Adam Scott has long been a student of investment bubbles, a fascination that began during his studies growing up in England and one that continues to shape his views on the markets and client portfolios as a certified financial planner with Westside Investment Management in Santa Monica, Calif. He’s also keenly aware of the negative impact taxes can have on retirement nest eggs. His focus on the latter has fostered his greater use of tax-efficient ETFs for clients, while his interest in the former informs his decisions on how to deploy ETFs in portfolios.

Schlegel: Tell us a little about your practice.

Scott: Westside Investment Management is a hybrid RIA on the LPL and Schwab platforms. We’re on the same team with a similar investment philosophy and similar models, but we all have slightly different client bases. My client base here in L.A. is quite entertainment-focused, along with creative entrepreneurs. Successful people in the entertainment field may be earning $1 million or $2 million a year, but that might last for only a short period of time, during which they get hammered on taxes. So it’s crucial to come up with strategies to manage their taxes so they can build a retirement nest egg.

Schlegel: How do you do that?

Scott: Part of the strategy is ETFs. They help my clients from getting hit with capital gains distributions associated with mutual funds. Previously, my clients were getting taxed on other people’s trades, whereas ETFs do not necessarily have to sell the underlying securities to finance investment inflows and outflows. The tax inefficiency of mutual funds propelled me toward ETFs.
And I’m concerned that over the next decade or two the returns on a classic 60% equity and 40% fixed-income portfolio may be less than past decades, particularly in a U.S.-focused portfolio. So every basis point in fees and taxes counts. 

Schlegel: How do you employ ETFs in client portfolios?

Scott: I like to use ETFs to target certain sectors. As the population ages, health care may be suitable for a long-term investor. This is quite a popular idea, but I tend to be a contrarian and look for value, so our health-care allocation was initiated during the election, when it had sold off. Our model also contains a strategic allocation to banks. This was initiated a couple of years ago when the sector was unloved, but it has since recovered on the hope of rising rates. ETFs are an easy way to target such themes. A difficult question is always whether or not to allocate new client funds to sectors that have done very well. Currently, I am allocating to natural resources.

Originally, we used ETFs to target sectors and used mutual funds for the core portfolio. However, over the past three years we’ve moved the core to broad index ETFs whenever we could do it in a tax-efficient way. I’m more about simplicity and low fees, so I’ve been gun-shy about newfangled, complex ETFs. There are only one or two complex ETFs that I’m interested in.

Schlegel: What’s your definition of a complex ETF?

Scott:  A complex ETF is one that is inversely correlated to volatility. This speaks to my investment philosophy. I think markets are pretty efficient 95% of the time, but when markets go down it’s such a painful behavioral experience for most investors that people who can manage their emotions can take advantage of that. So going back to inverse volatility, although no strategy assures success or protects against loss, it is a strategy that seeks to capitalize on that contrarian, behavioral point of view. I buy inverse volatility when the market declines over 15% to 20%. Such a market decline causes volatility to spike and investments in volatility are designed to go up, and correspondingly investments in inverse volatility decline greatly in price, creating a potential short-term buying opportunity. That is one of the few short-term trades that I’ll make. I hold an inverse volatility ETF only in small positions, and we’re not allowed to use leverage.

Schlegel: When did you start using ETFs in client portfolios in a meaningful way?

Scott: I started using sector ETFs about eight or nine years ago, and gradually ETFs have taken over. I was an early adopter of inverse volatility ETFs. I tend to use them for short-term trades. However, it is possible they could work long term.

Schlegel: Do you still use mutual funds?

Scott: I’m trying to be 100% ETFs in my retirement accounts, except for some bond funds. With taxable accounts, I have some legacy mutual funds that I like, especially if a fund is up a lot and I’m reluctant to trigger taxes. I have this internal debate about whether clients would be better off holding onto these funds or biting the bullet now to manage the ongoing tax and fee hits.

Schlegel: Any possible drawbacks to relying on ETFs in portfolios?

Scott: I’m aware of everybody being on the same side of the ship by piling into ETFs, and that the very things we’ve seen in other market bubbles could happen within certain realms of ETFs. However, a core holding like a total world stock market fund may be so broad that there is less likely to be a bubble in it.

If the majority of the world goes the route of passive ETFs, active will have its day. I’m not an ETF convert forever.