%
The dow jones business and Financial weekly
www.barrons.com
noVeMbeR 18, 2013
2013 ETF ROUNDTABLE
Ken Schles for Barron’s
New ETF
Strategies
for Your
Portfolio
Our expert panel offers insights on investing in ETFs now.
From left: Rod Smyth, of RiverFront; Peter Rukeyser, of UBS;
Ronald Stenger, of the Stenger Group; and Morningstar’s Andrew Gogerty
(over p lease)
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SPECIAL REPORT
The ETF business is booming—so much so investors are inundated
with options. Our experts share their tips for evaluating the field.
Picking the Best
by Brendan Conway
Choice is
good, but when it comes to investing, it is
possible to have too much of a good thing.
The field of exchange-traded funds these
days offers plenty of choice to the point
that investors are faced with more than
they need or even want. ETFs are no longer beholden to the realm of stock and
bond indexes; they represent increasingly
thin slices of the market, specific investing strategies, and, increasingly, esoteric
asset classes, such as private equity or
frontier-market stocks. ETFs are testing
the boundaries of what’s possible. Or even
advisable.
With some 1,500 exchange-traded
products holding a record $1.6 trillion
in assets, we thought it a good time to
convene a panel of ETF experts who use
ETFs in a variety of ways, and ask them
how they separate the wheat from the
chaff.
Peter Rukeyser, a nephew of Louis
Rukeyser, the former host of Wall Street
Week, and a managing director at UBS
Private Wealth Management in New York,
manages $2 billion from wealthy families,
foundations, and endowments. Rukeyser
uses ETFs as well as mutual funds and
private partnerships in his somewhat conservative management style. He says of
his 40 or so clients: “They’re stewards of
the capital for the next generation. They
are not looking to hit home runs.”
Ronald Stenger is executive director of
the Stenger Group at Morgan Stanley in
Oak Brook, Ill., where he manages $450
million in no-frills strategies built entirely
with ETFs. Citing Harry Markowitz’s
modern portfolio theory and emphasizing
asset allocation over security selection,
Stenger sticks to plain-vanilla index ETFs
and keeps trading to the bare minimum.
“Too many people want to chase alpha,
they want to make a killing,” Stenger
says. “We don’t believe in that.”
As chief investment strategist at RiverFront Investment Group in Richmond,
Va., Rod Smyth is something of an advisor to other financial advisors. RiverFront
builds so-called ETF managed portfolios.
Financial advisors can put client money in
these managed portfolios, which advisors
use effectively to outsource the management of client money. RiverFront, which
manages $4 billion, is not shy about taking active bets and uses its muscle with
ETF providers to modify their offerings
or create new products.
So who watches the watchmen? Andrew Gogerty. Gogerty runs ETF managed portfolio research at Morningstar,
where he casts light on a fast-growing
but little-understood market. ETF managed portfolios of the sort run at RiverFront increased their assets by 46% in
the 12 months ended in June. Gogerty’s
work underscores the way passively managed ETFs are often used actively. “Don’t
equate ETF investing with being passive,” Gogerty says. “Even if you were to
build a portfolio of ETFs, there are numerous active decisions still being made.”
Smyth: We take a strategic approach with
a tactical overlay, mostly in a separateaccounts format. It’s kind of anti-Markowitz, for those of you schooled in modern
portfolio theory we build global balanced
portfolios that have a dynamic, strategic
approach. We have no experience with the
daily needs of a retail client, but we have
collectively some 20 years of experience
apiece working with retail financial advisors.
Barron’s: We have a wide array of
approaches to ETF investing around this
table. Peter, let’s start with you. How do
you use ETFs?
Of the some 1,500 ETFs and other
exchange-traded products available today,
36% are less than three years old, and
86% have less than $1 billion in assets. Do
you like the newer products?
Rukeyser: We are absolute-return investors rather than relative-return investors.
Telling people they are down “only” 30%
because the index was down 38% doesn’t
work.
Gogerty: You can’t eat relative returns.
Rukeyser: Right, our clients are living off
this money. We start with a strategic asset
allocation as the bulwark of the portfolio,
then put on a tactical overlay to take advantage of shorter-term market trends.
Ron, you take a different approach.
Stenger: We use ETFs exclusively, and
only those that track common, everyday
indexes. We don’t “chase alpha.” We are
not tactical. Trading is kept to a minimum, except for rebalancing, so we reap
the benefits of very low operating-expense ratios. Our goal is to capture significant upside in rising markets with far
less downside risk in declining ones.
Rod, your firm creates portfolios advisors
use for their clients. How does that work?
Andrew, your role is to examine firms like
RiverFront.
Gogerty: We track $80 billion across 650
ETF managed-portfolio strategies. Advisors using this option are outsourcing either all or part of their clients’ portfolios.
These firms are growing very quickly:
ETF assets rose 7% in the first half of
the year, but ETF managed-portfolio assets gained 18%.
Stenger: We use ETFs that track very
basic, recognized indexes for U.S. stocks,
we use ETFs based on S&P indexes
for large, midsize, and small companies,
for growth and value. We use a mix of
BlackRock’s iShares, Vanguard, and State
Street ETFs.
So that’s one vote for the older, simpler
ETFs. Do any of you use fundamental indexes, which use specific criteria,
beyond market value, to select and weight
the stocks in the index?
Stenger: We had several fundamental
weighted funds in the portfolio. But over
time, they just did not outperform. So
when we rebalanced, we took them out.
Many of these funds have not been out
that long. Short track records give me
pause. In addition, the idea of favoring
certain sectors, which many of the funds
do, definitely adds more risk to the portfolio.
Smyth: The question is: Is it worth paying
Which do you use?
Smyth: In emerging markets, the PowerShares FTSE RAFI Emerging Markets
Portfolio [ticker: PXH] gives you a tilt
towards factors like book value and cash
flow and bigger weightings to certain sectors, such as energy. If we happen to like
a sector, we are going to want to buy a
product favoring it rather than the vanilla
ETF. One example is the WisdomTree
Japan SmallCap Dividend fund [DFJ].
Another is the PowerShares FTSE RAFI
Developed Markets Ex-U.S. Portfolio
[PXF], which gives us some extra cyclical
exposure absent from the vanilla index.
Besides cost, what are the other factors
you use to evaluate an ETF?
Smyth: Cost is relatively far down the list,
unless we’re talking about simple vanilla
beta. Even then, we have to compare the
ETF’s holdings. Vanguard’s emergingmarkets ETF is considerably cheaper,
charging 0.18%, than the iShares MSCI
Emerging Markets ETF [EEM], at
0.67%, but the portfolios aren’t the same.
The Vanguard FTSE Emerging Markets
fund [VWO] recently switched its index
from MSCI to FTSE, which views South
Korea as a developed market. So one has
Korea, the other doesn’t, and that’s a big
difference. Korea’s performance this year
has made a difference to the relative performance over and above expense-ratio
differences.
Stenger: We’ve found it is generally better
to keep the number of ETFs in the portfolio at a minimum, no more than 15 to
20. We’re all about providing clarity and
confidence: Too many ETFs in a portfolio
could work against that goal.
Rukeyser: Product innovation may be the
only way a lot of ETF providers can differentiate themselves. Just because something is new doesn’t mean that you need
it.
So how exactly do you pick when it comes
to these specialized ETFs?
Rukeyser: When you see new ETFs with
non-market capitalization indexes, or
ETFs built around some investing fac-
tor say, low volatility, or
equal-weighting be sure
you know the intent behind it. You have to ask:
Is the methodology simple
and transparent? Or is
the data cherry-picked? It
could be that the strategy
just happened to work
over the specified time
frame.
Smyth: Rule No. 1, beware
of back tests. Rule No. 2,
beware of back tests. Rule
No. 3, if you’ve got a back
test that doesn’t look brilliant, you are not trying
hard enough. When Rob
Arnott came out with his
fundamentally weighted
indexes, they were based
on historic work with
which we were comfortable.
ETFs are often launched
when their creators think
there will be high investor
demand which might also
be near the height of the
trend.
Smyth: Yes. We looked
Ron Stenger of the Stenger Group
at a value-oriented ETF
uses ETFs exclusively.
recently. Their own back
test showed systemic outThe mechanics of these complex ETFs’
performance; it was there.
mechanics are especially tricky.
But if you drew a trend line through that
outperformance, you could see that when Smyth: ETFs that use futures contracts
they were launching the ETF, the strat- to try to track daily volatility are another
egy was way above its own trend line. So example. At the time I examined one in
we rejected it out of hand. Even if it does particular, you’d lose about 14% a month
have a 1% to 2% potential for systemic if market volatility were to stay still, beoutperformance, it was currently per- cause the long-dated futures contract was
forming so far above its own trend line higher than the near-term contract. As
that it had a lot of risk. But that’s when the ETF rebalanced every day [selling
they decided to launch the product, when shorter-term contracts before they come
value stocks had been doing exceptionally due and purchasing pricier longer-dated
contracts], you’d lose. You had to believe
well.
you were going to make more than 14%
Leveraged ETFs are another example of
per month to want to own the product. It
funds that require a lot of scrutiny.
was easy to say no.
Rukeyser: Most asset allocators are not
You’re referring to the impossibly named
using levered ETFs.
Smyth: Leveraged ETFs are a tremen- BarclaysiPath S&P 500 VIX Short-Term
Futures ETN [VXX].
dously dangerous vehicle.
Gogerty: Well, they do exactly what they Smyth: Yes. They informed us the average
say they are going to do. The problem investor holding period of that product
is they do it each and every day. What was one day. So it obviously wasn’t for us.
happens when you compound returns on It’s a lovely idea in theory if you see volaa daily basis? If you lose 50% and gain tility really low, hedge yourself by owning
50%, you are at 75% you’re not back to it. But it is very hard to do. We don’t even
100%. Now leverage it two or three times. try anymore.
That’s where people are getting into trouble. If you don’t like leverage philosophi- Given the abundance of choice and the
cally, there’s nothing wrong with that, but increasingly complicated array of new
it’s only “bad” if you use it incorrectly.
products, are ETFs better off in the hands
Ken Schles for Barron’s
50 or 60 basis points [0.6%] extra for a
product that isn’t tracking a vanilla index?
We think the relative performance of
some more than justifies the fees. We go
to the firms that have pioneered what you
might call intellectual, alpha-driven strategies. WisdomTree initially built what
are called fundamental indexes, based on
dividend-paying stocks. PowerShares and
Rob Arnott also brought the concept of
weighting indexes based on price relative
to book value, earnings, and a whole host
of factors.
of advisors than used directly by individual investors?
Gogerty: I don’t think so. The onus is on
the individual to do the research before
building a portfolio. If they decide to pay
someone for advice, they’ve made a decision, too.
Smyth: I would argue ETFs can be dangerous for the individual if they lack the
ability to put together what are often
very specialized pieces of the puzzle.
We’ve gotten away from the notion that
the puzzle is the important thing not
the pieces. In a world of proliferation of
ETFs, RiverFront has only five products.
Three of them are designed to solve income challenges, with different levels of
risk. Two of them are designed primarily
for growth. It’s underneath where all the
complexity is taking place.
Stenger: A puzzle is the right analogy.
What we do as advisors is put together
the plan. The plan is different for each
investor.
Rukeyser: It’s a bit like going to a diner.
You get a broad menu. You can get the
eggs and bacon, the Standard & Poor’s
500, or you can go to the back of the
menu. I think it empowers the individual
investor. At the same time, there is such a
broad group of investments that, sure, it
can be overwhelming.
So the question is, who’s putting together
the plan the individual, the advisor, or
outsourcing by the advisor.
Gogerty: It’s up to the next generation
of investors to decide if they want Ron
and Peter to do it themselves, or if they
want an advisor who goes to Rod at RiverFront, or do they just want a “turnkey”
from an unbiased source? Price will factor
into that. Is advice still worth 1%? Or is
technology going to compress the price?
It’s going to come down to this: What is
the value of putting the puzzle together?
Stenger: Individual investors want transparency. They want to see their portfolio
on a hand-held device every day, too. But
will they get the same return as the fund
they’re in?
Rukeyser: If they are checking it on their
iPhone every day, they probably won’t.
Stenger: The challenge for advisors is to
give people transparency but also give
them someone to call. To give them a plan.
Smyth: Human beings are emotionally
wired to fail as investors. I’ve watched
boards of trustees react as emotionally as
individuals reacted in the 2008-09 period,
making exactly the wrong decision at exactly the wrong time. People need a log
to cling to. I often ask, “What’s the greatest thing about investing in real estate?”
Answer: You don’t know the value every
day. You care about whether the tenants
are paying the rent. You only need to care
about the value twice, which is when you
buy and when you sell.
Rukeyser: Returns can only come from
three places asset allocation, security selection, and market timing. Studies show
that something like 88% of your returns
come from asset allocation. That’s the
single most important decision. Over the
past decade, if you weren’t in emergingmarket stocks, you missed out on the bestperforming asset class. Which emergingmarket manager you chose didn’t matter
nearly as much as the fact of having an
investment there.
How should advisors and their investors
evaluate managed ETF portfolios? Is it
really a good idea for advisors to outsource the core of their asset selection?
Rukeyser: I think Rod is a terrific guy, but
[laughs] . . .
But you want to manage your clients’
money directly.
Rukeyser: Yes. I’ve got deep infrastruc-
ture.
So what’s the appeal of outsourcing?
Gogerty: Financial advisors have two
choices either build it themselves or outsource it. Where outsourcing is becoming
popular, it often highlights the demands
built into the advisor’s day. Depending
on the study, something like 40% to 45%
of an advisor’s day is spent with current
clients, and another 40% to 45% pitching
new clients. That leaves you 10% to 20%
of your day for investment management,
research, trading, asset allocation decisions, back-office issues, legal all of the
things that don’t have to do with the client.
Many advisors have a shockingly limited
amount of time in which to do investment
research.
Smyth: It is all about finding the financial advisor who, as Andy says, wants to
outsource the challenges of daily management. We want advisors who feel their
best time is spent managing clients’ expectations. They don’t want to be worried
about what is happening, say, in Japan or
as a result of the government shutdown,
or how to tactically navigate your way
through either.
It’s true that asset allocation is ultimately
more important than security selection,
but security selection in the ETF world is
increasingly tricky. ETFs are being created
for very specific purposes, often at the
request of firms like RiverFront.
Smyth: We work with providers to create more-complex ETFs for very specific
needs. We recently worked with WisdomTree Investments [WETF] to reformat
the WisdomTree Japan Hedged Equity
fund [DXJ], a yen-hedged Japan fund. We
were very excited about what Japanese
Prime Minister Shinzo Abe was doing,
but we didn’t like our investment choices.
Abe encouraged aggressive quantitative easing from the Bank of Japan and
the devaluation of the yen, among other
things.
Smyth: Yes. We wanted to get exposure to
the Japanese market, but not the yen. So
we asked WisdomTree to retool an existing ETF to favor exporters. This group,
we reasoned, would be the primary beneficiaries of yen weakness. And bingo,
we had DXJ. We were able to commit
a couple hundred million dollars to this
ETF, which today has nearly $11 billion
in assets.
You also were behind a bank-loan ETF, an
area of the market that has seen a tremendous amount of inflows lately.
Smyth: We were the seed investors for
the first bank-loan ETF, PowerShares
Senior Loan Portfolio [BKLN]. That one
meets a specific need for reasonable current yield and zero interest-rate risk, but
there’s also credit risk to manage.
Aren’t you concerned about the underlying market? The bank-loan market is
small and not very liquid, but the recent
demand is hot.
Smyth: Yes, that’s a concern. A sudden
mass exit from the ETF would be a problem, and we’ve capped our investment in
it for that reason.
Are there cases in which ETFs are just not
the best option?
Rukeyser: We are looking for the best
way to implement a strategy effectively.
That means we use ETFs, but we also
use separately managed accounts, mutual
funds, and partnerships, meaning hedge
funds or private equity. We examine fees
and other considerations when looking at
actively managed portfolios.
Smyth: There’s a place for active management. In fixed income, a given type
of bond can become a very large portion
of the index even though it is very illiquid when the initial investors just tuck it
away and never sell it. Some index components may be really hard to get on a
daily basis, which is a great opportunity
for arbitrageurs. But it’s also the reason
we have seen systemic underperformance
by some of the high-yield ETFs versus
the high-yield index. We’ve created our
own strategic fixed-income ETF, launched
in October, RiverFront Strategic Income
Portfolio [RIGS]. We can take down bonds
when the market is able to serve them up
to us. We are not forced buyers when everybody is trying to crowd in.
Rukeyser: We are very underweight fixed
income right now. We have no exposure
to traditional sovereign debt. We are
using a combination of the iShares highyield ETF, iShares iBoxx $ High Yield
Corporate Bond fund [HYG], and some
specialty mutual funds to get our exposure to things like J.P. Morgan Strategic Income Opportunities fund [JSOSX].
Bill Eigen, the manager of that fund, is
the sort of person who waits for the fat
pitches. He’s perfectly comfortable sitting
50% in cash until he sees a good opportunity. His major exposure right now is high
yield. We also use the DoubleLine Total
Return Bond fund [DBLTX] and Third
Avenue Focus Credit fund [TFCIX]. We
are concerned about rising interest rates,
and don’t want a lot of duration risk right
now. So we like specialty managers who
can be creative in how they make money
while also watching duration.
So most of your fixed-income allocation is
in actively managed mutual funds, rather
than ETFs.
Rukeyser: We think active managers can
do a better job. With the exception of
high-yield, bond ETFs tend not to perform as well. We are in an environment
where security selection and duration selection are really important. Opportunistic
funds give a manager flexibility. There
are cheaper alternatives in the ETFs, but
they are not better. The 10-year Treasury
was around 1.6% back in May. It went as
high as 3%. Now we’re back below that
number. That’s a big move in interest
rates. Many investors don’t know how to
invest for rising rates.
Let’s talk about “alternative investments.”
Both ETF and mutual-fund providers lately
are eager for you to view these as bond
substitutes.
Rukeyser: We are very active in alternatives. That goes back to the idea of wealth
preservation. You need some assets that
are going to zig when other things zag.
We’ve seen pure partnership-based investments, meaning hedge funds or private equity, lower their minimum investments. Now there are “liquid alternative
strategies.” These are built as traditional
mutual funds, which have daily redemptions during the financial crisis, many investors in partnerships got locked up or
“gated.” The idea in liquid alternatives is
to offer long/short and other strategies
without locking anybody in.
Are there ETFs that offer hedge-fund-like
strategies?
Rukeyser: There are, such as IndexIQ’s.
We are big believers. We have a significant
allocation to the liquid alternative space,
especially to real estate and REITs, plus
a small allocation to commodities. We have
a small allocation to IndexIQ’s IQ Hedge
Multi-Strategy Tracker ETF [QAI]. It is
basically a multistrategy hedge-fund replication type of investment that has been
fairly competitive with hedge funds. It
doesn’t have a ton of liquidity and it is not
that big a fund, so I have some concerns
around that.
The Stenger Group
at Morgan Stanley
What would you like to see in terms of
new products or changes in the ETF business?
Smyth: The industry has not solved how
to get exposure to commodities without
tax and performance headaches. When
commodities were hot, people were willing to put up with K-1s [tax forms that
partnerships distribute instead of a 1099]
just to get exposure. Commodities are
something we have to try to figure out, as
well as mechanisms for owning real estate
that aren’t in REITs or levered REITs.
Gogerty: An interesting area right now is
the trend of ETF providers building their
own managed portfolios, which means
ETFs of ETFs. BlackRock runs iShares
Morningstar Multi-Asset Income [IYLD].
State Street last year launched three of
its own ETFs. They are competing directly with some of their own customers firms
offering multiasset income strategies.
So the lines can get murky.
Smyth: Yes. Some of the providers have
come to us and said, “You have a unique
process. We would like to build a product
that simply bolts on your process.” We
would be very selective about whom we’d
work with. But we are not unwilling.
Is there such a thing as too close a relationship between portfolio managers and
ETF makers?
Smyth: As a client, you need to know the
manager is acting in your best interest.
For us, that means being product agnostic, provider agnostic and “outcome everything.”
Thank you, gentlemen. n
Please consider the investment objectives, risks, charges and expenses of the fund(s) carefully before investing. The prospectus contains this and other information about the fund(s). To obtain a prospectus, contact your Financial Advisor or Private Wealth Advisor. Please read the prospectus carefully before investing. An investment in an exchange‐traded fund involves risks similar to those of investing in a broadly based portfolio of equity securities traded on an exchange in the relevant securities market, such as market fluctuations caused by such factors as economic and political developments, changes in interest rates and perceived trends in stock and bond prices. (For specifics and a greater explanation of possible risks with ETFs, please consult a copy of the prospectus.) Investing in sectors may be more volatile than diversifying across many industries. The investment return and principal value of ETF investments will fluctuate, so an investor's ETF shares (creation units), if or when sold, may be worth more or less than the original cost. The indexes are unmanaged. An investor cannot invest directly in an index. ETFs are redeemable only in Creation Unit size through an Authorized Participant and are not individually redeemable from a Fund. Ron Stenger is a Financial Advisor with the Global Wealth Management Division of Morgan Stanley in Oak Brook, IL. The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Investing involves risks and there is always the potential of losing money when you invest. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC, or its affiliates. The Stenger Group
at Morgan Stanley
2211 York Road Suite 100
Oak Brook, IL 60523
630-573-9676
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