The explosive growth of ETFs over the past decade has fundamentally changed the wealth management industry in several ways.
For asset managers it has led to a distinct bifurcation between low-cost beta-tracking and higher-cost alpha-seeking products as managers find it increasingly difficult to sell actively managed funds that, upon inspection, are closet index strategies. Slightly higher cost factor-based strategies (so-called smart beta) call into question whether much of the historical alpha of many active managers was really just taking easily reproduced factor bets.
As the saying goes, all alpha eventually turns into beta.
For wealth managers serving high-net-worth families, the impact has been slightly different and mostly positive. For advisors whose primary value proposition was “I will find you better managers,” ETFs have been a distinctly mixed blessing, as so-called better managers get harder to find in a beta-driven world.
But there are three specific areas where smart advisors can truly deliver value -- asset allocation, fees and taxes -- and in these areas, the growth in ETFs is distinctly positive:
1. Asset allocation. Ignore the debate over how much of the variability of returns is driven by asset allocation. Everyone agrees that placing the right asset allocation bets over the investor’s investment time horizon is important.
ETFs make it possible to build and manage a globally diversified portfolio in a fairly straightforward manner.
This isn’t to suggest that all ETFs are good ETFs: Some should be avoided because of illiquidity, trading volume, tracking error and so forth. But if an advisor wants to allocate to a specific asset class, the chances are high that there exists an ETF that can make it happen.
A second benefit of ETFs in the asset allocation process is for advisors who prefer to take a more tactical approach to portfolio management.
When making a tactical move within a client portfolio, several things have to go right for the results to outweigh the friction costs of trading fees and taxes. The advisor has to get in at the right time, get out at the right time and pick the right investment vehicle for executing the trade.
Most advisors have suffered through the experience of making the right call and then watching a manager fail to deliver.
ETFs minimize this execution risk. The primary value of being tactical is getting the beta call right, and ETFs are a low-cost and easy way of executing that call.
2. Fees. Most advisors agree that some asset classes are more efficient than others with more information and more traders acting on that information, that delivering outperformance in those asset classes is difficult, and paying active management fees makes outperformance that much harder. Many advisors recognize the value of using ETFs to gain the appropriate beta exposure in efficient asset classes at a low cost.
3. Taxes. ETFs are fundamentally more tax-efficient than mutual funds for a variety of reasons, low turnover and no embedded capital gains risk being foremost among them. In addition, ETFs are a very appropriate tool for tax loss harvesting within client portfolios while maintaining the appropriate beta exposure and removing any wash sale risk.
Most advisors to HNW families would agree that three key drivers of success are intelligent asset allocation that meets the objectives of the investors over an appropriate time horizon, optimizing the bang for the buck of active management fees and managing taxes efficiently. It is also worth emphasizing that these three aspects of portfolio management are the only ones over which an advisor actually has direct control.
ETFs can play a critical role in all three and ultimately help advisors deliver a differentiated client experience.
