Explaining ETF portfolios to clients

When managing ETF-based portfolios, I focus on three important attributes: returns, risk management and cost.

When speaking to clients, I like to tell them a story about my experience with the Great Recession. The global financial crisis of 2008-09 was a turning point for the way I managed money. Like everyone else in the financial services industry, I felt helpless watching the value of my clients’ portfolios sink over an 18-month period. No one could have predicted the extent of the damage done by the recession, including the active money managers who tried desperately to avoid the full brunt of the market’s decline.

I did not lose my faith in capital markets during that time. Indeed, the greatest lesson I learned in the four years the markets took to return to their pre-recession highs was that trying to trade my way out of a market downturn was a futile exercise; staying invested in order to recapture full upside was the way to make money over time.

My experience during the financial crisis allows me to say with authority and conviction that I do not believe the majority of portfolio managers who use an active strategy can outperform their benchmark index. I use the S&P Indices Versus Active (SPIVA) Scorecard’s numbers to back up my claim. Since the crisis, the amount of financial literature available to support index strategies has grown considerably, but SPIVA has some of the most compelling marketing materials to convince clients that traditional index-based strategies have a better chance of outperforming over time.

“But what happens when markets go down?” we are often asked. “Can’t active management help limit losses?” Not necessarily, as is shown by calculations by the Vanguard Group using data from Morningstar Inc., and other data from Wilshire Associates Inc., MSCI Inc. and the Center for Research in Security Prices.

But statistics alone don’t sell portfolios. Financial advisors must use the right terminology when explaining ETFs to clients. Using the word “passive” to explain an ETF strategy has opened the door to questions — not only from clients, but from colleagues: “If we say we have a passive investment strategy, it sounds as if we aren’t doing anything.” Telling clients that you are charging them a fee to generate benchmark returns will certainly not get you far, because the inevitable response is “I can do that by myself. Why do I need you?” or “Benchmark returns are not enough. I want outperformance.”

That’s where the focus on the investment process plays a critical role in winning a client’s trust. Most portfolio managers agree that asset allocation has the greatest impact on portfolio returns. Even with the best suite of index investments, being overweighted or underweighted in an asset class, geographical region or sector can have an impact on portfolio returns.

Once I have made my investment case for using ETFs in our portfolios, I spend a lot of time explaining to clients how I interpret market research to build and diversify our portfolios so they can provide consistent returns over time. ETFs help with risk control because I know exactly how my portfolios are invested from one day to the next. I choose from a variety of index strategies — market capitalization, rules-based, low volatility — to determine the best asset allocation for all of our investment profiles. There is no more talk of “passive” in the way we manage money. The ETF sector has grown so much since I began managing portfolios that passive has become active because of the way we choose the products we use.

ETFs have helped bring about some of the biggest changes in the investment industry in recent years, such as transparency and the downward pressure on the cost of investing. I like to remind our clients that we were early adopters of portfolios that allow us to keep costs low.

There is no better way to convince a client that you are acting in his or her best interests than to say you are invested in the same products he or she is. I built all of our portfolios with my (and my family’s) money — and I tell clients that. I never put anything in our portfolios that I wouldn’t buy for myself.

I believed the late Jack Bogle, founder of Vanguard, when he said that in 60 years of investing, he had never met anyone who even knows someone who can predict where the markets are going.

So, although I will never try to pretend I’m the smartest person in the room, I just might be the most disciplined at taking as much of the emotion out of the investing process as possible. ETFs are the core of my investment thesis and I make sure clients understand why: with stories, numbers and language that is clear and transparent — just like my portfolios.