Jenna Dagenhart:

Hello, and welcome to this Asset TV Portfolio Construction Masterclass. The portfolio construction process can be broken down into a series of important decisions including asset allocation, manager due diligence, and more. Today we'll unpack the different steps of the process, and explore areas of opportunity across asset classes in the current environment. Joining us now, it's an honor to introduce our panelists, Austin Fitch, Managing Director, Consulting Solutions at Horizon Investments. Brooks Friedrich, Principal Director Investment Solution Strategy at in Envestnet PMC, and Lara Castleton, US Head of Portfolio Construction, and Strategy at Janus Henderson Investors. Well everyone, thank you very much for being with us today.

Lara Castleton:

Thank you for having us, Jenna.

Austin Fitch:

Absolutely. Thanks for having us.

Jenna Dagenhart:

Yeah, well great to have you all here. And Austin, determining your investment philosophy, or framework is a critical first step in the portfolio construction process. How does Horizon set a framework from which it can begin to construct portfolios?

Austin Fitch:

Yeah, that's a great question, Jenna, and probably a great place to start. I think the way that you define that framework is critical in that it's really your starting place, and it's how you think about the world, and that can vary. And there's not necessarily a right, or wrong answer for any one asset manager. I would tell you there are folks out there that view the world through a modern portfolio theory lens. They think about risk versus return in every instance, that's maybe a traditional framework. There are other folks that think about the world through maybe an income-based framework. Maybe they're thinking about a yield, or a component where they're trying to generate income for their clients. Here at Horizon, when we're working with our clients, we oftentimes are looking through a goals-based portfolio lens, which means that we're thinking about the world in different stages, right?

You're going to think about maybe accumulation a little bit differently than you think about preservation, than you think about distribution. And the reason that I bring that up is because however you think about the world, you have to define that framework on the front end, because that's really going to drive how you're actually going to construct those portfolios later in the process. And if you don't have that framework on the front end, then you can really end up just spinning your wheels, and end up with a portfolio that may have very little conviction, or may have very little direction at the end of the day.

Jenna Dagenhart:

And Brooks, you have a more unique role given your position as an asset manager within one of the industry's largest wealth platforms. One of your core businesses is to manage asset allocation model portfolios for financial advisors, and also consult with financial advisors in helping them build investment portfolios for their clients. How would you describe your approach to portfolio construction?

Brooks Friederich:

Yeah, thanks Jenna. And you're right, you're absolutely right. We do have a unique viewpoint where I sit within Envestnet of the intersection of all the asset managers within the industry, but also the large amount of financial advisors that use the platform. So, we have a good sense of investment insights from the Wall Street asset management firms, the products, the solutions that they're bringing to the table, but also from an understanding of what the financial advisors were looking for as they build, and construct portfolios. So, with that view, over the last 20 years, we've implemented a balanced approach to investing more, but very traditional active passive investment approach.

Some investors, some advisors might say, "Oh, I'm investing in that way because I use passive vehicles today." But our investment approach is much more methodical. It's based off of our 20 years of research that we've done in this space. We update our research papers that go back, look at 40 years of market history of the active, and passive landscape. And we use that as that guide both, that framework, to allocate investment products, whether allocating to traditional active managers, or lower cost passive managers.

Jenna Dagenhart:

And constructing a portfolio has been quite an adventure in recent years, to say the least. So, looking at the current landscape, Lara, what do you think about small mid-caps?

Lara Castleton:

Yeah, and just to take a step back to completely agree that portfolio construction, we like to think about it as modern portfolio theory, but in the end, it's not necessarily applicable to every single client that we work with. So, what we do here at Janus Henderson is as part of our multi-asset team, we will utilize our firm's models, but we leverage our 15,000 advisor models database to talk about the trends that we're seeing among the advisors. Because at the end of the day, we know that our goal is to keep our clients confident in their portfolio so that they can communicate that confidence to their clients. Their goals are to keep their clients invested in the market, and they will only be able to achieve that if they feel confident in what they're doing. So, we'd leverage this multi-asset capability, and intellectual capital that we have at the firm with the trends that we're seeing among advisor portfolios.

And so speaking of your question, over the last decade, we've been in very much one regime, and large caps have dominated the market, and a lot of advisor portfolios that we work with, and have seen over the years are very top-heavy. Does that mean we need to change everything, because modern portfolio theory would say you need to have X percent in small mids? Maybe not. However, we are at this inflection point where we're seemingly maybe in a regime shift whereby the last decade may not be exactly what the next decade will be. And the reason we are talking more about small, and mid-caps today are really for three reasons. One, it's just centered around that regime changes. The large caps were what dominated the market over the last year. Maybe we need to broaden our leadership going forward, and small, and mid-caps represent this unique opportunity where we're building more things.

We're reassuring supply chains, we're greener era the economy, and all of these things are additive to small, and mid-cap companies. So, one that's just a long-term trend that we can think about for three, five years down the line. But then secondarily is because of that concentration at large caps, the downing cap areas of the market have been undervalued, they're less loved, and it introduces a really nice buying opportunity right now. And then the last thing to think about is nobody, we do not pretend to know what's going to happen in the market. And anybody that does the full confidence, you should probably run the other direction. However, historically we have seen in a recession, small, and mid-caps tend to bounce quickly on the other end. Now, we're not saying we're in a recession right now, we're not necessarily saying with 100% we're heading into one, but there is an opportunity to start thinking about down, and cap to broaden leadership, and take advantage on the other side at this slowdown.

Jenna Dagenhart:

So, it sounds like there are a lot of implications of US large caps dominating the market over the last decade, or so, Lara?

Lara Castleton:

Yes, absolutely. And in hindsight, looking back, it's all you needed. And in fact, you didn't even just need large caps. You only needed 10 names probably, and that would've carried you through the entire market over the last 10 years. Those companies, you absolutely still need to own today, however, will they continue to provide that same level of growth going forward is the question. And that is why most clients we work with are owning a diversified portfolio that unfortunately has lagged this year. You really only needed seven companies in money markets, and so our clients that we're working with have had to defend that. But we just know that there are a lot of trends going forward whereby maybe there is opportunities outside of those bigger needs.

Jenna Dagenhart:

Austin, I see you nodding. Before we move on to the next question, anything that you'd like to add to Lara's comments?

Austin Fitch:

Yeah, I mean I think Lara's spot on, in terms of what has gotten us here the past 10 years may not get us to the next way point on a go forward basis. And that's something that we work with our clients with on a daily, if not weekly basis in the sense that readjusting, and looking at those weights on an active basis is really important to understand a changing market dynamic that's obviously at play today, but typically is in play, really, at any point in time just given how many different factors there are affecting the economy, and affecting the markets.

Jenna Dagenhart:

And Austin, sticking with you here, setting an asset class policy mix for your portfolios can be a great starting point for all other investment management decisions. How does Horizon think about determining policy mix targets, and ranges for different types of portfolios within an investment solution set?

Austin Fitch:

Yeah, no, absolutely, Jenna. And I think if we think through the idea that the framework, you have to have that in place, the policy mix is really kind of that next logical step. And really what that means to us is think about it as guardrails for your portfolio, and maybe building off what Laura was talking about, it can be very easy to start with a portfolio in a certain position, and then look up 12 months down the road, two, three years down the road, and you've drifted wildly from where your initial portfolio set up was. And that's where a policy mix is setting min and max weights for different asset classes, and basically painting a picture of, Hey, here's the maximum amount of risk that I'm willing to take for this given portfolio. Now we know that that's going to be different maybe say for a moderate client than it is for an aggressive client than it is for a conservative client.

But having those starting points is extremely important once you start to actually make those investment management decisions. That helps you set benchmarks for those portfolios, that helps you evaluate success over time of those portfolios. But having that policy mix, again, that idea of, "Hey, I'm willing to own X amount of large cap stocks, and put a tolerance band around it", right? Plus, or minus 10%, or 15%. Again, there's not a right, or wrong answer to that question, necessarily. It's going to vary by maybe firm, by practice, by client in some cases, what we work with our firms that use our consulting services in a way that helps kind of customize that to that specific situation, or that specific firm. But that's one where, again, you want to set that on the front end to be able to say, I'm willing to hold a maximum of this weight, and a minimum of this weight in this specific asset class.

And you want to set that on the front end, whether that's domestic stocks, international stocks, large caps, small caps on the bond side, maybe corporate bonds, treasury bonds, those are all things that at least thinking through that min and max positions on the front end then makes those actually making the decisions later down the path a little bit cleaner, and a little bit easier so you don't get out of whack over the long term.

Jenna Dagenhart:

And Lara, would you say that now is the time for active management? That's another topic that seems to come up a lot.

Lara Castleton:

I hope so. No, I honestly do think there are several reasons why it could now be the time for active management, but the biggest one is the return of cost of capital. We've had for, again, I'm going to say this probably five, or six more times over the last decade, but over the last decade we have had zero interest rates. That's an environment whereby taking risk doesn't really... You don't have to think twice about it. So, it was the time of the indiscriminate buyer price insensitive buyer just buy everything, take risks because money was free. That is not the environment today. We may not see rates as high as they are today for the next three, five years, but we do believe we're not going back to a zero interest rate policy environment.

So, when there is a cost of capital that's greater than zero, companies have to try harder at managing their balance sheets. They have to try harder at managing through higher rates inflation, and that no longer sets up an easy blanket passive beta rally. So, we do think that passive will never go away. In fact, in our multi-asset models, we still do blend active with passive, and in portfolio consultations there are certain areas of the models where passive will continue to make sense. But what we're doing today is having conversations with clients about where they can add an active management in this new environment. First, and foremost will be fixed income. That should always be active in our opinion, but there are other inefficient areas of the market in the equity market, small as international emerging markets where this is a really nice time to think about paying up a little bit for active.

Jenna Dagenhart:

Brookes [inaudible 00:12:45] Go ahead.

Brooks Friederich:

To echo in there, just to kind of capitalize a little bit, at least the shorter term data, we're seeing 100% agree with the lower interest rates. We just haven't seen the dispersion in the markets, especially on the equity side, the dispersion of some of these names, everything's kind of moved in tandem together. The cost of capital has been so low, you've seen these companies be able to grow. We're starting to see that in a little shorter term here, the dispersion of returns between companies that are using that capital more effectively. Those that do have to borrow, they're being more efficient with just their balance sheet. Higher quality companies coming more to the forefront. Now, again, no crystal ball whether we're heading into more of a down market, or recession, but those types of companies tend to weather the storm a little bit better.

Those types of companies prime more for active managers to take advantage to overweight those types of companies, and underweight those with lower quality balance sheets. Those that have to refinance at very high rates, again, no crystal ball, but it's setting the phase for a little bit more prime for active management.

Jenna Dagenhart:

So, Brooks, how has your approach to active versus passive investing evolved over time?

Brooks Friederich:

Yeah, markets don't drastically change shift from year to year, and neither does our investment approach. We're long-term investors, long-term thinkers. However, we do update our active passive research study every few years, and this incorporates the longer term trends of the markets, the cycles of the markets. And with that, the output does change slightly from year to year, and as a result of that, it's capturing more of those market cycles, the ups, and downs, not broader US equities, international equities, but all the niche year asset classes. Think of those diversifying asset classes. So, we're not looking at that point in time of just how is active management doing over the last one three years. Again, incorporating the longer term propensity, the ability for managers to outperform at a certain asset class, and another ability where we've enhanced our active passive investment approach is incorporating factor management into active.

So, factor for those aren't familiar, maybe more familiar with smart beta investing, what we call factor investing here at Envestnet, we are true believers in factor investing, and we put it in that active camp. A lot of folks will put it in that gray area because it's not passive, it's passively managed a benchmark, but yet it's taking views away from that market cap benchmark. It's not just owning the S&P 500, it could be owning the S&P 500 with overweighting towards certain factors like value, or quality, or smaller cap in size. So, we're strong believers. We've incorporated factor investing as a lower cost way to access active management, but active management through these factors, through these traditional academic vetted factors like value, quality, momentum, lower volatility, and smart caps.

Jenna Dagenhart:

Austin, anything you would add?

Austin Fitch:

Yeah, I mean I think the factor piece is really relevant, and important in today's environment. And kind of to Brooks's point, there's a lot of research that has been done that would suggest that there's value in those over time. And I think having that active approach when evaluating those factors is actually maybe even another step that's critical on top of that to be able to understand, hey, when is the time to overweight low volatility, or when's the time to overweight that size factor? I think all of those components, again over time, there's definitely value there. Holding them forever, and ever may lead to a little bit of volatility, but being able to be active amongst those factors, I should say, can be pretty valuable.

Jenna Dagenhart:

And asset allocation is often called the most important investment decision that you'll make when constructing a portfolio. Austin, what are the different types of methodologies that can be used to drive asset allocation decisions, and what are some of the pros, and cons of each?

Austin Fitch:

Yeah, no, for sure. I think we're kind of touching on that active piece that's going to be your tactical, or more dynamic asset allocation approach. But maybe to back up, maybe the traditional one is more of a strategic asset allocation decision that's oftentimes known as like a buy, and hold approach, right? Where we talked about passive is this idea that maybe a certain asset class, or a certain segment of the market maybe over a very long period of time is where you want to focus. Here at Horizon, again, and I think maybe Brooks, and Lara may agree, having that tilt forever, and ever, amen maybe is not exactly the ride that financial advisors, or in clients are looking for on a day-to-day basis. So, we tend to hear Horizon, and within our team to lean towards more that tax core dynamic approach where you have the ability to be more active.

Not to say that every asset class you have to have active management necessarily. I think the blend there can be important, but using that active component, you can break that down into quantitative approaches, qualitative approaches. So, on the quantitative side that can be trend following, that can be more reversion based on the qualitative side, maybe you can use some fundamental lenses, or thematic plays within that asset allocation approach. And again, I think I would tell you the pros of that is being a little bit more dynamic, or tactical allows for changes to a client's portfolio, changes to a changing, or dynamic marketplace. The cons being that again, and Brooks kind of said it earlier, nobody has a crystal ball. You're not always going to be right in that scenario, so you have to be willing to take a little bit of risk there.

Whereas the passive piece may be a little bit lower cost, but again, it can actually be maybe even sometimes a little bit more volatile over the long-term because of more of that buy, and hold approach. So, I think there are definitely some pros, and cons to weigh there, but I think focusing on that active passive blend where it makes sense, and being able to leverage the dynamic approach can be pretty critical to building a portfolio that does move with the market, knowing that the market changes. We all know that.

Jenna Dagenhart:

Yeah. Brooks, anything you would add to that?

Brooks Friederich:

Yeah, Jenna, as Austin was thinking there, there's obviously a behavioral element to this, the behavioral element of financial advisors, and their view of managing their client assets, but then the behavioral element as well as end investors, and we're all guilty of this as well, wanting to see some sort of movement within your investment portfolio, and the advisor expecting to see some sort of movement. So, we talk a lot about behavioral finance in our industry, but as a big proponent of that, of there's benefits to buy in bulk, and riding out through the storm, and coming out, but that sometimes that takes some pain. Sometimes every client's end client situation is different. They might need that money for one of their investment goals in the next three to six months.

Something needs to be done actively to meet that shorter term financial goal versus 20 year real retirement money that, hey, we could weather this storm by being more strategic buy, and bold through all that. So, the behavioral element in that is very important for one end clients to one them recognize that, but also financial advisors, which I know a lot of them incorporate that in their practice of coaching their clients through these storms that we weather together within the industry.

Jenna Dagenhart:

Yeah, we host a lot of advisors, and behavioral finance is one of those topics that always seems to come up, because it's one of the most challenging parts of investing for many people. Now, Lara, looking a little bit at duration here, should investors be leaning into duration, would you say?

Lara Castleton:

That is one area of the portfolios that you hopefully were a little more dynamic in at buying, [inaudible 00:20:59] over the last couple of years, fixed income seems to be going through its .com era, and we are now facing the third year by which core fixed income might be down. And that has never happened in history. And I'll admit that I have been saying ad duration for way too long. Nobody has been right if you've been downing that. But the reasons why we're still talking about it today, and maybe a little louder, it's just simply because we are coming towards the end, not calling the end, but towards the end of a pretty serious fed rate hiking cycle. So, they might have one, or two more rate hikes. I don't believe they're going to have another 500 basis points, which is what we've experienced. So, what we're talking with clients about, and this is a very popular topic.

Every single client conversation that I'm having, they ask when I should be adding duration. And so when we go about this, we obviously need to understand where the client currently is at, and there's a variety of spectrums by which they're in duration. The first is an easiest conversation that I have with clients about duration is when you're overweight money markets, and I know many clients have been overweight money markets for quite some time. For the client that is still holding onto that, and again back to investor psychology because their end clients really feel safe in those money market assets. The first and easy conversation that we can have is, okay, let's add a little bit into ultra short category. So, the ultra short bond category still has a duration less than one, but the reason we're actually advocating for this is because it can keep that advisor, and end client feeling a little bit more okay with adding out of money markets, you're not adding a material amount of duration risk, but the impact is that, that yield is a lot stickier.

If rates for some reason do plummet because we don't foresee something whereby the Fed needs to cut money, markets have only a couple of days before they reset lower. If you're in at least an ultra short type of a manager, you're going to have at least a stickier yield. So, that's, I feel like the first conversation that we're having, and then it is talking about, okay, how do we go further out from there? Again, the reason we're thinking about adding in more duration now is as we come towards the end of a rate hiking cycle, it does tend to be a time when longer duration fixed income tends to stabilize. And you can see rates either come down, or at the very least you get in at a moment where starting yields are at levels we have not seen for a very long time.

And the very fact that starting yield has such a high correlation to your four, or five year return, getting in at four point a half, 5% for longer, that is absolutely unheard of if you're looking at the market two years ago when the 10 year was under 2%. So, we're talking about a balance. We are not making a call for going all in on duration, not going all in into TLT, because there are aspects of this market where you should still continue to invest with what you know in an inverted yield curve where you can clip more coupon on the short end, where you avoid interest rate volatility while we're still waiting to see what happens with the Fed.

And with interest rates, that makes a ton of sense. We do want to start to take advantage though of those longer end yields, and what we do in our consultations. We have a very deep dive into fixed income. I think it's important how you take that duration. I know we'll talk about that a little bit later in sectors, but we'll look holistically at your overall yield mix, sector mix, and hopefully again, have you feel comfortable with where you're at so that you can keep your clients invested.

Jenna Dagenhart:

Yeah, those yields look very different than they did three years ago, or so. Now, Brooks, given the current interest rate environment, what's your view on active versus passive management as it relates to fixed income?

Brooks Friederich:

Yeah, I think Lara just sold it pretty well. It doesn't have to sell. I think it is prime for another current interest rate environment's prime for a bit more for active managers to outperform. I do want to highlight the short term, the money markets, the behavioral element of that as well is end clients. They're getting paid nicely to sit in cash, or a behavioral element, a total return of four, or 5%, and they're getting that into their bank accounts every month. And there's that feel good element to that, putting that money to work, adding some duration that takes some conversations, it takes some willingness. And I think with the active management in the space that we're at, where we're at in interest rates, whether we're at peak but don't expect much more higher on our side either, for these active managers to make those active moves, and those tactical calls with the capital.

You as a financial advisor making that call of shifting all the assets from the money market, not all, but some to a active manager timing that it likely would be too late. So, now is a prime time to think more about being active in fixed income.

Austin Fitch:

And Jen, if I could jump in there, we've done a little bit of work here, recently. We've talked about kind of that shift that we've seen to money market assets. We did some work internally, and over the last 12 months using some Morningstar data found that almost three quarters of a trillion dollars shifted to money market assets in the last 12 months. I mean, it's just a massive, massive shift. And kind of to Brooks' point from a behavioral standpoint, it's not necessarily surprising. And Lara, you brought it up, too, the fact that two years ago getting paid 5% on anything would've been amazing. So, the idea that now you can get 5% by basically taking zero risk is not necessarily surprising. But one thing we've been working with our clients on pretty consistently for the last three, six months at this point is getting a plan in place for how you're going to get out of that money market asset at some point.

Again, I mean Lara kind of touched on it, maybe that's dipping your toe in the water. Maybe that's moving to ultra short. Maybe that's looking at alternative asset. There's so many different ways that you can think about that, but it's this idea of, "Hey, let's take advantage of it while it's there for sure", but then don't get stuck in it because the risk is that you get stuck in those money market assets, and then whether you're missing out on that duration play at some point, or there's an equity rally that you're missing out on, there are going to be opportunities in the future. And that's where we're working with clients. To Brooks' point, if you're watching it on the front page of the Wall Street Journal, we're all too late at that point. You have to make the move a little bit ahead of time. And whether that's going to an active manager, or just having a plan in place to get out of those assets, I think is pretty critical, especially as we look forward.

Jenna Dagenhart:

Yeah, who knows what's going to happen, but if say rates were to come down to 2%, then you're only getting 2%, and you missed out on that price action.

Austin Fitch:

Yep.

Jenna Dagenhart:

Now, Lara, taking a closer look at different sectors here, which areas in fixed income offer better risk reward?

Lara Castleton:

Yeah, and that's such an important question when I consultations with clients, and it's just how do I add duration? It's not where do I add duration? And this is where we have always agreed, and thought that active management makes a ton of sense in fixed income. Unfortunately, the benchmark for fixed income is the Bloomberg Barclays Agg, and it is probably one of the worst benchmarks that you could have out there. It is missing so many sectors where you can find better opportunity. And again, it doesn't move around. So, as just a high level view of the markets today, almost anything in the securitized sector is offering better risk reward from our perspective. So, when you think about the core interest rate duration sensitivity of the Agg, you have three sectors that comprise that broadly, US treasury, corporate credit, investment grade, and agency mortgage backed securities as just an example of the securitized attractiveness, investment grade corporate credit has higher yields.

Unfortunately, the broader reason it has higher is the base rate. The spreads of corporate credit are still relatively tight to historical averages. And in a market where we're facing a slowing environment, tight spreads to us don't necessarily make sense, and we could see them widen out. Agency mortgage backs, on the other hand, if you've experienced the last year as a homeowner having to buy a new home, rates have increased dramatically. It has eliminated prepayment risk, which is one of the biggest risks of that sectors, and therefore that spread has already widened ahead of a potential slowdown. So, if you just think risk adjusted, that's just in that core investment grade landscape, most secure entice sectors of the fixed income market have already priced in more of a slowdown, and you're getting a lot more spread. And that's hugely important for us. When money markets are offering 5.5%, the bar to add risk in any sort of fashion is much higher.

So, if you are reaching for any sort of risk, you're hopefully getting compensated for that. For advisors that I work with... Securitized assets are hard to do on your own, again, active managers will help if they do have an overweight to credit, we talk about how you can diversify, be flexible. Treasuries was the other part of that benchmark that I mentioned in the Agg, it obviously is one of the best risk off assets. However, you are just missing out on that additional spread by going to some of these securitized sectors. So, it's not a one size fits all, but it is worth looking deeper into your fixed income allocation for the opportunities today.

Jenna Dagenhart:

And Austin, security selection is the step in the construction process when names finally begin to make it into the portfolio, which sounds like is a very important step here. What consideration should be made when deciding whether a security deserves a position in the portfolio?

Austin Fitch:

Yeah, I think when you get to the security selection piece of that overall process, and Lara kind of hinted at it, you really have to dive into what your active views are, and you want to make sure that those positions align with whatever those active views may be, right? So, we've been talking about duration. If that's a duration play, you want to make sure that whatever the position is, whether it's a passively managed product, or an actively managed strategy, is going to align with that. And you want to make sure that over time whether if it is an actively managed product that the drift of that security probably is going to be within a line of where you want to be from a policy standpoint. So, kind of going back to setting that, setting that structure up. I would tell you the other piece that you want to set on the front end when it comes to security selection is to be able to set expectations, and risk limits.

I think that's critical to be able... To some extent that's what folks call a thesis for an individual position. It's this idea of how do you expect this to play out, and at what point are you going to think about either getting rid of it, because that thesis has played out, so it's done what you expected it to do, or to the downside it hasn't played out, and now it's time to get rid of it, and move on. And I think that's where having it planned for a review frequency with individual securities, and those can be different, right? You can have securities that are more volatile that you need to review more frequently. You can have some positions, again, maybe passive positions that maybe are going to be more of that buy, and hold approach within the portfolio. Maybe you don't review those as frequently, but having that process in place for those securities, I think, is super important to be able to understand at any given point in time, does this portfolio, this composition of individual securities still align with where I want the portfolio to be based on those views?

And that's what you have to keep coming back to. Is each individual position that you're evaluating within that investment universe is that set up to drive the portfolio in aggregate forward? And if it's not, then there should be a conversation, or a decision internally within the investment committee to be able to say, "Okay, here's where we potentially need to make a change, or at least evaluate what's there." Otherwise that security selection piece kind of falls by the wayside.

Jenna Dagenhart:

And Brooks, I know you have a great pulse on what advisors are saying. So, what are some of the common themes, trends that you're hearing, or seeing from financial advisors as they relate to active versus passive investing?

Brooks Friederich:

Yes, again, given our footprint, and where we sit, and invest in, have a really good data set here of financial advisors building construction portfolios for their clients. And the short part of it is advisors still like active management. The data we have, they're still allocating heavily to active. If you look over the last year, if you look at their assets today, or even look at their last year of flows on the investment platform, it's about a 60/40 split, 60% active management, 40% passive. That's been pretty consistent for a while. That's high level as you get more granular to certain asset classes, for example, yes, large cap core is predominantly passive, but if you get to the value side of large gap, you're seeing more advisors use picking up some yield, some income there by allocating to traditional active managers that might have a dividend tilt, or bent within their active approach.

As you get to international non-US international cores typically passive through the investment platform. But again, when you go to value, or growth, you're seeing advisors make that active call the higher outsource to a third party active manager. Fixed income, I would say is a bit more, as my comments before, has been traditionally a bit more overweight, active in terms of the assets, and flows, unless it's on the shorter end, or short-term bonds, or money markets, there you're seeing just kind of more passive there. So, it is interesting, we see the continued industry trends of the increased use of ETFs across the industry, but when you get down to the nuts, and bolts of advisors building constructing portfolios, you do see this great blend, this balance between active, and passive investing.

Jenna Dagenhart:

And I'm glad you bring up international, Brooks. Obviously, we've seen some headwinds recently with the strong dollar in recent years. But Lara, would you say that international is an opportunity today?

Lara Castleton:

International is one of those thorny conversation topics that I feel like most advisors that I work with have a varying degree of hatred for the asset class. But again, it's looking over the last 10 years, that last decade in an era defined by rates coming down, interest rates, 0% inflation sub 2%, that's been a very additive environment for US, and growth, and technology. But we're at this point in time where the market could be shifting, and I don't know that that necessarily means US is no longer going to be the dominant player. I would not by any means go out, and make that prediction. But there are times throughout history where US markets underperform international, it just has been a very long time since one of those has happened. Most clients that I work with will still maintain international, it may be more underweight their peers, it most likely is underweight a global market cap benchmark, but they still have international. So, my job when I do consultations is one to just make sure that they feel confident, and have the bullet points for why they're owning that, which I'll go over.

But then secondly is are you owning the right type of international? So, the reason international to us makes sense right now is that, one, from a valuation perspective, it is cheaper. And I know there are already, I can hear the eyes rolling right now, because that is what we have been saying for international, for forever. Valuations don't necessarily matter, again, when it's a market where you're just taking a ton of risk, and it is the price insensitive buyer. Valuations do matter more when it is a slowing environment, and you get that cushion on the downside for a valuation to reset higher potentially. Two is just, you probably get more sector diversification when you go outside of the US, which we call the S&P the market, the S&P is not the market, it is a tech index pretty much, and dominated by seven stocks.

When you go outside to international in particular, you do get broad diversification of that. You get a lot of other sectors that you may not have as much exposure to in your US centric portfolio. And then third, and I think this is one of the most underrepresented, or under known facts, it's just you get a lot more dividends when you go outside of the US. The second you go international, your dividend yield almost doubles, and then you throw an active lens over that, dividend focused investing, in fact, all stocks with 3%, or higher yield, 60% of those are found outside of the US. And so in an environment where rates are higher, inflation is higher, dividend investing can be attractive. So, those are some reasons why to clients here that are having to defend their international, perhaps those are ways that you can, it's that hedge on what happens if we go into a time period where US doesn't outperform.

The last thing I'll just say is that it's are you owning the right type? So, I hear, and see portfolios, Brooks, what you mentioned, a lot of clients will just own the VEA, or the passive just to get all of the international. I would urge them to think about active in that space as one of those ways to find the right type of companies, and then also to not be siloed to the growth side of the international equation, which is where they have been, because again, over the last decade, growth has won out. So, incorporate the entire spectrum, owning the value, owning the dividends on top of the growth opportunities there, and that's what we would dive deeper into.

Jenna Dagenhart:

And Austin manager due diligence is an added layer of research necessary when considering actively managed products. How does Horizon evaluate actively managed strategies differently than passive vehicles on an ongoing basis to ensure that manager convictions continue to align with portfolio goals, and objectives?

Austin Fitch:

Yeah, that's absolutely critical, Jenna. I think the passive piece, really, when you're evaluating passive strategies, all you should probably really be looking at is just judging that strategy relative to its benchmark, and maybe looking at some simplistic tracking error stat. But when you're looking at active managers, you really want to look at are there views aligning with where you want your views as a portfolio to set up? And that can be through a lot of different, I would say, screens, and a lot of different research. For us that's both quantitative, and qualitative. I talked a little bit earlier about how you can use quantitative, and qualitative strategies differently in the asset allocation process, but when it comes to manager due diligence, that's manager interviews, that's talking to the portfolio managers on a regular basis to be able to understand how are they positioning the portfolio, what do they see?

And again, ensuring that consistency with where you as the financial advisor, or you as the portfolio manager want your portfolio to be tilted. I would tell you on the quantitative side, you can do a lot of work when it comes to peer groups, and other managers in that active space to get a sense for how do those managers stack up from a statistics standpoint. And again, those statistics are going to vary based on asset class, or segment of the marketplace. Some may be more relevant than others for fixed income versus equities versus internationals versus domestics. But I would tell you that relative approach to the quantitative side of things is pretty important. Again, just to get a sense for where that one strategy, or manager lives at any given point in time. And again, I would tell you not any one of those characteristics, whether it's quantitative, or qualitative, not any one single screen should be a reason for necessarily adding, or getting rid of an active manager.

But it's more of that mosaic approach where you're taking the entirety of that research to be able to understand, hey, I continue to feel confident in this position, this strategy, this manager. And if you don't, that's when you start to look for other opportunities, or other options. And I think that's important on an ongoing basis, because yes, you felt confident in that position when you put it in the portfolio, or at least hopefully you did. But the question then becomes do you continue to feel confident in that manager in that strategy, and in their thesis, and process on a go forward basis?

Jenna Dagenhart:

Turning to alternatives now they've always had a place within the portfolio, but they've really risen in popularity in recent years it feels like. Brooks, how are you seeing financial advisors allocate to alternatives given the current market environment?

Brooks Friederich:

Yeah, it's a good question, and something we keep our finger on the pulse here, and it's interesting, even going back to the volatility we had during the midst of COVID, and currently where we're at, we don't see a huge uptick in advisor's use of alternatives. And some of this could be current interest rate environment. You just talked earlier about, "Hey, great, I could just park... A client could park their assets, some of their assets in money markets, get that four to 5% sort of total return, be comfortable that I'm not going to lose it." But I think a bigger thing we've talked a lot about is just investor, and advisor education in this space. We continue to talk about it, but I think we're getting better as an industry. I think advisors are getting better at understanding the different types of alternative investments, how to use them in construction of the portfolio.

So, I think through this next phase of the market volatility, I'd expect more use of that. I think the different types of how to access them, you're seeing more products come to market, and different types of investment wrappers by wrappers, I mean traditionally it's been in mutual funds, but you're seeing some passive ETFs, but also active ETFs, and even the use of separate accounts as well. You're getting different access to alternative investments in different types of wrappers. And I think different types of technologies as well out there are accessible for advisors to get access to alternatives.

Jenna Dagenhart:

Yeah, we've certainly heard a lot about the democratization of alternatives. Now, Lara, how has the role of alternatives evolved in portfolios, would you say?

Lara Castleton:

Yeah, they've been a very hot topic over the last couple of years. We've been hearing the 60/40 is dead. The rates were low, expensive valuations across the board, and a lot of clients did go [inaudible 00:43:38] alternatives. Now, we wouldn't say the 60/40 is dead is definitely different, but we also recognize that most clients will own some sort of private allocation to alternatives in their portfolios. Portfolio construction overall is already personal. When you add in alternatives, and privates, that makes it even more personal. So, what we've been talking with clients about is as you're considering alternatives going forward, think about it from a goals-based framework. There are really three goals for your private allocation. It is either yield when you're thinking about privates, private credit, private mezzanine debt, et cetera, yields over public market. Diversification, diversification over what you can get in public markets, growth, venture secondaries, et cetera, over private public markets, apologies.

So, that is the framework today where maybe Brooks are not seeing as much going into the private realm. It's because finally that over public markets is a higher bar that clients will still continue to own privates. So, this framework that we've created is each individual client needs to look at their investors' entire portfolio. Are we looking to enhance risk? Are we looking to diversify the risk? Are we looking for income, et cetera? And so what we have, we have some tools on our end that can take those private allocations that you haven't really been able to map out into your overall portfolio analysis. And we've been able to bring the private aspect of that into portfolios, and make sure that, that over public market bar is being met, and it is satisfying the long-term goals that you have for your end clients.

Jenna Dagenhart:

And Austin, what's a position is in a portfolio, assessments must be made on an ongoing basis as to whether it should remain in the portfolio, what items should be included when monitoring the risk of individual positions?

Austin Fitch:

Yeah, I think Lara touched on this topic of alternatives, maybe dovetails into this assessing positions on an ongoing basis, because, and Lara kind of hinted at it, is they should be different by the different types of the portfolios, and by the positions themselves. And what I mean by that is, and Lara kind of touched on a goals based narrative, this idea that maybe you judge positions, and you judge the portfolio a little bit differently for clients that are trying to accumulate assets, for example, a little bit differently than clients that are trying to protect, or preserve assets, and maybe a third category for clients that are trying to distribute, or take income off those assets. And why that's important is because, again, you're going to look at maybe different stats, or different figures, different data points. So, for example, a client that's trying to grow assets, you want to grow that in the most efficient way possible.

So, yeah, you maybe use some sort of risk adjusted return metric, right? Maybe a traditional sharp ratio, or maybe just you're looking at consistency over time. What's known as the batting average ratio, right? There are different data points that you can look at there that are relevant to that long-term nature, and the ability to maybe withstand a little bit of short-term volatility, whereas clients that are focused on that preservation, or protection component, maybe you're looking more at downside deviation. Maybe you're looking more at components where a bear beta, so what's the beta of the portfolio when portfolios start to go down? And that's where I would tell you that maybe the alternative assets that we were just talking about, maybe you're more relevant for a preservation type portfolio, so you don't judge those in the same way that you judge assets that you would use in an accumulation based portfolio.

Same thing if we move to clients taking income. At the end of the day, and we have this conversation a lot with our clients. At the end of the day, the client that's taking income off a portfolio, the question they're really asking is, am I going to run out of money? They really don't care necessarily about sharp ratio, or downside deviation, or bear beta, or any of that. It's am I going to be able to spend as much as I want to spend for as long as I want to spend it? And if that's the case, how do you optimize that portfolio, and the positions they're in, in a way that allows you to do that? And I think that's what we have to think about from an evaluation standpoint, is each position in the portfolio, is it allowing me, and giving me the best opportunity to hit whatever the goal may be for that specific portfolio?

And I think at the end of the day, that's what we have to think about as we're focusing on evaluation is what's the position, what type of portfolio is it in, and what role is it playing? Otherwise, you can get yourself in trouble by saying, "Hey, I'm going to look at an accumulation type product, but score it in a preservation type mentality." And that's where you can start to get some confusion of whether, or not the position is truly successful, or not.

Jenna Dagenhart:

And I know we've covered a lot of ground today. There's a lot that goes into the process, but Brooks, what are some of the key takeaways that you would like financial advisors to walk away with after watching this panel?

Brooks Friederich:

Yeah, it's constructing portfolios for your clients. I'll echo some of the things we've talked about here, but thinking about working with your clients, understanding their risk tolerance, and making sure if they have different types of goals, allocating appropriately to meet those different types of goals, the importance of the due diligence, whether it's a traditional active manager, or even passive. Taking that next layer of doing that due diligence on active management takes a little bit longer, but even passive, it's not just as simple to pick a passive mutual fund, or ETF just to replicate a benchmark. There's another layer of due diligence need to be done on top of that. The blending of active, and passive together, the opportunity of course for active managers to outperform the benefits of low cost investing, blending those together. We believe it's beneficial for clients, better outcomes for clients as well. There's a behavioral element to that where it's not just about the costs, and fees, or the potential under performance of active management. So, the blending, the benefits of that. There's a behavioral element that we see that resonates with advisors, and their end clients

Jenna Dagenhart:

And tying everything together that we've discussed today, Lara, what's Janus Henderson's outlook moving forward?

Lara Castleton:

Yeah, it's a great question, and just I've been running with this little BarbenHeimer analogy. Just from a macro environment perspective, soft landing cannot be taken off the table, so we may be living in Barbie land going forward perhaps, but the hard landing economic data points are still worrying us. There's still some lags of interest rate policy that we think can be sorted out. So, that whole Oppenheimer doomsday situations should still be on the table. Nobody knows exactly what's going to happen, so we mesh the two with the BarbenHeimer, and then portfolios, the actual takeaways means having that perfect blend of offense, and defense.

You need to be invested, we know that. We can't just sit on the sidelines, so how do we take advantage of being a little bit more offensive in smart ways while maintaining some defense for whatever comes from a Janus Henderson perspective, we're fortunate to be bottom up investors, and when the macro environment is as difficult as it is to today, it is nice to be able to rely on our investment capabilities, and our talent here to go out, and just buy good companies, do our fundamental analysis that a lot of others may not, and be able to ride through the wave of whatever is going to come with smart tilts within fixed income equities, et cetera.

Jenna Dagenhart:

Finally, Austin, while all parts of the portfolio construction process are obviously very important, documentation is also a very important step. How does Horizon help its clients with documenting the decisions made during the entirety of the portfolio construction process?

Austin Fitch:

Yeah, Jenna, I think the idea of documentation really puts a bow on the process as a whole. And what I mean, there is this idea of you need to know why you own what you own when you own it, and that's extremely important for not just an asset manager, but also for a financial advisor that is putting a proposal, or something in front of a client. And that's our team here at Horizon, and on the consulting side's really focused on that documentation piece, because to be able to define what you're doing, document what you're doing, and be deliberate about that, is really critical to creating that confidence that the advisor can then have to go in front of a client. That structure. We work with firms to help provide meeting minutes for investment committee meetings. Those are the types of things that if a question is asked nine months in the future as to why you bought that position, you may not remember exactly why you put it into the portfolio as a financial advisor.

The ability to have that documentation to go back, and say, "Oh, that's right, here's what we were looking at, here's what we evaluated, here was the thesis, this is why we did it. And then on an ongoing basis to have those assessments, to have that due diligence, and research to say, and here's where we evaluated it, and why we continue to own it. That structure, and that process really is, again, building confidence for the advisor, but also building confidence for the end client. As Brooks has touched on, and we've talked a lot about, it helps the behavioral aspect of an end investor's mentality. It helps put that at ease. If there's a thesis, if there's a process in place, then the confidence level really just kind of goes up because of that. Because there's this feeling of, "Okay, we're doing the due diligence, we're maintaining, and monitoring it, and it's not just we're taking a shot here in the dark, we have a process, and we're sticking to it as we go through." Again, changing markets, and to some extent, pretty unique times from a market standpoint.

Jenna Dagenhart:

And as we talked about earlier with behavioral finance, having confidence in that process is crucial.

Austin Fitch:

Yep, absolutely. And that's where, again, our team on the consulting side is focused on, again, we're not always going to give the crystal ball ideas in terms of investments, but helping advisors deliver that confidence to their clients is really what we're focused on to be able to say here, "Hey, here's what you own, here's why you own it, and here's the process that we went through to get there."

Jenna Dagenhart:

Well, I wish we had time for more, but we better leave it there. Austin, Brooks, Lara, thank you all so much for joining us today.

Lara Castleton:

Thank you.

Austin Fitch:

Absolutely. Thanks for having us, Jenna.

Jenna Dagenhart:

Of course. And thank you to everyone watching this Portfolio Construction Masterclass. Once again, I was joined by Austin Fitch, Managing Director Consulting Solutions at Horizon Investments, Brooks Friedrich, Principal Director Investment Solutions Strategy at in Envestnet PMC, and Lara Castleton, US Head of Portfolio Construction, and Strategy at Janus Henderson Investors. And I'm Jenna Dagenhart with Asset TV.