In recent years, more investors have turned toward alternative-weighting methodologies in the ETF space, in hopes of zeroing in on the most promising corners of the market.
We recently had the opportunity to talk with Ted Lucas, Managing Partner at Lattice Strategies, about his firm’s unique “risk-first” approach, as well as the strategy behind the company’s lineup of four ETFs – RODM, ROUS, ROAM, and ROGS.
ETF Database (ETFdb): What’s your firm’s background? What motivated you to enter the ETF arena as an issuer?
Ted Lucas (TL): Lattice began managing global multi-asset portfolios in 2007, first working with family offices and later expanding our client base to advisors and institutions.
We were early adopters of ETFs, not only because they are liquid, transparent, cost-efficient and tax-sensitive, but because they have been a critical tool to help us to very intentionally allocate risk at the “macro” level across all of our multi-asset liquid endowment, diversified income, and liquid alternatives strategies. Our initial portfolio designs utilized ETFs based on cap-weighted indices to express exposure to each building block.
Several years ago, we engaged in a custom institutional design partnership to create building blocks for our client that would seek to improve upon the risk allocation offered within individual asset classes, resulting in three private-label ETFs that launched over the last year and a half and currently have $1.5 billion in assets. These strategies were custom-built to the client’s needs.
In parallel with this work, we began to examine how we could improve upon the asset class building blocks in our own portfolios and for other advisors by seeking to improve what might be considered “micro” risk allocation – essentially having a more intentional approach to allocating risk within individual building blocks. As a firm committed to risk-based research and investment strategy design, it is very exciting and empowering for us to now have the tools that allow us to manage risk across asset classes as well as within them.
ETFdb: Broadly speaking, please describe Lattice’s approach to money management.
TL: In many ways, our approach can be viewed as somewhat “upside down” from more traditional approaches to managing money. Instead of trying to maximize short-term performance as the critical focus, our investment strategies are guided by a risk-first approach. We believe that diligent risk allocation decisions – at multiple levels in a portfolio – are the most fundamental driver of capital growth.
With this view, all of our research focuses on applying rigor and creativity to better understand the risks and then taking disciplined action to be more intentional about how such risks can be better configured to achieve the goal of long-term capital growth. This isn’t about taking less risk, but rather using risk more efficiently to drive returns.
We work with many institutions and advisors who are likewise thoughtful allocators of capital and we all spend a great deal of time thinking about how to integrate exposures across asset classes. This is time well-spent, as asset allocation decisions are elemental to investment success or failure.
At the same time, we have developed strategy indexes that allow capital allocators to take intelligent risk allocation deeper into the portfolio. Whether an asset allocator is using cap-weighted passive exposure or active managers to express individual asset exposures, the risk allocation in such building blocks is often unintentional or not known in advance. Our ETFs provide building block tools that take rigorous risk allocation all the way to the “last mile”.
ETFdb: How have you incorporated your risk-first approach into your ETF offerings?
TL: Lattice ETFs are based on systematic, transparent, and rules-based strategy indexes. Each of the rules that drive the desired risk configuration within each particular asset class is codified into the index. The ETF structure provides access to what we believe to be a much more efficient means of pursuing risk-adjusted returns and long-term growth potential.
To take an example, Lattice Emerging Markets Strategy ETF (ROAM) seeks to offer investors more balanced risk exposure across countries, currencies and companies than you’d typically find in a cap-weighted index or active strategy, while also seeking to enhance returns by harvesting across a diverse set of risk premia. The ETF provides improved exposure to more emerging market economies with similar risk.
As contrast, if you look at a typical cap-weighted emerging markets index, you’d find very high concentration in just a handful of countries and currencies. For example, just three countries – China, South Korea and Taiwan – consume nearly half the capital allocation. There are several implications of this. First, it introduces a high degree of idiosyncratic risk in just a few countries and currencies. Second, the exposures are not exactly reflective of the “emerging” opportunity. These three countries are primarily export-led economies, with a high degree of linkage to the developed markets growth cycle. Third, the high concentration results in underrepresentation to the “true” emerging markets opportunity, markets earlier in their growth cycle with better demographics. In Asia, this would include the Philippines, Thailand, Indonesia and Malaysia. Several of the other large country exposures – Brazil, Russia and South Africa – in cap-weighted emerging markets indices are tied to the global commodity cycle and perhaps represent less of a pure exposure to local economic fundamentals.
These concentrations persist at the company level, where similar idiosyncratic risks are present. These are typically global multi-nationals like Samsung or TSMC – both over 20% of exposure within South Korea and Taiwan, respectively – where the majority of revenue is derived outside emerging markets. Alternately, significant company concentrations in other large countries such as China, Brazil and Russia are state-owned enterprises, and – to be generous – do not have the maximization of value for private shareholders as a primary management focus.
And, of course, exposures to countries and companies drift based on market sentiment, without regard to fundamental factors such as valuation or quality.
With that risk challenge outlined, we sought to create an approach to emerging markets that would more deliberately allocate risk in a more balanced way across countries, currencies and companies to reduce concentration, give broader exposure to the emerging markets opportunity set and emphasize companies with favorable valuation and fundamental characteristics.
In other equity regions the risk challenges vary and we apply different methodologies to address them systematically, but the fundamental objective of our strategies seeks to use risk more efficiently to improve risk-adjusted returns and long-term growth. This led to the creation of a US equity strategy (ROUS), developed markets ex-US strategy (RODM) and global small-cap strategy (ROGS).
With upwards of 90% of the risk in a diversified portfolio driven by equity exposure, we believe these strategies represent powerful tools for allocators to take better risk within the building blocks they use to construct portfolios.
ETFdb: How do your current products differentiate themselves from competitors in their respective categories?
TL: The goal of our strategies is to provide allocators a core exposure, with a more consistent experience in terms of performance. They can be used to supplement existing active or cap-weighted exposure in each category, or as a replacement for either.
With respect to other ETF-based equity strategies, our solutions fall into the camp of “alternative indexing” or other terms that serve as a catch-all for anything that is not cap-weighted. Where we differ from many popular strategies in this camp – say, low volatility indexing, fundamental indexing or dividend weighting – is that we attempt to address a wider set of risks in an integrated way, and avoid unintentional side-effects of blunter approaches that seek to emphasize a primary attribute.
Our analysis of such approaches suggests that – while such strategies may well have efficacy over longer periods – certain unintentional risk concentrations occur, such as country, currency, company and sector exposures. As a result, such strategies typically have more erratic value-add over cap-weighted approaches, and can suffer long periods of underperformance when the unintentional risk concentrations they generate experience difficulty.
This approach to managing risk has so far resonated quite well with investors. Our four ETFs have gathered close to $100 million in AUM in a very short amount of time.
ETFdb: What are some major economic trends you expect will persist on the global stage for the foreseeable future? Are there any noteworthy headwinds?
TL: The biggest challenge investors face looking forward is generating sufficient capital growth. It is mathematically impossible for core bond exposure to generate anywhere near the returns experienced over the last several decades given starting yields and the prospect of rising rates. Equities are likewise challenged looking forward with generally lower global economic growth and relatively full starting valuations in the US and many other developed markets. Asset allocation does not have a lot of easy lay-up answers given starting valuations across the spectrum of assets.
With this in mind, we believe it will become more critical than ever for investors to seek ways to use risk more efficiently at the building block level in the service of meeting long-term growth objectives.
The Bottom Line
Lattice Strategy’s lineup of ETFs certainly warrants a close look from investors looking for a unique core holding alternative. The funds’ focus on long-term, risk-adjusted returns
For more ETF analysis, make sure to sign up for our free ETF newsletter.
Disclosure: No positions at time of writing.