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Why Model ETF Portfolios Need Active Mgmt

Cinthia Murphy

John Davi has a long track record of providing macro insights for major institutional money managers. He spent 18 years working for Morgan Stanley and Merrill Lynch. Now, he’s bringing his expertise to the ETF strategist space, opening this month Astoria Portfolio Advisors, looking to bring institutional-caliber investing strategies to retail and advisor clients.

ETF.com: You've worked at Morgan Stanley and Merrill Lynch in their ETF efforts before starting your own firm. Why begin an advisory?

John Davi: It was always my aspiration to have my own company, and 10 years ago, starting your own investment advisory firm would have been very difficult, because you didn't have the tools that you have available today. Now you can build a global macro portfolio of ETFs fairly quickly and at a low cost.

My goal is to leverage all the institutional experience I've had working at Morgan Stanley and Merrill Lynch, and give retail investors and financial advisors access to institutional-caliber portfolio strategies.

ETF.com: ETF model portfolios today are practically commoditized. What's your investment philosophy? What's unique about the way you're doing things?

Davi: We do macroeconomic and quantitative research to evaluate whether asset classes are not only cheap but if the market will realize its potential. Take, for instance, Japan. It was a market that, for 20 years, stayed cheap. The catalyst that eventually turned Japan around was when Shinzo Abe came into office. I believe Japan still remains attractive in the context of this global economic recovery we’re seeing. That’s step one.

The second step is we focus on game theory. We look at a variety of positioning and sentiment indicators to determine whether there's a mispricing.

For example, there was all this concern about secular stagnation in the post-credit crisis period. People piled into curve, roll-down, and yield trades given that growth was perceived to be low. But what we had after the credit crisis was one of the greatest bull markets ever. And people were largely absent from it. We look for these mispricings.

The third thing is risk management. We look at cross-asset risk indicators, we take inputs from the derivatives market, and we use these signals to de-risk the portfolio during times of distress.

 

Given where we are in the economic cycle, the Fed shifting away from monetary policy and embarking on a tightening cycle, and global cross-asset correlations are at attractive levels, all of these conditions are attractive for active management.

The future is probably going to look very different from the past in terms of returns. The S&P 500 has more than tripled since 2009, and I don't think U.S. equity returns are going to be nearly as attractive going forward.

ETF.com: So your portfolios combine active and passive, correct?

Davi: That’s right.

ETF.com: Does every type of investor need an element of alpha in their portfolio? What's wrong with an all-passive ETF portfolio?

Davi: I don't think there's anything wrong with it, per se, but I believe there are times when you want to de-risk your portfolio to achieve higher risk-adjusted returns. There are periods when you're going to have drawdowns, and you want an active manager who can look at a variety of signals and de-risk the portfolio during times of stress.

ETF.com: So active investing is basically timing, which is very difficult to do. Does active investing always make sense, or just in certain environments?

Davi: There are two or three signals during the year the market sends you, and you have to capitalize on those signals. Right now, for me, global cross-asset correlations are at attractive levels.

You've got the Fed shifting away from monetary policy and beginning a tightening cycle. You've got dispersion that's rising among sectors. And we're in the later stages of the economic cycle. Now is when you want to have active management.

But I truly believe active management of low-cost, passive ETFs is the best of both worlds. That's the business I'm entering into.

 

ETF.com: You have three different portfolios?

Davi: Yes. The Multi-Asset Risk Allocation portfolio uses a combination of equities, bonds, commodities and alternatives. We're trying to capture returns using a one- to two-year time horizon. There’s not a ton of rebalancing given our time horizon. That's the flagship model portfolio.

The second model is the Risk-Managed Dynamic Income. We look at asset classes like loans, mortgage-backed securities, emerging market debt—I’d say nontraditional fixed-income ETFs. The risk/reward for some of the more traditional fixed-income areas such as Treasury bonds aren't nearly as attractive.

The third model is the Core Long-Term Asset Allocation. It targets investors who have retirement money and are thinking with a very long time horizon. I model those outcomes accordingly.

For all three, we use 100% ETFs, and use the three inputs I mentioned before—macro and quantitative analysis, game theory and risk management.

ETF.com: What are some of the ETFs included in your portfolios right now?  

Davi: In the Multi Asset Risk Allocation:

In the Risk-Managed Dynamic Income:

In the Core Long Term Asset Allocation:

 

ETF.com: What are your fees, and do you have account minimums?

Davi: There are no account minimums. As far as fees, there is a tiered system that caps out at 0.75% depending on the notional. For financial advisors who want to subscribe to the model, the fee is 0.30%.

ETF.com: How do you pick ETFs to express all these views? Do you focus on brands, costs, exposures?

Davi: We're not agnostic to any one particular fund family. We pick the solution that solves for the outcome that our model dictates for our investors. We are mindful of cost, because at the end of the day, high fees erode investor’s returns. We do pay attention to the ETF management fees, but ultimately we're trying to get the right solution for our clients, so if that means choosing an ETF that has a higher management fee, we'll do that.

ETF.com: Looking ahead, what’s your macro outlook? What assets do you like?

Davi: We like emerging market equities and FX. The environment right now for emerging markets is as good as it's been in several years. You've got a weaker dollar, low interest rates, loose financial conditions, China's credit-driven expansion, and finally more attractive valuations.

The big call I’m making is that this pro-growth, cyclical recovery continues to shift to the rest of the world where there’s a greater margin of safety, better EPS prospects and more leverage to global growth.

The market's repricing of the reflation trade was largely tied to the political uncertainty in the U.S. rather than a breakdown of the underlying dynamics, which has driven the reflation. A lot of the indictors I look at still point to an economy that's in an expansionary phase.

Given where we are in the economic cycle, you want to be overweight regions that have a higher sensitivity to global growth, like emerging markets, Europe, and Japan.

 

For equity investors, there's a lot of skepticism about Trump but, really, you should care about earnings growth—and more importantly, their rate of change. We've come off a pretty good U.S. earnings season, and we're about to embark on another. That should be the focus.

I’m mindful this is already the third-longest U.S. expansion since 1850. So you want to be careful of asset classes like U.S. high-yield credit, where late-cycle risks loom large.

Historically, Fed tightening cycles have coincided with credit spreads widening and U.S. high-yield credit valuations are already rich.

Within fixed income, there is more value in areas like senior loans, preferreds, EM debt, and mortgage-backed securities, the latter which has sensitivity to a strong U.S. housing market.

And a longstanding belief I have is that the back end of the U.S. curve is going to be capped around 3.5%, because there's so much demand for income globally, along with the emotional scars of two near-50% drawdowns in U.S. equities over the past 17 years.

One way we could get materially higher rates is by getting clarity on fiscal stimulus and tax cuts, which would boost growth and bring long rates higher. But the probability of any of that happening this year is low. So we model the fixed-income portion of our models accordingly.

We also like U.S. banks. Banks weren’t able to build their [net interest margins] in a low-rate, flat-curve environment where there was little organic growth and muted inflation. However, in an environment of higher growth with the potential for less regulation, banks are well-positioned given their greater margin of safety.

What I’m concerned about is all the money that's tied to these yield, roll-down and carry trades. Investors need to realize there’s an inherent linkage between volatility and liquidity. They should be wary particularly if the Fed embarks on a more aggressive hiking cycle than what’s priced in.

Contact Cinthia Murphy at cmurphy@etf.com

 

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