Typical financial advisory fees, when added to exchange-traded fund portfolio costs, prevent investors from sufficiently benefiting from ETFs’ fat cost advantage over actively managed mutual funds. But there are ways that advisors can offset at least some of their fees for clients desiring ETFs in their portfolios.
Here are four potential ways to add value to clients’ ETF portfolios:
> Asset Mix Design. Asset mix is not only the primary determinant of portfolio volatility but also of total returns. It follows that proper asset mix design is a potential source of added value. To the extent that clients are simply chasing returns or picking investments without the context of a guiding strategy, a competent advisor can add a lot of value.
In 2006 and 2007, I consulted on several portfolios for inves-tors aged 60 years and older. These portfolios exemplified the potential value of proper asset mix design because, without exception, these were 80%-100% invested in stocks.
I follow Benjamin Graham’s suggestion of having a minimum of 25% and a maximum of 75% invested in stocks. Thus, these portfolios ended up with recommendations to come down to 40%-60% in stocks.
This did not require forecasting a market crash — which I did not. But the advice resulted from the simple process of designing investment strategies directly tied to the clients’ stated short-and long-term goals.
In some cases, the excessive stock exposure was the result of another advisor’s advice. In other cases, it resulted from clients’ impatience with paltry bond returns and the allure of handsome stock market gains. Sound asset mix advice is a potential benefit for all portfolios, regardless of the securities selected to fill the different asset-class buckets.
> Security Selection. The benefits of security selection in the context of ETF portfolios are a bit different than when dealing with stocks or actively managed mutual funds. With ETFs, the potential benefit isn’t in picking the best-performing ETF — although that is the approach taken by some advi-sors. Rather, you can help clients by keeping their ETF portfolios as close as possible to the theory underlying indexing. In other words, get the broadest diversification possible at the lowest possible cost. And obtain this diversification using just a few of the broadest ETFs available. For instance, buying market slices by market cap, sector or region amounts to active management at best and speculation at worst.
You can also add value by becoming familiar with the construction and methodology of various indices and the resulting tax efficiency. For example, you may cast aside the popular S&P 500 and MSCI EAFE indices in favour of more comprehensive “total market” indices from other providers, which also tend to be a bit more tax-efficient (and, in some cases, cheaper). You might also look at underlying liquidity and tailor your recommendations to the size of the client’s portfolio.
> Core And Satellite. As almost everything I read on ETFs also serves as an argument against mutual funds, there is an opportunity for forward-thinking advisors to become skilled at blending the best of what mutual funds and ETFs have to offer. Too often, ETFs and mutual funds are discussed in an all-or-nothing context. That’s unfortunate, because significant portfolio benefits can be realized by using ETFs to benefit from the cost savings while keeping some active management to feed your clients’ desire to outperform.
>Asset Location. Asset location, part of portfolio construction, deals with which accounts are best suited to hold specific ETFs. The most simplistic example would see tax-deferred and tax-free accounts hold bond and some foreign equity ETFs while leaving the rest of the equity ETFs in taxable accounts. You could also become familiar with products designed for taxable accounts, such as structured bond and preferred-share ETFs. Finally, as most ETFs to which Canadians have access are domiciled in the U.S., helping your client avoid (or eliminate) exposure to U.S. estate taxes can pay for itself many times over.
Becoming skilled in most or all of these areas shouldn’t be a licence to charge excessive fees. But it should make it feasible for you to charge a fair fee while delivering solid value to your clients. IE
Dan Hallett, CFA, CFP, is direc-tor, asset management, for Oak-ville, Ont.-based HighView Financial Group, which designs portfolio solutions for advisors, affluent families and institutions.