As early adopters of ETFs, Lattice Strategies found itself looking for a fund that could match its approach of placing risk evaluation as the key metric for investing.

When it didn't find one that left them satisfied, it decided to launch its own strategies, says the San Francisco-based firm's founder, Theodore Lucas. "We've traditionally used capitalization-weighted ETFs to cover different equity geographies or different asset areas," he says. "And we're really obsessed with how we allocate risk."

Earlier in February, the separately-managed account provider launched its first three ETFs, and followed with a global small-cap fund offering in March.

Lucas and Darek Wojnar, head of single-asset strategies at Lattice and president of the Lattice Strategies Trust, sat down with Money Management Executive to discuss the firm's investment approach and newest offerings.

Does being situated in San Francisco, as opposed to being on Wall Street, have an impact on the culture of your firm and its investment approach?

Lucas: Having worked many years in New York, there's an advantage of being away. There's so much herding and common thought, and the density of investment firms and financial firms where the temptation to groupthink is in my opinion high. I know I did that when I was here. Being in a place where creativity, innovation and thinking a bit differently, all the things in Silicon Valley's cultural distinctions, that can be very helpful to an asset management firm.

To what we do, we approach investing a bit differently than other firms. We always start by thinking about risk. You think about risk, how to allocate it, and do that in a disciplined, thoughtful way, that's what drives return. From my experience in the larger firms, normally the preoccupation is with short-term returns, and risk is a bolt-on. So you'd go for the returns, and then whether it's marketing optics or it's taking place, risk is secondary. So the thinking at Lattice is you start with the risk; that is the primary thing.

When we started managing money for external clients in 2007, we focused on multi-asset portfolios - very diversified, all-asset strategies. However we created those in a way where the liquidity transparency structure simplicity was something we were aiming for, and we became very significant users of ETFs. When you construct a portfolio, you think about the array of different risk building blocks, and how do you integrate them in a manner where risk-adjusted returns and long-term growth can be achieved successfully.

The new ETFs - the motivation behind that was we've traditionally used capitalization-weighted ETFs to cover different equity geographies or different asset areas. And we're really obsessed with how we allocate risk. Our research led us to a view that capitalization-weighted approaches are very valid, cost effective and tax efficient, and we'd certainly choose those over active any day of the week. But from a risk perspective there really are inefficiencies that could be improved on. For our own multi-asset portfolios, the idea was to create building blocks that had that same level of risk discipline.

The ETF approach then is passive but with an active element?

Lucas: That's an interesting distinction. It's passive, in the sense that we have rules-based strategy and indices, so they're systematic and repeatable. However, the index that we've created for each of the strategies is very active with respect to deviating from traditional cap-weighted exposures. We're arranging the risk configurations in a very substantial way. We're probably more active than most traditional strategies delivered in mutual funds, where the manager is trying to add value through stock selection, but will typically have very similar country exposures, currency exposures, sector exposures, to that of the benchmark so that they don't create too much tracking error.

Wojnar: The active nature of the strategy index is still systematic. It's rules-based, and the active delivered reallocation of risk is built into the index methodology, in terms of the weighting. It's not active in the sense that a manager makes a decision everyday about where to allocate capital. It's expressed in a way that is clear to investors upfront, re-weighting of the indexes is done semi-annually, and if the rules were to be enhanced, they would require an index committee decision, and they would be published again.

The vehicle is entirely passive, the index is systematic, and it expresses the view - if you think about natural deviations from the market cap universe, any deviation from those allocations is an expression of active view. In our case, every decision that deviates from the market capitalization is driven by our distinct need to address risks, and reallocate risks more efficiently.

How does Lattice's approach to risk differ from the other providers who say their products are also driven by that consideration?

Lucas: We frequently get compared to smart beta, so things like fundamental weighting, dividend weighting, low volatility - really, the distinction is that all those strategies seek to express certain risk factors, with a view they can enhance returns and reduce risk over time. What we have found looking at those strategies is that they are very blunt. Take low volatility: if you target portfolio construction and stock selection around low volatility, you end up a lot of high sector concentrations. That is a risk that is an outcome of the strategy, not an intended design feature. So our approach is, let's think about risk more comprehensively. Our strategies tend to extract the low volatility premium, but we also think about valuation, we think about concentration at multiple levels in the portfolio. We think about the quality of the companies and we think about momentum. The whole construction is more intentional about risk at multiple levels, so that we're not dealing with a bunch of buy products that are spurious.

In designing our strategies we start by asking, 'What are the risks that investors are accepting by investing in emerging markets?', for example. And then the design of the systematic strategy tries to go at each of those risks and then balance the tradeoffs between them, as opposed to going at one characteristic.

Having launched your first ETFs earlier this year, can you talk about the challenges apparent to your firm as you enter a market that by all accounts is very competitive?

Wojnar: I do know the competition and I spent the last 15 years helping develop and grow the market, both in Europe initially with UBS, and in the U.S. with UBS in 2002 and those ETFs are now with the SPDR brand. Then I had the privilege of joining iShares and head the team on the product side. So I certainly know the space.

One thing that was very insightful for me was that Lattice was not a firm trying to distinguish itself from the competition by trying to come up with something that is different. It was a firm that had the view that was distinct but not unique - there are other firms thinking about risk. But Lattice was very distinct about risk at the multi-asset portfolio level, and wanted to identify additional risk challenges that it could address for its own clients, but couldn't find to satisfy that. So it was effectively helping to build a product line to satisfy needs that were unmet for a client. And that's a unique perspective.

Clearly, as a new sponsor though we're an existing firm with history and experience, we still have a challenge. But I think that we have a distinct offering that does things that were very deliberately thought out for a number of years, ahead of us coming to market. That doesn't make it easier to distribute to a broader group of advisors and institutions, but in many ways we think there will be many that will find it as appealing as we did.

What strategies then will you rely on to break into the market?

Wojnar: Recognizing that deliberate allocation of risk is the single-most important long-term contributor to capital growth, and not accepting risk as a by-product or side is important to us, and we think many investors perhaps need to be more educated on that area, but many embrace it as much as we do. Any product that you find from Lattice, everyone starts from the same viewpoint: deliberate allocation of risk is going to drive the characteristics of the product.

How will the firm market the ETFs so that the offerings can stand out in the market noise?

Wojnar: For one thing, they're not tactical products, even though some of them maybe very timely. Broadly we think about our portfolios as very long-term portfolios. They can be core to any portfolio, but at the same time they can very well complement investors and advisors' allocation to market cap because they live well next to each other. They can also live very well next to a high conviction active manager.

Lucas: As we think about how we're even approaching clients, the natural audience will be advisors and institutions who are sensitive and deliberate in thinking about their portfolios from the perspective of how do you allocate across asset classes and within asset classes. They're doing a good job thinking about how much should be in equities, how much should be in developed versus emerging markets, large, small, however you want to cut it up. What we're trying to do is take the idea of deliberate risk allocation deeper into the portfolio. So we see ourselves as a tool company to asset allocators.

So your preference is for an institutional investor to take a position in one of the ETFs as opposed to scaling up a base of retail investors?

Lucas: We're really building our marketing and distribution effort now. We've got some great people coming on board, such as the head of Guggenheim's ETF business and was the senior sales leader at iShares prior to that, and she is building that effort for us. We've gotten good reception from institutions so we've built a number of good relationships with the large endowments, particularly for emerging markets, because a lot of them are prioritizing getting more capital invested there, but they can't do it fast enough. They're trying to get on the ground people who have Southeast Asian exposure, and a lot of it is private equity oriented. But in the meantime, there's kind of a holding tank for their emerging market allocation. So there's been a lot of receptivity to having a much more balanced approach to taking risk in emerging markets.

At the same time, we want a wider set of investors to benefit from this. So we're working with advisors who can improve outcomes for clients. Our vision is to deliver things that will help people do better things for their clients. 

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