Can you believe that annuities are not only still hanging around but actually making a comeback thanks to the retirement of the baby boom generation? Ditto for mutual funds. To paraphrase Lee Iacocca, mutual funds have been just too lucrative to fail. At least until now. But an event as catastrophic as the credit crunch will surely have some long-term effects on the financial services industry. One of those effects might finally be the ascendance of exchange traded funds, and along with them, the death knell of modern portfolio management.
One of the only bright spots we've seen in the financial services industry during the past six months or so has been those firms offering ETFs that short the markets, use leverage, or track commodities indexes: the established Rydex and ProShares ETF shops, and their newest competitor, Direxion Funds. Assets at all three firms are up, way up: according to data from the National Stock Exchange, last November over $26 billion flowed into ETFs, nearly 43% of all U.S. equity trading. That's because these firms not only offer the ETF tools that enable advisors to "strategically allocate" portfolios, they also actively don't discourage the movement of large sums sometimes required by what was formerly known as market timing.
Advisors scrambling to protect client assets from last autumn's market freefall poured funds into commodities, currencies, and most of all, short funds. What might have been a disaster for the global economy was surely a windfall for ETF platforms. "We don't like to think of [the down market] as an opportunity," says Dan O'Neil, president and chief investment officer of Direxion Funds, which nearly doubled its AUM, taking in almost $1 billion in the last two months of '08, "but we do want to help people make money, especially when other people are losing money."
Today's bear market may be putting ETFs on top of the heap because it's causing advisors to question their buy-and-hold investment strategies based on modern portfolio theory. When I started covering financial advice in the early 1980s, the stock market had been flat for 10 years, inflation was in double digits, and a "well-allocated" portfolio consisted of equal parts real estate, oil and gas, and gold. Then, the Reagan bull market began to gather momentum, resulting in a DJIA climb from under 1,000 to eventually 14,000 in the fall of 2007, a 25-year period during which stocks and bonds have been king. Consequently, a properly diversified portfolio now holds small and large caps, growth and value stocks, some bonds, and intermittently, some international securities, which periodically look very good but seem to invariably end in large losses.
Today, the "accepted allocation" may change again. With the current crisis causing massive global losses across all classes of equities, corporate bonds, real estate, and commodities, advisors are reevaluating their most strongly held investment strategies. How can all investment classes go down at one time? Is inverse correlation between assets a myth? Is diversification? What's the real lesson here? How do you explain what's happened to your clients?
When the stock market goes down, buy and hold has always been a bitter pill for clients to swallow. But with sufficient handholding by their advisors, most of them have been able to stay the course and watch their portfolios recover with the economy and the Dow Industrial.
For one thing, there were always some bright spots to point out--small caps were up, or value stocks out performed. For another, historically markets go up a lot more of the time than they go down, so it usually wasn't long before a recovery started to put smiles on everyone's faces again.
Is it different this time? Much as those words (which usually precede some really dumb decision) make me involuntarily cringe, in some ways it is. If for no other reason, we've never seen such losses across all asset classes and styles, with the only exception being Treasury bonds. Yet there were a few investment professionals who had some or all of their clients' money in Treasuries.
Yes, I'm talking about strategic allocators, or tactical allocators, or whatever "those people" have been calling themselves since "market timer" went out of vogue.
Yes, I'm aware that if there's an Antichrist for mainstream independent advisors, they are it. There is probably no more strongly held belief among most advisors than "no one can consistently predict the direction of markets, economies, interest rates, or investments." Therefore, anyone who says they can must be a huckster of the first order, not to put too fine a point on it.
You Can't Ignore Them Now
With all that said, at a time when most "mainstream" advisors and their clients have had their theories shaken to the core, it's hard to ignore folks who seem to have gotten it right when most folks got it very wrong. That is the driving force behind the surging success of ETFs today: the folks who use exchange traded funds predominantly use them to capture predicted market movements, and with the many leveraged ETFs, they can greatly magnify their successes.
It's natural for financial consumers to be mesmerized by good past performance: just look at the investment flows that follow the Morningstar ratings. But what are professional advisors supposed to make out of tactical allocators whose portfolios were on the sidelines or even short as the markets melted down? We all know that when you have a large number of folks making predictions, some of them are bound to be right, on sheer odds alone, and that's when our star-struck, ignorance-is-bliss, uncritical society then proclaims them to be "geniuses." That is, until the next crop of "geniuses" magically replaces them.
Still, with the buy-and-hold allocation strategy in some doubt, you don't have be Nostradamus to predict that more advisors than ever are going to take another look at the "theories" behind strategic and tactical allocation: the temptation posed by those magic words--"but if you could avoid most of the market's down moves..."--is just too enticing. What will we find when the advisory industry turns its semi-critical eye toward today's amazing track records and the strategies behind them? It's too early to tell, but let's just say I have my doubts.
What I am more certain about is that some folks--clients and advisors alike--will buy into the timing model, if only because they've lost their faith in MPT. That means more assets will flow into ETFs, probably a lot more. Ironically, not because they are a better investment vehicles--cheap, transparent products that capture all or part of a market in a highly efficient manner--but because they support the renewed interest in tactical allocation.
The folks who will not escape this scenario or something similar are the broker/dealers and custodians. Already facing rapidly shrinking margins due to the loss of high commissions and heavily loaded proprietary products, brokerage firms and their fee-only brethren will be hard pressed to survive a wholesale transition from mutual funds to ETFs in client portfolios. At least, not in their present form. Lower-expense ETFs have far less padding than fund companies have historically been willing to share with B/Ds and custodians in return for the distribution of their products. With ETFs paying brokerages only ticket charges when the shares are bought and sold, those bourses become essentially clearing firms, with margins that can only be supported by massive trading volumes. That means many fewer firms.
It also means that in-house brokers will become a thing of the past, and independent advisors--who will be the only advisors--will have to look elsewhere to get the support services (technology, compliance, practice management, transitions, etc.) that they currently receive from their B/D or custodian.
In other words, we're looking at a whole new ballgame for independent advice. The good news is that advisors who manage to stick to their buy-and-hold strategy will undoubtedly see their portfolios skyrocket--where else can they go but straight up?--and they will become the heroes of tomorrow's financial services industry. By that time, though, they may be the minority.
Bob Clark, former editor of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at email@example.com.