transformation, butterfly with caterpillar and chrysalis

The global financial crisis and ensuing “Great Recession” of 2008-09 was a game changer for many financial advisors. In my case, it was the catalyst for a deep reflection on how I managed my clients’ money, eventually leading to my subsequent adoption of what was then called a “passive” investment strategy using ETFs.

Mutual fund portfolio managers came under intense scrutiny in the aftermath of the global financial crisis as statistics revealed that an overwhelming majority of active portfolio managers were unable to outperform their benchmark indices over long periods. Specifically, more than 50% of active managers in the U.S. were unable to fare better than the broad U.S. Wilshire 5000 total market index even in bear markets — and especially from 2007 to 2009. These lacklustre results begged the question: Why was I placing my clients’ assets into mutual funds with higher management fees when a passive cap-weighted index-tracking ETF had a statistically significant chance of garnering better returns over time?

Of course, there always are exceptions to the rule, and some active managers do beat their benchmarks. This could certainly be the case for smaller, less liquid asset classes, such as emerging markets and preferred shares. But the reality is that most active managers with top-quartile performance one day no longer are top-quartile performers after a five-year period. Therefore, the lack of “persistent” performance using mutual funds was another compelling reason to make the transition to ETFs.

One of the most important lessons from the financial crisis was the fact that it took, on average, four years for many investors who were able to sit tight with their investments to recuperate the losses they suffered. Although a portfolio of equity ETFs is not immune to downside risk, it ensures full participation in the upside once stock markets turn around.

But even if you use a portfolio of ETFs for clients, most of them won’t capture full index or market returns during a 10-year period. As famed U.S. investor Warren Buffett once famously said, most investors will try to time the market and end up buying when the market is high because of greed and sell when it’s low because of fear.

My takeaway from all of this, in the post-financial crisis shake-out, was that the best way for me to achieve good returns for my clients over time was to invest in a diversified portfolio made up primarily of ETFs, and to manage asset allocation, along with my clients’ emotions, diligently.

What might sound simple was not necessarily easy. My conviction regarding portfolio management using ETFs also had to be a viable business model in which clients understood the investment process and felt that they did, indeed, need to pay a fee for me to manage their money. Passive investing did not mean charging clients for either “doing nothing” or for doing something so easy that clients could do themselves. Rather, the focus of the services provided turned to asset allocation, tax efficiency, hedging strategies, rebalancing discipline and the importance of following a financial plan.

In the months and years that followed the financial crisis, I made the gradual conversion to a fee-based (and later, discretionary) approach to portfolio management. I did this so that I could get paid for managing ETF-focused portfolios with the belief that I was doing the best thing possible for my clients based on performance, price and risk management.

I wasn’t the only advisor who made this paradigm shift, but it was an uphill battle based on conviction with the process and wanting to do the right thing. As ETFs subsequently gained popularity, the offerings became increasingly diverse. Client conversations evolved from explaining what an ETF was and became more of a discussion about which ETF to invest in, when, where and why. This transition has been a challenging but rewarding one for me — and it continues to evolve to this day.