From the August 2013 issue of Research Magazine • Subscribe!

July 29, 2013

Secrets to Building a Top ETF Firm

Four leading advisors share their success stories about their ETF businesses

What does a world class ETF investment advisory practice look like? How does it get built? And how can advisors position their businesses for the next wave of growth?

Research spoke with four leading advisors from across the U.S. about their views. We asked them about their ETF businesses and how they’ve managed to separate themselves from the pack. Along with sharing their success formulas, they share valuable insights about today’s ETF marketplace and where things are headed.

Panel

Douglas Wolfe, Principal and CIO at Saddle River Capital Management ($30 million AUM) in Saddle River, N.J.

Hugh Fitzpatrick, CEO at Princeton Capital Management ($115 million AUM) in Princeton, N.J.

Jeffrey C. Anderson, Jr., Sr. Vice President, National Sales Manager at Efficient Market Advisors ($305 million AUM) in San Diego.

Michael A. Gayed, CFA, Chief Investment Strategist at Pension Partners ($127 million AUM) in New York.

How do you differentiate your ETF advisory practice from the competition?

Anderson: Primarily, we are an outsourced solution for advisors looking to create scale in their practice by utilizing a turnkey asset management solution as opposed to being a local market RIA. Secondarily, we are different from our peers because we utilize a “liquid endowment model” combing strategic, tactical and opportunistic allocation into all our portfolios.

Gayed: While many may use ETFs as a low-cost alternative to mutual funds as part of a passive overall asset allocation, Pension Partners uses them to actively and tactically buy and rotate across various segments of the investable landscape. Through the use of our ATAC models used for managing our mutual fund and separate accounts, we have the ability to quickly and efficiently completely reposition our asset allocation exposure in a single day, altering what we are tracking based on market conditions and intermarket trend movement.

Wolfe: We build our own portfolios. When we first started our practice in 2004 we wanted to stand apart from other advisors. We had a strong background in research and trading, and we had a very good understanding of a fairly new product at the time, exchange-traded funds. We thought that if we could be “the expert advisors” in this new product that would be enough to differentiate ourselves from most. We put together five ETF portfolios, based on client risk categories, and placed our clients in them. So, we can now be called an asset manager as well. Our practice is now almost 100% dedicated to exchange-traded funds.

Fitzpatrick: The broker-dealer community is additionally resisting the move by regulators and consumer activists to impose fiduciary obligations on registered representatives. The instinct is to offer bland, standardized financial products that will be “safe” by being formulaically diversified and conservative. As the large firms drive to protect themselves from legal liability “when things go wrong,” they are standardizing financial products more and more. The goal is protecting the broker-dealer and the investment advisor from liability; the trade-off lowers the investors’ likely returns in order to lower the vendors’ risks. This approach is particularly damaging to investors when the compounding effects of time are factored into the equation. The flight from liability by large investment managers and large broker-dealers creates the independent investment advisors’ opportunity.

How do you decide which specific ETFs to use to build portfolios?

Anderson: Our screening process begins with the universe of approximately 1,200 U.S. based ETFs. For us, the primary considerations are structure, liquidity and cost. We then focus on long only, non-levered ETFs of the traditional cap weighted indexes. It’s important for us to focus as much as we can on the allocation as opposed to trying to be too creative around the construction of the index.

Gayed: Our models primarily focus on broad based equity and bond segments, allowing us to target multiple inexpensive ETFs which track those areas for our clients. By spreading out our investments across several ETFs, we can more efficiently rotate large sums of money and help diversify away some of the tracking error risk that might otherwise occur through such an active strategy.

Fitzpatrick: We find the current tools for understanding ETFs inadequate. We struggle to understand what we want to buy. We view our first task as understanding the building blocks, that is the individual ETF. We are hopeful that Stock Smart’s (developing) new analytical approach will let us both “unzip” an individual ETF and see what is in it and then compare that ETF to others in analytically meaningful ways, as well as “unzip” a whole portfolio of ETFs and then “merge” them to see what the portfolio actually owns. ETFs can also be combined with stocks to create the clearest picture of ownership, diversification and risk exposure.

Wolfe: We had a strong research background, so decided to come up with a research process that would break down each ETF by its underlying constituents and score each ETF by a number of fundamental and technical indicators. The ETFs that score in the top of their asset classes are the only ones considered when building the portfolios. We also have incorporated a number of outside research products into our process to act as a check against our own research.

What type of tools or technology are you using to help with portfolio management?

Anderson: Our technology vendor for portfolio management is Orion Advisory Services. They are a very responsive partner and have helped us do a great job at constructing and maintaining a GIPS compliant performance composite.

Gayed: We primarily use Fidelity, and execute ETF trades through various algorithms designed to minimize NAV impact.

Fitzpatrick: We are changing our approach to technology, primarily to enable us to change our business model. We are planning to implement a business model that uses ETFs within model portfolios within defined contribution plans. The Invest N Retire patent on this approach caught our eye and we believe the approach is powerful. It changes the balance of power in our industry and gives a small player like us a unique value proposition versus the traditional large vendors. Invest N Retire’s abilities to allocate this week’s payroll deductions to the underweighted assets in a professionally managed model portfolio at the plan participant level, and to calculate account performance at the plan participant level, is powerful. Hudson Canyon’s ability to develop model portfolios using relative strength disciplines with ETF’s is also powerful. The analytical capabilities that Stock Smart and Quant Advisor are developing are promising.

Wolfe: We have created what we call “The Black Box.” It is a gigantic Microsoft Excel program that we use to pull and sort all the data sources together and ultimately score each ETF. Some of the other tools we use are Thompson/Baseline for mining our proprietary fundamental and technical research, S&P Marketscope for their ETF analysis, Dorsey Wright for their Technical research and Morningstar for their ETF research.

Name one marketing savvy tip that has contributed to the success of your business.

Anderson: Complete transparency into our process and performance has helped us with credibility. Our chief investment officer, Herb Morgan, does a weekly narrated commentary, which is published via our website. This has helped the advisors and their clients stay in touch with the inner workings and research process of our investment policy team. In addition, we publish performance numbers every month to the front page of our website for public consumption.

Gayed: We no longer live in a solicitation world. We live in a search world. Be visible.

Fitzpatrick: The advice to build a new mousetrap by combining several unique features based on new approaches to old problems gave me the courage to try.

Wolfe: When we first got into the business of marketing ETF portfolios we confronted a lot of headwinds. Advisors who were either doing their own portfolio management or believed they could put a few ETFs into a portfolio and call it a day. Either way, they didn’t need us. We also ran into, and still do, many advisors and institutional investors that needed to be educated on the product. Some who were just beginning to open themselves up to the use of ETFs and some others who were trying to grasp the inner workings of an individual ETF itself. This business is still in its infancy. Simply believing in the product and being persistent through thick and thin would be my simple marketing tip.

Looking ahead, where do you see the biggest growth opportunities for ETF focused advisors?

Anderson: The next biggest opportunity, but even possibly more substantial from an asset flow perspective, is the role ETFs are playing in the retirement plan space. With open architecture firms like Verisight and trading platforms like Mid-Atlantic, I believe we’ll continue to see more plan sponsors gravitate towards ETFs due to the lower cost and enhanced selection of asset managers and their advisor counterparts who now have a great opportunity to deliver a fiduciary based solution at a lower price point.

Gayed: Tactical asset allocation using ETFs likely will have growing appeal as individuals and advisors look towards diversifying away from mainstream stock and bond concentration risk. Volatile stock markets and rising yields will make holding “all the risk” all the time, a difficult strategy. Rather, the future investing environment will likely be about holding the right risk and the right time.

Fitzpatrick: The ETF’s combination of focus and diversification makes them powerful building blocks for designing portfolios. We are trying to build a business by using ETFs to attack what we see as the biggest problem the country faces: the fact that millions of Americans face retirement without enough savings. If we can increase savings, improve returns and cut costs, we just might be able to build a business! The politics of addressing this impending crisis will be nasty. Expect more government intervention into the retirement business.

Wolfe: The business of providing ETF portfolios as an advisor or simply using ETF’s as a part of your practice is in its infancy. Other advisors are just beginning to understand the benefits of their use. The fact that becoming an independent advisor is growing and many of these advisors are becoming more comfortable with the idea that they don’t want to be a client’s portfolio manager, but would rather outsource that function and be the asset gatherer and trusted Advisor. This opens the door to firms that want to focus on the actual ETF managed Portfolio function. Another area that may take a bit of time but would be a huge benefactor of managed ETF portfolios is the 401(k) market.

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