Being an active asset allocation firm, the ETF solution was tailor-made for our investment process. So we began converting Amerigo and Clermont to ETFs from actively managed mutual funds to exchange-traded funds.
What are the advantages of using nothing but ETFs?
The widely touted advantages of ETFs to investors are their low cost, liquidity, transparency, intraday trading capabilities, can be shorted, tax efficiency. They provide instant diversification. Options are also available on ETFs.
While all these advantages are appealing, transparency was a big plus for us. With traditional mutual funds, it is very difficult to determine why the fund is performing as it is, since you do not know what securities the fund may be holding at any particular time. With ETFs, transparency enables the investor to "lift the hood" and see what is driving performance. For us, knowing what we are buying and why it is performing is important.
What are the disadvantages?
The biggest disadvantage of exchange-traded funds is that, like equities, there is a ticket charge for executing the purchase or sell order. For smaller investors, that could be cost-prohibitive, or at least offset some of the low-cost advantage to ETFs. Also, to the best of my knowledge, providers have not yet found an effective way to enable investors to dollar cost average ETFs. If there was, that would open up ETFs to the 401(k) universe.
Our way around dollar cost averaging in 401(k)s has been to use a "core and explore" strategy using our two mutual funds as well as other traditional funds. Also, given that exchange-traded funds track indexes, outperformance from superior stock selection is eliminated.
How do you decide on an asset allocation?
For an individual client, a risk profile is completed, identifying their objectives and tolerance for risk. Each client is then assigned a "risk budget." While many managers attempt to control risk by a rigid stock-to-bond ratio -- like 60% equity vs. 40% bond for a conservative client -- we focus on the volatility of the allocation.