Advisor Portfolio ConstructionBuilding Risk-Conscious Portfolios

About the ResearchSummaryIn summer 2019, Cerulli Associates wascommissioned by Rafferty Asset Management, LLC,the advisor to Direxion ETFs, to interview advisorsand professional users of ETFs (investment strategistsand home-office due diligence functions) about theirportfolio construction approach and use of ETFs.Cerulli held approximately 30 conversations with suchusers, which, in combination with data from surveysof thousands of advisors, provide a view into theirallocation practices and preferences.After a long run-up in equity markets and given lowyields, advisors are focused on risk management—and specifically ensuring that clients avoid apermanent impairment of capital. Strategic assetallocations are increasingly important to theseadvisors, and they become less likely to makemeaningful “tactical” shifts. Cerulli’s research findsthat advisors may not be fully appreciative of theactive nature of some of their decisions, and that theirETF use may be overly reliant on their trust in acouple of the largest firms. Cerulli believes thatadvisors have the opportunity to expand productuse to access more thoughtful exposures in a capitalefficient manner.Our Key Findings Advisors are increasingly risk-focused and place the most emphasis on their strategic asset allocation. Strategic asset allocations are developed based on a mosaic of information, including home-office and third-party modelsas well as newspapers and trade publications. It’s likely that advisors underestimate the active decisions that go into developing their strategic allocations. Despitestating they are not seeking alpha, advisors use factors, sectors, and international allocations to express views. Advisors are most likely to use inexpensive ETFs from a few of the most trusted brands to build a portfolio core, and theyare cautious about using fixed-income ETFs and newer, non-passive ETF offerings due to liquidity considerations. It’s possible that advisors’ reliance on models, over-reliance on select brands, and liquidity concerns may be leading themto overlook more tailored ETF products.Advisor Portfolio Construction: Building Risk-Conscious Portfolios2

Advisor Portfolio Construction: Building Risk-Conscious Portfolios3

IntroductionADVISORS’ MOST FREQUENT CLIENTQUESTIONS ON INVESTMENT TOPICS, 2018Take a peanut butter and jelly sandwich. A PB&Jsounds simple enough to make, but a number ofimplicit decisions go into its preparation. Some willplace peanut butter and jelly on separate pieces ofbread and combine, while others will layer the jelly ontop of the peanut butter. A chunky or smooth varietymay be preferred—and the sandwich can be slicedvertically or diagonally. Keeping the crust is an entirelyseparate issue.KEY POINT: Clients are seeking income and safety.The process of advisors building portfolios is inessence similar to that of making the PB&J—advisorsare likely to rely on inputs from various sourcessuch as internal and external models as well asrecommendations from others including assetmanagers (recipes), but the final product will beheavily dependent on their available product set(ingredients) as well as the advisor’s skill (culinarytraining) and firm infrastructure and capabilities(kitchen tools). No meal, or portfolio, exists in avacuum—it is shaped by the environment around itand particularly the palates and experiences of thecommunity (whether hungry seven-year-oldsor investors).In summer 2019, when research calls for thiswhite paper were conducted, the key attributessought by advisors on behalf of investors weredownside risk protection and diversification. Aftera decade-long run-up in markets and with yieldsat multigenerational lows—as well as speculationabout outright negative rates—advisors were far lessfocused on excess returns and alpha generation.Instead, they were seeking to build portfoliosdesigned to minimize losses and that clients wouldfeel comfortable holding through fluctuating markets.As advisors seek to guide investors toward their goalsthrough uncertain markets and an environment ofheightened scrutiny, it can be easy to overlook therole that active decisions play in the investmentprocess. For example, in conversations with Cerulli,many advisors report they are passive investors,even while making implicit asset allocation decisions(e.g., equity vs. fixed income and domestic as well as factor tilts via their strategicallocations. Building client portfolios is an inherentlyactive process.For advisors who choose to build their own portfolios,Cerulli recommends that they embrace the role activedecisions have in portfolio construction and, whereappropriate, broaden the set of solutions they use.While the volume of data can sometimes be daunting,advisors have access to more information andinvestment options than ever before to help clientsachieve their outcomes. This white paper exploreshow advisors build client portfolios, the tools theyrely upon, and the investment vehicles and productsthey use.Advisor Portfolio Construction: Building Risk-Conscious PortfoliosInvestment TopicAll AdvisorsIncome generation68%Downside protection67%Impact of fees and expenses47%Tax efficiency45%Outperforming benchmarks30%Global diversification22%Inflation protection20%ESG/SRI16%Non-correlated investments11%Sources: Cerulli Associates, in partnership with the Investments& Wealth Institute (formerly IMCA) and The Financial PlanningAssociation (FPA )Analyst Note: Advisors were asked, “What investment topics haveclients asked unsolicited questions about in the last six months?”ESG/SRI refers to Environmental, Social, and Governance and SociallyResponsible InvestmentsEverything Begins with RiskThe portfolio construction process takes many forms,but advisors always start in the same place: assessinga client’s goals, and just as importantly, their risktolerance. Across wealth tiers, an advisor’s abilityto effectively carry these conversations is often afundamental component of the health and strength oftheir overall client relationships.An often-cited reference point is determining howa client would respond to a 2008-type drawdown—understanding how a client will react during periodsof calamity allows advisors to fulfill one of theirprimary responsibilities—helping their clientsrealize goals. When advisors have established arealistic assessment of a client’s relationship torisk and volatility, they are better equipped to keepinvestors focused on their long-term objectives andavoid selling assets at the worst possible time andexperiencing a permanent impairment of capital.Advisors have extensive conversations and use bothqualitative and quantitative methods to get to theheart of an investor’s ability to take on risk—while alsoaccounting for their cash needs. One advisor notesthe importance of planning for specific transactions(e.g., purchasing a boat, medical emergencies) thatmay not appear to be a reach relative to existingassets, but can become problematic should marketsdecline. One advisor explains the challenge aptly:“When clients seek cash, they want it yesterday.”4

Risk Management ToolboxA number of software tools have emerged in recentyears to support advisors in assessing investor risktolerance. One such resource that advisors frequentlycited in conversations with Cerulli is Riskalyze, whichprovides the client with a risk number that can beused to derive a broader allocation.FINANCIAL ADVISORS’ PORTFOLIO OBJECTIVES,2018KEY POINT: Advisors are more than twice as focused ondownside protection than alpha generation.Very focused100%80%SOFTWARE USED BY ADVISORS60% 40% Riskalyze: One of the most popular softwaresolutions used by advisors who value its abilityto assess a client’s portfolio and provide a risknumber.eMoney (Envestnet) & MoneyGuidePro (Fidelity):Personal financial planning and analysissoftware that is used by advisors to identify aninvestor’s required rate of return, and to performMonte Carlo simulations to identify portfoliosustainability, among other tasks.Morningstar Advisor Workstation: Assistsadvisors with researching investments as well asclient reporting and communications.Risk tolerance has always been at the heart ofportfolio construction, but it appears even morerelevant after a broad rise in equity markets and asyields remain low. Across its research, Cerulli notesa broad shift in what advisors are looking for fromfinancial products. Specifically, advisors primarilyseek downside protection and portfolio diversification(57% and 55%, respectively, report that they are veryfocused on these objectives), while alpha generationis a distant goal. The sentiment is also sharedby advisors whom Cerulli interviewed, with onesummarizing the issue succinctly: “Alpha is neither ascreen nor a criteria for us, so less importance isplaced on it.”Advisors are more risk averse rightnow because they think recessionshappen every five to 10 years,therefore, we are overdue. If you turnon Bloomberg, it’s all about risk,which is making advisors risk averse.They’re not experiencing irrationalexuberance.Strategist PerspectiveAdvisor Portfolio Construction: Building Risk-Conscious Portfolios20%0%Somewhat focused3%40%Not a focus6%33%40%45%57%55%22%Downsiderisk ce: Cerulli AssociatesStrategic Allocation Comes FirstOnce the risk tolerance for an investor has beenidentified, advisors shift their focus to identifying theasset allocation (largely driven by the equity vs. fixedincome split) that they recognize will drive the client’sinvestment performance. Cerulli research finds thatthe vast majority of advisors use a strategic allocationapproach, either with or without a tactical overlay.The importance that the strategic asset allocationdecision plays in an advisor’s portfolio cannot beoverstated—especially as advisors seek to protectclient portfolios (as opposed to generate alpha viatactical shifts) and home offices nudge advisors awayfrom an investment selection role.When asked, advisors often share that they createcustom portfolios for each of their clients, but a farsmaller portion actually do so. For large practicesthat can dedicate personnel specifically to investmentmanagement or for smaller practices committedto limiting their client base to a manageable size,building truly bespoke portfolios and using morecomplex portfolio construction strategies (e.g.,absolute return, risk budgeting) is feasible. The reality,however, is that for most practices, a balance must bestruck between customization and scalability.In its latest research, Cerulli finds that only onequarter of advisors create custom portfolios for eachclient, while the remainder rely on models developedby their practices, home offices, or third parties. Foradvisors who choose to build practice-level models,combining the repeatability of strategic allocations5

ADVISOR USE OF MODELS, 2018KEY POINT: Most advisors seek a balance between building custom portfolios and the scalability afforded by model use.Portfolio Construction ProcessMain InfluenceAll AdvisorsCreate custom portfolio for each clientPractice23%Start with models developed by practice and alter as necessaryPractice20%Use models developed by practicePractice19%Start with models suggested by B/D or custodian and alter as necessaryB/D or custodian19%Use models suggested by B/D or custodianB/D or custodian6%Start with third-party provider models and alter as necessaryThird party7%Use third-party provider modelsThird party6%Total practice influence62%Total B/D or custodian influence25%Total third-party influence13%Sources: Cerulli Associates, in partnership with the Investments & Wealth Institute (formerly IMCA) and The Financial Planning Association (FPA )with the added active management of tacticaloverlays creates an efficient way to better ensureconsistency of client experiences while also addingvalue situationally. Advisors are most likely to reportusing a strategic allocation with a tactical overlayportfolio construction approach (38%), while a muchsmaller portion uses other approaches such astactical allocation (8%).TOP PORTFOLIO CONSTRUCTION STRATEGIES,2018KEY POINT: Two-thirds of advisors use strategic allocationswhen building portfolios.45%40%38%35%30%25%27%20%A Mosaic of Models and InformationAdvisors are not limited to using only one set ofmodels—they may place the greatest weight on thosedeveloped by the practice or firm, for example, butalso accept the recommendations of trusted assetmanagers such as BlackRock and J.P. Morgan. Anumber of advisors report that they find explanatoryinformation from asset managers helpful even if theydo not entirely depend on these firms’ models. Oneadvisor suggests that, “When large asset managersfine-tune models, we are very interested aboutwhy they are making that particular shift.” Duringthe 2016 election, for example, BlackRock wasprepared with a model reallocation scenario in theevent of a Trump victory and was quickly able to bothimplement changes and communicate the reasoningto tens of thousands of advisors immediately after.It’s helpful for advisors to have contextual informationbehind the shifts so that they can gain comfort withthe reasoning and, when necessary, explain the shiftsto clients.15%10%8%5%0%StrategicStrategicalloca on alloca onwith a tac caloverlayTac calalloca on6%5%AbsolutereturnRiskbudge ngSources: Cerulli Associates, in partnership with the Investments& Wealth Institute (formerly IMCA) and The Financial PlanningAssociation (FPA )Advisor Portfolio Construction: Building Risk-Conscious Portfolios6

WHAT INFORMATION SOURCES DO ADVISORSRELY UPON? Asset manager research and publications(e.g., J.P. Morgan Guide to the Markets) Newspapers and magazines: Wall Street Journal,The Economist, Financial Times Trade publications and websites(e.g.,,, Asset TV) TwitterCerulli finds that despite the growing importance ofmodels, advisors use a mosaic approach to developtheir strategic asset allocations to the extent thatthey use a wide variety of information from differentsources (model recommendations, but also industrysources and publications) to make decisions.Indeed, despite the growing reliance on models,the portfolio construction process remains unique toeach advisor—they are likely to begin with differentbaseline allocations and their perceptions of marketswill be shaped by the various resources that theyrely upon.Asset Allocation Is More ActiveThan It AppearsWhen Cerulli discusses tactical positioning withadvisors, a recurring theme is advisors’ unwillingnessto shift away from their strategic asset allocationsin search of alpha—risk management is front andcenter for the advisors and they are uninterested inmaking shifts that take them away from their carefullydesigned strategic positioning. When advisors domake tactical changes, the shifts (e.g., underweightingor overweighting) are reported to be relatively small—one advisor references shifting portfolios frominternational to U.S. by 1% last year, noting that eventhis is rare. Cerulli doesn’t consider this an exception—and believes this is attributable to a fear of makingan incorrect move and losing clients or even exposingthemselves to liability, especially in an uncertainregulatory and internal compliance environment.This trend is also evident in the increased use ofmultifactor products. Cerulli believes that growingadvisor use of multifactor ETFs is indicative ofadvisors’ interest in gaining exposure in line withtheir strategic asset allocations while making smallfactor tilts as recommended by asset managers thatthey know and whose research they trust—in effectoffloading responsibility.Within the strategic asset allocation component,however, Cerulli finds that several discrepanciesexist with how advisors add or subtract risk—in turnamounting to active management. Advisors may tilt their portfolios toward specificfactors to customize the portfolio or enhanceperformance, but they likely don’t perceive thisas adding risk. Cerulli notes that greater returnscannot be achieved without greater risk—evenif the risk is that of missing out on a gain andnot that of a greater loss (e.g., low-volatilitystrategies). Similarly, while some advisors use factors toexpress views, others may choose to add orsubtract sector exposure to achieve the sameobjective. The energy sector can be perceived ascyclical while healthcare is countercyclical anddefensive, for example. The decision of usingsectors to express views is an active one even ifthe products themselves are passive. While some advisors may view internationalinvestments as a necessity to providing a wellbalanced portfolio or diversifying, others viewinternational investing as risk-on behavior.Politics may play into the decision as well—oneadvisor mentions that many of his clients areaverse to holding non-U.S. equities because oftheir perception of foreigners.KEY INSIGHT12%While a small percentage of advisors (12%)will rely on models developed outsidetheir practice entirely, the risk focus ofthe remaining advisors suggests that theyshould be aware of the active nature oftheir portfolio construction process, andseek to use investment tools that allowthem to best express their views in themost capital-efficient manner.Source: Cerulli Associates, 2018Advisor Portfolio Construction: Building Risk-Conscious Portfolios7

ETF Use Largely Remains PassiveADVISOR-REPORTED ALLOCATION TO ETFS BYPRODUCT TYPE, 2018 VS. 2020EIn conversations with Cerulli, advisors consistentlystate that they seek to lower the underlying expensesto the end-client as much as possible when buildingportfolios. Following the financial crisis, the swirlof attention that surrounded the industry focusedheavily on the fees that investors pay. This hasevolved from the now-defunct Department ofLabor (DOL) Conflict of Interest Rule into the SEC’sRegulation Best Interest (Reg BI). While Reg BIbegan facing challenges in fall 2019, the message toadvisors since the recovery has been a consistentone: advisors need to be prepared to defend theirinvestment decisions, especially when there’s a lessexpensive option available.KEY POINT: Advisors plan to gradually use more active andstrategic beta ETFs.When I choose investments, fundexpenses are really important, thoseexpenses are a big return impact andpeople are already paying me so Ineed to limit the rest as muchas possible.Advisor PerspectiveEven though mutual funds are still the mostcommonly used investment products, ETFs havesteadily been increasing their share of clientportfolios. In 2018, advisors allocated approximately14% of their portfolio holdings to ETFs and expectto increase these allocations by almost one-thirdthrough 2020. The trend is also reflected in relativeflows—in the first half of 2019, ETFs gathered 50%more in inflows than their mutual fund counterparts.The shift to ETFs has been accelerated by activemanagers’ struggles in recent years as the increasinglybroad-based nature of the recovery has made itharder to beat passive offerings. As one advisorframes it, “The evidence says that it’s hard to beatthe index and it costs a lot to do so.”Advisor Portfolio Construction: Building Risk-Conscious Portfolios6%4.6%4%1.5%2%0%-2%-4%-6%-8%-6.1%Pure passive(e.g., marketcap-weightedindex ETFs)ActiveETFsStrategic beta(i.e., passivenon-marketcap-weighted orfactor-basedstrategies)Sources: Cerulli Associates, in partnership with the Investments& Wealth Institute (formerly IMCA), and the Financial PlanningAssociation (FPA )At the highest level, advisors share that they aremore likely to use active strategies and mutual fundsin retirement accounts while preferring to use ETFsfor nonqualified assets to take advantage of theirtax efficiency. They are also more likely to take theactive route for fixed-income solutions and assetclasses seen as less efficient (e.g., emerging markets,domestic small-cap equity). Fee-only advisors are farmore likely to use ETFs than commission-based ones.Despite increased use of passive strategies, advisorsare still using active and factor-based strategies aslong as they feel they are priced appropriately.Advisors’ willingness to combine active and passivesolutions has helped drive the development of newETF offerings in recent years, when asset managershave sought to use the product to arm advisors withnew tools. In 2018, fund companies launched 239ETFs—and as the passive landscape has becomelargely saturated, 56% of the new products wereeither active or factor-based strategies. The SEC’sapproval of non-transparent active ETFs will onlybroaden the types of offerings being launched, evenif the rate of new offerings coming to market slows.Still, Cerulli notes that most advisors who use ETFsuse them for passive options and while use of nonpassive ETFs is growing, adoption has been slow.8

IMPORTANCE OF ETF ATTRIBUTES, 2018KEY POINT: Advisors focus on liquidity and 27%23%20%10%0%Performance Liquidityof underlyingholdingsExpenseIndexSize ofratio andBid/AskspreadAge ofissuerfirmIndexbrandSource: Cerulli AssociatesAdvisors Over-rely on Brands asProxies for QualityWhen asked about the factors that influence theselection of ETFs, advisors report placing the heaviestemphasis on performance, liquidity, and cost. Thesefactors have unquestionably contributed to thedominance of a select group of players in the ETFmarket. In 2018, the three-largest ETF sponsorsrepresented 82% of all ETF assets. This marketsharefigure jumps to 90% when expanded to the top five.The largest sponsors have reaped the benefits offirst-mover advantage by rapidly attracting assets inwhat was historically a passive space. Their resultingscale has granted them incredible pricing power. Just30% of advisors report finding brand a very importantconsideration—but the previously mentionedadvantages have firmly entrenched these fundfamilies in the minds of both advisors and investors.Some of these new products have offered relativelystrong performance since inception; however, thefact that these results have been generated duringwhat has now become the longest recorded U.S. bullmarket leaves uncertainty as to how they performboth in periods of volatility and for when the marketexperiences a true bear market. Questions of scaleand liquidity become inextricably linked to theseconcerns. When discussing their hesitance to explorenewer ETF offerings, advisors frequently return tomemories of headline-grabbing swings generatedby VIX ETFs in early 2018 and the performance ofAdvisor Portfolio Construction: Building Risk-Conscious Portfoliosexchange-traded notes (ETNs) during the financialcrisis. This is in spite of the fact that newer offeringsrepresent a range of exposures and risk profiles thatare not reflective of prior products.While being able to point to lengthy track recordsis valuable, advisors risk missing out on keycontributions that newer tools provide. It is criticalto implement risk management strategies beforethey are needed, not after. As one advisor states,“Putting on your seatbelt after the accidentdoesn’t do you any good.” These issues in timing,however, play out frequently across product typesand sectors. Numerous studies have shown thatclients and advisors alike can make the error of hiringmanagers right at the peak of performance—just asstrategies begin to lag—and, conversely, firing themjust as they are coming back into favor.KEY INSIGHTCerulli believes that advisors usebrands as a proxy for liquidityand cost characteristics that theydefine as most important. In turn,this reliance can result in use ofproducts that are not optimizedto these advisors’ specific needs.9

Though many advisors express interest in learningmore about new investment solutions, they are alsofrank about lacking the time to dedicate towardresearching and understanding them. In 2018,advisors reported dedicating just 11% of their time toinvestment research, due diligence, and monitoring.The balance of their time was allocated to crucialclient-facing activities (55%) and administrativeresponsibilities, including actual trading andrebalancing. This can make it particularly challengingfor practices that don’t have specific personneldedicated to investment management to sift throughthe wealth of options now available. Taking the timeto learn how different strategic beta and active ETFofferings within portfolios can allow advisors andclients to reap the benefits of the strategies in theperiods when they are truly capable of adding value.In an era of low forecasted returns,the idea of capital efficiency comesinto play. From a bang for the buckperspective, there’s value in givinginvestors more thoughtful exposureto return streams that they want.Strategist PerspectiveConclusionThrough interviews with advisors, Cerulli finds a divergence between their goals and how they implement investmentdecisions. Advisors are extremely risk-focused at this stage of the market cycle, and their portfolio construction processlargely relies on the implementation of a strategic asset allocation—often by outsourcing the most impactful decisions tohome-office gatekeeping functions and asset managers they trust most. However, selecting and implementing a strategicasset allocation still consists of active decisions.Opportunity exists for advisors to enhance their portfolio construction approach and toolset: Advisors have increasingly gravitated toward products from the largest ETF sponsors, but offerings from otherproviders may allow them to express specific views in a more targeted manner and build portfolios that better meetclient objectives. The current market environment has made advisors exceptionally risk focused, a sentiment that is unlikely to fade,however being risk aware should not prevent advisors from building portfolios that can perform well in differentmarket environments. Advisors should assess the full array of tools available to them, including factor-based and outcome-orientedstrategies, as well as products with embedded capital efficiency to identify how to best achieve the optimal outcomefor their clients.Cerulli believes that advisors should exercise increased awareness of the active decisions involved in the portfolioconstruction process. With those insights, they can consider more tailored investment products for the purposes of bestexpressing their investment views. In selecting products, advisors should evaluate additional solutions—beyond the mostcommon passive and strategic beta ETFs—for the purposes of accessing the unique exposures they seek, and at times bewilling to go against the grain to differentiate their process and add value to client portfolios.Advisor Portfolio Construction: Building Risk-Conscious Portfolios10

GlossaryAlphaOutperformance of an investment product versus an appropriate benchmark.Bid/Ask SpreadThe difference between the prices at which a security is being offered for sale (ask price) and forpurchase (bid price). More liquid products will have tighter bid-ask spreads.LiquidityThe ability to buy or sell a security without impacting its price—often measured via sharestraded (volumes) and bid-ask spreads.VolatilityThe standard deviation of investment returns over a specified time period—one measure ofrisk for a financial product. Investors may find a higher-volatility product (whose price changessignificantly) more difficult to stay invested in, but lower-volatility products may harm theinvestor’s ability to meet long-term objectives.Tracking ErrorDivergence of the performance of an investment product and the underlying benchmark towhich it is meant to provide exposure or track.Investing involves risk including possible loss of principal.Before investing carefully consider a Fund’s investment objective, risks, charges,and expenses. A Fund’s prospectus and summary prospectus contain this and otherinformation about the Direxion Shares. To obtain call 646-798-9337 or visit the websiteat Read carefully.Distributor: Foreside Fund Services.

Morningstar Advisor Workstation: Assists advisors with researching investments as well as client reporting and communications. KEY POINT: Advisors are more than twice as focused on downside protection than alpha generation. Advisors are more risk averse right now bec