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How To Use Active Funds In A Diversified Portfolio

Active management has been out of favor for a while-high fees, high tax burdens, and poor long-term performance. But with the slow rise of actively managed ETFs, which have lower costs and more tax efficiency than traditional active mutual funds, the gateway to active management has potentially been reopened. This is certainly a positive move, but cheaper more tax-efficient active funds don’t answer the question of how should one use active exposures in a portfolio. We address this question in this post and propose several reasonable approaches one can take to incorporate active ETFs in to a diversified portfolio: Core-Satellite: The core of the portfolio is cheap index funds, the satellite funds are concentrated active ETFs. High-conviction: The core is active ETFs, combined with strategies and asset classes that tend to work well at different times. Let’s dig into each of the approaches in more detail. Core-Satellite Approach: The Core-Satellite approach is fairly simple – for the “core” of the portfolio (let’s say 80%), invest in passive index funds. For the “satellite” of the portfolio (the other 20%), invest in highly active ETFs. Additional information can be found from the CFA institute and Vanguard . Why would this be good for an advisor or a DIY investor? One issue with going “all-in” on actively managed ETFs is that they tend to have a large deviations around an index (i.e., tracking error). For advisors who have to answer to short-horizon clients that review their accounts daily (or DIY investors who always compare themselves to an index), tracking error can create angry clients very quickly. The core-satellite approach may be optimal in this situation, because, by construction, a large part of the portfolio is allocated to passive index funds, which always keep the portfolio roughly inline with broad benchmarks. This core-satellite approach will lower tracking error of the overall portfolio, but give clients a shot at outperformance over time. How much is dedicated to passive and how much is dedicated to active really depends on the client-advisor relationship and the amount of time the advisor spends educating clients on thinking long-term when it comes to portfolio performance. The details of creating an effective core-satellite approach can get complex, but we outline some basic principles of concepts related to a core-satellite approach here . High-Conviction: The high-conviction approach is the approach we take with our personal wealth and most of our clients. Why we take this approach is described here and here . In this approach, the passive part of the portfolio does not exist because it is effectively captured in a long-only diversified portfolio already. There are many active strategies available, but we believe that Value and Momentum are the best long-term bets when it comes to active management. Of course, the problem with high-conviction active portfolios is they aren’t the entire market, and can gyrate wildly around an index. If an advisor has short-term focused investors and the gyration is positive, you’re a hero, but if short-run performance is negative, you no longer have a career in asset management-yikes! We recommend that advisors building a high-conviction active portfolio combine a variety of top-shelf concepts so they help diversify their client’s exposures and also so they limit their own career risk (unless this isn’t a factor because of unique clients). Sounds great, but if high conviction has a higher expected risk-adjusted return, why diworsify? Consider high conviction value investing, which sounds so simple – buy the cheapest highest quality stocks you can find. The problem with these strategies is they can underperform for long stretches of time! After 6 years of underperformance, are you really going to stick with the strategy? For most advisors (and their clients) and DIY investors, the answer would be NO! So diversifying across high-conviction active ideas is critical! Ideally we could find strategies that work well at different times, and then just allocate a portion to each of the strategies. For example, as shown here and here , Value and Momentum tend to work well at different times. So one might consider investing in BOTH value and momentum, as opposed to focusing on the absolute merit of one over the other. Conclusion: Overall, we outline two reasonable approaches to using high conviction active ETFs: Core-satellite and high-conviction. For those advisors and investors who want to track an index and hope to beat the market by a small amount, the core-satellite approach may be the best route. For advisors and investors who are not as concerned with more informed clients and less short-run career risk, the high-conviction route may be a better approach. Good luck.

SEC Proposes New Liquidity Rules For Mutual Funds And ETFs

By DailyAlts Staff The Securities and Exchange Commission (“SEC”) has proposed new rules designed to cut risks in the multi-trillion-dollar asset-management industry. The rules, which were proposed on September 22, would require mutual funds and ETFs to take more precautions to protect against periods of large investor withdrawals. “Changes in the modern asset-management industry call on us to now look anew at liquidity management in funds and propose reforms that will better protect investors and maintain market integrity,” said SEC Chair Mary Jo White. Liquidity Risk The 2008/09 financial crisis identified weaknesses within open-end fund structures and their ability to manage large redemptions during crisis periods. In response to this, the SEC has proposed Rule 22e-4 that would require funds to have liquidity risk-management programs, that would include each of the following elements: Classification of the liquidity of portfolio assets; Assessment and management of a fund’s liquidity risk; Establishment of a three-day liquid asset minimum; and Board approval and review. Perhaps most notable of these elements is #3, which would require funds to carry enough cash and “assets that are convertible into cash” within three business days at a price that doesn’t “materially affect the value of the assets immediately prior to sale.” Other Proposals Liquidity risk isn’t the only bogeyman the SEC is out to slay. Regulators also proposed amendments to Investment Company Act rule 22c-1 that would permit mutual funds (but not ETFs) to use so-called swing pricing. This concept is designed to protect existing shareholders from dilution by passing on trading costs to purchasing and redeeming shareholders. Moreover, the SEC also outlined new disclosure and reporting requirements for N-1A Forms, and the recently proposed N-PORT and N-CEN Forms. What’s Next? The SEC published a white paper titled Liquidity and Flows of U.S. Mutual Funds explaining how portfolio liquidity varies depending on a fund’s redemption history and how portfolio liquidity is affected by large redemptions. The paper is available for download from SEC.gov. The SEC’s proposals were approved in a 5-0 vote . Its proposal will be published in the Federal Register, followed by a 90-day comment period, before taking effect. For more information, visit SEC.gov . Share this article with a colleague

Getting Out In Front Of The Next Bear Market

Summary Anyone that has been investing for any reasonable length of time knows that bear markets are inevitable. Most of the financial media and experts agree that the definition of a bear market is a drop of 20% or more from the high water mark. Keep an open mind to multiple scenarios and avoid becoming overly confident in a specific outcome. Anyone that has been investing for any reasonable length of time knows that bear markets are inevitable. It’s just part of the normal cycle of capital flows that swing from risk to safety with little dependable timing or logic. Most of the financial media and experts agree that the definition of a bear market is a drop of 20% or more from the high water mark. Of course, there is no way to accurately forecast when or where the next bear market will appear. They simply come and go with only hindsight as our guide as to what perceived causes led to the pernicious drop in your portfolio. Right now the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) is approximately 11% off its all-time high. I think that most people would probably put that number next to “correction” in the dictionary rather than bear market. Nevertheless, many experts are already saying this is the big one. The first bear market since the 2008-2009 financial crisis. It’s already here and you better prepare yourself for Armageddon. If you bear with me for a moment (no pun intended), I want to lay down some thoughts as to the motivations for this sentiment. This may very well be the start of the next bear market, but no one knows with absolute certainty where the bottom might be or how the pattern will play out. My advice is to keep an open mind to multiple scenarios and avoid becoming overly confident in a specific outcome . Everyone wants to be the guy or gal who “called it”. They knew from the beginning that this time was different, and after a half-decade run, that the probabilities are favoring a down cycle. This is probably more driven by ego and self-satisfaction than trying to guide your hard earned nest egg or protect capital. Be wary of those who scream the loudest on the way down, for they are likely the ones who will be left on the sidelines as the market heads higher. Changes to your portfolio during a correction or bear market should be made with calculated steps. This may include selling into rallies or making subtle changes to your asset allocation in order to reduce your overall risk profile. That also means fighting the urge to capitulate on big down days or making drastic changes at inopportune times. Nothing goes straight up or straight down in a perfect sequence. The market does move fast, but you have to pick your spots in order to avoid making a big mistake born out of short-term panic rather than sound logic. The Bottom Line I find myself fighting the same cycles of fear and greed that everyone else does. It’s simply a natural psychological reaction to get more pessimistic on the way down and more optimistic on the way up. Yet, letting those impulses translate to big shifts in your portfolio may result in taking too much risk near a top and being too conservative near a bottom. In addition, I always find it helpful to tune out the noise of the financial pundits who thrive on this emotional roller coaster. They don’t know anything more than you do with respect to where the market is headed and they certainly don’t know anything about your personal needs. You should be working with an advisor or managing your own portfolio with well-defined parameters that relate to your specific situation. Share this article with a colleague