By Tony Davidow, CIMA
“A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”
Burton Malkiel A Random Walk Down Wall Street
In his classic book, “A Random Walk Down Wall Street,” Burton Malkiel threw down the gauntlet beginning the debate about active versus passive investment management. Of course, when Malkiel wrote his book there weren’t passive options available for individual investors. In recent decades, especially after the global financial crisis, this debate has gotten louder, with advocates of both points of view claiming victory.
Today, we have seen a blurring of the lines with passive mutual funds and active ETFs. We now have non-transparent ETFs and growing interest in direct indexing. For purposes of this article, we will refer to ETFs as passive strategies, and mutual funds and separately managed accounts (SMAs) as active management.
The Rise of Passive Options
Today, in the United States alone there are over 2,200 ETFs, representing approximately $6 trillion in assets under management. ETFs have helped ‘democratize’ investing by making it easy to access virtually every segment of the market in a cost-effective, tax-efficient manner. They let investors gain exposure to broad market segments, with no minimums, in a single trade.
Before ETFs, investors who wanted to own the S&P 500 had to purchase the underlying securities and assemble them in the same weights the index used. This was very expensive and difficult to accomplish, and market appreciation meant an investor’s exposure would typically deviate from the index returns over time. But now in a single trade, it is easy to own the underlying basket, at prices at or near zero, without transaction costs and with built-in automatic rebalancing.
ETFs have evolved from ‘cheap’ beta to ‘smart’ beta. The first generation of passive options was designed to mimic the market in a cheaper and more efficient fashion. It was about providing lower-cost access to the marketplace. These strategies benefitted from the difficulty that many active managers had in consistently outperforming the market.
However, if we look under the hood and examine the way that most indexes are constructed, we realize that most indexes are market-capitalization weighted; meaning that they provide the largest weights to the largest companies. This works fine when the biggest companies are the best companies.
In recent years, many have challenged the notion that owning the market based on market capitalization is the best way of gaining exposure to various segments of the market. Leveraging academic research that has shown there are certain persistent factors that have outperformed over time, we began (as outlined in “Strategic Beta Strategies: Do they work outside our borders?”, which was published in the November-December 2018 issue of the Investments & Wealth Monitor), to see the introduction of ‘smart’ beta strategies – strategies designed to exploit these factors by using alternative weighting methodologies. Factors like value, size, quality, volatility, and momentum have been shown to outperform the markets over time, and across market segments.
Today, advisers and investors can gain exposure to virtually every segment of the market, and they can select amongst a host of cheap beta and smart beta options. Advisers can align their views of the markets in the ETFs. They can overweight value relative to growth, or preference low volatility stocks versus high beta stocks. These new tools offer greater precision in building portfolios.
The Role of Active Management
While some have predicted the demise of active management, I would argue that active management still has a role in a portfolio. Despite the difficulty in consistently outperforming the market, active managers are better equipped to deal with market uncertainty and can play defense when warranted. Index-based strategies by their very nature must track an underlying index whether the markets are rising or falling.
An active manager can adapt to the prevailing market conditions and be more aggressive or defensive, depending on their forward-looking views. Active management also makes sense in less efficient asset classes (emerging markets), niche strategies (option overlay), alternative investments (hedge funds and private markets), and tax-managed strategies. Active managers can demonstrate skill in challenging market environments, where there is a bigger difference between winning and losing companies and security selection is at a premium.
During the bull market of 2009–2019, momentum stocks dominated the market. Their growth was fueled by money pouring into ETFs, which pushed these stocks even higher. The next 10 years are likely to be different than the last, and we may see a market environment that rewards skillful stock pickers. Market cycles tend to ebb and flow, and the next cycle will likely be more discerning in distinguishing between the winners and losers.
Many of the most successful fixed-income ETFs are actively managed, and all fixed-income ETFs have an active element. The fixed-income markets and equity markets are different. If you want to own the S&P 500, you can easily buy an appropriately weighted basket of a finite number of securities. But fixed-income ETFs do not seek to own the same bonds in the same weight as the Barclays U.S. Aggregate Bond Index (the most popular bond index). Rather, they seek to own bonds with similar characteristics to the benchmark (sector, quality, duration, etc.).
The Rise of Model Portfolios
A new type of active management is beginning to gain traction: Asset allocation models that primarily use ETFs and mutual funds as building blocks to gain exposure to market segments. Asset managers, wealth advisers, and the home offices of many of the large wealth management firms are developing these models. Because of the abundance of raw materials, both the number and the diversity of models have grown substantially, solving for everything from total return to specific goals.
Although asset allocation model portfolios have been around since the early 1990s, they have evolved a great deal over the past couple of decades, due in large part to ETF diversity. The first generation of models primarily used mutual funds or selected individual securities. ETFs have dramatically expanded the toolbox, making it easy to access markets and alter weighting methodologies to provide different outcomes. Asset allocation models can represent a total portfolio solution or a specialized sleeve.
Asset managers have seized the opportunity to leverage their expertise and capture a significant portion of the overall portfolio allocation. This helps staunch the bleeding of assets from mutual funds and SMAs, as well as fee compression across the industry. Leveraging third-party models can free up advisers to focus on other wealth management issues and deepen their relationship with high net worth (HNW) families, as well as help investors receive dedicated portfolio management expertise.
Many advisers believe that their value proposition is enhanced by creating portfolios. But according to Cerulli Research Reports, just 28 percent of investors believe their advisers have the highest level of investment expertise, and 35 percent prefer a dedicated investment team. Investors value a team of dedicated professionals, each with their area of expertise: investment management, financial planning, tax management, trust and estates, and philanthropy. The wealth adviser’s value is in assembling the team and accessing these resources as appropriate.
Models may not be appropriate for every adviser or every client, but they represent an evolutionary step forward for our industry. Asset managers can leverage their asset allocation and portfolio construction expertise, advisers can spend more time and energy addressing wealth management issues, and investors gain a broader team of experts working on their behalf. As with many shifts over the last couple of decades, some advisers may fret that these changes represent a threat to their business models, and others will embrace these changes and evolve their practices. Some advisers will become commoditized, and others will flourish as they pivot to focus on broader wealth management issues.
About the author: Tony Davidow, CIMA®
Tony Davidow, CIMA®, is president of T. Davidow Consulting, an independent advisory firm focused on the needs and challenges facing the financial services industry. Davidow leverages his diverse experiences to deliver research and analysis to sophisticated advisers, asset managers, and wealthy families. He has held senior leadership roles at Morgan Stanley, Charles Schwab, Guggenheim Investments, and Kidder Peabody among others. He is focused on developing and delivering content relating to advanced asset allocation strategies, alternative investments, factor investing, sustainable investing, and other topics. In 2020, Davidow was recognized by the Investments and Wealth Institute, with the Wealth Management Impact Award, which honors individuals who have contributed exceptional advancements in the field of private wealth management.