The advent of the Exchange-Traded Fund (ETF) has permeated all levels of the investment management landscape as a (relatively) new and efficient tool for the implementation of asset allocation strategies.
These tools have allowed investors and traders to access various markets in one fund, in one trade, intraday. These features, combined with general tax efficiency (compared to mutual funds), make ETFs one of the ultimate tools for active, as well as passive, asset allocation strategies.
A subset of asset managers that have accepted these tools has evolved into a group called ETF Portfolio Managers (EPM) or ETF Strategists. It is generally understood that in order to be considered an ETF strategist, 50% of your investment allocation must be in ETFs. This investment categorization is defined and tracked by a number of consultants, platforms, and other data-collecting firm catering to all facets of the investment management industry.
The formation of this space began in earnest in 2008 as the bull market came to a halt. Strategies outside of the standard benchmarked asset allocation (ie: 60/40 stock/bond) demonstrated risk management capabilities. They either avoided much of the market drawdowns through tactical asset allocation or adjusted enough to change the risk/return profile versus standard passive allocations. A number of the prominent, early pioneers of ETF strategists displayed these characteristics during the period and gained notoriety by offering value added solutions to investors.
While the philosophy of allocating part of a portfolio to active strategies was not new, the timing was right for the space to gain recognition. The accelerating use of ETFs in the mainstream combined with investor concern prompted by the Great Recession, created an opportunity for ETF managers to implement asset allocation strategies. As a result, advisors and platforms alike began to view the ETF strategist space as offering legitimate and promising solutions.
While still a young segment only a few years ago (maybe still), the asset growth rate in the ETF managed portfolio space was substantially higher than traditional managers, pushing total AUM up near $100B by the end of 2013 (as noted in the Q4 2013 Morningstar ETF Managed Portfolio Landscape Report). Prior to recent issues, ETF strategists were still growing significantly and far from exhibiting traits of a mature market segment.
In 2014 and early 2015, the ETF strategist space encountered substantial headwinds which began to attract attention. For what was recently the fastest growing space in the industry, this resulted in an unfavorable PR perception. The above reference is significant within the scope of this paper as the issues encountered were idiosyncratic in nature. Nonetheless, concern and negative attention created a narrative that threatened to muddle the overall efficacy of the value being offered by ETF strategists as a whole.
Before we continue, let’s address a common misconception: neither the ETF nor the ETF strategist is or has created a new asset class.
An ETF is a vehicle that creates access to specific asset classes (equity, fixed income, real estate, commodities, etc). An ETF strategist, just like any other asset manager, seeks access to one or more of these asset classes to implement a strategy but utilizes ETFs instead of individual stocks or bonds. They offer an extension, or an option, of existing strategy applications that have been employed in the asset management space for years. The vehicle used to implement the strategy, the ETF, is just different.
Managers across the investment landscape employ similar strategies such as tactical allocation, strategic asset allocation, or a hybrid approach.
With the space under scrutiny, our inclination was to examine investment profiles and outcomes to discern how ETF manager solutions were different from the broader, comparable universe of managers. Although we can’t blindly dismiss the skeptics, there has been a lack of evidence (actual data) comparing the two options (ETF managed portfolios and traditional mutual funds) and, therefore, chose to investigate. After all, we are biased. What if the skeptics are wrong?
The primary evaluation method for this test was to identify a comparable sample group to one from the ETF strategist sub-categories. Fortunately, we didn’t have to look far. Morningstar maintains the SACIT Database which contains performance of many of the ETF strategists broken into three categories: tactical, strategic and hybrid. The reported performance is based on separately managed account composite performance for each listed strategy.
Morningstar also tracks thousands of public mutual funds, categorized by strategy. One category happens to be tactical allocation. A handful of managers occupy both lists but, by and large, the Morningstar mutual fund category represents a broad and diverse group of tactical strategies utilizing various tools (stocks, bonds, ETFs, funds, futures) for implementation.
Criteria for inclusion:
After identifying the sample group, the next step was to screen the constituents of each group. The strategies were screened on the below criteria:
Morningstar Mutual Fund Category: 3-year track record, $25M in assets
Morningstar ETF Strategist Group: 3-year track record, $25M in assets, GIPS compliant
The thought process was to allow strategies with enough history to contribute meaningfully to the study as well as set a minimal yet critical asset level. It was important that the performance was verifiable. Mutual funds are audited and publicly recorded, so that was sufficient. For the ETF strategist group, each strategy had to be listed as GIPS (Global Investment Performance Standard) compliant. These criteria set a level playing field for comparison.