The Smart Beta Way To 401(k) Investing

The ‘Smart Beta’ Way To 401(k) Investing In 2015, ETFs have continued to capture market share from mutual funds. But one area where mutual funds remain the dominant product choice is in 401(k) retirement accounts, and specifically in target-date funds.

Today nearly 75 percent of all new ETFs in 401(k) assets are allocated to target-date funds that have average expense ratios of 0.84 percent, or $84 for each $10,000 invested, according to Morningstar's 2014 research study. By the way, when 401(k)s using index funds are eliminated, and when you measure only active target-date funds, that average expense ratio jumps to 1.13 percent.

What's more, 401(k) platforms charge other administrative fees that bring the average cost of a small 401(k) plan to 1.4 percent—and that's without the inclusion of the cost of retaining a financial advisor or independent fiduciary.

Enter A 'Smart Beta' Option I believe that the advent of "smart beta" strategies provides an opportunity for ETFs to provide enhanced goals-based solutions for 401(k) investors. However, this is not as simple as replacing expensive active management with intelligent ETFs. Edhec sites the nexus of smart-beta indexing as a response to the findings of Herfindahl and Hirschman. Their work was focused on anti-trust law, but also highlighted the unintended concentrations created by market-cap-weighted indexing as well as the tendency to overweight size and growth factors.

Smart-beta ETFs attempt to address some of these inefficiencies, but before I explore the selection of these products, let's discuss the unintended consequences created by traditional riskbased glide paths.

Asset Allocation: Is It Time To Get 'Smart' Here Too? To begin, most target-date funds are based on a traditional modern portfolio theory glide path.

The chart below illustrates the basic changes over time, and the simple description is that the arc of an investment lifetime begins with overweighting high-risk assets (equities) and ends with overweighting low-risk assets (bonds).

The entrenchment in the minds of advisors and investors of this glide path likely comes from its ease of understanding and, no less important, the fact that its building blocks dominate the mutual fund landscape.

Problems With Glide Path I believe there are two major problems with this approach.

First, the asset allocation manages the client's assets to retirement, and not through retirement.

During the distribution phase, the client is dependent on income produced by traditional bond products and by principal.

With bond yields at historic lows, there's likely to be a shortfall on required distributions.

Additionally, with impending rate hikes, low-risk bonds may be more volatile than even equities.

Second—and crucially—this allocation glide path is based solely on the past behavior of two asset classes.

So rather than solving for the clients' desired outcome, this glide path seeks only to move slowly from an aggressive to a conservative allocation.

Framing The ETF Solution Perhaps, using ETFs, there is a better way to solve for the clients' retirement goals. Let's begin by defining the goals.

In general, young investors at the beginning of their careers seek to accumulate and grow assets.

As investors near retirement age, the goal moves to a principal-protection or low-volatility approach.

Finally, with retirement, the distribution phase begins, and income becomes the primary goal. By approaching the concept of a target-date allocation via outcomes or goals rather than asset classes, investors should be able to make the decisions that help them meet their retirement needs.

The chart below illustrates the way Toroso frames the glide path. I begin with overweighting growth assets or alpha-seeking ETFs. As the accumulation phase ends, I increase the allocation to low-volatility multi-asset-class core.

Finally, as the distribution phase progresses, the core emphasizing low volatility and multi-assetclass reduces, and income becomes the dominant allocation and goal.

Security Selection: Enhancing The Portfolio With Smart Beta Now that we have defined the asset allocation glide path for outcome-oriented retirement investing, let's discuss security selection. Essentially, we have three goals to solve for: accumulation; low-volatility core; and income.

Accumulation Phase: Goal – Growth And Alpha My favorite smart-beta index methodology focuses on characteristics of businesses that are often sought out by active managers. Many of these ETFs also fall into the ETF.com category labeled "alpha seeking."

This is a fitting description, because these ETFs allow investors access to concepts like "buybacks," "spinoffs" and "hedge fund clones" in a cost-effective way. Additionally, they have in general produced strong relative performance to traditional market-cap-weighted ETFs. So, to return to my discussion on reframing challenges associated with retirement, during the growth and accumulation phase of a glide path, I feel many of these characteristic-based ETFs continue to be prudent investments to meet this goal.

Transition Phase: Goal – Low Volatility And Principal Stability The approach I take to core investing is also goals-based—in this case, keeping a tight focus on the stability of principal.

To be sure, many strategies claim to provide stable and low-volatility returns, but they usually charge exorbitant fees and construct the portfolio with an amalgamation of derivatives and other opaque products.

Toroso's Core investment strategy is based on the "permanent" or "all-weather" concepts that combine what we see as the four economic conditions that drive returns. We represent "prosperity" through equities; "recession" through cash; "inflation" through commodities; and "deflation" through bonds.

Historically, our index data show that this methodology can provide investors with a good rate of return without the large losses many investors experienced in 2000 and 2008.

This lower volatility is achieved through the offsetting effects of the four economic conditions and the uncorrelated returns of the corresponding asset classes.

To get very specific, each of these economic exposures is built around a core ETF like the SPDR Gold (GLD | A-100) or the iShares Core U.S. Aggregate Bond ETF (AGG | A-98) but are enhanced through smaller allocations to smart-beta ETFs.

So, as I choose ETFs to improve the core equity allocation to the Vanguard Total Stock Market ETF (VTI | A-100), revenue-weighted products like the RevenueShares Mid Cap Fund (RWK | C-77) are employed to avoid the concerns with the suspect earnings and concentrations of traditional market-cap-weighted ETFs. I wrote about what I consider valuable about these types of ETFs on ETF.com some time ago.

Distribution Phase: Goal – Income And Meeting Distributions One of the techniques I use to address the need for current income in this low-interest-rate environment is to build an "income barbell portfolio." One example of this approach combines equal weightings of cash like ETFs and income-oriented ETFs. Using these two extremes, I can synthetically construct a higher-yielding and less volatile portfolio than investors can find with traditional bond funds.

An "income barbell portfolio" expands the potential universe of income-oriented investments.

In the Toroso model, I construct the risk end of the income barbell by combining smart-beta ETFs consisting of bonds, closed-end funds, preferred stocks and dividend stocks.

Meanwhile, the safety component—which consists of cash-equivalent ETFs—reduces volatility and provides a compounding base to protect principal. I developed this alternative-income concept in greater detail in a previous piece published here on ETF.com.

Real ETF Choices In 401(k)s Many people only invest in the market through their company-sponsored retirement plan. Mutual funds and risk-based glide paths remain the entrenched option available to most 401(k) plans.

But I believe there are smarter alternatives through a goals-based glide path and through intelligent use of smart-beta ETFs. The advancements in technology at many 401(k) platforms, such as Professional Capital Services, Verisight and 401kDirect afford advisors the ability to use ETFs in an intelligent way.

And lest the ultimate objective is lost in the details, all this can be achieved at a substantially reduced cost while providing clients better outcomes for their retirement assets.

At the time of this writing, Toroso clients had investments in GLD, AGG, VTI and RWK. Toroso is affiliated with Global X Management Company. Toroso is a New York-based investment advisor focused on researching ETFs and other exchange-traded products and designing asset allocation strategies, using ETFs, that seek to perform well in various economic climates while

emphasizing future objectives over past correlations. For more information about Toroso, call 646-545-5195, visit www.torosoinv.com or email info@torosoinv.com.