RIAs are being buffeted by significant headwinds, including:
– Competition from newer entrants like robo-advisors
– Cost pressures and fee compression
– Time and resource scarcity – more to do in the same 24 hour day, product proliferation and complexity, and increasing regulatory demands
These cross currents and challenges seem to make it harder than ever to help clients achieve their goals, and for advisors to meet their own business objectives. But adversity creates opportunity, and successful advisors in this new era will recognize that the tools and means to thrive are within their grasp. These include: leveraging the benefits of low-cost investing using ETFs, effectively constructing diversified portfolios in a changing investment environment, and capturing the potential benefits of factor investing.
Like the age-old debate of passive vs. active, viewing the new era as a contest between human and robo-advisors misses the point. The best thing for clients, and the clear path forward for advisors to succeed in this new era, is to embrace the best of both. Why wouldn’t you take advantage of technology to systematically rebalance client accounts and improve tax efficiency in taxable portfolios? How can you pass up the cost advantage of the diversified beta available in ETFs at only a handful of basis points in certain cases? At key life stages, will clients really forego an advisor’s judgment, experience and guidance to settle for an entirely digital experience?
Let’s start with the most straightforward: cost. Investment professionals know that costs are simply negative returns that detract from asset growth and compound over time. So, in acting in our clients’ best interest, we should always be looking for opportunities to lower investment costs. But using ETFs doesn’t mean an exclusively passive approach. Advisors can build the core of clients’ portfolios on low cost, systematic and diversified investment vehicles, and be selective, and perhaps more effective, about active allocations. Certain ETFs can provide your clients with exposure to the broad U.S. stock and bond markets for less than five (5) basis points! On behalf of your clients, how can you not take advantage of the scale these ETF manufacturers have built?
But don’t stop there. A straight-up indexed approach will generate index-like returns and index volatility, including the full brunt of downside participation. Remember the Great Financial Crisis and the markets of 2008? How about the Tech Wreck of 2001? If they were invested in those markets, your clients most assuredly do. Will bonds provide the same equity-drawdown counterweight after 35 years of falling interest rates? Maybe, but maybe not. It behooves a client-focused advisor to explore other potential diversifiers such as liquid alternatives. The ETF product landscape has expanded to include alternative products and strategies, with pricing generally more reasonable than mutual funds and certainly cheaper, more liquid, and more transparent than private hedge funds. But alternative strategies require additional research time, resources, and expertise – do you have it? If not, this is an area where you might consider outsourcing to a specialist, an ETF Strategist who has expertise navigating the space.
What about achieving the returns your clients may expect or need for their goals? Many market participants will acknowledge that both stock and bond valuations are stretched. What this has often meant (though the timing is uncertain), is that go-forward returns from overpriced asset classes are lower than historical norms. That is, the returns like the long-run averages that some investors may be expecting, may simply not be in the cards.
There are two rational responses: mitigate volatility and drawdowns, and seek higher than average returns.
In order to be truly considered a diversified portfolio, we believe it must protect against the possibility that stocks and bonds decline simultaneously. How do you protect your client’s capital in that environment if the portfolio consists of long-only, fully invested stock and bond ETFs? Are you going to retreat to cash (a.k.a. market timing)? The fact is that it’s really hard to do, because among other reasons, the portfolio manager has to get two decisions right in real time: when to get out and when to get back in.
What about generating excess return over the index? Well, again, it’s really hard to sustain over time, after fees and adjusted for risk. (See, for example, Morningstar’s Active Passive Barometer 2015 or Vanguard’s “Keys to Improving the Odds of Active Management Success”, 2015) However, there is some good news; a key driver of returns, including excess returns over benchmarks can be attributed not to security selection skill, but rather to what is known as factor exposure or factor beta. And the ETF landscape has again provided advisors access to reasonably priced factor ETFs, singly or in combination. What has happened over the past 40 years is that the price for beta exposure has been driven toward zero, reducing costs and improving results for clients.
So a new era for advisors and their clients – characterized by complexity, competition, pricing compression and time and resource scarcity – has what we believe is a clear path forward for success:
- Leverage low cost beta, especially via ETFs
- Embrace technology and new methods of client communication and interaction
- Employ factor based and alternative investment strategies, to potentially improve return capture and better diversify portfolios
It’s important in this new era, buffeted by change, not to lose sight of the fact that people still – and will continue to – need experienced, ethical, thoughtful financial professionals rendering effective advice. Healthy competition and innovation should be welcomed by advisors who truly add value; it’ll make you better at what you do and help drive better results for your clients.
The statements herein are based upon the opinions of Palladiem and the data available at the time of publication and are subject to change at any time without notice. This communication does not constitute investment advice and is for informational purposes only, is not intended to meet the objectives or suitability requirements of any specific individual or account, and does not provide a guarantee that the investment objective of any model will be met. An investor should assess his/her own investment needs based on his/her own financial circumstances and investment objectives.