Luke King – Main Management

Luke King serves as Managing Director at Main Management. His focus is on trading and business development. We recently spoke with Luke, who will be speaking at our ETF Strategy Summit (Oct. 15 - 16 – Dallas), as he discusses actively managed ETFs and sector rotation.

ETF Strategy Summit: Does the world need any more ETFs? Are we at “peak” ETF?

Luke King: New ETFs bring innovation, competition, and cost savings to the investing public. We view new ETFs and new ETF issuers coming to market as a positive and believe we will continue to see innovation in the ETF space particularly in the area of actively managed ETFs.

ETF Strategy Summit: Are you employing active ETFs in your strategies, and if so, how are you selecting ETF managers?

Luke King: Yes, we employ actively managed ETFs within our investment strategies. We utilize our own actively managed sector rotation ETF as a key holding within some of our investment strategies. In addition, we utilize actively managed ETFs of other ETF issuers with a focus on actively managed fixed income ETFs. When it comes to selecting ETF managers we look at the team, process, track record, and cost in seeking to identify best in breed providers.

ETF Strategy Summit: Can you explain how Main Management meaningfully blends active and passive management through sector rotation?

Luke King: Main Management’s approach seeks out the best aspects of active and passive management by focusing on generating alpha while managing risk and controlling costs. Our sector rotation strategy employs a quantitative and qualitative approach to identify market sectors, sub sectors, and industry groups which appear to be undervalued and have a positive catalyst present which may propel them to revert back to a more appropriate valuation. The strategy is implemented with exchange traded funds and has a GIPS verified track record going back to 2002.

ETF Strategy Summit: How does the sector rotation strategy respond to the kind of volatility we saw earlier this year? What about the global financial crisis?

Luke King: The sector rotation strategy is an equity based strategy so it is not immune from market volatility. However, we do have three tools that have helped us successfully navigate the market volatility experienced in February of this year as well as during the global financial crisis. The first tool is to be able to go up to 20% cash which may help cushion the downside and provide us with money to opportunistically put to work. The second tool involves rotating into more defensive sectors. Defensive sectors may help cushion the downside during times of increased volatility. The last tool available to us is the use of covered call options on a portion of the portfolio to potentially further reduce portfolio volatility. These three tools have helped us successfully navigate periods of market volatility in the past and we believe will continue to do so in the future.

ETF Strategy Summit: Are you concerned that certain sectors may be prone to disruption and long-term multiple compression in the future?

Luke King: We are always on the outlook for sectors/industries that have been disrupted, but who’s price has discounted the disruption. Consumer Staples have experienced the “Amazonization” and have lost their pricing power for branded goods. As technology driven continues to occur we expect to see continued disruption across multiple sectors.

ETF Strategy Summit: Thanks Luke. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 - 16 in Dallas.


Steven Schoenfeld – BlueStar Indexes

Steven Schoenfeld is the Founder & CIO at BlueStar Indexes. He is a 31-year veteran of the investment management industry, author of Active Index Investing and co-founder of We recently spoke with Steven, who will be speaking at our ETF Strategy Summit (Oct. 15 - 16 – Dallas), as he shared with us his thoughts on Global Asset Allocation, Israeli Equities and Global Thematic ETFs.

ETF Strategy Summit: What geopolitical headline risks are you looking out for the balance of 2018?

Steven Schoenfeld: As we have seen in this year in the late Summer with the Turkish financial crisis, Emerging Markets as a group remain subject to the flames of financial and geopolitical contagion. And with the US Federal Reserve committed to tightening monetary policy, the margin for error for countries that have fragile financial systems and/or balance of payments is slim.

On the geopolitical front, there is significant instability across the Middle East – especially in Syria, Iraq and Yemen - as well as in North Asia, despite the nascent understandings between the US and North Korea.  Another major concern for investors would be if Turkey and Iran are drawn closer to Russia due to the economic stresses both Mideast countries are experiencing.  Finally, while not on the radar of many investors, the Venezuelan economy is ever-closer to the brink of collapse, and a massive migration or civil war are both distinct possibilities that could impact Mexico, the US, and Venezuela’s neighbors in Latin America and the Caribbean.

ETF Strategy Summit: When considering global allocation, are the benefits of investing by country, versus by region, worth the additional cost and complexity?

Steven Schoenfeld: While a well-diversified, broad-based allocation to global equities is the key foundation for long-term investment, I believe that it is essential to also make country-level allocations to address the shortcomings of cap weighted indexes - both for US and International stocks.

For example, the Technology sector weighting in both the US and Emerging Markets is more than 20%, while it’s only around 10% for Developed International Equities (aka EAFE-benchmarked assets).  Thus, investors should consider an allocation to Developed Market Tech stocks to ‘fill the gap,’ which the NYSE-listed ITEQ® Israel Tech ETF tracking BlueStar Israel Global Technology Index can serve this purpose.

Furthermore, certain highly-attractive markets - for example, Israel, Norway and New Zealand in Developed Markets - have such small weights in the standard index-based strategies (as well as actively-managed portfolios) that investors should consider a strategic allocation to gain exposure to these markets.  In the volatile year of 2018, all three of them would have improved diversification and returns for an international portfolio.

ETF Strategy Summit: When considering Israel as an investment opportunity, how should investors balance their views of its progressive, robust economy with the potential for a regional conflict?

Steven Schoenfeld: As BlueStar’s research has proven, Israel’s economy is resilient and Israeli companies are global in scope.  Thus, small-scale conflict with Hamas-controlled Gaza and Iranian backed proxies like Hezbollah in Lebanon and militias in Syria has minimal impact on the Israeli equity market.   In fact, Israeli stocks as measured by the broad-based BlueStar Israel Global Index (BIGI®, tracked by ISRA®, the NYSE-listed VanEck Vectors Israel ETF) are much more correlated to global equity trends than to regional geopolitics.   Furthermore, Israeli Technology companies are even more focused on the global marketplace, and thus the correlation of the BlueStar Israel Global Technology Index (BIGITech®, tracked by ITEQ®, the NYSE-listed BlueStar Israel Technology ETF) is more correlated to global technology benchmarks than to the local TA-125 benchmark of Tel Aviv-listed stocks.

ETF Strategy Summit: What does Bluestar look for in technological investment themes?

Steven Schoenfeld: Building upon our deep knowledge of cutting-edge technology trends gained from years of researching the Israeli tech ecosystem and the companies that emerge from the ‘Start-Up Nation,’  BlueStar identifies industries and tech sector themes to isolate where drivers of current and future business demand is derived.  We design our thematic indexes with one goal in mind — Provide indexes with the highest degree of thematic integrity.

ETF Strategy Summit: How might advisors deploy today’s thematic ETFs within portfolios?

Steven Schoenfeld: Similarly to my philosophy for International Equities, Thematic Tech ETFs can strategically complement a broader-based technology allocation, and also generally can help address the US-bias of most investors’ technology exposure.

Furthermore, investors can also tactically overweight Thematic areas that that they have a strong conviction about, for example, toward Augmented and Virtual Reality, or into the more advanced Quantum and Machine Learning areas of computing technology.

ETF Strategy Summit: Thanks Steven. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 - 16 in Dallas.

Doug Blanton – Merit Financial Advisors

Doug Blanton is the Director of Investments at Merit Financial Advisors. Doug assists financial advisors in developing investment strategies that focus on their client’s needs. We recently sat down with Doug, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as he shared his thoughts on investing in bonds in a rising rate environment.

ETF Strategy Summit: Investors have become comfortable with active fixed income ETFs and many strategists argue that they are superior to bond indexing – is there still room for passively managed bond funds in wealth management portfolios?

Doug Blanton: During this phase of the credit cycle, we prefer active fixed income to passive. As rates rise, and investors shift assets out of bonds, liquidity may become a concern. You will want nimble active managers to navigate a major spread widening or credit crunch. Credit research will also be key as we reach higher interest rates. We don’t believe credit-worthiness becomes much of an issue until 2020, however the market has a way of accelerating the pain for the most vulnerable names which we would expect active managers to recognize and limit exposure. We believe passively-managed U.S. Treasury and short-term high quality debt ETFs will make it through the next credit cycle without much consequence.

ETF Strategy Summit: With lower returns projected well into the future, should advisors re-think the proportion of assets they allocate to traditional bond strategies? Does the “balanced portfolio” need a facelift?

Doug Blanton: Our team regularly challenges the traditional balanced strategy. Bonds are historically less risky, and still offer some of the best negative correlation to extreme market or economic events. However in the absence of such events, one must consider the long-term return expectation of each asset class. The mistake we see some making today is an emphasis on value-oriented stocks and other high dividend-paying income alternatives. Most of these have a very long implied duration and will likely experience continued drawdown as rates rise. So you must choose your bond alternatives wisely to avoid the excessive interest rate sensitivity.

ETF Strategy Summit: What kind of tools does Merit use to navigate the rising rate environment?

Doug Blanton: Our process utilizes a number of economic and market indicators to assess our views on inflation and interest rates. Inflation during this expansion is being born from the expense side of the ledger, meaning higher wages and raw materials have accelerated price increase. We follow the inflation dollar to determine how much impact the consumer is likely to feel. So far, companies have been able to absorb much of the increases in part due to rising revenues and stiff competition. In addition, we believe there is a lot of data between the month-ends, so we look at how markets react to certain events or stress points no matter how small. We evaluate the behavior of our portfolios during these “mini-cycles” and adjust accordingly.

ETF Strategy Summit: Are you concerned that the use of bond ETFs as hedging tools might send investors false signals about the state of fixed income markets?

Doug Blanton: The asset inflows bond ETFs have seen during the past few years does tend to lead investors to conclusions. At the end of the day, the bond market can be a very illiquid environment. Asset flows influence investor outcomes, and those flows often get the direction and the magnitude of a particular view wrong. We don’t view asset flows as a reliable data point to determine strategy.

ETF Strategy Summit: How do you feel about hedging against inflation? Are TIPS sufficient?

Doug Blanton: The implications of higher inflation on the credit markets is one of our largest concerns. We have been steadily decreasing our interest rate sensitivity since 2015 in anticipation of rising rates. We have gone from a 5+ year duration down to 1.5 years, with 50% of our bond exposure including some floating coupon rate feature to hedge against rising rates. TIPS are a good inflation hedge in a worsening economic environment. However we find the credit alternatives offer a larger total return given the positive global economic picture. Should inflation become destructive, dampening economic growth, TIPS would be our top pick for an inflation hedge. But as of today we have very little exposure to TIPS.

ETF Strategy Summit: Thanks Doug. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.

John Davi – Astoria Portfolio Advisors

John DaviJohn Davi is the Founder & CIO at Astoria Portfolio Advisors. The firm specializes in construction, management and subadvising of ETF model portfolios. We recently spoke with John, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as he provided his thoughts on having a diversified approach to factor investing.

ETF Strategy Summit: What are the advantages to using a multi factor or factor-cycling product versus implementing single-factor ETFs in portfolios?

John Davi: The evidence suggests that higher risk adjusted returns are available if one were to invest in a set of factors that are robust, persistent, pervasive, intuitive, implementable, etc. compared to a single factor strategy. This is a large reason why Astoria invests in a diversified portfolio of factors not only across equities but across asset classes. I don’t know (and I doubt many others would know) when a particular factor will go in or out of style. The data suggests that some factors can be in and out of favor for decades. Astoria prefers a diversified approach to factor investing.

ETF Strategy Summit: Factor investing mavens often warn that it’s impossible or incredibly difficult to time factors – are they right?

John Davi: There is no evidence to suggest that you can time factors in such a way that is systematic, repeatable, and profitable across varying time periods. Do people try anyways? Of course, people are human and will try anything even if the odds are stacked against them. Do some people profit from factor timing? Anything is possible. But the key is can you do it systematically, repeatably, and in a scaled fashion? Astoria believes (which aligns with the actual evidence) that it’s significantly more important to pick a set of factors which are robust, pervasive, repeatable, explainable, implementable AND to invest in them for the long run. The bottom line is that investors should pick factors that have strong evidence, harvest them in a cost-effective manor, and stick with them for the long run – this gives you a higher probability to achieve attractive risk adjusted returns rather than trying to time factors. Moreover, I need to make an important point. Unfortunately, the investment management industry has become enamored with short duration capital. I don’t know too many strategies (if there are any at all) that have a high probability of making money in a systematic, repeatable, and scalable format with short duration capital.

ETF Strategy Summit: What are the advantages to actively managing factor exposures?

John Davi: People will always justify some rationale for doing what they do. How many people do you know that can time the market in a repeatable, systematic, and scalable format? Not many. If market timing is difficult, why on earth would you think you can time factors?

ETF Strategy Summit: What are the implications for interest rate increases and monetary tightening for factors widely available in ETFs?

John Davi: The repercussions of monetary tightening are quite significant, especially on the margin, and has enormous portfolio implications. Nobody is prepared for an aggressive fed rate cycle or a cycle with liquidity declining on the margin. People have plowed $2.5 trillion into bond funds since 2009 and I have yet to see any meaningful outflows. Keep in mind that aside from the Fed implementing QT and hiking rates, liquidity will further decline due to the ECB curtailing their QE program and eventually the BOJ will follow suit. My point is that we are entering a new cycle of less liquidity and liquidity is what ultimately drives markets. This year financial conditions have tightened significantly, and we believe this is a primary reason why the S&P 500 couldn’t sustain a more meaningful rally despite the blow off the top earnings in Q1. Stocks and bonds are positively correlated, people are underweight alternatives, and cash is an asset class that nobody wanted to own during the past decade. The bottom line in our view is that portfolios are not prepared for this transition period. A meaningful change in the liquidity cycle will likely revert in meaningful price action across factors. Astoria believes that the overarching theme in one’s portfolio should be value, quality, and mixing in other factors (Astoria likes momentum, carry, trend) to further enhance your portfolio risk characteristics.

ETF Strategy Summit: Where has the “value” factor gone – are there ETFs still delivering strong returns using value?

John Davi: The value factor has been out of favor – just like it has many times throughout history – as investors have been enamored with growth and momentum stocks. Astoria believes that investors should allocate now towards value & quality (along with the various other risk premiums we are harvesting) and avoid growth as the market transitions to this new liquidity cycle. We simply think there is a greater margin of safety in value stocks while growth is crowded with a high degree of vulnerability as this liquidity transition period picks up pace.

Be careful with how you pick your factor ETFs. Investors need to run bottom up screens to ensure they are getting the desired exposure they want. Most value ETFs have extremely low active share. In a previous life, we would work with institutional investors to construct optimized long/short baskets to purely isolate a factor exposure. There is a long/short Value ETF (CHEP) but it never got any significant traction. QVAL and IVAL are 2 long only value ETFs that provide meaningful active share. We use the latter for our international value exposure.

ETF Strategy Summit: Thanks John. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.

Lorraine Ell – Better Money Decisions

Lorraine EliLorraine Ell is the CEO at Better Money Decisions. Author of the book, Bozos, Monsters and Whiz-bangs: Bad advice From Financial Advisorsand How to Avoid it!, Lorraine is also frequently quoted in MarketWatch, Investment News, Investor’s Business Daily, Yahoo Finance, and The Wall Street Journal. We recently spoke with Lorraine, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as she gave us some insight on building portfolios which address clients’ needs and concerns.

ETF Strategy Summit: As average career, lifecycle and longevity trends among women continue to diverge from those of men, should advisors think about ETF portfolio construction differently for their female clients? How?

Lorraine Ell: The current statistic is that 80% of those living into their 90s are women. Longevity considerations are therefore more important when constructing a portfolio that must be capable of providing income for women well into their 90s. ETFs because of their low internal expense ratios are an ideal vehicle to improve investment returns over a long period of time. Longevity also increases the importance of a portfolio keeping up with inflation. An allocation that is too conservative may not work in the long run.

ETF Strategy Summit: Clearly, the ranks of asset managers and analysts still skews towards males, even in the more progressive realm of ETF managers. Do female clients need or desire access to a broader range of female ETF managers and strategists?

Lorraine Ell: Women do not necessarily care about the person managing the fund. In fact, a client’s relationship is with the advisor, and clients generally have no interest in the individual managers at fund companies. Having said that, the industry has an image problem; numerous studies have demonstrated that female fund managers do just as well as male fund managers but still make up only 10% of the group. And that has persisted for years despite an increased representation of women in other professions: 37% of doctors, 33% of lawyers and 63% of accountants. Some of this may be a result of the lack of interest on the part of females to become portfolio managers but also there is a reluctance to hire women.

ETF Strategy Summit: Women investors and impact, sustainable, SRI and ESG investing are often mentioned in the same breath, so much so that it’s nearly become cliché – in your experience, is there a greater desire to do well by doing good among your female clients?

Lorraine Ell: Yes. More women than men come to my firm requesting sustainable/SRI/ESG investment vehicles. We do caution women that they need to “sustain” themselves first in making investment decisions but the increasing prevalence of sustainable options is making it easier to comply with their request.

ETF Strategy Summit: As a practitioner of sustainable investing, how do you typically approach the subject with female clients – do you take a values-based approach, a risk-awareness approach, or some other tactic?

Lorraine Ell: We start every client relationship with a comprehensive financial plan and then construct a portfolio to meet the needs and goals outlined in the plan. If requested, we use whatever sustainable funds and ETFs available to meet both the client’s concerns but most importantly the client’s needs. Sustaining the client is first and foremost.

ETF Strategy Summit: To what extent do you think the differences between male and female clients is an outgrowth of our culture, and what other attributes might explain the differences?

Lorraine Ell: The cultural perception that still exists in the U.S. today is that men are better at managing money than women even though the data does not support this idea. But there is a pervasive collective consciousness surrounding the belief that men are better at math than women. A “gender-equality paradox” has been noted in that there are more women in STEM in countries with lower gender equality. Women make up 40 percent of engineering majors in Jordan, for example, but only 19 percent in the U.S.
Sadly, there is still a stereotype that women make decisions emotionally and men technically, yet personal finance is emotional – for both men and women! The emotional aspect of a change in financial circumstance is far more impactful than the actual material loss. Our minds function to remember the negative more intensely than we remember the positive events in our lives which explains the reason the market crash of 2008-2009 is still so front-of-mind for most clients.

For the most part, clients, both male and female want to know that they will be okay throughout retirement and to the end of their lives. That is the biggest concern for all clients.

ETF Strategy Summit: Thanks Lorraine. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.

Benjamin Lavine – 3D Asset Management

Benjamin Lavine serves as the Chief Investment Officer and sits on the executive management and investment committees at 3D Asset Management. Ben works closely with 3D’s investment committee to refine and enhance the investment architecture underlying 3D’s ETF managed portfolios. We recently spoke with Ben, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as he shared his thoughts on how to invest in factors.

ETF Strategy Summit: Since a multi-factor ETF may shift between factor, style and sector exposures as it rebalances, how should advisors think about implementing one within a client portfolio?

Ben Lavine: Most rules-based ETFs will reconstitute semi-annually and rebalance quarterly although some multi-factor ETFs will reconstitute quarterly to account for higher turnover factors such as momentum. Regardless of reconstitution frequency, the underlying factor exposures should not change too significantly over time unless there is a change to the multi-factor model itself. Many multi-factor ETFs also optimize their risk exposures versus a cap-weighted index like the S&P 500 or Russell 1000 Index, so investors can be reasonably assured that they will be invested in a strategy anchored to broad market risks. Hence, multi-factor ETFs can serve as a close substitute for traditional cap-weighted ETFs to provide core market exposures, but the devil is always in the details, so make sure to analyze both basket design and implementation and how multi-factor ETF candidates interact with other components within an investment program.

ETF Strategy Summit: Are there specific factor combinations or blends that investors should try to avoid? Which pairs or combinations make the most sense in today’s market environment?

Ben Lavine: Factor combinations or blends can run afoul of data mining resulting in a model with the best performing factors combined in the best performing manner over the testing period. The ETF provider should be ready to explain the economic or intuitive rationale for, say, why a dividend factor should be combined with a low volatility factor. Most investable factors can be combined into two categories: value and sentiment. Many multi-factor model ETFs will combine factors from these two categories because they have historically blended well resulting in performance where the ‘whole’ is greater than the ‘sum-of-the-parts.’ There is some ongoing debate over whether low volatility is an investable, alpha-generating factor or is better implemented as a risk control. For instance, several multi-factor ETFs use volatility as an initial screen to weed out high volatility stocks from the starting universe before generating factor scores. Some recent multi-factor ETFs use a dynamic approach to time factor exposures based on a backward assessment of fundamentals (i.e. factor valuations) and/or a forward assessment of the economic backdrop with the idea that certain factors perform better depending on the stage of the cycle. If investors believe that we are about to enter a recession, historically, you would have wanted to avoid ‘value’ and increase exposure to more defensive factors such as ‘yield’ and ‘quality.’

ETF Strategy Summit: Does it matter if factors are accessed actively or passively?

Ben Lavine: Probably not, but the ‘rules’ underlying a passive implementation provide greater transparency and more assurance that an ETF will follow its intended mandate. In addition, passive ETF managers will more likely use the basket creation/redemption to minimize realized capital gains distributions so as to minimize the tax impact from periodic rebalancings. On the other hand, active implementation of factors, unconstrained by a tracking benchmark, enables an ETF manager to (potentially) create a basket with more targeted factor exposures versus a passive implementation as the ETF manager can rebalance much more frequently – an important aspect for higher turnover factors like momentum.

ETF Strategy Summit: How has sector neutralization impacted the performance of factor ETFs thus far in 2018? Should advisors seek single factor or multi-factor ETFs that are sector neutralized, or employ more unconstrained factor products?

Ben Lavine: Group neutralization (whether sector, country or even risk buckets) can make a huge difference in factor performance over the short-term such as what was experienced in 2017 when the technology sector ran ahead of the major sectors. In 2018, it’s been a mixed bag for neutralization. The technology sector had been handily outperforming the other sectors throughout the first quarter but then reversed in April when energy and industrial cyclicals took over sector leadership. However, the impact from group neutralization tends to decline over longer periods of time. In addition, group neutralization has generally not worked for sentiment factors like momentum because much of momentum’s performance comes from both sector and stock-specific exposures. On the other hand, group neutralization has worked better for fundamental-based factors such as value. At the margin, group neutralization can help reduce factor volatility by removing group-level effects, but it can also reduce factor efficacy. Advisors should always consider how a single or multi-factor ETF fits within a broader investment program. A factor ETF that does not neutralize groupings may make more sense if it is offsetting group level bets from other strategies held in the program.

ETF Strategy Summit: Are ETFs and strategies that cycle through factors more desirable than factor blends?

Ben Lavine: The jury is still out on the efficacy of factor timing and whether it can produce consistent excess returns versus a static model. Some investors believe that factors exhibit momentum tendencies over a 12-18 month period, similar to the momentum effect at the security level. Others believe that factor exposures should be determined on where we are in the macroeconomic cycle. We believe that there are periods when factors look exceptionally overbought or oversold, but these are infrequent moments at best; hence, investors will probably be better served with a strategic factor blend.

ETF Strategy Summit: Thanks Ben. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.

Justin Sibears – Newfound Research

justin sibearsJustin Sibears is a Managing Director at Newfound Research. He’s responsible for the ongoing research and development of new intellectual property and strategies. Justin also serves as a Portfolio Manager for Newfound’s direct offerings. We recently spoke with Justin, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as he shared with us how they incorporate behavioral finance into their investment process.

ETF Strategy Summit: Factors, geographies, sectors, asset classes, styles, strategies – given today’s environment, are there any methods for slicing up the markets with ETFs that are clearly superior to others?

Justin Sibears: We believe it is equally important to view a portfolio through all of these lenses. We have a saying at Newfound that “risk cannot be destroyed, only transformed.” Oftentimes, viewing risk through only one of these lenses may lead us to make decisions that appear to reduce risk, but instead simply shifts the risk in a way that hides it from view.
As example, consider value strategies. Value strategies can be classified in many ways, but one important way is how they manage sector risk. Some value strategies are sector unconstrained. They will pick the cheapest stocks regardless of what sector they are in. Some value strategies constrain their sector allocations to be in line with the broader market. Others may fall somewhere in the middle. It’s entirely possible that two value strategies, one sector unconstrained and one constrained, may quantitatively have similar exposure to the value factor. If we stopped our analysis here, we may miss potential sector exposures that could be problematic. For example, the investor may have a large strategic position in energy stocks and so may not want to own a value strategy that can simultaneously make a large bet on energy.

ETF Strategy Summit: What methods can advisors use to keep abreast of a portfolio’s exposures as they blend things like style, factor and active ETFs with alternative strategies, country ETFs or sector ETFs?

Justin Sibears: We recommend that advisors blend quantitative and qualitative tools. Today, there are many quantitative tools that allow advisors to measure risk and stress test portfolios. These are undoubtedly valuable. However, it’s also important to note that these tools have limitations. They are only as good as the assumptions they make. Relying on quantitative tools exclusively has the potential to lead to over optimization and false confidence. To protect against this, we advocate complementing quantitative analysis with simple qualitative rules-of-thumb. As an example, we think it’s hard to go wrong with equal-weighting exposures, whether that be sectors, factors, or asset classes. As Harry Markowitz, the father of modern portfolio theory, said, “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualized my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.”

ETF Strategy Summit: You’ve noted that modern portfolio theory is imperfect – how are you incorporating client behavior to optimize asset allocation?

Justin Sibears: At a high level, we incorporate behavioral finance into our investment process by acknowledging that investors dislike losing money more than they like making money. We know that investors care deeply about protecting the capital they have worked hard to accumulate and as a result our first focus is on risk. Specifically, the majority of our strategies seek to improve risk-adjusted returns and manage sequence risk by avoiding large drawdowns.
We also recognize that while investing shouldn’t be complicated, that doesn’t mean that it is easy. In the real world, short-term emotional decisions can threaten even the best-scripted financial plan. As a result, we believe strongly that the optimal investment strategy for any client is, first and foremost, one that they can stick with. This means recognizing that managing client anxiety is paramount for long-term success.

We take a multi-dimensional view of anxiety. Specifically, our optimization process is built around the following three tenets:

  1. Not risk averse, but loss averse. In modern portfolio theory, volatility is used as the main metric of risk. Investors, however, are not necessarily risk averse. In fact, a 2014 paper by Frazzinni and Pederson finds that investors actually have a preference for high risk, “lottery” style investments. By using volatility as the primary measure of anxiety, modern portfolio theory punishes both bad, downside risk and preferable, upside risk equally. Our process focuses explicitly on downside risk.
  2. Keeping up with the Joneses. When evaluating outcomes, humans often have an established reference point. Outcomes are classified as gains if they are above the reference point and losses if they are below. In investing, reference points are often established public benchmarks (e.g. the S&P 500), but may also be the performance of peers. Our process considers tracking error as one measure of anxiety. If we are going to make bets that move the portfolio away from the benchmark, we have to be adequately compensated as these bets will inevitably lead to angst during periods of short-term underperformance.
  3. A preference for a smooth ride. While modern portfolio theory is concerned with optimizing for the end result, investors live in a continuous environment. Behavioral research finds that investors who monitor their portfolios more frequently will actually perceive their investments to be riskier: a phenomenon known as myopic loss aversion. Framing investment results over short investment horizons, compared with an asymmetric view of gains and losses, creates a preference for a “smoother” ride over time. As a result, our process is willing to sacrifice some long-term return for a more enjoyable experience since this can reduce investor anxiety and increase commitment to the investment plan.

ETF Strategy Summit: You’ve also advocated for lowering withdrawal rates as the assumed future rates of return for traditional investments decline – should investors and advisors also become more comfortable with risk taking to achieve their goals?

Justin Sibears: It’s hard to make a credible case for future stock and bond returns living up to past experience. The unfortunate consequence is that financial rules of thumb – like the 4% withdrawal rule – may fail going forward since they were calibrated to the past. One easy solution for retirees is just to withdraw less money. For obvious reasons, this solution is far from ideal, if not impossible for some.

There is no silver bullet for solving this problem. Fortunately, we do believe that there are many marginal improvements that when compounded can get withdrawals back up to acceptable levels. Some of these improvements are more planning than investment centric (e.g. managing fees, increasing savings, being smart about asset location, and using dynamic withdrawal strategies).

On the investment front, we do believe that risk plays an important role. However, it’s not as simple as being comfortable with more risk. When expected returns are high across the board, we have the luxury of making risk profile choices as a matter of personal preference. If we are a conservative person, we can allocate conservatively and vice versa. In our current environment, however, this is no longer an option for many people. Instead, it’s crucial to choose a risk profile that has a realistic shot of delivering on a client’s long-term objective even if this means taking more risk than you might otherwise take in a perfect world.

We also believe that it’s very important to diversify your diversifiers. Low interest rates are so detrimental to retirees because they make the most common risk management tool, bonds, extremely expensive to hold in large quantities. In this type of environment, one way to improve returns is to move beyond fixed income as a risk management tool. This means incorporating other asset classes and strategies that have a proven track record of strong performance in times of financial crisis. One example of an investment style that fits this profile is trend-following.

ETF Strategy Summit: How are you using active and passive products together in a meaningful way in your portfolios?

Justin Sibears: We use active strategies that attempt to harvest the risk-adjusted outperformance of evidence-based factors like momentum, value, carry, and defensive. Generally speaking, these types of strategies can outperform over the long-run for three reasons. First, the outperformance may be compensation for bearing risk. Second, the outperformance may be the result of taking advantage of other investors’ behavioral biases. Third, the outperformance may result from taking advantage of structural inefficiencies in the market.

In all three of these cases, underperformance, especially over the short-run, can and will occur. This underperformance is a necessity for the premium to exist. If it never occurred (i.e. if a premium is compensation for bearing risk and the risk never materializes), too many investors will adopt the strategy, capital inflows will drive up the prices of the underlying securities, and the forward return of the strategy will approach zero.

As an example, investors are broadly aware that value investing has historically generated excess risk-adjusted returns. However, actually capturing this return required suffering through excruciatingly long periods of underperformance (consider that the Barron’s cover article in December 1999, What’s Wrong, Warren?, opined that “Warren Buffet may be losing his magic touch.” The bubble peaked three months later.).

Simply: if we expect to generate long-term outperformance, we must expect periods of potentially short-term underperformance in which weak hands that fold pass the premium to the strong hands that hold. The trick of asset allocation, in our mind, is to make the ride bearable so that investors stand a chance of staying committed to these active strategies so that the benefits can be reaped over the long-term.

We seek to achieve this goal in two ways. First, we seek to diversify both across active strategies (e.g. pairing momentum and value) and within active strategies (e.g. diversifying how our value strategies measure value, think P/E vs. P/B vs. EV/EBITDA). Second, we recognize that this type of diversification may reduce the magnitude and duration of underperformance, but it will not eliminate it. Therefore, we blend passive strategies into the portfolio to manage tracking error. In addition to helping us manage tracking error, the passive component allows us to manage overall portfolio cost to a level that we deem acceptable.

ETF Strategy Summit: Thanks Justin. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.

Linda Zhang – Purview Investments

Linda ZhangLinda Zhang is the CEO at Purview Investments. She specializes in ETF managed solutions, ESG/Impact Investing, ETF research and execution. We recently spoke with Linda, who will be speaking at our ETF Strategy Summit (Oct. 15 – 16 – Dallas), as she shared her thoughts on ESG investing.

ETF Strategy Summit: Recent research has muddied the debate as to whether ESG adds positive or negative alpha to a portfolio – how do you think about this issue?

Linda Zhang: The comparison of ESG investing and traditional investing is often misguided. First, the time horizon issue. At any given period, one may have performance better or worse than the other. Second, the benchmark issue. A clean energy ESG product might be compared with the broad market index. Third, the measurement issue. The benefits of environmental cleanness and social fairness are not counted, as these benefits are often not measurable in financial return terms.

The view, that ESG is just another alpha generation tool, is not complete. ESG investing brings multiple benefits, beyond financial returns. Purview sees positive impact from ESG investing as the third dimension of modern finance – Return, Risk and Impact. Together, they lift and expand the traditional 2D efficient frontier line (return/risk) to a new 3D efficient surface (return/risk/impact). Investors have choices to choose a portfolio on the efficient surface that best combines the dual investment objectives of return and impact, subject to the risk tolerance.

ETF Strategy Summit: While indexes based on ESG scoring are maturing, is this still a space best accessed via active management?

Linda Zhang: Several companies have become leaders in the ESG scoring business. ESG measurement systems have become more accepted and better understood in the investment community. This is a healthy development for both index-based products and actively managed products. Active managers are better equipped with more research tools and data to more informed decisions.

ETF Strategy Summit: Two groups are often associated with ESG investing: Women and millennials – should the industry be proactive about diversifying the ranks of ESG investors with more men and members of other generational groups?

Linda Zhang: A few survey based studies have pointed out women and millennials tend to be open to ESG investing. However, it would be a mistake to assume that ESG investing should only serve women and younger investors. Education is the key to help investors better understand the reasons for ESG investing. The investment community needs to do a better job reaching out to a broad audience by gender, age, geographical and social economic scopes.

ETF Strategy Summit: How do you think ESG investors should approach digital privacy issues faced by companies like Google, Amazon and Facebook?

Linda Zhang: Digital privacy is a corporate governance issue, it’s a business ethics issue. Investors need to follow whether these companies have a comprehensive and sound corporate governance policies regarding digital privacy. Do these companies follow local and global standards? Do they abide by the regulations regarding digital privacy? The recently implemented GDPR in the European Union sets the standards for company practices regarding digital privacy. If ESG investors find that some companies do not meet the investor’s criteria on corporate governance, they should exclude these firms.

ETF Strategy Summit: Can the ETF structure allow managers and investors to more precisely target ESG outcomes?

Linda Zhang: ETF structure is index based. Index providers can design a specific index to target the desired impact along environmental, social and governance principles.

ETF Strategy Summit: Thanks Linda. We look forward to hearing more of your thoughts at the ETF Strategy Summit October 15 – 16 in Dallas.