Posted by on Oct 18, 2012 in Articles & Advice, Blog, Featured, Posts |

By Jason Zweig | Oct. 15, 2012 6:20 p.m. ET

Image credit: Pixabay


Exchange-traded funds have quickly become one of the cheapest and simplest investing tools in the world.

They also are the raw material for an increasingly popular but potentially expensive and confusing way to invest.

An ETF is a basket of stocks, bonds or other assets that trades like a stock. Shop wisely, and you can spread your money across low-fee ETFs that will give you access to just about all the worthwhile investments on earth, with no trading commission.

But growing numbers of investors instead are turning to professional advisers who cobble together “managed portfolios” of ETFs. There, your money passes through a thicket of tollgates that can send the annual costs of managing a $100,000 portfolio of ETFs to $2,000 or more—at least 20 times the cost of a penny-pinching do-it-yourself portfolio of ETFs.

What’s more, instead of staying put and rising without incurring current income-tax bills, your money might flicker back and forth at high speed among different ETFs, generating short-term capital gains and even sometimes triggering the need for you to file unfamiliar tax forms. And because ETFs extend across a much broader range of assets than traditional mutual funds, say industry experts, financial advisers face a greater temptation to venture into obscure, risky areas.

The good news is that there are ways to find a financial adviser who will pursue a similar approach at an economical price and a long-term outlook. By focusing not only on fees but on how the adviser represents performance and assembles portfolios, you can maximize your odds of ending up with a safe, cheap strategy that won’t deliver nasty surprises.

“Managed accounts” are broad bundles of securities that financial advisers run for an ongoing fee, rather than earning upfront commissions.

The latest wrinkle in these accounts: a brokerage firm or financial adviser hires a specialized firm called an “ETF strategist” to assemble model portfolios of exchange-traded funds. ETF strategists use economic indicators and mathematical formulas to decide when to move money among ETFs that hold stocks, bonds, cash and other assets.

At year-end 2009, ETFs in managed accounts totaled $82 billion in assets; by this June, they reached $220 billion, or 19% of all the money invested in ETFs, according to Cerulli Associates, a research firm in Boston. Assets at ETF strategists tracked by Morningstar, the investment-research firm, rose 48% between last September and this June to $49.6 billion.

What has driven the growth? Many advisers are good at financial planning and managing their clients’ emotions—but not necessarily at the time-consuming details of running money, says Matt Hougan, head of ETF analytics at the research firm IndexUniverse. Therefore, many of them are eager to deputize other firms with the task of running at least a portion of clients’ portfolios.

The financial crisis was a turning point, says Patrick Newcomb, a senior analyst at Cerulli. The market volatility since 2008 has caused many investors and advisers to doubt the “traditional, strategic, long-term approach to asset allocation,” he says. “They want more-flexible programs that could move [out of stocks] to cash or fixed income, and these ETF strategists solve for that.”

The fees, however, can be considerable. While the underlying ETFs charge, on average, 0.25% to 0.5% in annual management expenses, ETF strategists also take a cut, from as little as 0.1% to 1.25% or more. On top of that are custodial fees to safekeep the assets—generally 0.1% to 0.25%. Transaction costs to trade the ETFs might tack on another 0.15% or so. Then your financial adviser gets his cut, usually between 0.3% and 1%.

Add it all up, and an ETF managed portfolio can cost 1% to 3% of your assets annually.

To be sure, these costs are comparable to those of a traditional “wrap account,” in which a broker spreads your money among various assets and managers. They also aren’t higher than the expenses of conventional mutual-fund portfolios put together by financial advisers around the country. And for investors who lack the time, interest, inclination or skill to manage their own money and can find a cheap managed-account provider, an ETF portfolio that costs 1% or less in total can be a sensible choice.

But a much greater proportion of the cost of a traditional wrap account comes from the management expenses of the underlying assets. The raw material of an ETF managed portfolio, by contrast, costs only a fraction of 1%—meaning that most of your total expenses come from everyone who stands between you and the funds.

Fees aren’t the only potential pitfall among ETF managed portfolios, says Mr. Hougan of IndexUniverse. Some ETF strategists, for example, tout their returns with abandon—especially in the marketing materials they send out to the financial advisers who recommend the portfolios to clients.

Perhaps the most pressing concern is “backtesting.” Many ETF strategists didn’t get into the business until the 2008-09 financial crisis escalated the demand for purportedly low-risk portfolios. One-third of the 485 ETF strategies tracked by Morningstar don’t have even three years of performance history.

That is where backtesting comes in. In this technique, a manager devises a trading strategy, then uses computers to rake through the historical returns of the financial markets to see how well the strategy would have done. Through repeated trials, the manager keeps tweaking the approach until its phantom record is as good as possible.

In such a backtest, a manager knows exactly when stocks and bonds did badly and when they did well—and can design a portfolio that would have been 100% in cash during bad markets and 100% in other assets when they shone.

With the luxury of employing 20/20 hindsight at will across time and markets, a manager can burnish a backtested “model portfolio” into the appearance of blinding brilliance.

Many—but not all—ETF strategists use backtesting, and investors who are accustomed to mutual funds, where regulations generally forbid this practice, need to be on guard against it, experts say. Investing with someone solely on the basis of backtested results is like giving your money to a racetrack tout who can tell you who will win every race—but only after the horses cross the finish line.

Consider the Risk Managed GEMS model portfolio from Niemann Capital Management of Scotts Valley, Calif., which manages roughly $350 million. (The firm’s motto: “Don’t just allocate. Rotate.”) The GEMS strategy, which trades ETFs that invest in emerging-market stocks, returned an impressive 11.65% annually over the five years ended Sept. 28, 2012, according to Niemann’s website.

But Niemann’s GEMS strategy didn’t open to external clients until Jan. 1, 2012. The results before December 2011 were calculated after the fact and weren’t earned by any outside investors.

As Niemann’s disclosures note, “The information given is historic and backtested and doesn’t indicate actual past or future performance. Backtested performance was derived from the retroactive application of a model with the benefit of hindsight.”

“We made it very clear that these are backtested numbers,” says Alan Alpers, a senior portfolio manager at Niemann. “I don’t think there’s a problem if you educate, but I suppose a lot of people might not listen as well as they should.”

Another concern: ETF strategists can make their performance look better by switching the yardstick they use to measure it.

Take the $170 million ETF asset-allocation models designed by iSectors of Appleton, Wis. In September 2009, the firm compared its Liquid Alternatives model—which trades ETFs that use commodities and private-equity and hedge-fund strategies—to a 60/40 mix of the Standard & Poor’s 500-stock index and the Barclays Capital Aggregate bond index. In its June 30, 2011, performance update, iSectors compared Liquid Alternatives to a 50/50 mix of the same stock and bond averages. The portfolio trailed that blended benchmark by 3.5 percentage points over the previous 12 months.

Then, in the update through June 30 of this year, iSectors compared Liquid Alternatives to the HFRX Global Hedge Fund Index—which, it turns out, the model beat by a full percentage point over the previous 12 months.

Vernon Sumnicht, chief executive of iSectors, says the hedge-fund index was always the internal benchmark for the Liquid Alternatives model, but that the firm that reports iSectors’ returns to advisers and clients wasn’t able to obtain full access to the hedge-fund index data until recently. As soon as it did, he says, iSectors switched.

To avoid ending up with a costly and complex ETF portfolio, start by asking about expenses.

Stephen Cucchiaro, chief investment officer at Windhaven Investment Management, which runs nearly $13 billion in such assets, estimates that the typical client who uses his firm’s three ETF portfolios pays between 1% and 1.25% in total costs, including the fees that go to the client’s adviser. That is about as high as you should be willing to go.

Rick Ferri of Portfolio Solutions, an investment adviser in Troy, Mich., builds portfolios of ETFs and other index funds for just 0.25% on top of the underlying fees of the funds, which average just above 0.1%. With transaction fees, total costs come to roughly 0.45%, says Mr. Ferri.

Several online-only services also charge low fees to build ETF portfolios—although typically without a personalized human touch. charges 0.5% for a buy-and-hold portfolio;, 0.25%; and, 0.15%.

In addition to the expenses of the underlying funds, custody and transaction fees might add another 0.25% or so.

You could save even more by doing it yourself, of course. But if you do want help and think an ETF managed portfolio is part of the answer, ask your financial adviser the following questions.

What is my total cost for investing in this ETF managed portfolio, including your fees, those of the underlying funds, the ETF strategist and the custodian or “platform”? Are transaction fees included in that total, or will I be charged extra for each ETF trade in the portfolio?

When was the firm that runs the managed portfolio established? Is its historical performance based on actual results or on backtesting?

Has this managed portfolio consistently compared its returns to the same benchmark over time, or has it opportunistically shifted the comparisons?

Are the disclosures of the ETF strategist “GIPS-compliant”? The Global Investment Performance Standards, or GIPS, are set by the CFA Institute, the organization that trains financial analysts world-wide.

At least three-quarters of major investment managers around the world comply with these guidelines, “which provide assurance that a firm adheres to global best practices” for reporting their returns, says Jonathan Boersma, who runs the program at the CFA Institute. In the latest iShares Connect guide, an online directory of 227 ETF managed portfolios, just 53% report that they are GIPS-compliant.

What is the average internal turnover rate of this ETF portfolio? If the ETF strategist turns over 100% or more of the portfolio annually, that means the typical holding remains in the basket for less than a year—and could contribute to a higher tax bill for me.

What proportion of the total return on this ETF managed portfolio last year was taxable as short-term capital gains?

Does this portfolio invest in commodity ETFs that could require me to file K-1 tax forms, which could raise my accounting bills by hundreds of dollars?

If your adviser can’t answer these questions, you should decline to invest in the ETF managed portfolio he or she is recommending. You might even consider getting a new financial adviser.

SourceThe Wall Street Journal