What advisers should know about ETF model portfolios

In 2011, the Exchange-Traded Fund (ETF) industry passed a key milestone when total assets invested in ETFs crossed the $1 trillion mark. While the growth of the industry has been impressive, particularly given the market conditions that greeted many ETF launches over the last five years, there is still reason to think that these products are just getting started. To this point, flows have been driven by a number of factors, including their liquidity, cost structure, tax efficiency, usefulness as tactical investment tools, and the fact that ETFs can be traded at any point during the day, just like a stock. But by now, most advisers are aware of those attributes, and many are incorporating ETFs into their client portfolios to gain exposure to particular markets, strategies, or asset classes. The next big wave of ETF growth is a logical outcome of the increasingly diversified range of ETFs available in the marketplace: ETF Model Portfolios. These packaged portfolios, made up largely or entirely of ETFs, are becoming a major component in many advisers’ strategic planning and tactical allocations. Interest in these models has been growing quickly, and the total amount of assets committed to these portfolios is believed to be anywhere from $25 to $100 billion, and has been growing at a rate of around 40%, according to some estimates. As more model portfolios make their way to the marketplace, ETF providers have a responsibility to step up their education efforts around these products to help ensure that the adviser community understands how they work and how they might assist advisers in their strategic planning and tactical allocation. As one of the first firms to build and provide ETF model portfolios, we’ve had a front row seat as what was once a small corner of the ETF universe has grown into a major area of innovation. We believe this evolution is still at an early stage. However, as with all new products, there are plusses and minuses that advisers need to weigh when considering ETF model portfolios. On the positive side, the themes and strategies that investors and advisers can explore via ETF model portfolios are nearly endless. The models can be built to reflect a wide range of client risk profiles, or to target specific asset classes or geographies. However, the models themselves are only as good as the ETFs that go into them, and as the allocation tools used to determine the weightings. As with ETFs, we are likely to see an explosion of new offerings making it a challenge to sort out competing performance claims. For this reason, it is imperative that advisers understand just what is contained in any model they may be considering and that the model demonstrates exposure to the particular market segment or sector an adviser is trying to capture. Broad equities, fixed income, international, and alternatives—a space we know well since we launched the only liquid alternative ETF model portfolio back in 2007—are all investment focuses targeted by a large number of models. But with expanded choices comes even more reason for research and due diligence. Major ratings services are beginning to step into the breach. Morningstar, for example, now tracks about 370 strategies with collective assets of around $27 billion. This is a great first step in creating a framework for systematically comparing product offerings. But a Morningstar rating and a short research note are no substitute for diligent research and a commitment to “looking under the hood” when investigating ETF model portfolio options. Your model portfolio provider, be it a fund sponsor or a large RIA, should also be able to give you materials explaining exactly what the model in question is designed to do, how it has held up in past market cycles, how it rebalances, and other important questions. As the number of models creeps closer to the number of ETFs, the best strategy in a crowded marketplace is education, so you and your clients can make the most effective use of the innovative new ETF-based products. Adam Patti is the CEO of IndexIQ.