Earlier this month, at Exchange, Evan Harp sat down with New Frontier Advisors chief investment officer Robert Michaud to discuss portfolio construction, optimization, and more.
Evan Harp: Let’s kick things off with a mile-high view. Tell us a little bit about New Frontier Advisors and your general take on the markets.
Robert Michaud: I’m trying to figure out how to put the asterisk on this statement: Basically, we’re the first true ETF strategist. We’ve been doing this since 2004. We didn’t just take our mutual fund and convert it into an ETF. We did organic ETFs from the start, because we thought this was really the best way to implement a sophisticated institutional investment process and make it available to regular people, rather than just institutions with multiple billions of dollars.
Evan Harp: So you immediately saw the wrapper itself as a useful tool. Can you can you dig into that a little bit? What makes the ETF a special wrapper?
Robert Michaud: Our background prior to the ETF was somewhere between academic finance and institutional investment management on the quantitative side. How institutional asset managers would tend to invest is they would try to understand, first, what the investment objective of this portfolio is. Basically, why are you investing? What are the goals of investing? From there, they would build the whole portfolio to try to best meet those goals.
They’d use a technique like portfolio optimization to take all their information and put it into a portfolio that’s appropriate for those goals — that matches the liability. You’ve heard about pensions and long-term liabilities and why they care about income? Well, it’s just one little piece of the investment goal. It’s going to be an obvious piece, which is why people talk about it a lot. But the other part is understanding the relationships between the asset classes, understanding where the return over time is coming from, and then thinking about how to make sure you’re getting clear exposure. So things like small-cap, or emerging markets, or credit risk are extremely transparent in ETFs. And so, in some sense, they’re the perfect building block if you are trying to institute a sophisticated institutional investment process. If you have an ETF, you know exactly how to put that into a portfolio because you know exactly how it behaves.
Evan Harp: New Frontier does a lot of portfolio construction, and that is very much your bread and butter. How do you feel like that sets you apart as an ETF strategist?
Robert Michaud: First, I can tell you a little bit of a background for why we focus on portfolio construction. So, this question is, what can portfolio construction really get you, right?
If you have a perspective of how the whole portfolio behaves, that’s much more powerful than if you’re thinking about just one asset class at a time. We’re already thinking about ETFs, so we’re not thinking about just one stock at a time or one bond at a time. Fortunately, we’re way beyond that — even just thinking one asset class at a time, that’s really not as rich a portfolio as you could have, if you are thinking about the whole portfolio and how it fits together.
Portfolio construction and portfolio optimization gives you a couple of things. One, it gives you an understanding of how assets are correlated together, how they fit, and how one will move in a certain direction, how the risk and return trade-off is. It allows you to think about optimizing the risk and return trade-off, rather than trying to just guess and say something like, “It seems like I should have a little bit of emerging markets in this portfolio. How about 5%?”
What’s really the scientifically correct amount of emerging markets to have given what’s going on with your other assets and what your expectations are for them is critical. It’s really the right way to build a portfolio for an investment goal.
It’s very difficult to think about if you have a very specific goal that you can quantify to determine what’s the right amount of every ETF to meet that goal. Portfolio optimization is solving that problem for you.
Evan Harp: I really appreciate the thoroughness of the perspective there. I’d love to hear what you make of the current unusual markets here in 2023. We’re coming off of a bizarre year, what do you think is in store for the markets over the short and the long term?
Robert Michaud: 2022 was obviously a tough year. It was also an unusual year in that it was so far out of the norm for fixed income. Of course, if people are thinking about maybe a recession as possible, everybody understands that their stocks are going to do poorly. But nobody is expecting that could happen to a fixed income investor.
Since we are all about portfolio optimization, one thing that’s different about what we do is that a conservative portfolio doesn’t simply have more bonds — the whole portfolio is built to be more conservative. In 2022, even though our conservative portfolio did relatively well, it did much worse than a conservative investor deserved to happen to them in a normal economic environment.
With that in mind, I’m particularly thinking about how different types of investors should be thinking going forward. So, aggressive investors should be thinking about, well, asset prices are low, risk premia are high both on the fixed income and the equity side — there’s a lot of return opportunities out there.
For balanced investors, there’s a lot of trade-offs that you can make, and in terms of being able to think about the right mix of stocks and bonds and different asset classes.
For conservative investors it’s, again, a different type of portfolio and a different type of expectation. They have the good fortune that fixed income is actually paying them, they can actually get some return. Very importantly, real yields are actually positive now. So, interest rates are high enough and inflation has come down enough — that’s really changed things. For a conservative investor in 2022, there was a dilemma, right? You know, inflation was so high, that if you were in cash, you’d lose a lot of purchasing power. In hindsight, if you were anything else, you would lose even more purchasing power! But you knew for sure, if you’re in cash, you’re going to lose. So, what is a conservative investor supposed to do in such an environment? And there were no good answers.
Evan Harp: What is New Frontier doing differently now?
Robert Michaud: What we’re doing differently now is on the fixed income side. Everything has changed. I just mentioned that real rates are positive, so all types of fixed income investors have the opportunity to actually do what investors are supposed to do — which is accumulate over time by taking a measured amount of risk.
Thinking about how this works in a portfolio when short-term interest rates are so high, it is now possible to achieve roughly the same return as you might hope from many other types of fixed income. Thus, you can move more of the portfolio weights into higher yielding less risky things, which means now you have an opportunity to be taking more risk with other parts of your portfolio that, in turn, might have even more return.
So the portfolios are going to look less like a generic market portfolio now, because things have dispersed, if that makes sense.
Evan Harp: That totally makes sense.
Robert Michaud: This is really giving more opportunities for an optimization process to take advantage of the differences between the asset classes.
Evan Harp: Can you dig into portfolio optimization more, as it seems to be a driving force for New Frontier?
Robert Michaud: Portfolio optimization was the big idea that we founded our firm on. My dad and I did this research, we wrote it in a book about a new way of creating an efficient frontier, which is an update and correction of Markowitz portfolio theory.
We’re understanding ways in which Markowitz’s portfolio theory worked and the ways in which it didn’t. The big thing was that it assumed that you had perfect understanding of the risk and return and correlation between all different asset classes. That doesn’t mean you had perfect understanding of what the future was, but you had a perfect understanding of how the future could work, and we know that that’s wildly unrealistic for financial markets.
No one knows exactly what the expected return or exactly what the correlation of two ETFs is. We just have guesses — educated guesses, based on data, based on history, based on things that we know about the markets now — but just educated guesses.
What we did is we said, “Well, what happens if you break this assumption, and you assume that actually financial information has some uncertainty component to it?” And then we did that. We created a process where you can examine thousands of ways that the future can unfold that are different than your best guess of just one way that it might work.
We created this new efficient frontier. It’s a scientific process that gives you an actual efficient frontier, an actual precise way to invest going forward, but it’s much more diversified. It accounts for many ways the future could unfold.
This is a new take on portfolio optimization. Most sophisticated investors are thinking about, “Well, how do we invest if we’re not perfectly correct about the future?” When you say it like that, it sounds obvious, of course, you’d do that! But we were the ones that came up with this new way. It’s a way to do all the things that you want to do with portfolio optimization and build a portfolio that’s really meeting the goals of living by the axioms of what portfolio optimization should be. It should be understanding risk and return and building a diversified portfolio.
Markowitz built a very concentrated portfolio. We found a way to take into account taxes, liquidity, expense ratios, the very specific investment objective, preferences for income — all of these things can be fitted into a portfolio optimization context and a much richer way of building portfolios.
Evan Harp: We’re at Exchange right now, which is in its second year as an ETF conference. What’s been your biggest takeaway?
Robert Michaud: I was sort of a brat of quantitative Wall Street. As a kid, I heard my dad and his Wall Street friends complaining about the mutual fund industry, and talking about how it’s just got to go away. There are all these new things, and they had all sorts of weird names for them, none of which was ETFs. Like, “We’re going to come in and get rid of this, this horrible old mutual fund industry,” is what they would say.
When ETFs finally came around, I was super excited about them. We were thinking from the start, “How can we take advantage of ETFs to really build a much better portfolio than anyone has ever built before?” We were excited that we could build a whole portfolio that was really taking the investment process of the biggest and most sophisticated institutions and putting it into a portfolio that a regular person could have in their account if they’re assisted with a technology platform. And then AssetMark came to us as one of the first and most forward-looking technology platforms servicing financial advisors, to bring this first truly institutional portfolio of ETFs to advisors.
That’s the backdrop here. I’ve been so excited about ETFs for so long, so I’ve been going to ETF conferences, I got to speak at some of those conferences, and seeing it grow up amid the development of the ETF industry has been incredible.
In the early days, there were a lot of holes in the ETF ecosystem, there are a lot of asset classes that investors needed and wanted that they hadn’t figured out how to make a good ETF for. In the last couple of years, all those holes have gone away. There’s hardly any type of portfolio that is invested in anything remotely liquid that they can’t make an ETF for.
This conference is a great peek into where the ETF industry is now that it’s fully matured. Now that there’s no more real fight between ETFs and mutual funds or struggle for ETFs to gain broader acceptance, I’m looking forward to where the industry goes. ETFs are the standard, and that’s exciting.
Evan Harp: I’ve got one more question for you. What is something that you feel like not enough investors are paying attention to right now?
Robert Michaud: Markets are extremely good at incorporating current information into prices, and so no one should worry about whether they know more about what the Fed is saying than the market does.
But sometimes they’re sort of focused on just one issue, and can pay less attention to how other things are affecting the relationships between asset classes. So I think it’s very important for investors to not forget that diversification still matters, that there are assets that will not all react the same way to the Fed and inflation and interest rates that they did in 2022 — which is just everything was negative.
There is a straight causality in the past. Inflation drives the Fed, the Fed drives interest rates, and interest rates simultaneously mean we’re more likely for a recession and the bond prices are going down. There was that very straightforward way of thinking about almost all the news in the past. And that’s not what’s going on anymore. So, you need to have a different perspective than you had in the recent past, and you need to pay more attention to diversification.
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