August 02, 2023 • Reviewed by Kent Thune, Edited by Lisa Barr
Stephen Kolano, CFA, is managing director of investments at Integrated Partners. He shared his insights with etf.com’s Kent Thune on a wide range of ETF portfolio construction ideas, from targeted tactical shifts to longer-term secular themes to managing fixed income in a challenging rate environment.
etf.com: How do you use ETFs in your investment tactics and portfolio strategies?
Stephen Kolano: ETFs have become a core part of portfolio implementation across the full spectrum of needs. They provide a foundation of beta exposure for a globally diversified portfolio for both taxable accounts and tax qualified/retirement accounts. They have even become key in asset class exposure for institutional clients in place of synthetics asset class exposure.
Beyond the basic asset class building blocks, we use ETFs to access isolated factor exposure as well, such as minimum variance, carry/yield, style (growth/value), quality/free cash flow, etc. From a policy portfolio perspective, beyond asset class exposure, ETFs are providing strategic factor exposure as well in a more targeted fashion than trying to infer or pull out factor loading from active managers and strategies.
From a tactical perspective, ETFs allow for easier and more targeted tactical shifts in portfolios. They often complement an active strategy in an asset class where an active strategy can be used as a core asset class holding, and then factor-based ETFs can be used alongside the active strategy to make factor tilts or overweight/underweight shifts without impacting the weight of the active strategy.
This is especially helpful in taxable accounts where oftentimes active strategies are housed in a ’40 Act vehicle, where shorter-term money flows can have adverse tax implications for all the holders of the mutual fund. ETFs are also helpful in accessing thematic investment areas or longer-term secular themes to complement core asset class exposure.
The universe of ETFs has grown such that ETFs are able to almost completely cover the necessary asset classes and styles that an investor seeks in building and managing a diversified portfolio. Additionally, the tax efficiency of ETFs makes them especially attractive for use in taxable accounts implementation.
etf.com: The Fed just raised its key rate another 25 basis points. Do you expect this to be the end of the rate hiking cycle or do you believe more rate hikes are coming? And how much does Fed policy play into your portfolio strategies?
Kolano: Currently my baseline expectation is that we will see one more interest rate hike of 25 basis points, most likely in September. From there, I think interest rates will remain at that level for a period of time longer than the markets are anticipating.
It seems expectations from the markets are for cuts in interest rates to occur in the first half of 2024, but my baseline expectation is that, unless growth and inflation both slow significantly in the first half of 2024, interest rates will remain constant into the second half of 2024.
Long-term Fed policy plays little impact in portfolio strategy in terms of setting a strategic policy portfolio in relation to client objectives given the time horizon is at least a full economic cycle or more, and in that time horizon, Fed policy averages out and returns are driven more by longer-term economic growth and productivity.
Additionally, longer-term policy portfolio strategy is also driven by specific client needs rather than market opportunities. Shorter-term portfolio strategy is impacted more by Fed policy, and specifically, the expectations of Fed policy.
Shorter-term portfolio strategy tends to relate to near-term market dislocations and opportunities that can be harvested within a disciplined investment process and risk budget. Near-term dislocations can be created by several things, one of which is shifting expectations related to Fed policy and economic surprises of growth and inflation.
etf.com: Fixed income is a challenging area of the market now. How are you balancing associated risks, such as interest rate risk and credit risk now with ETFs?
Kolano: The short end of the Treasury yield curve is offering some of the most attractive risk-adjusted yields in the markets given its inversion. As such, we’re taking advantage of shorter-term yields through money market funds but also through short-term Treasury ETFs that focus on Treasury bills between three months and 12 months, as well as ETFs that focus on one to three years.
The risk we’re targeting to reduce is reinvestment risk, whereby attractive short-term rates now could be much lower a year from now, as the inversion of the yield curve is not sustainable. Our expectation is that the yield curve inversion corrects through a combination of short rates coming down and longer- term rates moving up in a nonparallel shift of the curve as policy tightening comes to an end.
To offset that risk, we tend to use term ETFs that are a basket of bonds that mature in the same calendar year, and as a result, the ETF then matures in December of that calendar year. BulletShares from Invesco and iBonds from Blackrock are examples.
These have the advantage of a diversified basket of bonds that behave like a single bond, where it can be held to maturity to insulate the investor from interest rate movements before maturity. They also have the added benefit of daily liquidity should there be a need to sell before maturity.
The Treasury and investment grade yield curves offer attractive yield out to about five years before yields tend to fall off, and/or the curve is flat and offers little to no compensation for duration risk.
As such, we’ve been using these ETFs to lock in attractive yields out several years as a way to reduce reinvestment risk. In the Treasury and IG markets, we haven’t been going out long duration, as there is little compensation for the duration risk, and we expect that long rates may move up slightly as the curve eventually reinverts.
We’ve been focusing on Treasury and investment grade credit risks given quality cash flows in the face of slowing economic growth. Despite attractive yields in the subinvestment-grade space, we’re watching defaults closely that still sit below longer-term averages in relation to spreads. Given refinancing that still needs to occur in the near term, we’re staying more focused on Treasury and investment grade credit.
The situation is different in the municipal space. The yield curve in the muni space is not nearly as inverted as the Treasury curve, and actually gets relatively steep further out and offers more attractive compensation for longer duration.
As such, in taxable account implementations, we’re laddering out muni bonds with term ETFs out 10 years, and then in some cases, also including longer duration muni strategies, including ETFs that are offering 8%-9% yields on a taxable equivalent basis. We’re also including some high yield muni strategies. The selection of high yield muni ETFs is relatively limited.
etf.com: For retired clients, what are examples of ETFs you’re using for income, and why?
Kolano: For most, if not all, of our retired clients, their financial plan drives their investment program and portfolio construction. Our time-segmented release planning methodology is driven by income needs projected into the future based on necessary living expenses. The projected living expenses are then considered as a yield necessary to be generated from the asset base.
Term fixed income ETFs are an important part of building a foundation for generating the necessary yield from the client’s asset base that provide a lump sum heading into each calendar year for the client to then take regular income distribution from over the course of the following year.
In addition to term fixed income ETFs, we utilize core fixed income ETFs that have more of a perpetual structure and offer core exposure to traditional core fixed income, such as aggregate bonds, as well as targeted credit tranche ETFs that over-aggregate investment grade, subinvestment grade, fallen angels and emerging market fixed income in order to build a globally diversified yield course for client assets.
Lastly, we also incorporate yield-oriented equity ETFs to offer a combination of income-producing assets but also incorporate a component of capital appreciation from equity appreciation.
etf.com: For clients with long-term time horizons, such as 10 years or more, what are some of your go-to ETFs you tend to buy and hold?
Kolano: ETFs form a core part of a policy portfolio which, by nature, has a long-term time horizon. Core U.S. large cap equity ETFs, also large cap growth and value, tend to be buy-and-hold components of a client’s policy portfolio given the overall efficiency of the asset class.
We use core large cap ETFs from a number of providers and are usually looking for cost efficiency and liquidity in that asset class. Midcap U.S. equity also tends to be a place where we use ETFs as part of the core allocation and often supplement with factor ETFs and/or active strategies. Yield-oriented equity ETFs are also part of an income-oriented client portfolio in order to capture carry as a factor.
We employ international equity ETFs as part of the core implementation vehicle, and then oftentimes with use of active strategies to complement a core ETF that allows for an active manager to take advantage of additional investment dimensions of country, region and currency. We also use yield-oriented international equity ETFs as part of a long-term income-oriented portfolio, such as the Schwab International Dividend Equity ETF (SCHY).
In the emerging market space, we use a few different approaches that are a blend of active strategies and ETFs. Often we use a core EM ETF, such as the Vanguard FTSE Emerging Markets ETF (VWO), and complement it with active strategies.
In addition, we can employ a geographic implementation that allows for shifting among regions of EM such as Latin America, Europe and Asia. As part of the regional implementation, we also employ an implementation approach that isolates mainland China A-shares and combines with an ETF that focuses on EM ex-China to be able to tilt, over a full market cycle, between China and non-China EM exposure.
On the fixed income side of a policy portfolio, we employ ETFs for aggregate bond exposure, investment grade credit exposure and subinvestment grade credit exposure. We tend to also use ETFs to gain exposure to inflation-linked debt such as TIPS.
Within the fixed income portion of a portfolio, we utilize ETFs to provide isolated duration exposure (short, intermediate and long) to be able to shift portfolio allocation based on the shape of the yield curve and changing expectations related to policy and where yield opportunities are attractive.
All of the above ETFs tend to be buy-and-hold ETFs in a portfolio but are used to be able to make near-term shifts over a full market cycle. As such, where they buy and hold ETFs, their allocations may shift over time.