ETFs tracking popular large-cap indexes like the S&P 500 and DJIA are clearly producing impressive returns and repeatedly hitting new highs. Nevertheless, advisors say they don’t always provide the diversification or risk management clients require, forcing them to seek it elsewhere.
Given the significant rise in the Magnificent 7 and other AI-related stocks, concentration risk has increased in the S&P 500, which can reduce the benefits of diversification. The State Street SPDR S&P 500 ETF Trust (Ticker: SPY), for example, is up a not-too-shabby 14.5% in the past 12 months. Nevertheless, the top 7 holdings, magnificent as they are, make up a third of the fund.
The SPDR Dow Jones Industrial Average ETF Trust (Ticker: DIA), meanwhile, holds 55% of its total assets in its top ten with Goldman Sachs (Ticker: GS) at 11% of the fund. The price-weighted index it tracks recently eclipsed the 50,000 mark and is up a healthy 13% in the past year.
Bob Hostetter, chief investment officer at VestGen Wealth Partners, mitigates this concentration problem by building client-optimized solutions that incorporate many of these indexes into a “well-diversified allocation that is inclusive of equities, fixed income and alternatives.”
By complementing low-cost index equity exposure in total portfolios with higher-cost diversifiers, Hostetter says he can further optimize client outcomes beyond the allocation by paying for "active returns in categories that have historically offered the greatest opportunities for excess return from active management."
“In this way, we seek to maximize the net of fee expected return that is available for a client’s risk profile,” Hostetter said.
T.J. Kistner, chief investment officer of Retirement Plan Advisors, believes strategies such as buffer ETFs, which can offer investors protection against market downturns, allow investors the opportunity to fine tune the amount of risk they are willing to take in their portfolio. Depending on an individual investor’s needs, circumstances, and risk tolerances, outcome-oriented ETFs such as buffer ETFs, derivative income ETFs, or factor-based ETFs can serve an important role when mixed with passive ETFs like the SPY and DIA, according to Kistner.
“Some of these types of strategies can be rules-based and don’t require active management, however, we feel as though active management should offer an enhanced risk management framework that can add value, albeit, at a higher price,” Kistner said.
Similarly, Hostetter believes both Buffer ETFs and Derivative Income ETFs add value in helping clients better translate their investment in the capital market into a more discrete set of possible outcomes.
“In our experience, one of the biggest values of these strategies is that it lowers ambiguity for clients and opens up opportunities for advisors to better serve their clients. By nature of their rules-based approach, we don’t believe these strategies necessarily benefit from having underlying exposures to active equities,” Hostetter said.
That said, there is plenty to look for when selecting a service provider in Hostetter’s opinion.
“It is vital that advisors using these portfolios select a provider who can clearly explain the expected outcomes for their clients and has appropriate capital market access and experience to service these investment strategies,” Hostetter said.
Finally, Daniel Snover, president and chief investment officer at PMV Capital Advisers, points out that ETFs tied to major stock indexes diversify against company-specific risk, but they do nothing to diversify against the risk of stocks themselves. In his view, this is where ETFs that track assets outside of stocks become necessary.
Snover notes that there are several ETFs on the market that actively combine stocks, bonds, commodities, and currencies in a way that can create more value than a static allocation to these assets. These kinds of strategies used to only be available to wealthy investors in private funds but are now available to everyone through the ETF structure.
“Examples include systematic global macro, long/short equity, which can take advantage of pricing differentials within equities while limiting market risk, and managed futures, which can go either long or short the various asset classes to provide protection in falling markets,” Snover said.
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