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Portfolio > ETFs

Diversification, Discipline Still Important in 2015

By Noah Hamman

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The start of a new year is often a time to visit with clients and review their financial plans, assess the portfolio and engage in some sort of conversation about what to expect from markets over a period of time relevant to the client.

The last few years have obviously been a very good run for domestic large-cap equity markets, and it is likely that clients will quickly recognize just how much that asset class has outperformed small-cap, foreign equity, emerging markets and even commodities and alternatives for advisors who allocate that type of diversification for their clients.

Maintaining a diversified asset allocation and decisions about rebalancing is arguably an active process. ETFs nevertheless present the most modern tools to gain exposure to asset classes and specific strategies. Regardless of whether index or active strategies are used, advisors can use different combinations of ETFs to help clients focus on a portfolio and its goals, and not on a specific position.

For example, while foreign equities have lagged far behind domestic equities for the last few years, the former dramatically outperformed during the 2000s. Between the two, one must outperform and one must lag, and if an advisor owns both, it is because he or she does not believe in guessing with their clients’ money. One area will deliver better results and of course this diversification offers the benefit of reducing portfolio volatility. The same applies for a diversified portfolio that uses five asset classes—one must be the best performer and another the worst. Of course, nobody can know ahead of time which area will be best, which is the reason for diversification—a message that cannot be repeated enough.

Another message that bears repeating is that no asset class can be the best performer for all times. Gold outperformed equities for most of the 2000s. In the five years ending Dec. 31, 2009, gold as measured by SPDR Gold Trust (GLD) was up 145% versus an 8% decline on a price basis for the S&P 500. Back then, investors clamored for gold and hated equities, but fast-forward and over the last five years ending Nov. 30, 2014, the S&P was up 89% on a price basis and GLD was down 2.5%.

The willingness to abandon discipline occurs because of increased greed or conversely, increased fear. As important as it is for clients not to panic out of an asset class after a large decline, it remains equally important not to panic into an asset class after a large rally.

There are multiple, proactive solutions to address the issue of impatience with asset allocation, including manager diversification. With the evolution of the ETF industry, advisors are allowed discretion to coach from the sidelines, be active on the playing field or do both—channeling their inner George Halas or Bill Russell. Advisors can make active decisions using beta or tap an active manager from the bench for a specific area of a client portfolio. The last couple of years have witnessed the advent of ETF strategists, further allowing advisors to outsource portfolio management either for diversification purposes or to effectively concentrate on the most needed areas of their practice. An ETF of ETFs also presents a natural extension of the strategist role where a diversified strategy utilizes other ETFs for its underlying holdings and can be accessed via a single ticker symbol.

A consistent message reiterating what strategy is being employed allows for easier interaction between advisors and clients, especially with the full daily transparency and overall efficiency that ETFs deliver. By sticking to a plan rather than focusing on upward and downward movements of an individual position, it is much easier to bring clients back around in case they want to go off the path.

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