As Risk Mitigation Replaces Alpha Generation, Advisors Can Miss the Forest for the Trees
January 9, 2020 — Boston
After a long run-up in equity markets and given low yields, advisors are more focused on risk management, and less fixated on excess returns and alpha generation
After a long run-up in equity markets and given low yields, advisors are focused on risk management—specifically on ensuring that clients avoid a permanent impairment of capital. As a result, they are less fixated on excess returns and alpha generation and seek to build portfolios designed to minimize losses. While advisors are trying to mitigate risk, their overreliance on select brands and liquidity concerns may be leading them to overlook more tailored exchange-traded fund (ETF) products, according to a new white paper issued by Cerulli Associates on behalf of Rafferty Asset Management, LLC, the advisor to Direxion ETFs.
The uncertain regulatory environment coupled with tightened internal compliance have made advisors refrain from bold tactical shifts in favor of strategic allocation. According to the white paper, two-thirds of advisors use strategic allocations when building portfolios and seek downside protection and portfolio diversification (57% and 55%, respectively) over alpha generation (22%). This shift has implications for both advisors and issuers.
“Advisors want to construct portfolios that their clients feel comfortable holding through fluctuating markets. At the same time, they could be building portfolios that are too conservative to meet their clients’ objectives. Issuers need to tell a different story—one that explains how their product is a strategic fit for advisors’ client bases instead of pure alpha generation,” according to Ed Louis, senior analyst at Cerulli.
While many advisors state that their days of seeking alpha generation are over, they may underestimate the role of active decisions in the portfolio construction process. According to the findings, many advisors are making active decisions, pivoting toward multifactor ETF products to gain exposure with their strategic asset allocations or making small factor tilts as recommended by asset managers they know and trust. “Within the strategic asset allocation component, advisors are expressing their views by adding and subtracting sector exposure risk, selecting asset classes to overweight, or choosing to use passive products. At the earliest stages of portfolio construction, selecting and implementing a strategic asset allocation consists of active decisions,” according to Daniil Shapiro, associate director at Cerulli.
The product decisions that follow have had a positive impact on ETF flows. As advisors seek to lower the underlying expenses to the end-client, ETFs have gained in popularity. In the first half of 2019, ETFs gathered 50% more flows than their mutual fund counterparts. The white paper cites performance (75%), liquidity of underlying holdings (58%), and expense ratio (54%), as the factors that influence the selection of ETFs and tend to evaluate well-known brands. “Advisors over-rely on brands as proxies for quality and liquidity and they are more likely to seek ETFs from a few of the most trusted brands to build a portfolio core. This reliance can result in use of products that are not optimized to these advisors’ specific needs,” adds Shapiro. According to the white paper, the top-three largest ETF sponsors have 82% of ETF assets; marketshare jumps to 90% when expanded to the top five.
Advisors have increasingly gravitated toward products from the largest ETF sponsors, but offerings from other providers may allow them to express specific views in a more targeted manner and build portfolios that better meet client objectives. “Advisors should assess the full array of tools available to them, including factor-based and outcome-oriented strategies, as well as products with embedded capital efficiency to identify how to best achieve the optimal outcome for their clients,” says Dave Mazza, Managing Director and Head of Product at Direxion.