A couple of weeks ago I was invited by the guys at “The Market Traders” to join in on their weekly roundtable podcast as one of three guest panelists.  If you check out their site, you’ll see that they’re big on commodities.  Possibly a bit more of a speculative bent to their site with ads that make me think that it’s a place where stock pickers come to congregate.  However, I was surprised to find that I wasn’t the only one commenting on ETFs and my fellow panelists didn’t really spend a lot of time discussing specific stocks although a few ETFs were mentioned (not just by me).

We basically comment three times:  Once on energy, the second time on the US dollar and finally with thoughts on areas of the market that we like.  Some who have followed my writings and have become accustomed to the way I do things might be a bit surprised by my final comments.  I basically state in explicit terms how I don’t believe now is a time to think like a traditional asset allocator.  I don’t think now is the time to stick to the “60%-equity/40%-fixed income” strategic asset allocation model.  Frankly, to have a “buy-hold” mentality all of the time requires a stomach of immense fortitude.  (What you are hearing now are people from Vanguard and DFA squirming in their chairs.)  Does that mean I’m leaning towards market timing?  On the spectrum, I don’t think I’m at the far end which is market timing, but I’m certainly not at the buy-hold end.  I’d like to think that the “strategic asset allocation” process which I think is so important (cool with that Vanguard/DFA?) should, in this environment as well as others, be allowed to deviate in two ways:

1.  Allow for some tactical asset allocation.  That may mean allowing min/max constraints for asset classes to deviate even more from “home” or what may be defined as the policy allocation.  That may also mean allowing the asset allocation shifts (rebalancing, delaying implementation of cash equitization, etc.) to happen a little more frequently than normal.  This allowance for tactical decisions could actually mean several things but generally I’m saying that I believe some allowance for deviation from standard asset allocation protocols is warranted.

2.  Allow for exposure beyond the traditional asset mix.  This means to make sure that alternative investment exposures are in place.  Is it too late today for gold, oil, agriculture and other commodities that seem to be getting all the attention these days?  They’re volatile (and I believe, getting more volatile) but their diversification properties are undeniable.  Caveat:  I’m talking about exposure to the commodities via ETFs, ETNs or derivatives, not indirect exposure via equities (like gold producers).  I don’t think it’s too late to get into infrastructure and other inflation hedging asset classes and the only question is how much of these alternative asset classes is warranted as a buffer to the core of traditional asset classes (stocks/bonds/cash)?

Buy-hold philosophies for multi-asset class exposures made a lot of sense for anyone from the period of 1980 to now.  The only major hit was 2000-2002.  The big question I ask myself is whether we are still in this secular up market or did that end one year ago.  In other words, are we in a sideways or down market that has the potential to be anything as bad as the 2000-2002 bear market?  My sense is that for broad regional market exposures like the S&P 500 the answer is likely to be yes.  However, for various sectors and foreign exposures, I feel confident the answer will be no.  We’ve come out of an environment where nearly everything did well fueled by a world of cheap money.  That doesn’t mean that the pendulum will swing causing nearly everything to plummet.

A very important consideration is also the role of private equity and hedge funds given my comments above on the importance of alternative investments.  I can’t stress this enough:  As much as I am a fan of passive instruments, I’ve never said that one should completely disregard active management.  Is it hard to pick the successful managers ahead of time?  Yup.  Do they cost a lot.  More than ETFs and mutual funds but if you’re finding non-correlated returns, they should cost more.  The key question in today environment is what proportion of your portfolio do you want to allocate to market risk and how much to manager risk?

That one takes a bit of time to sink in once you really think about it.

Then you have to ask yourself, is it possible that regardless of which way I choose, it’s likely that the result will be very similar?  In other words, you put all your money in one of two possible portfolios:  All ETFs or all hedge funds … and the result is both go up or both go down!  Of course it’s possible that these portfolios go in opposite directions but that’s what we would expect and that’s why we assume the active-passive proportion decision is important.  But if they go the same way, then we’re likely to lose faith in what we were promised by someone.  The passive route promises very little.  The returns are what the markets provide.  It’s the active route that promises quite a bit more … sometime more than what was provided.  The real bummer is allocating significantly to private equity and hedge funds hoping that they will provide a buffer to the traditional core portfolio of more liquid positions but not reaching that result.  In other words over-promising and under-delivering.

Today’s deleveraged environment provides opportunities but an ever changing landscape for investors travelling the PE/HF path, some good and some bad. We hear of pension funds allocating more and more to many alternative asset classes and strategies.  I wonder if they are pleased or disappointed with their results.  Are the fees worth it?  Are managers providing alpha?  Is the illiquidity constraint more than they bargained for?  Were they too late in making asset mix shifts?  Have they improved their asset/liability situation?

Everyone is talking about credit problems (mortgage, auto, credit card) and the various tentacles of the US economy that are breaking down.  My sense is that it could be as dire as some are stating but the press is likely doing a decent job of sensationalizing the story.  But what about the pension landscape?  Low interest rates plus negative market returns of the past 12 months are bringing us back to the asset/liabiility mismatch situation we first saw during the market slide of 2000-2002.  Are these funds doing so well with their portfolio returns that the relatively low interest rate environment is not causing havoc to their books?  Is this yet another cause for concern for the US financial “infrastructure” landscape?  So many questions and I only wish I could provide simple yes or no answers.  Then asset allocation would be like ordering a pizza.

Despite the volatility we expect to find in international markets and especially in the so-called “developing and frontier markets” (I’m very much not liking those names anymore) there are so many reasons not to have anything but minimal exposure to the US whether it be equities, fixed income or dollars.  Fareed Zakaria’s commonly cited view that one must notice it’s not “the fall of the US” but “the rise of the rest” is important.  It’s important for investors because there’s a parallel to a shift in asset allocation that will surely happen … and it’s already started.  Just how much is an appropriate allocation to the emerging markets?  Defining what is or is not an emerging market or frontier market or even developed market would help in answering this.  But just as important, I believe that the simple move away from “home biased portfolios”, driven by an acknowledgment that intelligent/selective global diversification, is a necessary move in what is likely no longer a simple long-term up market.  Diversification may not be what it used to be, but along with compound interest, it’s one of the very few free lunches we investors have.

Put another way, imagine you are one of the sovereign wealth funds that the press and politicians seem to enjoy commenting on these days.  Recent allocations of these funds to western financial conglomerates (investment banks in need of capital and quickly) is a move to use some of their US dollars to buy relatively cheap assets that will provide some yield (surely negotiated to be better than what others are getting) as well as a buffer to their home grown commodity exposures.  I spend a lot of time thinking about what else is on their shopping list to diversify themselves away from existing commodity and US dollar related risks.  It’s the same exercise any investor should have with their portfolio and the positions held within it.

An article titled “ETFs Enter Transition” (free subscription required) written recently by Julie Henderson at IPE International Publishers describes how institutions are now using ETFs for cash management purposes. Actually, if you’re familiar with BGI and SSGA’s institutional business, transition management is part of the service lineup so the connection between transition management and ETFs is no surprise.

Transition management is important for any investor. Here are a few situations every investor must consider:

1. You have decided to pull your money from a manager and have not decided on the selection of a replacement manager. However, you want to keep your exposure to that asset class.
2. You are an investment counselor for a private client and they are transferring their account to you either a) all in cash, b) securities “in kind” or c) a combination of the two.

3. You are a fund manager and get a large inflow of new monies that should be invested to keep the portfolio exposed to its existing proper proportions.

4. You are a “do it yourself” investor and make periodic investments into your account and are looking for the appropriate process to implement a globally diversified portfolio in a cost-effective manner.

These are just a few examples, but I’ll take them in sequence.

The Manager Replacement Strategy

In this example, I am referring to an active manager in a relative return environment such as a mutual fund rather than a hedge fund. This manager usually has some area of expertise whether it be a region, style (growth or value), or sector specialty. Let’s say that you’ve decided to exit your position with an actively managed fund providing exposure to large cap Latin American equities. Assuming that your asset allocation strategy remains unchanged and you still like the region, but only have a problem with the manager, you could implement a position in ILF or even a combination of country specific ETFs in the region as an interim replacement until you decide (if at all) to replace this with another active manager.

New Client Transition

Here, I’ll take a common example of an advisor with a new client who is transferring their portfolio over from another advisor. If it’s coming over all in cash, then the transition into an all stock portfolio could involve an interim step of implementing purchases of ETFs to gain the broad exposures required immediately. Thereafter, stock specific purchases can be made based on the portfolio manager’s required entry points. For an incoming portfolio that is not all cash, the portfolio manager will have to make the decision whether to sell the stock positions outright or transition into matching ETFs (to keep the existing exposures as it may not be an appropriate time to exit from them). In this case, the transition could be (at its most complex) as follows: stock portfolio -> ETF portfolio -> cash (or directly to) -> ETF portfolio -> stock portfolio.

Fund Manager with New Monies

Imagine you’re a fund manager (mutual fund or hedge fund) and you’re either just starting out fresh with cash or are established but have just received a giant inflow of cash. It may not be logistically possible to simply implement the total cash position into a portfolio of stocks and/or bonds due to size constraints. Of course, the manager could and usually does implement purchases bit by bit through multiple brokers to lessen the market impact. However, the use of ETFs also helps in this situation. Then, in time as the overall fund increases in size, ETF holdings can be peared down in a systematic matter with offsetting stock/bond purchases to keep the proportion in cash in check.

The Do-It-Yourself Investor

For many individual investors, like in the above scenarios, ETFs are more of an interim tool than a long-term hold. Many smaller investors can start out by making regular deposits into their trading accounts as a disciplined means to save. To control costs, this monthly (for example) deposit could be invested in a no load index mutual fund. Then, in time either periodically or during a significant market dip, the investor can move these over to comparable ETFs. The next step, if required, would be to implement a stock or bond specific strategy to fine tune the portfolio.

At the end, you can see that this is all about cash management and the quick equitization of cash to avoid “cash drag”. I’m surprised that the quoted article says that institutions like pension funds are just getting into the use of ETFs for transition management now. Perhaps it’s just that they have relied on outside consultants/managers to handle this process for them, but like with the empowering of individual investors, ETFs (and the broad array of them) have allowed for yet another group of investors to have yet another use of these instruments for the overall benefit of their portfolio.

My point here is that even if you don’t believe in ETFs as a long-term hold within your portfolio but would rather make stock specific calls, there are everyday situations where ETFs are actually quite useful.

One last strategy to consider is based on the cloudy space between strategic asset allocation and tactical asset allocation. SAA is your relatively longer term asset mix decision which can now easily be implemented entirely with ETFs if desired. TAA decisions are more shorter term in nature. However, what happens when you determine that it’s time to rebalance your portfolio? This could be based on a passage of time (such as an annual rebalancing) or based on deviations of your asset mix from your pre-determined SAA framework. Let’s say for example that you’ve had big gains in your equity portfolio and they’re considerably overweighted in your overall portfolio. If you leave it as is, then technically you’ve made a tactical decision to overweight equities. Selling the appropriate amount and moving the proceeds to the currently underweight position(s) would remove the tactical decision and be faithful to the strategic model.

However, doing nothing might be the preferred path for any number of reasons, tax consequences being one, even though tactical measures are desired. In such cases, the existing portfolio holdings could be left intact and tactical positions established using levered ETFs (long or short) or derivatives. This is an area that many large pension plans and endowments are now putting significant resources into in terms of research and manpower. Strategic asset allocation, and models to govern this decision have been around since the beginning of these funds as it’s the foundation of their investment process. However, in many cases, the tactical decision is being internalized as institutions continue to assert themselves as deliverers of alpha yet in a cost conscious manner. These tactical decisions could be, and I believe should be, implemented with the big broad ETFs like SPY or EFA, not necessarily the newer niche ETFs. Trading all of these new ETFs opportunistically I think causes too much of a burden to the vast majority of investors. Holding a position in international real estate or alternative energy shouldn’t be for less than a year or even two in my opinion.

I’ve always thought that the niche sector ETFs and regional exposure ETFs were meant to provide added diversification to the core portfolio. The question is to what degree? A common theme I have often discussed in the past is the increasing correlations among nearly all asset classes as capital markets around the world become intertwined along with their economies. The easy flow of money and information is like fuel to a fire. Even Ray Dalio of Bridgewater Associates, one of the largest hedge fund managers concedes that hedge fund returns have seen greater correlations in time with broad equity indices. If this is truly the case (again, I’ve mentioned this phenomenon several times in past postings), then what’s left for investors in terms of uncorrelated investments to protect them when sh&t happens? Cash and a small handful of other reasonable choices, I suppose.

This is an excerpt from an article in the New York Times:

According to Mr. Dalio’s analysis, over the last 24 months, hedge funds were 60 percent correlated to the Standard & Poor’s 500-stock index, 67 percent correlated to the Morgan Stanley Capital International EAFE (for Europe, Australia and the Far East) index of foreign shares, and 87 percent correlated to emerging market equities (unhedged). They were 41 percent correlated to the Goldman Sachs Commodity Index, 52 percent correlated to high-yield, or junk, bonds, and 42 percent correlated to mortgage-backed securities.

The first caveat is that there are so many possible data sets which could represent hedge funds and anyone can find the appropriate data set that will lead to their pre-determined conclusion. Nevertheless, the 60% correlation with the S&P 500 is higher than many would believe. The other values given are higher. If your hedge fund was marketed as being market neutral and “performing well in both good and bad markets” it should not have correlations similar to what has been provided here by Dalio. But the numbers get worse for some particular hedge fund strategies:

The letter also parsed the correlations by strategy, which is a more precise way to think about hedge funds, since different types of funds take different kinds of risks. Short-biased hedge funds have a negative 70 percent correlation to the S.& P. index, while equity long-short, the description applied to what most people think of as a hedge fund strategy (betting that some stocks might go up and others might fall, usually with leverage) had a huge correlation of 84 percent.

This is actually not new information. Long-short strategies have not only had high correlations especially with the S&P 500 for quite a while (84% is incredibly high) but there’s also the added volatility they bring. VIX overlays are often required. I’m actually happy about these developments because I’ve built a business and expertise in “beta filtering” to deal with this problem which is a serious concern to the institutional investment community.

What’s key is the fact that over a decade ago, the correlation figures were lower:

Then Mr. Dalio looked at data back to 1994, which showed that historical correlations were in the range of 49 to 54 percent; high, but not as high. So as equity markets have done well, hedge funds have done well — not necessarily because of their genius but because they have the wind of the stock markets at their back and because a lot of them use leverage to magnify their bets.

Clearly, beta filtering was not required until roughly the past five years. It’s hard to get data back from the 1970’s and 1980’s since hedge funds were truly secretive and rare beasts at that time. However, it’s fair to assume that with fewer hedge fund participants, among other factors, correlations of their returns with benchmark indices were likely far lower than what we find today. A final excerpt from this article:

Still, no one cares about correlations, or anything else really, until the markets head down.

Which brings me back to my comments on beta management and the SAA/TAA decision. You can rely on hedge funds to protect you in the event of a major market meltdown in the future. But if hedge fund correlations are strong and have been getting stronger in time as the markets have risen, who’s to say that the high correlations will remain during a major market decline? You buy insurance to save you during times of trouble. Investors who look at hedge fund investments as an insurance policy and choose accordingly should do better than those who look at them as return enhancers. In time, if hedge fund returns continue to have increased correlations (and even higher correlations) with broad indices, investors may take it upon themselves to provide their own appropriate “hedge”.

If ETFs represent some form of freedom or power to the individual investor, then perhaps they will be able to better protect themselves when the need arises. For some reason, I now recall old European and Asian sayings that power is great to have but can work against you without wisdom.