Are they strange bedfellows-or pillow talk?
Separately managed accounts (SMAs) have taken on a
broader definition over the past few years. They used to be known
primarily as an account run by a portfolio manager in which the
securities are owned directly by the client instead of being pooled
into shareholder units.
Now they can mean anything, from an entire basket of different separate
account managers (MDA, MSA, MSP, etc.) to an account also holding
mutual funds, cash, and exchange-traded funds, or ETFs.
Of these companion investment vehicles, ETFs are
proving to be one of the most popular. Take, for example, the recent
growth numbers of the Select Sector SPDRs ("Spiders"), which slice and
dice the S&P 500. According to State Street Bank's Greg Ehret,
assets under management in Select Sector SPDRs had increased
approximately 26% to almost $12 billion as of June 30.
Why are ETFs becoming so large a part of the
investment landscape and how does their use complement an SMA
portfolio? Let's explore possible answers to those questions, as well
as take a brief glimpse into the future of ETFs and what that future
may mean for advisors who use SMAs for their clients.
The Ingredients Of ETF Popularity
The recent regulatory difficulties faced by the
mutual fund industry have fed the growth of SMAs. The latest Money
Management Institute figures place that growth at 12.5% in the first
quarter of 2005 compared with Q1 2004. Total industry accounts
increased by 31% in 2004. But often, advisors find it difficult to
implement a robust allocation for smaller investors. Because of their
breadth of market exposure and ease of use, ETFs have become the
complementary vehicle of choice.
Their advantages are diverse-they have lower costs
because of their management structure; they are more tax efficient
because of the lower turnover characteristic of passive management and
the mandate of the ETF structure to avoid throwing off capital gains;
and there are now ETFs to cover practically any industry sector or
asset class, including emerging markets and real estate. In short,
since ETFs can be found that track practically anything, they can be
the perfect complement to an SMA strategy.
ETFs have multiple characteristics that lend
themselves to living compatibly with SMAs. According to Valerie
Corradini, senior strategist at Barclay's Global Investors in San
Francisco, ETFs' popularity can be attributed to something different.
"When you start talking to consultants who are using SMAs and they
learn the breadth of ETFs, their eyes light up because they can
implement strategies in ways that didn't exist five years ago. This
isn't just a product. This is a whole new opportunity set for index
investments, alongside the active managers they're hiring," explains
Corradini. "For example, five years ago when SMA minimums were still
around $100,000, it was difficult for an investor with $250,000 to get
proper diversification using only SMA managers. With the broader access
to almost any asset class or industry sector using ETFs, it's much
easier to round out allocations for such clients."
Says Ron Pruitt, chief investment officer for
Placemark Investments in Wellesley, Mass., "When you look at the asset
size a client has to invest, you can't really get a 7.5% allocation to
small-cap growth or a 10% allocation to international with a $250,000
client. Even though we've been able to get smaller minimums from SMA
managers through Unified Managed Accounts (UMA) accounts, you don't
want a $250,000 portfolio with 500 securities in it."
Another problem with small- and mid-cap exposures is
the limited capacity of SMA portfolios in these asset classes. "SMA
allocations for small cap are always difficult to fill because the
managers get to capacity so quickly," continues Pruitt. "Small-cap
products generally have a billion to billion-and-a-half capacity-the
wirehouse distribution alone can eat up half of that in no time. ETFs
offer exposure to such asset classes without capacity concerns,
allowing smaller investors to have a more robust allocation than they
might otherwise."
Corradini broadens the allocation "rounding out"
feature to include exposure to the Morgan Stanley EAFE index or the
Russell 2000 growth index, exposure to each of which can be obtained
through a single security. A second asset allocation problem solvable
by using ETFs occurs when advisors terminate a manager, or a firm
decides to restrict a manager on the approved list to new assets. By
using ETFs, "they're able to maintain the integrity of the asset
allocation and be fully invested according to their master plan without
being pressed to find a new manager to fill the investment in that
category," says Corradini. Advisors can park the funds from the
restricted manager's account in an ETF representing the same asset
class or strategy, buying time to research possible replacements while
avoiding imbalance in the portfolio's exposure.
All-inclusive platform structures for both wirehouse
and independent advisors have also strengthened ETF popularity. Before
the user-friendly UMA-type structure, advisors would have to place SMAs
in a fee-based account and place ETF exposure to asset classes like
small-cap and international equity in a separate brokerage account.
"So, it was difficult for them to do holistic
planning because the client would get two different statements and the
advisor would have to reconcile them by hand. The brokerage firm
statement would just list the position and its value on the last day of
the month-it didn't calculate performance like an SMA statement. But as
ETFs have proven they're here to stay, platforms have adapted as well,"
Corradini adds.
Strategies
As ETFs have grown in popularity, so have the
strategies advisors use in deploying them alongside SMAs for the
benefit of clients. The specific strategies used to round out asset
allocations using ETFs vary among advisors, but we'll discuss several
of the most popular.
Most portfolio strategies stem from the asset
allocation component and are driven by various factors. It is within
this context that ETFs show their greatest advantages. Asset allocation
strategies generally are based on clients' risk tolerance and
investment objectives.
Within those generalities lie customized options.
For example Drew Washburn, CEO of Washburn and Fisher Investment
Consulting Inc. in Parker, Colo., begins with an optimization process
designed to follow market trends. "We use ETFs for allocations where we
believe an active manager really can't add a lot of alpha right now.
Currently, that means using ETFs to set up a core portfolio exposure to
large-cap growth and value, then selecting satellite active managers to
fill out the allocation," he explains.
Washburn adds that the strategy can change according
to market cycles, but the strategies employed are governed by a
combination of the optimization model and what they see happening in
the market. Another part of Washburn's strategy is to use ETFs to add
negative correlation component to manage risk. "We've found that some
of the indices [to which we gain exposure through ETFs] have a pretty
substantial negative correlation to our satellite active managers,
which benefits the whole portfolio," he explains.
The increasingly popular core and satellite strategy
can also work the other way around. A client with smaller assets can
choose an SMA to fulfill the core allocation and use ETFs to fill out
the allocation with exposure to small cap, mid cap, EAFE, emerging
markets, or other asset class exposure.
The second most strategic use for ETFs involves tax
management. Pruitt offers this example: "We usually use an overlay
approach for tax-efficiency, but perhaps a client only wants to harvest
losses. In that case, you're left with a choice. You either sell your
losses and wait 30 days in cash so you're losing your capital market
exposure, or you can invest into other securities in the model or
alternates the manager may possibly provide, or you can substitute an
ETF for the exposure and buy back into the security after the 30-day
period."
A similar challenge occurs with a security
restriction. "At some point, if I overweight all the other stocks in my
portfolio because of the restriction, that restriction is going to have
to be unwound. With an incremental ten to 15 trades incurred with every
account that has restrictions, a sponsor is faced with the challenge of
deciding how many restrictions can he allow if it involves all these
little trades."
If the restriction happens to be a small-cap or
mid-cap stock, the costs to the client are also higher. Spreads in
those securities tend to be wider, potentially adding a number of
embedded costs to the client with the execution of so many small
trades. "ETFs tend to have very narrow spreads compared to small-cap,
mid-cap or international stocks, so I can trade into those and avoid
the drag on the performance of the account associated with wide spread
securities," explains Pruitt.
ETFs can also be used as hedging instruments. They
can be optioned, margined and shorted. According to ETF pioneer and
developer Gary L. Gastineau, a managing member at Summit, N.J.-based
ETF Consultants LLC, the short interest in ETFs tells the real story
behind their popularity. "The interesting thing is the short interest
in the typical ETF is about 20% of the shares outstanding," says
Gastineau. "As of year-end 2004, total ETF assets were reported at $226
billion. If you add the short interest, it's 20% higher. So in effect,
there are a lot more long positions in ETFs than have actually been
issued, which means they're even more popular than they get credit
for."
As Washburn mentions above, some ETFs provide a
natural hedge through their low correlation to other securities in the
portfolio. Tactical asset allocators, however, may find ETFs an easier
venue through which to create portable alpha, according to Pruitt.
"ETFs create a marketable vehicle for an index that can be shorted via
an option. It's certainly more available (than index options)."
Other Advantages
ETFs can also add stability to an overall portfolio,
depending on the desirability of combining active and passive
management based on market conditions. During the late '90s, indexing
became quite popular as active managers found it increasingly difficult
to beat the market. But in the current environment, a 'stock picker's'
environment, according to Washburn, the combination of the two may be
more attractive.
According to Rick Brooks, CFP, CFA and portfolio
manager at Blankinship & Foster Family Wealth Advisors in Del Mar,
Calif., larger investors ($10 million to $15 million) can use ETFs to
provide an easy way to overweight a particular style or sector quickly.
"That's not something an SMA manager is really going to be able to do,"
explains Brooks. The ability to move funds around within an SMA account
can be accomplished quickly by using ETFs since they are traded on the
exchanges like stocks but add multiple exposure through a single
security.
What's the downside?
With all of their advantages, ETFs do have
disadvantages of which advisors must be aware. "ETFs are a closed-end
product and they can trade at a discount to the underlying securities,"
offers Pruitt, "and for some of the benchmarks that are challenging to
use such as fixed income, the ETFs don't necessarily track them well."
And, although small, there are management fees on
ETFs, creating a 'below-the-line' expense that must be disclosed to the
client, according to Pruitt. Washburn alerts advisors to the fact that,
since ETFs trade like stocks, their valuations must also be considered,
just as with stocks. "The market maker's making money, so if you're
paying too much of a premium for the ETF, it may eat into the
value-added on the performance side, even though ETF costs in general
may be very low."
Future
The future for ETFs looks bright at this point.
Regardless of market cycles and whether active or passive management
should be used, the popularity of ETFs likely will increase simply from
an increasing breadth of product/exposure availability.
For example, Pruitt predicts that ETFs will be
created that offer exposure to specific fixed-income durations,
allowing investors more customization in asset allocation. Gastineau
cites the work already being done to create commodities and managed
futures ETFs, which will offer clients easier access to commodities and
futures products, and, again, allow investors more robust allocations
and enabling better risk management.
The increasing versatility and breadth of ETF
offerings promises to sustain them as a valuable complement to the SMA
consulting process. The ability to use ETFs to increase the customized
allocations and tax management fostered by the SMA process will only
serve clients better going forward.
Financial writer and veteran wealth manager Lisa Gray assisted with the research and interviews for this article.