Key trends in portfolio management can get lost in the sound and fury of new product announcements. To cut through the cacophony, we asked industry experts to provide their thoughts on the portfolio trends and products with the brightest future to help advisors focus.

Their responses include detailed views on investment and strategic planning, and many provide insights into the future of the advice business — regardless of the market’s direction.

Direct Indexing

Although Ben Johnson, director of Global ETF Research at Morningstar, doesn’t see direct indexing — which replicates the performance of an index by buying the individual securities instead of buying an ETF or mutual fund — replacing ETFs, others believe this trend will impact how advisors build portfolios.

One advocate, Michael Kitces, the Nerd’s Eye View blogger and head of planning strategy at Buckingham Wealth Partners, calls direct indexing “the most notable emerging investing trend.” It “provides the potential for tax benefits (via tax loss harvesting), potential cost savings (eliminating the ETF or mutual fund wrapper costs), is more feasible now that custodians charge zero commissions, and will be even more feasible as more custodians roll out fractional shares,” he said.

“The trend is especially notable when advisors then begin to adapt the index ‘funds’ they use via direct indexing, such as adapting them for factor investing or to construct ESG portfolios,” Kitces explained.

Brian Price, senior vice president of investment management for Commonwealth Financial, agrees: “The ability to purchase fractional shares on many trading platforms has made direct indexing more accessible for retail investors,” he said.

“This concept isn’t mainstream in the investment advisor community yet, but it could be in the future. And there is a potential for a large impact for both active and passive mutual funds and ETFs,” Price added.

Bob Seawright believes this trend likely will disrupt ETFs. The chief investment and information officer for Madison Avenue Securities sees direct indexing as “potentially the most disruptive in how it relates to how advisors are going to construct their portfolios generally, but more specifically on how they’re going to go about it and what pieces they’re going to use to do it. When I speak with folks in the ETF industry, they’re convinced that they’ve won … [and that] mutual funds will always exist but ETFs will rule the day.”

But think about it, Seawright says. “If you’re an advisor in [Silicon Valley], you have a real need for the ability to sort out your client’s firm from their holdings.

[You may] prefer to own the S&P 500 index, but your client works for Apple and has a ton of Apple stock. It’s great to be able to pull Apple from the S&P and still provide the index — and create your own index if you choose.”

He also points to the benefits of direct indexing, especially as it relates to socially responsible investing, i.e., when clients want to eliminate certain products or negative screens.

“With direct indexing you have the ability to sort to whatever extent you want to create an individualized portfolio for your clients. And in a way that you can support with academic research as being viable — you’re not just throwing something against the wall and seeing what will stick — but actually coming up with a well-diversified, well-constructed conceptualized portfolio. That’s pretty powerful,” Seawright explained.

Sustainable Investing

Sustainable investing as an investment category has about $30 trillion dollars in assets globally but is not yet widely embraced by the advisor community.

Many experts say SI and all that it covers — environment, social and governance, impact and social investing — is a significant trend in portfolio management, especially as earnings and the investing power of millennials expand. The United States alone has more than $12 trillion in assets, with flows quadrupling year-over-year, according to Morningstar.

“The move towards socially conscious/ESG investing is only going to increase in coming years,” said Price. “Offering advisors and clients ESG resources and portfolio solutions is no longer going to be a ‘nice to have’ but rather a requirement in the future.”

He sees more targeted ESG mutual funds and ETFs on the horizon, and believes “building a portfolio that is exclusively comprised of ESG funds will become much easier in the future.” Plus, “investors will be able to focus their portfolios on environmental and social issues that are most important to them,” Price explained.

SRI or ESG has been a factor in the industry, and there’s no shortage of products that advisors can utilize for portfolios today. BlackRock and State Street Global Investors, for instance, have taken major steps in developing products and making other moves in this direction. They’ve also become vehement in their support of this investment choice.

“We will be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them,” wrote BlackRock CEO Larry Fink in his January letter to CEOs of the firm’s portfolio companies and to its investor clients.

Cyrus Taraporevala, president and CEO of State Street Global Advisors, was even more strident in his January letter to corporate board members:

“Beginning this proxy season, we will take appropriate voting action against board members at companies in the S&P 500, FTSE 350, ASX 100, TOPIX 100, DAX 30 and CAC 40 indices that are laggards based on their R-Factor scores and that cannot articulate how they plan to improve their score.”

Across the pond, Norges Bank Investment Management, the world’s largest sovereign wealth fund with $1.13 trillion, recently called for businesses to improve metrics to ensure they disclose “relevant, quantitative and comparable information on ESG issues.”

Likewise, the Business Roundtable, made up of some of the largest companies in the United States, proclaimed last year that it was pushing toward “stakeholder” importance, and lessening the focus on shareholder returns.

All of this means ESG is not going away anytime soon, and as Larry Adam, Raymond James chief investment officer, explains: “Moving forward, we believe there is still work to be done to define the standards that can be more universally applied to different industries and companies so investors can fully understand and appreciate what they are investing in.

“One thing for sure is there is growing evidence that non-sustainable firms are facing ever more pressure to conform, including increasingly higher costs of capital, greater shareholder activism and capital outflows,” he said.

And advisors should take note that “sustainable investing is no longer confined merely to institutional or millennial investors, but now comprises all demographics and investor classifications,” Adam added.

But despite this growing demand, many advisors still seem reticent to learn more about and to discuss these products with their clients. Ann Senne, head of Advice and Solutions for RBC Wealth Management, acknowledges the advisor quandary, but says her firm has been active in developing portfolio models that are focused on sustainable investing, which have captured advisor interest.

“While we don’t disclose raw asset inflows, that data is proprietary, the interest from advisors — and their clients — has been very strong [for RBC],” Senne said. “Client assets flowing into the funds have grown swiftly since launch [of RBC’s SI model portfolios]. In fact since [early March], inflows have jumped another 10% — despite a steep drop in the broader markets.

“Many of the advisors who have tapped into these new resources for their clients have never utilized the firm’s model portfolios before. And advisors are using these strategies with multiple clients; a sign that it’s not only clients who are interested in responsible investing, but advisors themselves are convinced of the value of the investment strategy,” she explained.

Alternative Investments

While not a “new” portfolio trend, the use of alternative investments (or alts) is growing in importance as a source of new alpha and for hedging strategies. It also covers a lot of ground, from liquid alts to futures and options to private equity and beyond.

“There is an increased interest in historically non-correlated alternative investments as evidenced by the standing-room-only breakout session that I hosted at the Inside ETFs conference,” said Vance Barse, wealth strategist and founder of Your Dedicated Fiduciary, affiliated with Commonwealth Financial.

“There is an increased appetite for knowledge of alternative investments. What are they? How do they work? How should they be — or not be —incorporated into portfolios? Advisors don’t have much experience with [alternatives] and the concern is that [they] might be in the late cycle [of using them] at the moment,” Barse explained, generally referring to liquid alternatives.

“The asset class [overall] needs to be demystified, because there’s a lot of misunderstanding on how the underlying investment strategies work in a portfolio,” he said.

RBC’s Senne agrees and says her firm has been building out its alternative investments space “and making sure that we have a good, diverse selection of investment solutions for those asset classes as well.”

Taking a broader look at the alternatives space, Lou Lemos, chief administration officer of Luma Financial Technologies, believes now is the time to look at other risk-based solutions.

“Structured products are increasingly being utilized in portfolio construction due to their potential to provide investors with a more predictable investing experience by elevating the certainty of reaching their desired outcomes,” Lemos said.

“As the market volatility increased over the last month, the number of structured product pricing requests on [our] platform doubled, possibly implying an increased use of structure solutions to build more efficient portfolios,” he explained.

Lemos adds that previously, structured products were seen as “too complex to understand or too difficult to use. But new technology has made it easier for advisors to “understand how these products can potentially improve client outcomes.”

Outcome-Based Portfolios

Baby boomers also are bringing their own portfolio issues to the advisory world, points out Commonwealth’s Price: “Due to the large number of baby boomers in or nearing retirement, there is going to be an increasing need for outcome-oriented portfolio solutions in the coming years.

“The model portfolios landscape has been dominated by solutions designed for the accumulation phase, but I feel like there will be a significant need for portfolios that accommodate the decumulation phase of retirement. Model portfolios that target specific retirement income goals and/or ranges will be prevalent in the coming years,” he explained.

Michael Finke, the American College of Financial Services professor of wealth management and chair in economic security, has a similar view. “Boomers are also the first generation of retirees that will rely on spending down their defined contribution savings to fund a lifestyle in retirement,” he explained.

“The focus of defined contribution portfolio construction has been accumulation. Now retirees need to invest for spending. This changes the dynamics of the traditional portfolio model because the objective is to fund spending goals over an unknown lifespan,” according to Finke.

“This means paying attention to how retirees spend their money, when they need to spend the money, and how to protect them against the risk of outliving savings. Plan sponsors are aware of the benefits of keeping employees in low-cost fiduciary plans after retirement and are looking for ways to give them an investment that makes it easier for them to live comfortably,” he added.

Target date funds with retirement income as the goal “will continue to gain traction as an investment approach for retirement,” said Marlena Lee, head of Investment Solutions at Dimensional Fund Advisors.

“TDFs that robustly manage the key risks to retirement income can reduce the uncertainty around affordable income in retirement and enable advisors to provide meaningful information about retirement income to their clients,” Lee explained.

“As a result, advisors using these TDFs can help clients decide if they need to save more, work more or retire later to achieve their desired standard of living,” she added.

Like TDFs, “goals-based narratives that reflect stages of clients’ financial journeys” will become more important, according to Matthew Schlueter, executive vice president and president, Wealth Management Solutions, of Advisor Group. An approach of this broker-dealer network is “to build detailed narratives around the milestones that clients are striving for during specific chapters in their lives.

“Early on, clients are trying to ‘build a foundation’ — meaning growing their capital, buying first homes and having children. Later they’re ‘using their wealth’ as they move up in their careers and make meaningful investments, such as their children’s education,” Schlueter explained. “After that comes ‘making their money last,’ as they manage their health, retire and organize their estates.”

He adds that “these narratives create a financial planning-based framework that naturally leads to productive conversations with clients on where they want to go on their financial journey and how to get there.”

Northern Trust Chief Investment Officer Bob Browne sees the industry doing a much better job of bridging a gap between what is a low cost approach to asset allocation to “one with a better understood story that truly makes clients feel comfortable.”

This not only means differentiating between the needs of a 30-year-old vs. 60-year-old, but differentiating “between the needs of a high income 30-year-old who’s highly educated and has a good net present value of salary vs. a 30-year-old who’s an entrepreneur and may be all in on a small business, verses a 30-year-old who’s a high school graduate and has a very different income profile,” Browne explained.

“That’s going to be really exciting for the industry. [Advisors] who get that differentiating correct and can take and provide the appropriate solution to each of those three types of 30-year-olds is going to set the trend for the next several years,” he said.

Bonds, Yes Bonds

Bonds have taken on new fervor according to a couple experts. For example, bonds in taxable accounts have seen a dramatic inflow, according to Finke.

“There seems to be a strong appetite for lower-risk assets, which makes some sense since the wealthiest cohort of Americans in history (the boomers) is now at or approaching retirement. Flows into municipal bonds are equally dramatic,” he explained.

“Both trends are a little worrying because interest rates are so low, and because corporate debt is not at a peak of around 52% of U.S. GDP (as of Feb. 21). And 2019 saw a large net inflow into high yield funds to capture higher potential returns in a low-yield category, but there’s mounting evidence that investors are taking on too much risk for the credit premium they’re hoping to capture,” Finke added.

DFA’s Lee says her firm believes “systematic bond strategies are set to dethrone” those that are more popular today. “Many investors want diversification, higher expected returns and better risk controls. They don’t want surprises.”

Looking at a broader picture, Raymond James’ Adam believes it’s a losing game to position bond holdings based on who’s in the White House. “While it is important to understand the policies of the presidents and their respective party, the person sitting in the White House is of secondary importance,” he said.

“We believe more important factors to assess in determining preferred sectors include the strength of the economy, valuations, earnings growth, Fed policy and investor sentiment,” Adam added.

Active Management

Adam also believes that “as we expect volatility and dispersion to remain elevated in 2020, active money managers should outperform.”

In his mid-February comments (when the S&P 500 was still in a bull market), he explained that “Valuations are at multi-year highs, building geopolitical (e.g. coronavirus) and political risks (2020 election), selectivity within portfolios will be critical over the next 12 months and likely will lead to active money manager outperformance.”

He added: “Opportunities for active money managers are already building, as S&P 500 sector dispersion (the difference between the best and worst sectors — tech vs. energy in 2019) rose above the previous 20-year average in 2019.

“In addition, intra-sector dispersion, literally companies that compete against one another, saw great diversion as well. For example, brick and mortar retailers (that sell similar goods to consumers) saw more than a 140% difference in their 2019 performance,” Adam explained.

Kitces isn’t so sure, noting that advisors “are so increasingly focused on providing financial planning advice that ‘investments’ themselves are fading into the background; advisors are simply focused on low-cost broadly-diversified portfolios, ‘just’ try to track the index results (net of fees), and focus their conversations elsewhere.

“To some extent, this is simply an extension of the passive investing trend, but it’s occurring for different reasons,” he explained. “It’s not a matter of ‘we want to be passive because we don’t think active adds value,’ and is simply ‘why bother spending time trying to add value with active portfolio management when there’s so much more value to be added with financial planning instead!?’”

Ginger Szala is executive managing editor of Investment Advisor. She can be reached at gszala@alm.com.

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