Institutional and self-directed investors alike have embraced ETFs for their ease-of-use, cost-efficiency, and unparalleled transparency; these financial instruments have proven to be worthy “core building” blocs for countless portfolios, in addition to serving as “tactical tools” for more active traders. F-Squared Investments, the second largest manager of ETF portfolios on the street next to Schwab’s Windhaven, has been utilizing these innovative funds for clients of all walks for over a decade now. Richard B. Weed, Managing Director of Alternative Investments at F-Squared, recently took time to discuss the role that ETFs play at his firm and what the industry’s future may have in store [Download Free Report: How To Pick The Right ETF Every Time].
ETF Database (ETFdb): How long have you been using ETFs for? Do you see this product structure as the preferred means for building diversified, low-cost, long-term portfolios?
Richard B. Weed (RW): We have been using ETFs for over a decade as a fundamental building block to implement our strategies, which focus on protecting investor capital in down markets while offering meaningful participating in bull markets. Our strategies are quantitatively-based and can aggressively de-risk portfolios in bear markets in order to protect our clients from losses – we call this “investing with airbags.” We believe ETFs are a transparent and efficient means to get exposure to market sectors and their liquidity enables us to implement dynamic risking and de-risking of portfolios [see also The Complete Visual History of SPY].
In our AlphaSector model, ETFs pricing and volatility data are a core input to our quantitative engine, so execution through ETFs is particularly efficient and appropriate for us. In our core AlphaSector long-only equity and long-short strategies we invest in 9 sectors of the S&P 500. ETFs allow us to enter and exit these sectors rapidly and at an extremely low cost compared to purchasing a basket of the underlying securities one by one.
ETFdb: Are there asset classes where you’re more comfortable using ETFs and others where you prefer mutual funds or other vehicles?
RW: There is no theoretical reason why you would not use ETFs for all asset classes but in practice there are differences in liquidity and index replication that make some ETFs superior to others. We have strict requirements for ETFs to display certain characteristics particularly in terms of cost and liquidity before they become eligible for inclusion in our strategies. We need ETFs that have sufficient liquidity and support from sponsors and market makers to ensure that our actively managed strategies can be implemented with the least amount of market impact for our clients and at minimal implementation cost.
ETFdb: ETFs have received some bad press over the past few years. Have you had any bad experiences with ETFs that turned you off?
RW: Most of the negative press has involved so-called “synthetic” ETFs that gain market exposure through swaps. The credit risk, collateral quality and opaqueness of the relationship between the sponsor and broker-dealer have definitely raised questions. We rely exclusively on traditional ETFs that replicate indices using physical underlying securities. We are very conscious of risk in our portfolios and, as such, we do not use derivatives that could cause liquidity issues in a crisis, or expose our clients to counterparty credit risk. In 2008, we were able to move into cash rapidly, which protected investor capital during a very traumatic time in the market. (Our AlphaSector strategy was only down roughly 2 percent in 2008)
ETFdb: What do you expect in terms of ETF adoption going forward? What types of investors have been slow to adopt or are potentially major beneficiaries of embracing ETFs?
RW: We believe ETFs continue to have a bright future. Adoption by both institutions and retail investors will continue to expand as people discover how the “Lego” building block approach to investing can create a return stream to meet almost any investor’s need. There are many strategies that can be implemented using ETFs and we believe that their ease of use and flexibility will lower the barriers to entry in the industry and allow managers with innovative strategies across asset classes and investment styles to develop new business models [see also 10 Questions About ETFs You've Been Too Afraid To Ask].
ETFdb: How are your strategies evolving in the current environment?
RW: We continue to develop strategies that meet the real needs of investors – that is, meaningfully participating in markets when they are rising, but employing mechanisms to avoid dramatic losses. We have more than doubled our asset base to about $15 billion over the last two years as investors have embraced our approach to investing and risk management. The next few years will be challenging as investors looking for performance are faced with the end of the 30-year rally in bonds. This will require a re-thinking of how portfolios are assembled and ETFs will contribute to the flexibility for firms like ours to design appropriate solutions.
Bottom Line: Whether you are managing a billion dollar portfolio for a client or planning your own IRA, ETFs warrant a closer look from anyone looking to minimize investing costs over the long-haul, while at the same time enjoying the ability to easily access virtually any asset class around the globe with transparency.
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Disclosure: No positions at time of writing.