Active managers have found a way to make exchange-traded funds—in the form of so-called ETF strategist funds—their friends.
ETF strategists are active managers who design their own asset allocation models but have to make their market bets with at least 50 percent of holdings in ETFs, according to Morningstar's widely accepted definition. They are the only investment products growing faster than ETFs themselves. As of year-end, about $100 billion had poured into this sector.
But are these ETF funds of funds a good development for retail investors?
An increasing number of affluent investors are gravitating to these portfolios as a method of protecting against downside risk while banking on the ETF strategist's ability to find upside in the market on a more selective basis. There are now enough ETFs to gain exposure to everything from Thai bonds to copper.
Institutional investors, including foundations and pension funds, are taking a serious look at them, too. "We hear from our strategist clients that they have been getting mandates from pensions," said Katharine Earhart, director of BlackRock's iShares Connect program, which works with the ETF strategists.
Once something becomes popular among affluent investors and pensions, a run for the run-of-the-mill retail investor is usually next. But with any trendy investment, there are risks—and ETF strategist funds are no exception. In fact, there are some classic investing red flags that should be applied to ETF strategist funds before a financial advisor tries to sell you on one.
1. Defining these strategies is no simple thing.
ETF strategist funds are like alternative investments and hedge funds: blanket categories that don't tell you much on the surface. An alternative investment or hedge fund isn't anything until you know its precise approach to investing, which is also the case for the ballooning number of ETF strategist funds, now totaling at least 648 strategies, according to a recent Morningstar tally.
"There are very different approaches in the space," said Patrick Newcomb, senior analyst at Cerulli Associates. "You might have two managers defined with a similar-sounding 'tactical core' name, but they could be different in terms of investment process."
"Some are doing very mundane asset allocations; others are expecting to beat the lights," said Ben Johnson, the Morningstar analyst who oversees managed ETF portfolios research. "A lot of these strategies look a lot like global allocation or hedge funds, not at all like ETFs."
That means an investor really needs to understand the individual manager's approach under the hood and expect that it will be very different from a standard mutual fund or index ETF. From the ETF strategists' point of view, that's exactly why you want to be investing with them.
2. Style drift as a strategy can be dangerous.
A standard mutual fund has to fit into a "style box" that, at least theoretically, limits a portfolio manager's choices and risk profile—small-cap value stocks or large-cap growth stocks, for example.
The negative side of style boxes is that it paints managers into a corner. Many active mutual fund managers have become nothing more than "closet indexers" managing as close to the S&P 500 as they can so they don't trail it.
Most ETF strategists don't benchmark themselves against the S&P 500. In fact, again like alternative investments, the idea of offering downside protection means that, by design, there are years when these portfolios won't outperform the S&P 500.
So you can't hold these ETF strategy funds to the same benchmark as a standard mutual fund or active manager, but in conjunction with a financial advisor, you do need to decide on a standard that applies and that you can hold them to over time. And speaking of time ...
3. The test of time is one these funds still need to pass.
You've heard the one about past performance, right? That it is no guarantee of future success.
These ETF strategists have become darlings of advisors and the affluent because they held up so well in the downturn. "If the next 2008 comes around, advisors are saying, 'I want to be with a manager that has their eyes on the horizon and has the ability to move from stocks to bonds," Johnson said.
Of course, that sounds good in theory, but the strategists haven't been around for another down market yet in order to test that theory. And the majority of ETF strategist assets are with a handful of top firms, even if there are now hundreds of strategies in the market. A rough estimate would place 75 percent of assets in the ETF strategist space in the hands of no more than four managers.
"It's a little too early to tell if it's good for a majority of retail clients," Newcomb said. "It's a very interesting approach, but if one firm has really bad performance, that will hurt the whole industry."
4. ETFs are typically low-fee, but these funds ... not exactly.
"In many ways, this category has been a beneficiary of the halo effect of ETFs in general," Johnson said.
Using ETFs does allow these managers to obtain some of the classic ETF benefits—transparency and tax efficiency among them. But the transparency of the ETFs isn't as important as a clearly defined management strategy in the cases of these "go anywhere" funds.
The biggest ETF benefit of all—low cost—is also an important issue with these portfolios.
Individual index ETF fees can be as low as 10 basis points (0.10 percent) or even a little less. These portfolios' fees are akin to actively managed mutual funds—0.50 percent to 0.75 percent on top of what the underlying ETFs charge.
Advisors can also tack on a wrap fee—one reason these portfolios have become popular at wirehouses, allowing them to find an economic model including ETFs that can still share revenue with individual reps and asset managers.
It's become a great way for ETF providers to expand their reach among the affluent, too. "It's a great distribution tool for them," said Tom Lydon, editor of ETFtrends.com.
"They're climbing all over each other to get in front of them because they're their biggest and fastest-growing clients," Johnson said. He added: "You need to be careful of layering fees on top of fees."
That said, it can still look pretty good compared to hedge fund managers, who typically charge 2 percent of assets and 20 percent of profits—if these ETF strategists can really do the job of tactical alternative investments.
5. Staying ahead of the Fed is a tough task.
Since these portfolios are often tactical by definition, that means they move between bonds, stocks and cash to minimize risk while also capturing market upside. That also means they have to deal with a bond market that is changing in ways it hasn't during the previous 30-year fixed-income bull run. It's hard enough to be an equity manager, harder still to wear the hats of both equity and bond strategist.
"Watch for how well they're going to manage this rising interest-rate environment," Lydon said. "How good are their fixed-income models?"