Expanding RIA Investment Approaches Beyond SMAs

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Change is constant in the wealth management industry, but during the past year, the COVID-19 pandemic has dramatically impacted the way advisors think about and carry out their business and investment strategies. To survive and thrive in today’s environment, advisors have had to become more innovative and dynamic in their client outreach efforts and prospecting methods, while also keeping a close eye on their proprietary investment strategies to make sure they’re continuing to deliver on client portfolio construction needs. For many advisors, this past year, challenging as it may have been, may in fact have them thinking about ways to broaden the reach of those proprietary investment approaches, looking beyond SMAs, to achieve greater reach and hold in the marketplace.

Any approach packaged in a traditional SMA may have a very compelling and successful investment case but it has its limitations, such as the high barriers to entry for new investors and the related marketing challenges that it can bring. One interesting approach that is gaining momentum in the RIA community is to port such successful investment strategies into more the more versatile ETF wrapper. This is an approach that should not be taken lightly but which can, in the right circumstances, lead to a number of potential positive outcomes for advisors, their clients and the broader investor community.

Things to Consider When Repackaging a Strategy as an ETF   

It seems like a given, but I cannot stress this enough—you need to start with a strong strategy to get strong results. A clear and well-structured investment strategy allows firms to tell their story simply, moving quickly from the “why” part of any discussion with the marketplace to the “how” as in “how does this fit in a portfolio.”

For example, we recently partnered with one such firm, Euclid Investment Advisory, which has been successfully making its approaches available in SMAs for several years. They have a smart, systematic, structured process that has delivered quality returns for years and though their methodology is unique, their story can be simply communicated. To us, they stood out as an excellent example of a boutique RIA, serving other RIAs, that would be well-served, and better serve the marketplace by moving some of their approaches to a more accessible wrapper.

Years ago, this type of move was only available for the largest firms in the industry. Costs were prohibitive, the time frame from the idea stage to actually listing a fund could stretch into years rather than months, and regulatory hurdles were, quite often, an immediate impediment, particularly to a smaller firm. However, in recent years with the changing dynamics of the industry, regulatory changes, and the growing interest in ETFs, new opportunities have been afforded to the boutique RIA community. So the timing might be good, but should you jump into ETFs with both feet? Absolutely not. Every firm’s situation is different and with the same prudence you bring to your decision making on behalf of your clients, you need to weigh the major pros and cons, which include:

Pros

  • The opportunity to introduce your strategy to the retail market, other advisors and, potentially, the institutional marketplace as well. ETFs trade on an exchange, like a stock, making them far more accessible and potentially opening up access to large pools of investor capital.
  • Tax efficiencies. If we had another several thousand words, we could lay out all of the specific points around the tax treatment of ETFs that make them so appealing, but at a high level, the fact is this: like any investment, an ETF is subject to capital gains tax and the taxation of dividends; but ETFs are structured in such a way that necessary trading in the underlying can be managed so that end investors are generally not left exposed to capital gains on individual securities in the underlying portfolio.

Consider that in late 2020, Morningstar looked at the ETFs backed by the 12 largest ETF sponsors in the U.S., totaling 1,392 funds (representing more than 60% of all ETFs listed in the States). How many left their investors with capital gains bills? 70. Or just over 5%. It’s no wonder, for this reason alone, why so many advisors and investors have been gravitating to the ETF structure.

Cons

  • You’re entering a crowded space. “If you build it, they will come,” wrote W.P. Kinsella in his classic book “Field of Dreams.” A better axiom for entering the ETF industry might be, “If you build it, be prepared to find them and show them … repeatedly.” Assets remain concentrated among the biggest funds with the biggest firms. But there have been several examples in the past two years of “independent” fund providers, outside of the Big 3 of BlackRock, Vanguard and State Street, carving out a healthy niche, and building several $1 billion+ funds, with a differentiated idea and a strong approach to marketing.
  • Giving up your “secret sauce.” In reality, while I’ve included this in the “con” list, it is now far less of a potential drawback than it was even two years ago. After a lengthy review process, the SEC in late 2019 finally cleared the way for a handful of ETF approaches that have been labelled “non-transparent” or “semi-transparent.” Several other entire articles could be written about the merits of each of these approaches, but at their heart what they allow a portfolio manager to do is shield the specific moves, and often the specific holdings, of their portfolios, making it difficult for other market participants to front-run their trades or produce exact copies of their strategies.

Whether your ETF holdings are fully transparent or not, one thing the ETF industry has proven itself good at over the years is identifying a good idea and saying “I’ll try that too.” Copycat products abound, which is why I keep this entry on the cons list, since you’ll need to be prepared for direct competition should the marketplace react favorably to your investment idea. First mover advantage is real though, so you’ll need to weigh that as well as you consider your options. 

Changing product wrappers is not something that should be taken lightly, and is a conversation any RIA should have internally and with those clients who have trusted its investment approaches for years. But investor interest in ETFs is undeniable, and with the right partners and plans, an RIA with a unique investment approach that has far-reaching applicability could find the shift to ETFs to be a meaningful plus for its business.

John Creekmur is the founder of Creekmur Wealth Advisors