot of them got blown out because of it. But I would say that’s the time for active management is to navigate choppy waters, particularly when you feel there might be a 15, 20, 25 percent down movement coming in front of you.
Dodd: But that’s why I think it’s important to establish the role in advance, because I’d hate to wake up today and realize the markets are difficult and I need to find a manager with downside. Our view is to understand the role that they play. We would argue that we’ve seen all the evidence, it’s very difficult to consistently outperform, but I agree with Luciano. The active manager should earn his stripes when the markets get difficult, because they can change. As much as well all love these index based strategies, by definition, they can’t alter what they do.
Ideally what you’ve done is you’ve identified that manager with better downside protection in advance and then you have the ability to toggle. If you’re already in market cap fundamental or active, all you then need to do is redeploy capital. If you wake up today and you come to the realization that there’s a fair amount of geopolitical risk out there and there was a lot of unknowns and you have to go and find somebody, you’re at a big disadvantage, because we all know how long that process can take. I really think it’s important from the beginning to establish the role and the expectation of each one of the underlying investments. Then you have the flexibility to move and allocate capital around that going forward. And if the markets are difficult, that’s where the active manager earns their stripes.
David: That’s to me really why we’re seeing some trends evolve in regard to markets. One of the things we’ve seen recently among ETFs is just tremendous pickup in sector and industry type investing. Because either the third party strategists that Dodd mentioned are leveraging these tools to be more nimble in their approach.
We don’t necessarily need to think about the S&P 500 as just those 500 stocks in one representation. We can break them up into sectors and industries and find advantages to the fact that, of course utilities can be more defensive versus energy and materials, which are going to be much more pro cyclical, rotating around them. Among the growth of our fundamental weighted strategies and advanced beta is really this multifactor type approach. Is that many investors were taking advantage of just one premium, just low volatility or something of that nature, which works well, but maybe we want to balance low volatility with an expensive valuation and high quality. Because again, over the long run, it provides that more steady return stream, so it’s less about hitting a particular home run in a certain market. Again, a lot of active managers can give you that home run. But maybe we want to provide something else, which is hitting more singles and doubles over the long run so we benefit from that compound effect.
Evan: Dodd.
Dodd: One of the areas that I think is particularly relevant with ETFs and the choices that investors have today is international equities. Just to highlight the importance of choice and the value that they can bring to the market. Prior to currency hedged exchange traded funds being out there, investors really defaulted to an unhedged position. They didn’t realize they didn’t have the ability to control for one of the primary drivers of risk and return in any international equity investment, and that’s currency fluctuations.
I think it’s a great example to take a look at being able to get equity exposure and be able to bifurcate out some of the risk, control for some of risk, and virtually eliminate currency fluctuations, particularly in an environment where many are calling for a stronger US dollar versus the yen and the euro. Again, just one example.
It depends on your perspective as an investor or an advisor. If you’re managing it yourself, you’ve got more tools out there than ever before to reflect your view in an accurate way. But your view has got to be right. But the ETFs can promise that they’re going to do that, and do that in the most efficient package possible. If you don’t have a view, you’re just looking for somebody to help protect you against unknown risk, you probably want to outsource, and that’s either an ETF strategist, that’s an actively managed fund. Who cares about the delivery vehicle, you want to outsource that investment process.
[Asset allocation]
Evan: As all of you were talking, I was thinking that the asset allocation process has gone from two dimensional to three dimensional. It just seems much more complicated to figure out where and how to turn the dial on everything. How do you figure that out if you’re an advisor? Do you outsource all of it? Do you outsource some of it? How do you think about it yourself when it seems much more complicated than it used to be?
Luciano: There’s a lot more choice. Fortunately there are a lot more tools, too, so that if you run a screen, you should be able to identify who are the top managers in any asset class. Then the question is what do they do in particular market environments? I would be more interested in how they did in 2008 than how they did in the last three or four years. Then you want to check that the same manager who was there then is there now. There are a lot of different things to consider, but I think Dodd’s point about currency is a great one, because that’s an area where there’s been a lot of innovation recently, and now advisors who didn’t have that kind of sophistication before can basically hedge their bets. They don’t have to be 100 percent unhedged. They can say, “I’ll be 50 percent hedged and 50 percent unhedged.” At least there I know at least I’d be able to limit some volatility in the case of euro.
I don’t spend a lot of time speaking to advisors about how to find and vet active managers. We contain most of ourselves to what’s happening on the ETF front, and typically on the ETF front you have a choice. You can use cap weight beta, or you can use some of these more innovative indexes that are designed to try to get you a specific exposure. We’ve seen advisors adopt them. Last year, the yen lost value and Japanese equities rallied. They wanted to get Japan unhedged, and that worked, excuse me, Japan hedged, and that worked really well. It was a very great tactical exposure.
This year it’s Europe. Mario Draghi is trying to weaken the weak euro here, doing everything they can to resuscitate Europe, and now you’re starting to see advisors gravitate to hedging out the euro in their European equity exposure. I would say that’s really a lion’s share of our discussions happening.
Evan: Tony.
Anthony: With choices come complexity and opportunities. I think it’s really the balancing out of the two. I would argue it’s a really good time, because you have a lot of tools at your disposal. It is more challenging, but I would argue you need to do the research in advance.
I think that for many, many years, a lot of the advisors spent their time evaluating active managers. In my discussions with advisors, there’s a lot that have completely given up on that. I would just argue that if they’re giving up on active management, where they really should spend their time and their analysis is to understand what’s in their toolkit. How does it perform in a given market environment, and what’s the optimal combination?
Again, I’d wake to wake up in a very difficult period of time to figure out what to do. I’d like to have it figured out well in advance. I’d like to understand how these strategies perform in various market environments, and frankly, it is a challenge and I applaud asset.tv and other organizations who are trying to help educate advisors. We all write and speak a great deal because we know that there’s demand to better understand the toolkit.
But I would argue it’s a much better environment today than it ever has been, because you’ve got so many more tools. Dodd mentioned something like currency hedging. That’s something that the average investor could never do on their own, but now it’s actually pretty easy to do in a passive structure. I wouldn’t want to go backwards just because it’s gotten a little bit more complex, but I would argue that we’re in a much better environment because there’s a lot more research.
One of the points that I think Dodd and Luciano made earlier that we can’t lose sight of is a lot of this has really existed in the institutional world for 30 years. These strategies may be relatively new to the ETF and the retail marketplace, but the institutions have been using these for many, many years. Let’s learn from what the institutions have used, how they’ve used them, how they’ve built portfolios using them. I think the individual consumer benefits from a lot of the heavy lifting that’s been done by the academic community, by the institutional community, and by those who develop and deliver these products.
David: When I’m in a meeting with advisors and institutional investors in my role at State Street recently, it’s been less of a dogmatic discussion of either passive versus active. Even though the complexities have increased because the toolkit has expanded tremendously, it’s gotten a little bit back to basics, if you will.
Think about the old four Ps of active management due diligence. It goes back to people, philosophy, process, performance. Of course sometimes we gravitate towards the performance side, because that’s probably the funnest part. Either on the upside or maybe the worst part of the downside.
But if we, again, take a step back from the active side and understand the people, the firm behind it, the resources. Dig into the philosophy, the process. It is repeatable? How does it perform in up markets? How does it perform in down markets? When will they outperform, when will they underperform?
What’s interesting is that you can apply those same techniques with some slight modifications to advanced beta and strategic beta; less necessarily about the people behind it, but more about the methodology and the approach because, again, performance is going to be a fallout of all of the drivers of the methodology. That to me is what the most interesting component is. You could probably take a step further and do that on just pure market cap weight indexes, or indexing as well, and weigh them all against each other, because that’s really — as opposed to getting bogged down with the complexities — what we’re trying to do here in identifying the best exposure.
[Education]
Evan: I was wondering, as you were all talking about toolkits, it makes me think of going to Home Depot. I have some basic tools at home, but of course my eyes open wide at Home Depot. There’s all this great stuff and I think, “Gee, what I could do with all this great stuff.” The truth is I can’t make great furniture. If I had the best tools possible, I wouldn’t know what to do. I’m not saying advisors don’t know what to do with all these great tools, but it can be kind of daunting. When you have all these institutional type tools that were never at their disposal now there, and advisors can do pretty much anything in a way that an institution can, where do you go for help? What should advisors do if they’re saying, “This is great, but I need a little help here.” Where do you go?
Luciano: I think, one, we mentioned the toolkit. I’m thinking of a benchmark. If you’re an advisor and you’re using an actively managed dividend fund, for the sake of argument, how do you evaluate that dividend manager? What benchmark should you measure them against?
The index plays a great role there. Because if you know how all the dividend stocks in America performed, then you should have a way to evaluate your active manager. If he’s under performed that index or he’s charging too much and not getting the return or the dividend distributions are a lot lower because the fees are higher...
Evan: What’s a dividend index?
Luciano: I mean WisdomTree has a dividend index that includes 1,400 dividend paying stocks, so it’s the broadest measure of the dividend paying part of the market, and it’s got $17 trillion of market cap. Over the last five years, that’s returned about 20 percent per year. So if you have an equity-income active manager or a dividend active manager and you look at the five year returns and they’re 12, 13, 15 percent annualized, you need to know, what would you have gotten just by getting the benchmark return?
I think that’s the starting point because a lot of people who grow up believing in active management and paying for their expertise need to always say, “Well, how did you do against basically the no fee index, which I can buy in an ETF structure for 7, 10 or 20 basis points and have some certainty about what my exposure’s going to be going forward?”
I would say, really, the burden is to separate 75 percent of those active managers from the fold, and then make your choice: the smart beta index or the truly outstanding active managers being able to demonstrate performance in excess of the index over time.
Anthony: Using your Home Depot analogy, I don’t shop in all the isles when I go. I know in advance what I’m looking for, and that’s where I spent my time and my effort. It’s daunting if you look at the whole universe of ETFs or the whole universe of active managers, or frankly if I was looking at the whole universe of all the stocks that I could choose from. But if you can narrow your focus, really focus on what you think you can get comfortable understanding, develop a stable, and in that stable maybe have some flexibility of what you use in a given market environment.
But understand the breadth and the capabilities that you can bring to bear. If you don’t have those capabilities or you really don’t perceive that your value add is, Dodd’s mentioned a couple times. I think the growth of the ETF strategists is terrific because they’re doing a lot of the heavy lifting for you. But I think for the average advisor, they can spend enough time to get comfortable.
There’s a lot of information out there. All of us are providing a lot of research. You’re doing a great job here on asset.tv educating consumers. They can go to Morningstar, they can go to ETF.com. There’s places out there, but don’t try to learn every aisle and every row of Home Depot. You’re going to get lost. Narrow your focus. Really understand what works with your philosophy. Some people don’t believe in sectors, so they’re not going to spend the time there. But if they can narrow their focus and get comfortable, then it’s easier to bridge out a little bit beyond that.
Evan: David didn’t like hearing that some people don’t believe in sectors, but go ahead. [
David: It’s not that I didn’t like hearing that. I think it’s more that I think it more goes back to the point about when we’re thinking about this toolkit or in regards to shopping for additional tools. Figure out what’s missing. Figure out, if you already have a hammer that’s been trusty and been passed down in your family, you probably don’t need another one, even though it’s shinier and looks a lot better. Because it’s the utility to you. It’s going to perform the same function.
But if you do need something unique and you do want to work on building that couch that you’ve been trying to figure out for so long or that table, you can go to the class that a shop like that would offer and get some education, and you can do that through a multitude of ways. Either with providers’ websites or with third party type options. Or, quite simply, you could figure out, well, that’s an area which I don’t necessarily need to touch. We could say here is something that’s missing because I want to have advantage, I want to have the ability to outperform given these set of factors. I’m going to go either with a third party manager who could use passive tools in an active fashion in regards to ETFs or a traditional active manager.
Again, it’s not about saying, throwing your hands up and that there are too many tools and these stores are too big and it’s daunting. It’s saying, what lanes do I want to drive in? What do I need? Then when I come home, what do I want to add to my collection in a way that’s going to be accretive and a value add, not just for tomorrow and today, but for the long run.
[ETF construction]
Evan: Let me play devil’s advocate here just for a second, because I do this with the active fellows who come and talk about their strategies. In the ETF world, especially in somewhat of the more liquid strategies, is there a danger during times of market panic that the structure or the market making mechanism within ETFs could somehow, not falter, but not exactly provide the liquidity that people assume? Might there be price breaks within the ETFs just because of the way the ETFs are constructed?
Luciano: I would say that’s not a, it’s not a structural issue with the ETF itself. It has more to do with the underlying securities that are being picked and included. If you pick a illiquid or a less liquid asset class and try to create an ETF around it, particularly when it might have different settlement issues, yeah, there could be issues with that particular product. It’s not a structural ETF issue, and I don’t think it’s a market mechanism issue.
The way around that is not to put illiquid securities into an ETF, or at least have some idea of how much investment capacity could that product really take on before you’d have to expand it and broaden it out so that it could hold more assets, but the structure itself has been tested. We went through a financial crisis where there was record, record volume on the New York Stock Exchange and exchanges around the world, and often the most liquid, efficient vehicle that was being traded was the ETF, because of the buying and selling around it.
Anthony: I would agree with that. I think a lot of people want to blame ETFs for all the ills of the market, which means they’ve come to fruition and they’re a meaningful part of the marketplace. But the flash crash, for example. People were blaming the flash crash on ETFs.
ETFs, as Luciano pointed out, they’re just a structure. The problem there is all the fast traders, the high frequency traders stepped away from the market, and there was a collapse until you could come to equilibrium. The structure itself isn’t problematic, but I do agree that the investor should spend the time to understand the liquidity of the underlying. That’s really important, and I am fearful when you get to very narrow slices of the market whether they up as well if there are mass redemptions.
David: Last year we actually did a study on this entitled “Stress testing ETFs.” We looked all the way from the market closures after the tragedy that was 9/11 where ETFs were able to actually, again, provide that price discovery tool as markets began to reopen.
We’ve also seen this with the issues with the tsunami in Japan. Another, of course, tragic event, but ETFs were able, even though markets were shuttered and markets were somewhat delayed getting information, was pricing all of that in. We saw that in the worst of the global financial crisis. In individual events like the flash crash, ETFs are not necessarily the point of blame at all; they’re actually a tool that investors are using, and a lot of their growth has come after these stress points, which is interesting.
Of course, a lot of it leads to, and we touched on this with questions, about what might happen in regards to the fixed income market and the more opaque and illiquid areas there. But again, we’ve seen is dealer inventories have come down. Because of issues with balance sheets and regulatory environments, ETFs have actually grown.
Even though investors do need to expect that they might trade differently than what your experience would be with a simple S&P 500 type ETF, they’re still providing you with that exposure and ability to express an opinion both positively and negatively intraday, and at a cost that is transparent to you. There are a lot of benefits to that, particularly because the ability to build a diversified bond portfolio of individual issues has increased because spreads have widened so much. There was a lot of utility to using the ETF structure, which is the ability to give a lot tighter spreads than what you’d find with any individual issues across the market.
Evan: Dodd, what would you say?
Dodd: I think Anthony hit the nail on the head there. It’s ETFs...Investors haven’t focused enough on the advantages that ETFs offer. Certainly one should focus on the risks as well. But during periods of market distress, like we’ve talked about, ETFs have allowed investors, if they wanted to, to be able to transact at a market consensus price. If you look at the underlying markets, 20 percent of the high yield market on a given month, a normal month, trade five days or fewer. During periods of distress, maybe none of the bonds are trading, but you still can trade the ETF. Now you don’t have to, but you have that ability, which is a beautiful thing. Discounts can happen then, but again, it allows people to have more control over their investments instead of being locked up. During normal market conditions, to be able to get access and buy a broad basket of emerging market stocks at a penny wide is unheard of.
David: You can’t do that, yes.
Dodd: You can’t do that. Even if you hit a button, execute a program trade, you’re going to be done in a multiple thereof. The beautiful thing is, and I think one of the themes we’ve all talked about today is ETFs’ role in democratizing investing — bringing institutional caliber strategies, tools, pricing to the average investor. That’s really one of the biggest advantages that they’ve done.
[Takeaways]
Evan: We’re reaching the top of the hour, so we’d like to get some takeaway points. What should advisors come away with from this session? We’ll start with Luciano.
Luciano: It’s very hard to beat the market. It’s very hard to do it as an active manager. It’s not easy to do it as a smart beta index manager. But it does happen, and there are certain markets where the less efficient the market, the more efficient you are at tapping into some of these return drivers the more successful you’ll be. I would just say that people should keep an open mind. There’s a lot of new data. There’s a lot of new evidence now that people didn’t have 10 years ago to evaluate equity returns around the world. As long as they continue to have an open mind, I think going forward you’ll see more and more adoption of these advanced smart beta approaches, which is really a middle ground between traditional beta and the alpha that the active managers used to seek.
Evan: Tony?
Anthony: With choices come complexity and opportunities. I’d argue the opportunities far out way the complexities. We believe there’s a role for active, market cap, and fundamental strategies. We think it’s really important to understand the role they play in a portfolio in advance of building a portfolio. Then you can think about how it translates to different market segments, and different market environments. If you do your homework in advance, you’re not going to have the surprises along the way.
David: Focus on the full spectrum advantages, as we’ve all touched on. Moving all the way from traditional market cap weighted passive, up to advanced beta, into active management, and then really peel back the onion, do your due diligence in any of those individual exposures, and really think about how they each can meet discrete needs.
Because every client’s different, every opportunity set is different, and with all the access points we can weigh all that historical information, and really think about what the future will look like, and how they all can play a role together, and spend more time fighting about in individual asset classes, and either passive and active. Think about how they can all blend together.
Evan: Dodd, you have the last word.
Dodd: Wonderful. The world’s largest investors for the past 40 years have been blending index and active strategies together. Now all investors can do that because of the opportunity set that’s been broadened. There’s no right or wrong framework here. To me it boils down to conviction.
I think that we haven’t talked enough about some of the great manager discretion type, actively managed, portfolios we’ve seen on the mutual fund side. That hasn’t gone away. The bar has arguably been raised, and raised pretty high for them, because of other solutions, including exchange-traded funds. But one of the most successful portfolios we see out there are those that blend index and active across multiple asset classes.
Evan: I think with all this discussion about smart beta, we’ve had a very smart discussion about ETF’s. I think all of you, Dodd, David, Tony, and Luciano. Thank you so much for being here. Thank you all for joining us.
For Asset TV, this is Evan Cooper.
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