The Advisor's Portfolio

ETFs & Model Portfolios: A Powerful Combination

Satisfying your clients’ need for income, ESG and low volatility

by Nadia Papagiannis

Ms. Pappagiannis is Practice Lead, Multi-Asset Solutions for Northern Trust Asset Management. Please visit www.northerntrust.com/.

They say money talks. So, what is money saying these days? Ringing out loud and clear is that investors and their financial advisors are choosing ETFs. ETFs saw record net inflows in 2020, close to $500 billion, and 11% more than the year before according to Morningstar, which at the same time reported large net mutual fund outflows.[1]

What was the driving force behind these ETF flows? Well for this we must read between the lines. Bond ETFs saw 42% of the inflows, which means that equity ETFs and the few “other” ETF categories saw just under 60%.[2] Sounds a lot like a 60/40 model portfolio. Probably because it is.

Per Broadridge, more than half of advisors’ fee-based assets are in model portfolios, in which ETFs are steadily gaining market share—44% of the pie of in 2020, versus 36% two years prior.[3] The top three reasons cited by Broadridge for increasing ETF use are sound: cost, tax efficiency, and exposure to diverse asset classes.[4]

Broadridge also reports that advisors, especially younger ones, plan to increase their use of model portfolios, primarily to scale their practices.[5] And according to Cerulli, advisors who use model portfolios report cutting their time spent on investment management in half, leaving more time for financial planning and prospecting.[6] But outsourcing to model portfolios doesn’t mean your clients receive less sophisticated investment solutions or reduced service. In fact, it can mean the opposite, a win-win proposition for both advisors and clients of all types. Here are three ETF model trends that advisors should consider:

Trend #1: Income

It’s no surprise that the number one financial goal of 72% of fund investors is retirement, as reported by the Investment Company Institute.[7] The benefits of ETFs cited by advisors—cost, tax efficiency, and diversified risk/return exposures align well with this goal. However, the plain-vanilla ETF combinations used by many advisors do not. What Americans overwhelmingly desire—whether they are still working or currently in retirement—is sufficient and reliable income, according to the Employee Benefit Research Institute.[8] A typical 60/40 balanced ETF portfolio is barely generating income these days, with the S&P 500 dividend yield and 10-year Treasury rates both hovering around 2% as of March 18. As the retirement rule-of-thumb is a 4% spending rate, what is an advisor to do?

ETF models specifically designed for retirement income goals can help. First, these models tend to diversify far beyond a simple mix of just stocks and bonds to improve both the return outlook and the income generating potential. For example, over the next five years, Northern Trust Asset Management (NTAM) forecasts high yield bonds and global listed infrastructure stocks to return 5.5% and 5.8% respectively, which is higher than the 4.7% it expects from the broad U.S. stock market, with the majority of those returns expected to come from yield.

Second, more sophisticated retirement income ETF models recognize that market forces can shift quickly, as we learned with the recent pandemic. More nimble solutions can adjust allocations if necessary–if inflation rears its ugly head, or if a virus mutation impedes the global recovery, for example. The goal is to keep both growth and income goals on track for retirement in various market conditions.

Third, many retirement income models allocate to dividend-paying equity strategies, rather than broad market indices, to squeeze out extra income. When doing so, it’s important to avoid over-concentration in the traditional dividend-paying sectors, which come with sector-specific risks (financial and energy stocks during the COVID-19 bear market for example).

Besides offering the potential to achieve better outcomes for clients, many retirement income ETF models come with client-friendly, kitchen-table material that can help advisors explain the basics of retirement planning, and how the solution can help clients achieve their goals. These materials can help win new clients, as well as keep existing clients invested.

Trend #2: ESG

According to Statista, there are at least 72 million millennials in the United States, more than either the boomers or Gen Xers.[9] The oldest millennials just turned 40, and they are starting to amass some wealth. Looking at a Morgan Stanley report, a remarkable stat regarding all millennials is found concerning their investing preference — 95% are interested in ESG (environmental, social, and governance) or sustainable investing.[10] It unquestionably behooves advisors to offer ESG solutions that appeal to this demographic.

However, ESG investing with ETFs is not easy, and constructing an entire ESG ETF model portfolio is even more difficult. ESG is a relatively new investment trend with limited data available, particularly outside of U.S. and developed-market equity asset classes. Furthermore, the few ESG-oriented ETFs that exist outside of these asset classes tend to be smaller and harder to trade.

In addition, regardless of asset class, there is no standard way to invest sustainably. Some ETFs simply exclude certain stocks from broad market indices, such as fossil fuels or controversial weapons. Some funds begin with an investment universe that is more ESG to begin with–companies that follow the Ten Principles of the U.N. Global Compact, for example. And some strategies go a step further, purposefully including securities of companies that score highly on certain sustainable metrics, such as a carbon emissions reduction target, the percentage of women or minorities on the board of directors, or policies against child labor in the supply chain.

More than half of advisors’ fee-based assets are in model portfolios, in which ETFs are steadily gaining market share—44% of the pie of in 2020, versus 36% two years prior...

Even though investing sustainably appeals to many millennials (and other generations for that matter), advisors are ultimately responsible for meeting their clients’ financial goals. Partnering with an ESG ETF model provider who is both an experienced ESG investor and skilled at portfolio construction and risk management is key. Another benefit of partnering is that model portfolio providers are likely to offer marketing material and experts to help you promote ESG investing in your business and explain it to your clients.

Trend #3: Low Volatility

The COVID-19 fallout of early 2020 spooked a lot of investors. Unfortunately, anyone who pulled their money out of the market after the first quarter missed out on the record gains over the next three quarters. Advisors know that the Rule #1 of investing is to stay invested. After all, $10,000 in the S&P 500 index at the end of 1981 (after the outlier stagflation years) would have grown to $488,000 by the end of 2020. Missing only 5 of the best days of that 39-year period, dropped the growth to $302,000 –a $186,000 reduction! While volatility is a part of markets and investing, you fortunately can potentially protect your clients from its impact quite significantly.

Low volatility ETF model portfolios may help. The idea of these portfolios is to stay invested in the equity market in a lower-risk manner, without reducing exposure to stocks, the primary long-term growth engine. Similar to defensive strategies, low volatility equity ETFs systematically screen out stocks that exhibit higher price fluctuations relative to peers. Capturing most of the upside of the stock market, but less of the downside, may be a winning long-term growth strategy that may keep your clients in their seats through tough times. It’s important to avoid sector-focused strategies, however, if you want to avoid unintended risks.

For example, similar to bonds, utility stocks can underperform in rising-rate environments. Combining low volatility equity ETFs with other diversifying asset classes can help improve long-term returns and reduce price fluctuations for the entire portfolio. For example, NTAM data shows that through 2020, high yield bonds achieved more than half of the upside of global stocks since January 1993, but only a third of the downside.[11]

Finally, just like the income and ESG strategies, low volatility ETF model providers can help your business by giving you materials to explain investing to your clients. A booklet with charts plainly showing why your clients should take a long view is one example. A presentation with a script that you can use for a prospecting webinar is another.

The trends towards investor interest in income, ESG, and low volatility strategies will likely persist for quite some time. Learning how ETFs and model portfolios combine to meet these demands may measurably enhance your relationships with your clients.

 

 

 

Northern Trust Asset Management is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC,  Belvedere Advisors  LLC and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.
© 2021 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A. Incorporated with limited liability in the U.S. Products and services provided by subsidiaries of Northern Trust Corporation may vary in different markets and are offered in accordance with local regulation. For legal and regulatory information about individual market offices, visit northerntrust.com/disclosures. For Use with Institutional Investors/Financial Professionals Only. Not For Retail Use.
1. https://www.morningstar.com/articles/1017899/us-fund-flow-records-fell-in-2020
2. https://www.morningstar.com/articles/1017899/us-fund-flow-records-fell-in-2020
3. https://www.broadridge.com/press-release/2020/model-portfolio-market-ends-q1-2020-sized-at-3-trillion-usd
4. https://www.broadridge.com/_assets/pdf/broadridge-des-etf-outlook-2020-portrait.pdf
5. https://www.broadridge.com/press-release/2020/model-portfolio-market-ends-q1-2020-sized-at-3-trillion-usd
6. https://www.cerulli.com/news/model-providers-need-to-confront-the-reasons-why-advisors-are-not-using-models-to-reach-potential-addressable-market
7. https://ici.org/pdf/2020_factbook.pdf
8. https://www.ebri.org/docs/default-source/rcs/2020-rcs/2020-rcs-summary-report.pdf?sfvrsn=84bc3d2f_7
9. https://www.statista.com/statistics/797321/us-population-by-generation/
10. Source: Sustainable Signals, Individual Investor Interest Driven by Impact, Conviction and Choice, Morgan Stanley Institute for Sustainable Investing, 2019.
11. Source: Northern Trust Investments. Data from 1/29/1993 to 2/26/21. Global equities as represented by the MSCI ACWI NR index. High yield as represented by the Bloomberg Barclays Global High Yield TR USD Index.