October 6, 2022

    ETF Insider

    Welcome to this week’s ETF Insider. The pressure on advisors to show their value through personalized portfolios is strong, but options like direct indexing or custom separately managed accounts don’t work for every client – and selecting individual stocks isn’t scalable. Thematic funds may be a more accessible option to tailor investments to clients’ interests, argues one top ETF provider.

    Meanwhile, at the core of client portfolios, fixed-income buckets have taken an unprecedented beating. That’s causing more investors to question the value of a 60/40 portfolio, new data shows. But as bad as it’s been for bonds, researchers and investment pros still argue that the income and diversification benefits fixed income can offer mean that the balanced allocation strategy is far from dead. Plus, you don’t want to get out just before a rebound, they argue.

    And finally, a bit of personal news: This week is my last writing this newsletter. It has been a pleasure to help advisors with understand how ETF developments might affect their practices.

    We will be taking a hiatus, but please keep an eye out for the next chapter here and reach out to the team with any suggestions for what content you’d like to see as we aim to serve you moving forward: editorial@financialadvisoriq.com

    Jackie Noblett, producer of ETF Insider at Financial Advisor IQ

    Looking to Personalize Portfolios? Try Thematics: Schwab

    Personalization is the “it” service for financial advice providers: whether it is matching investments to specific outcomes, like income generation, or handling unique tax situations, or even reflecting specific ethics or interests. Direct indexing and custom separately managed accounts are starting to dominate the discussion of how to best provide this personalization, but Charles Schwab says there is another way to tailor holdings to a client.

    That would be through allocations to thematic ETFs.

    “Everyone should have exposure to large-cap and small-cap and international, but what you can actually do is just complement that with areas that interests of you,” said Schwab Asset Management Chief Executive Omar Aguilar at the FT’s Future of Asset Management North America conference last week. Regardless of the niche, such products can allow clients to generate greater returns, or express personal values.

    “To us, those two things are what thematic does,” Aguilar said.

    Omar Aguilar says thematic strategies can serve as important tools for expressing personal interests or ethics at the FT's Future of Asset Management conference.

    And, Aguilar said, casting these products as a means to meet client needs for exposure to a specific trend or aspect of the economy is a much more powerful story than how they provide better or different financial returns than a traditional holdings.

    This is an important frame for advisors for two reasons. One, it refines conversations with clients to understand exactly what they seek in an investment – and helps guard against the temptation of a flavor-of-the-week ETF with little long-term investment merit.

    If you’re struggling to explain how thematic ETFs differ from traditional sector funds or active strategies, Aguilar suggested this: “It’s something that has fundamental economic or financial values that you want to have exposure to, and you don’t have a place to do it with the traditional investments you have today.”

    For example, for exposure to something like the metaverse or electric vehicles or blockchain, investors would have to look across a number of sectors and have expertise in understanding the full ecosystem of companies involved and exactly what exposure a particular stock has to a theme. Artificial intelligence and machine learning makes this possible, Aguilar argued.

    Further, making allocations to thematics geared toward addressing individual goals and interests, and not purely relative returns, also helps clients stay true to their investment thesis – even when the market turns against them.

    Indeed, investors need to buckle in for a wild ride if they are true believers in some themes. The poster child of thematic investing since the pandemic in 2020 has been Cathie Wood’s $7.7 billion Ark Innovation ETF. The product, which seeks exposure to companies behind disruptive innovation, boasted a 152.8% return in 2020, only to post a 23.4% decline last year and a 59.9% drop year-to-date in 2022, according to Morningstar data.

    But Aguilar argued that active thematic ETFs like Ark Innovation don’t always share the same motives as index-based approaches to theme-based investing, like Schwab’s. Active management, by its nature, is designed to outperform, and portfolio managers are inclined to focus on the companies that have the best chance of doing that, even if its tie to the theme is not as strong. Indexes are bound by pre-determined metrics that dictate whether a company expresses a theme, and by how much.

    Framing thematic investments as a purer way to articulate personal views may be a good way to tell the trend ETF story, but it remains to be seen whether investors will remember their personal fervor for the metaverse or solar power when cheaper, vanilla indexes outshine in the returns department.

    Why Beaten Down Bonds May Reward the Patient Investor

    2022 has been a brutal year for bonds. How bad? The industry’s largest fixed-income ETF has never had a worse month, and even some strategies designed to protect investors from pain have seen significant declines.

    But things have gotten so bad for bonds that it may be time for investors to start bargain shopping, one Morningstar analyst argues. And one of the biggest bond ETF shops is arguing that fixed income still gives portfolios balance, even if the 60/40 framework has not lived up to expectations this year.

    First, the bad news: while equity fund performance improved over the third quarter (though still posting declines) the bond market turmoil intensified with spiraling inflation and a tough stance on rates over the summer.

    The average fund in Morningstar’s intermediate core bond category fell 4% last quarter, and the average government bond fund fell by 9%, according to a performance review posted on the website of the Chicago-based fund tracker. U.S. stock funds as a whole declined about 3% in the quarter.

    September was a particularly brutal month for some big ETFs: the $80.3 billion Vanguard Total Bond Index ETF’s 4.18% decline marked the worst month in the fund’s 15-year track record, according to Morningstar. The $322 billion iShares iBoxx $ Investment Grade Corporate Bond ETF – a popular fund in the credit space – saw declines of 5.98%.

    Long-duration bond funds have experienced even more pain, given their greater sensitivity to interest rates. The $24.5 billion iShares 20+ Year Treasury Bond ETF is down 28.81% through Monday, while the $4.1 billion Vanguard Long-Term Bond ETF – which includes government and corporate securities with a slightly shorter duration – is down more than 27% in the same period.

    The beat down in bonds has been particularly frustrating for advisors to explain, since bonds usually tend to hold up relatively well when stocks sink, Morningstar analysts note.

    But correlations between stock and bond returns have soared this year as the Federal Reserve hikes interest rates, depressing bond prices. Between 2011 and 2021, the correlation between Vanguard Total Bond Market and the Vanguard Total World Stock ETF was 0.21, with 0 being totally uncorrelated and 1 meaning they move in lockstep. But since the start of the year, correlation jumped to 0.79% according to Morningstar.

    Even Vanguard’s Chief Investment Officer Greg Davis noted in an article on Vanguard’s website this week that rising correlations are “negating some of the diversification benefits” balanced portfolios offer. But he argued that “proclaiming the death of the traditional balanced portfolio is premature” given that, over the long run, bonds have served as portfolio stabilizers, regardless of interest rates.

    Further, rising rates mean investors can generate higher incomes from bond payments, meaning “holding bonds makes even more sense now.”

    The carnage in bonds may have reached a point where the securities are a relative value and investors are comfortable trying to time a rebound, wrote Morningstar’s senior manager research analyst, Peter Marchese, in an article last month. Long government bonds were the second-best selling bond category, and fourth-best selling category overall last month, pulling in $4.5 billion, according to Morningstar Direct. That haul was just behind intermediate core bonds’ $4.9 billion in sales.