By Tony Davidow, CIMA
“A blindfolded monkey throwing darts at the financial pages of a newspaper might pick a portfolio that would do as well as a portfolio carefully selected by experts.”
Burton Malkiel Random Walk on Wall Street
In his classic book, âA Random Walk Down Wall Street,â Burton Malkiel challenged by starting the debate on active versus passive investment management. Of course, when Malkiel wrote his book, there were no passive options available to individual investors. In recent decades, especially after the global financial crisis, this debate has intensified, with advocates of both views claiming victory.
Today we are witnessing a blurring of the lines with passive mutual funds and active ETFs. We now have non-transparent ETFs and a growing interest in direct indexing. For the purposes of this article, we’ll 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 facilitating access to virtually all market segments in a cost-effective and tax-efficient manner. They allow investors to gain exposure to large market segments, with no minimum, in a single transaction.
Before ETFs, investors who wanted to own the S&P 500 had to buy the underlying securities and put them together in the same weights as the index used. This was very expensive and difficult to achieve, and market appreciation meant that an investor’s exposure typically deviated from the index returns over time. But now, in a single trade, it’s easy to own the underlying basket, at prices close to zero, with no transaction fees, and with built-in automatic rebalancing.
ETFs have gone from a âcheapâ beta to a âsmartâ beta. The first generation of passive options was designed to mimic the market in a cheaper and more efficient way. The aim was to provide lower cost access to the market. These strategies have benefited from the difficulty many active managers have in systematically outperforming the market.
However, if we look under the hood and examine how most indices are constructed, we realize that most indices are weighted by market capitalization; which means they provide the biggest weights to the biggest companies. It works well when the biggest companies are the best.
In recent years, many have questioned the idea that owning the market by market cap is the best way to gain exposure to various segments of the market. Take advantage of academic research that has shown that there are some persistent factors that have outperformed over time, we started (as discussed in âStrategic Beta Strategies: Are They Working Outside Our Borders?â which was published in the November-December 2018 issue of Investment and wealth monitor), to see the introduction of âsmartâ beta strategies, strategies designed to exploit these factors using alternative weighting methodologies. Factors such as value, size, quality, volatility and momentum have been shown to outperform markets over time and across all market segments.
Today, advisors and investors can gain exposure to virtually any segment of the market, and they can choose from a plethora of cheap beta and smart beta options. Advisors can align their views on the ETF markets. They may overweight value over growth or favor low volatility stocks over high beta stocks. These new tools offer greater precision in the construction of portfolios.
The role of active management
While some have predicted the demise of active management, I would say active management still has a role in a portfolio. Despite the difficulty of consistently outperforming the market, active managers are better equipped to deal with market uncertainty and can play defense when warranted. Index strategies, by their very nature, must track an underlying index whether the markets are rising or falling.
An active manager can adapt to existing market conditions and be more aggressive or defensive, depending on his forward-looking views. Active management also takes on its full meaning in less performing asset classes (emerging markets), niche strategies (overlay option), alternative investments (hedge funds and private markets) and tax-managed strategies. Active managers can demonstrate their skills in challenging market environments, where there is a greater difference between winning and losing companies and stock selection is paramount.
During the bull market of 2009-2019, dynamic stocks dominated the market. Their growth was fueled by money poured into ETFs, which pushed these stocks even higher. The next 10 years will likely be different from the previous ones, and we could see a market environment that rewards skilled stock pickers. Market cycles tend to fluctuate, and the next cycle is likely to be more demanding in distinguishing the winners from the losers.
Many of the top performing fixed income ETFs are actively managed, and all fixed income ETFs have an active component. Fixed income markets and equity markets are different. If you want to own the S&P 500, you can easily buy a properly weighted basket of a finite number of stocks. But fixed income ETFs don’t seek to hold the same bonds in the same weight as the Barclays US Aggregate Bond Index (the most popular bond index). Rather, they seek to hold bonds with characteristics similar to the benchmark (sector, quality, duration, etc.).
The rise of model portfolios
A new type of active management is starting to gain traction: asset allocation models that primarily use ETFs and mutual funds as the building blocks to gain exposure to market segments. Asset managers, wealth advisers and home offices of many large wealth management companies are developing these models. Due to the abundance of raw materials, the number and variety of models has increased dramatically, solving everything from total yield to specific goals.
Although model asset allocation portfolios have been around since the early 1990s, they have evolved a lot over the past two decades, largely due to the diversity of ETFs. The first generation of models mainly used mutual funds or selected individual stocks. ETFs have significantly expanded the toolbox, making it easier to access markets and changing weighting methodologies to deliver different results. Asset allocation models can represent a total portfolio solution or a specialized pocket.
Asset managers seized the opportunity to leverage their expertise and capture a significant portion of the overall portfolio allocation. This helps stem the drain on mutual fund and ADM assets, as well as cost containment across the industry. Using third-party models can allow advisors to focus on other wealth management issues and deepen their relationship with high net worth (HNW) families, as well as help investors benefit from dedicated expertise in portfolio management.
Many advisors believe their value proposition is enhanced by building portfolios. But according to Cerulli Research Reports, only 28% of investors believe their advisers have the highest level of investment expertise, and 35% prefer a dedicated investment team. Investors appreciate a team of dedicated professionals, each with their own area of ââexpertise: investment management, financial planning, tax management, trusts and estates, and philanthropy. The interest of the asset advisor lies in the constitution of the team and the access to these resources if necessary.
Templates may not be right for every advisor or every client, but they represent an evolutionary step forward for our industry. Asset managers can leverage their expertise in asset allocation and portfolio construction, advisors can devote more time and energy to solving wealth management issues, and investors can invest a larger team of experts working on their behalf. As with many changes over the past two decades, some advisors may fear that these changes pose a threat to their business models, and others will embrace these changes and evolve their practices. Some advisers will become commoditized and others will thrive as they pivot to focus on broader wealth management issues.
About the Author: Tony Davidow, CIMAÂ®
Tony Davidow, CIMAÂ®, is President of T. Davidow Consulting, an independent consulting firm focused on the needs and challenges facing the financial services industry. Davidow draws on his diverse experiences to provide research and analysis to discerning advisors, asset managers and wealthy families. He has held executive positions at Morgan Stanley, Charles Schwab, Guggenheim Investments and Kidder Peabody, among others. It focuses on the development and dissemination of content relating to advanced asset allocation strategies, alternative investments, factor investing, sustainable investing and other topics. In 2020, Davidow was recognized by the Investment and Wealth Institute, with the Wealth Management Impact Award, which honors individuals who have contributed to exceptional advancements in the field of private wealth management.