Meeting clients' investment needs today is challenging. Yet even experienced, sophisticated financial advisers are not taking full advantage of the right investment vehicle.
The three most popular vehicles— mutual funds; active and passive exchange traded funds (ETFs); and separately managed accounts (SMAs)—each have benefits and drawbacks. Taking time to fully comprehend these issues is an easy way to help clients.
MUTUAL FUNDS
Still the best way for many investors to access active strategies, mutual funds are efficient ways for investors with smaller accounts to meet investment objectives. Minimums are readily attainable, and funds can be easily accessed on low-cost supermarket platforms.
Broadly accepted and highly-regulated, investors generally consider mutual fund products dependable. Asset managers package the great majority of their best strategies in mutual funds, often with long track records publicly available to judge performance.
Some investment classes—including global bonds, real estate, international equities and strategies that utilize options or derivatives—are more readily packaged as mutual funds than as ETFs or in SMAs.
However, transfer agent and sub-accounting fees can cut into performance. Mutual funds disclose holdings quarterly, a potential turn off for investors who want more transparency. Plus, as pooled vehicles, they can have large embedded gains, making them very tax inefficient.
EXCHANGE-TRADED FUNDS
ETFs have become wildly popular by combining liquidity and tax efficiency at low costs. Costs can be very low for passive ETFs that mimic an index's performance. Passive ETF vehicles have famously outperformed some actively-managed mutual funds, particularly in U.S. mid-cap and large-cap equities. But those returns mask risks.
Market-cap weighted ETFs are "diversified" because they hold lots of names, but large-scale, index-tracking ETFs often follow methodologies that buy proportionally more of the largest capitalization stocks, making larger bets on the most popular names and sectors. Investors in passive indexed products may be unaware of their exposure to what can become undue concentration risks.
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Smart beta ETFs can address this problem. They pursue rules-based approaches that periodically rebalance to reflect changing market conditions, at lower costs than actively-managed products. Smart beta products have mushroomed in recent years, but the specific rules of each ETF matter. Investors can face bewildering arrays of offerings that defy easy apples-to-apples comparisons.
We should show clients how they can take advantage of the many different smart beta strategies—and their many outcomes. The possibilities can be tailored to specific portfolio needs and allow investors to access a high-quality systematic manager at a lower cost.
Actively managed ETFs can be terrific, low-cost solutions. Active management offers opportunities passive strategies cannot. Active ETF strategies, traded throughout the day, provide full transparency, carry less administrative fees and are much more tax efficient.
Active ETFs can also mitigate risk: fundamental security analysis can identify stocks or sectors that are overvalued or poised for correction, then adjust position sizes. Adoption of active strategies should grow as the advantages of the ETF vehicle in an active strategy become more widely understood.
SEPARATELY MANAGED ACCOUNTS
The success of SMAs lies in their advantages: customization, transparency, tax efficiency and professional management. They also offer flexibility in fees and perceptions of higher value for clients attracted by the cachet of professionally-managed strategies in more exclusive wrappers.
SMAs generally serve retail investors wealthy enough to invest $100,000 who want to move beyond pooled vehicles like mutual funds into portfolios with individual security ownership that are actively managed by professional asset managers.
(More: As cash flows to companies after tax reform, here's how to invest.)
They are attractive to clients with specific investment guidelines, and who may want more hand-holding from their financial advisers. Since these are often customized portfolios, advisers can choose managers who run tax-efficient, low-turnover portfolios. Growing demand for environmental, social and governance (ESG) portfolios is also fueling SMA strategies.
The trend away from traditional style box investing to outcome-oriented SMA solutions addressing income, longevity and volatility risk also contributes. But SMAs are not for all clients. Many may not want to tie up a large amount of money in a single strategy.
Choosing the right investment vehicle to meet clients' needs can be an easy win for advisers. More should take advantage of it.
Jeff Masom is the Head of U.S. Distribution for Legg Mason.
