At this hour, it may be that advisors and investors are finally putting the unprecedented market volatility of 2008 and 2009 behind them. But the "new market normal" we're all coming to realize is hardly the same. We're beginning to know the critical importance of effectively managing portfolio risk. And that means there is an urgent need for the ability to separate and manage various sources of portfolio returns to improve portfolio structure — to build a kind of portfolio efficiency that combines return-generating opportunities with the means to manage volatility.

It's still true that the overwhelming majority of a portfolio's return is the result of asset allocation decisions and not individual securities selection. The effective allocation of assets across equities, fixed income, alternative investments, and cash is the most important step when building a client's portfolio.

Today, true diversification — the kind achieved through the assembly of low-correlating assets — has become the primary focus of smart advisors. To that end, and to the benefit of these advisors and their clients, a wide range of well-built exchange-traded funds has emerged to represent just about every asset class available.

Building Blocks

ETFs are particularly effective tools for financial advisors implementing asset allocation strategies. Some of the key benefits of ETFs include transparency, lower costs, tax efficiency, trading flexibility (margin, limited orders, stop-loss, short-selling) and diversification. The proliferation of ETFs has helped advisors develop better asset allocation strategies beyond stocks, bonds, and cash. More than that, marrying some of the key benefits of ETFs allows the advisor to achieve both long-term strategic objectives, as well as incorporate overlay strategies. It's no surprise that some 70% of advisors are using ETFs in their practice, according to those surveyed in AdvisorBenchmarking research in 2011.

The sample portfolio represents a diversified asset allocation mix incorporating a wide spectrum of investments; from growth, value and international, to private equity, real estate and Treasury Inflation-Protected Securities (TIPS). Fortunately, a wide range of well-built ETFs has emerged to represent just about every asset class available and that is helping to meet the demand among advisors. True diversification — the kind achieved through the assembly of low correlating assets — has become the primary focus of advisors.

Over the past several years, ETFs have become very popular. They have radically changed the face of investing to the extent that there's more than $1 trillion residing in ETF products today, according to research by Morningstar. By giving investors low cost access to a wide range of asset classes, they are transforming the process of asset allocation. Beyond that, many of the newer ETF offerings use leverage and sophisticated trading strategies intended to achieve a certain trading or investment objective. Some are even designed to perform in the inverse direction of the underlying market they track. And these increasingly complex offerings are being introduced to the market at an exponential rate.

Enhanced Choice

The whole notion of "owning the market" is being challenged today, with leading product makers rolling out several different types of fundamental and equal-weight ETFs. The investment decision, in other words, has evolved well past merely "active" versus "passive." It now includes different methodologies of owning the market.

And that may be where the real story for ETFs lies: In the growing sophistication of the marketplace and new investor choices with well thought out products that overcome concentration risk and provide more balanced exposure across market capitalizations, sectors, and other broad risk factors.

None of this makes the asset allocation process easy of course. In many ways this enormous list of offerings can be a little but dangerous. But the growth of the ETF industry and the emergence of alternative weighting strategies is offering investors many more ways to own just about any market segment. Access is a good thing for the asset allocation process. I'm willing to say it's ideal.


Carl Resnick is Managing Director, Exchange-Traded Products at Rydex|SGI.