ETFs are catching on with more and more retail and institutional investors alike as the product structure has demonstrated its unparalleled efficiency in more ways than one over the years.
We recently had the opportunity to talk with an institutional money manager that has been utilizing ETFs for over a decade – long before the mainstream financial media was touting their benefits. Below, Scott Kubie, the Chief Investment Strategist at CLS Investments, discusses why his firm has embraced the exchange-traded product structure along with his outlook for the rest of the year.
ETF Database: What’s your firm’s story? 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?
Scott Kubie (SK):: CLS was founded with one specific mission, which has endured as our guiding principle: to be a trusted partner to financial advisors and to deliver innovative investment solutions and reliable portfolio management to individual investors.
CLS’s founder, W. Patrick Clarke, left the stockbroker business in 1975 to focus on developing highly customized financial plans and investment management options for individual investors. Other financial planners began to express a need for this individualized approach, so he began to partner with them as a third party asset manager, and created the organization that would become CLS.
CLS started using ETFs in the late 1990s, and we are now one of the largest active money managers of this versatile investment vehicle. CLS has a verifiable ETF management track record and dedicates significant time and resources to ETF research and utilization. We adopted ETFs as our preferred investment vehicle because they offer broad advantages to clients and particular advantages to our risk budgeting methodology. ETFs’ low costs, multiple sources of liquidity, and tax-efficiency are big advantages to clients. ETFs also publish their holdings daily, diversify around a central theme, generally track indexes, and cover a wide range of asset classes. These characteristics make them excellent tools for a risk-focused active asset allocation firm like CLS.
ETF Database: Why do you think many investment advisors have generally been slow to embrace ETFs in their practice?
SK: ETFs, like any innovation, challenge some while being embraced by others. The proliferation of ETFs, and the range of choices, from total stock market indexes to industry–focused ETFs can leave some advisors with an overwhelming array of choices. For many advisors, mutual fund trading provides better opportunities for efficiency than trading in the market. CLS helps advisors by providing its expertise and knowledge of ETFs to portfolio design and by being an organization highly experienced in trading securities.
ETF Database: Aside from the well-known benefits offered through the ETF wrapper, what do you personally embrace about this product structure?
SK: ETFs’ stable history and transparency make estimating the risk they add to the portfolio much easier than doing so with active mutual funds. Manager changes, style drift, and new investment approaches move the risk characteristics of mutual funds around, while ETFs are much more stable, in our opinion. Longer periods of relevant history provide our risk budgeting methodology with better information from which to calculate a risk score.
More accurate risk scores result in improved risk management for clients.
ETF Database: What are your thoughts on how the industry has evolved in the last few years? Going forward, what do you see as the potential growth areas for ETFs?
SK: Many of the initial funds were broadly diversified index funds with the major advantages being cost, improved liquidity and tax characteristics. ETFs continue to encroach upon the territory of different investment strategies and to democratize strategies previously only available to elites.
For example, owning gold is much easier with an ETF. Bond ladders become diversified bond ladders with ETFs.
ETFs allow for running strategic beta or factor strategies and bring a larger set of quantitative strategies, to a wider range of investors. ETFs make currency hedging a real option for investors. The range of asset classes available in ETF form will only continue to increase their share of the investment marketplace.
Investors should also ponder how ETFs will change their existing investments. Mutual funds and separate account managers must now compete with cheaper strategies using some of the same factors they rely on to add value. Those managers are likely to react by further concentrating portfolios on their best ideas. The increased concentration means more volatility. So interestingly, whether you use ETFs or not, they are changing your portfolio.
ETF Database: How are your strategies evolving in the current environment? What are some of the most compelling investment themes you’re looking to take advantage of?
SK: Every year, CLS’ Investment Committee determines the investment themes to focus on for the year. In 2015 we’ve narrowed it down to four:
- High Quality
- Emerging Markets
- Tactical Fixed Income
I’ll break these down in more detail and offer some examples of ETFs for each.
Currently, economic growth is expected to be below average and interest rates have a greater likelihood to rise than fall. And, in this kind of environment, we believe higher quality companies should outperform.
- iShares MSCI USA Quality Factor ETF (QUAL ) – This ETF invests in companies with low earnings variability and low debt-to-equity, but high return on equity (ROE), which we believe is one of the purest ways to get exposure to high-quality companies.
- PowerShares S&P 500 High Quality Portfolio (SPHQ ) – The screening process on SPHQ is more quantitative. It’s based on growth and perceived earnings and dividends stability from the past 10 years, the S&P Committee determines which companies have the highest quality.
In recent years, the U.S. stock market has outperformed international stock markets, causing some pain for global asset allocators. However, we are more optimistic for the future, and the prospect of emerging markets outperforming the U.S. market.
- iShares Core MSCI Emerging Markets (IEMG ) – An ETF with a broad exposure to emerging markets, and small-cap companies. IEMG is a low cost ETF and is a great way to get a broad emerging market allocation.
Technology is an attractive sector from a valuation perspective. Currently, technology is below its long-term standard deviation average, therefore, we believe, it’s attractively valued.
- Vanguard Information Technology (VGT ) – This technology ETF is an ideal allocation to the sector because of its low cost and broad coverage of the sector.
U.S. equity markets are at all-time highs, but there are still benefits in allocating to fixed income. Investors just need to look a little harder to find the opportunities, for example there was a spread in excess of 6 percentage points of performance separating the best and worst performers: emerging market debt and bank loans.
- PIMCO Total Return Active Exchange-Traded Fund (BOND ) – A good core allocation, BOND has diversified exposure, and is actively managed for opportunities to increase returns.
The Bottom Line
CLS Investments is a perfect example of a professional asset manager that has truly embraced the exchange-traded vehicle as the preferred portfolio building block. Investors who are still wary of utilizing ETFs should consider the numerous advantages these instruments offer over comparable mutual funds.
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Disclosure: No positions at time of writing.