Discerning & Sophisticated

The Oscar Rogers bit never gets old.

A reader pointed me to this post by Matt Hougan from IndexUniverse about more investment advisors using ETFs for their clients.

Matt opines that the model of relying on actively managed OEFs to generate alpha (so outsourcing alpha) for their clients won't cut it anymore. Matt goes on to say that with ETFs advisors can do a better job for their clients.

This reality of this is multi-faceted. One hand ETFs are merely a tool, a relatively new tool, which create flexibility for all sorts of things. I primarily use narrower ETFs for sector exposure for a couple of sectors usually in conjunction with a stock or two.

For example in the energy sector most clients have a combo of WisdomTree Energy (DKA) and one or two stocks. DKA makes up most of the sector because as the bull market wore on the sector got riskier so it made sense to me to go from all stocks to less single stock risk--so less risk in a possibly played out theme.

Other folks use broad-based ETFs as core holdings and there are countless other ways to use the product.

I can't disagree with Matt I just think there is more to it. One thing that an advisor can do, and from the top down point of view this might be more important that investment selection, is prevent a client from doing something stupid. Many people have done all sorts of research about how normal human thought process works against long term success with investing; behavioral finance. Most people are inclined to do the exact wrong thing which is why different studies show similar results about most actively managed mutual funds lagging the S&P 500 by a couple of percentage points but that the fund holders get about 1/3 the result because they buy and sell at precisely the wrong time and they repeat this behavior.

Simply avoiding stupidity (sorry to be blunt here) is likely more important than how much alpha is generated. Anyone who saves properly and can avoid stupidity has a good chance for having their financial plan work out and if an advisor accomplishes that I would say that is important.

As far as using ETFs to generate alpha in some way that is new, I guess I would say maybe but there are open ended mutual funds that offer many of the same things. The ETF could be a better wrapper (I believe this is generally true) but not always. I use OEFs for absolute return. There have been inverse and levered inverse OEFs trading for ages--again the ETF is a better wrapper but the concept has been available for a while.

More important than adding alpha I think is risk adjusted returns. Beating the market is not necessarily the appropriate goal. To pick an extreme example if your plan on relies on averaging 5% returns to work are you going to take the risk needed to average 20%? You might target more than 5% in that case but targeting 20% would not make sense. As a quick note, averaging 5 or 6 or 7 or whatever percent means you will have a couple of years where you are up 20% give or take because the market will have years where it goes up that much.

The concept of how much risk to take and where to take the risk is crucial to understand and ties in with Taleb's idea of 90% t-bills and taking a lot of risk with the other 10%. If you could get that 10% to double while taking no risk with the other 90% you would be getting all the return you need. Getting that 10% to double is no easy feat but it makes the point.