Adding ETFs to client portfolios – Part 2

Because their many benefits outweigh their few shortcomings, we expect ETFs to represent a much greater share of managed assets in the future. But some structural issues within the advisory industry need to be addressed if ETFs are going to take centre stage alongside today’s more mainstream managed products.

There’s no doubt more and more ETFs are found in client portfolios today. Yet these aren’t complete portfolio strategies. Rather, investors are using ETFs in specific applications within existing portfolios usually not composed of ETFs per se.

For example, an advisor may hold a Canadian bond ETF until the specific bond wanted becomes available, at which point the ETF will be sold. Or, an advisor could realize capital losses on, say, energy stocks and replace them with a sector ETF, permitting a continued participation in the sector while writing off the realized loss. ETFs are also used sporadically to participate in various geographic markets, specific sectors or asset classes not present in the main holdings of the portfolio. Many fully licensed, commission-based brokers have already taken to using some of these strategies.

The bigger challenge is to offer a portfolio-management solution whose core consists of ETFs; it’s in this case that all the hurdles come to light.

Transition to ETF-based portfolios

In early 2006, a colleague and I formed a partnership with the objective of transitioning to a discretionary fee-based practice whose main investment offering would be our own line of ETF-based portfolio solutions. These portfolios would be recommended to existing clients as a replacement to their present investments, and to new clients as the core of their investment holdings.

I started at the firm in 2003, bringing with me years of experience in portfolio management, mainly for private clients, and with little retail experience. I also brought with me a keen interest for ETFs and how they could be used to build less costly and more complete portfolios. I was already using ETFs trading on American exchanges for a sector-rotation strategy I managed for my clients.

But by 2006, I had started to attract assets based mainly on my investment offering, a mix of F-series mutual funds and ETFs within fee-based accounts. As the assets, numbers and liquidity grew, ETFs became more and more prevalent in my client portfolios.

My partner, meanwhile, had been with the firm for 18 very successful years, accumulating considerable assets mainly invested in a core of mutual funds complemented by individual fixed-income securities and some stocks. He had also developed excellent business practices and was well positioned in the HNW space. Despite his success, though, he was always looking for ways to improve his business.

Fast-forward a little over four years later, and ETFs represent the core of our portfolio management solutions. For many of our clients, ETFs represent 70% to 90% of their investments. We no longer speak of mutual funds nor individual securities, apart from the very rare occasion.

The transition actually implied four major challenges; forming and working within a new team of two complementary yet very different individuals, transitioning to a discretionary model, adopting a transparent approach to fees, and shifting our investment offering to ETFs. Oh – and why not do all of this during the worst market environment since the Great Depression?

The planning phase

We should all have people around us whose opinions and insights we value. Although a project such as ours rarely goes away once the seed has been planted in one’s head, you can get invaluable insight by presenting it to trusted advisors.

At first, it may be to validate the idea itself. Exposing ourselves to dissenting opinions tested the resolve we had for the project. You may very well find the nay camp has very good arguments you hadn’t thought of, and decide that now may not be the best time to take on a change. For our part, we found that although some people did present relevant arguments against the transition we proposed, they didn’t really resonate with us or reflect our situation or vision for the future. On the other hand, those who shared our enthusiasm gave us a lot of great ideas and also gave us great encouragement.

In addition to colleagues and friends, we also all have clients we can approach more easily than others. So, although our project was still in its definition phase and there was no specific proposal yet, we began talking about its broad lines to some of our important clients whom we felt comfortable with to gauge their reaction.

The sell

Such a big project requires whole days away from the daily distractions of the office to brainstorm and really delve into all the different aspects you can think of, knowing that you can’t possibly think of everything in advance.

The most important realization to come out of these meetings was that we should approach this as a sales project:

• Could we sell the idea to people whose opinion we value (confirmation)?
• Could we totally sell the idea to ourselves (commitment)?
• Could we sell the idea to our staff, whose participation would be vital to the transition (team commitment)?
• And most importantly, could we sell the idea to our existing clients? If they didn’t come on board, the whole exercise would be pointless.

Proposing such an important change to clients is not easy and presents real risks. We approached it like any other sale, and prepared accordingly. If you’re eventually going to have to bring your existing clients on board with your new service offering, you’ll need to be convincing and well prepared. You also need to be fully versed in the values and advantages behind the proposed change, and well documented to communicate it all effectively. We went through thorough off-site exercises, digging into the essence of our team’s new service offering. We defined and elaborated on the different core beliefs behind it, as well as the value we saw in it for our clients, and our reasons for wanting to adopt this route. We wrote one, then another, then another mission statement as our own understanding of the service offering evolved.

In other words, we prepared and drank the Kool Aid ourselves before we pitched it to anyone else.

This exercise alone required several off-site days over several months to complete. Yet it was invaluable, as going through the process changes the person sitting in front of your client (namely, you, the advisor). That person will be thoroughly convinced and convincing from having been through the experience. At their highest level, staff can be an important sales asset within the existing clientele. But for them to achieve this level of value and commitment, they have to internalize and adopt the vision as their own, in addition to understanding the whats and whys of the new business model.

The key to achieving that is to make them part of the process.

My partner and I pitched our new portfolios to our staff, just as we now do with a new prospect – PowerPoint presentation and all.

We felt it was important for all staff members to know the terminology of ETFs and the main attributes of our new portfolio solutions. And the final outcome: each team member now has his or her own sphere of responsibility in delivering our service offering.

Once we’d sold the idea to our staff, they became an indispensable part of our success. As they have a lot of contact with clients through day-to-day servicing, they’re able to reinforce our offerings.

The product

In deciding to become discretionary portfolio managers with our own line of investment solutions, we were in fact taking up the space occupied by the mutual funds and SMAs we had relied on in the past.

We now had to not only develop, but package and sell our own product, all of which are areas mutual fund companies excel at.

In fact, it’s amazing the service you get with mutual funds: sales material, brochures, colourful graphs, manager commentaries, quarterly performance reporting, fact sheets for each of their many funds with their top holdings, and a blurb on their investment approach.

We had to fill this space and develop our own tools for our new product. So, we produced very detailed documents covering topics like ETFs, cost, investment philosophy, service plans, and of course, the new ETF core portfolios we were planning to introduce – just like the mutual fund companies.

Taking the plunge

When a company decides to change its business, it must change the way it does business as well. There has to be a fit between organizational structure and strategic objectives for the company to realize its goals.

Well, it’s the same for an advisor. It stands to reason that if, as advisors, we’re organized to deliver a certain business offering, then if we make the decision to change the offering, we should change the way we are organized.

For example, if an advisor were to decide to go to a new-issues-based business model from a fee-based delegated SMA management model, his or her revenue streams would go from steady but lower gross margin per assets to transaction-dependent yet higher margin per assets. In addition, daily activities would look very different – perhaps going from an asset-gathering and servicing model to a focus on searching for new issues and trading opportunities to present to clients.

An important step for us in the transition to building a business using our own ETF-based portfolios was to define our responsibilities and how we could effectively use our time in the best interest of our new objectives. Again, we posed a number of questions to come up with a working plan.

In the end, we felt it was important to stay focused on selling our proposal to existing clients before going on to find new ones. To that end, we made a conscious decision to refrain from other business development for one year.

Together, we met each client in person and made our case, and this is where our preparation and off-site meetings really paid off. We had such intimate knowledge of our intentions, our product and its advantages that we were utterly convincing.

The core of the message was a joining of our forces and respective strengths in order to bring to the client a new and higher level of service and ETF-based portfolio solutions — all for lower fees than they had been paying in the past.

After the initial sell, regular communication is vital during this transition phase. As mutual funds and stocks were sold off and replaced by our own ETF portfolios, our staff made follow-up calls. Clients were assured that the minimum possible commission had been charged on the sale of any securities. The goal of the exercise was not to generate commission, but to put in place our new portfolio. We also assured them that all mutual fund positions were sold at no cost, with no DSC schedules to consider.

An additional phone meeting was also scheduled in the service plan so we could go over the changes with our clients and help them understand their client statements and answer any questions.

Making it stick

All of the above turned out to be the easy part; up to this point, we were able to control everything and set the timing. The next stage brought with it the unexpected, where things beyond our control appeared at the unlikeliest times. Inevitably, we found client education and communication play a huge part in dealing with the surprises that inevitably come along. But that’s another story – to be continued next month.

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Guy Lalonde is an investment advisor and portfolio manager at National Bank Financial and is based in Pointe Claire, Quebec.

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