The Rise of Customization: Emerging Products in Portfolio Construction with Ryan McKee

How are you?

[00:00:26] Doug Heikkinen: I'm really good. Why don't we start by having you tell us about yourself and your journey of how you got to Fidelity.

[00:00:34] Ryan McKee: Yeah, no problem. Great to be here. Great to spend the time with everyone here. So I've been with Fidelity for about 20 years.

It'll be 20 years actually this coming March, and I've done a number of things during that period. I've had the fortune and good fortunate opportunity to work in different geographies and different channels with Fidelity. But I originally came to Fidelity, got networked in through a personal friend of mine.

And over the past 20 years, I've worked in a lot of different distribution capacities here on the East Coast, where I'm based now. And during that time out on the West Coast as well. Where I sit today, as you reference in your opening is, working with our emerging product strategists. So I work within Fidelity Institutional.

We're primarily working with intermediaries and financial advisors and helping support them in their investment conversations. And in my capacity there, I work specifically with the emerging products line, but I have lots of exposure to lots of other strategists and specialists across Fidelity. So hopefully a really good seat for the conversation that we're about to have here today.

[00:01:40] Doug Heikkinen: Yeah. And from that seat, let's start with what trends you're seeing with emerging products, product innovation that advisors should be thinking about.

[00:01:49] Ryan McKee: Yeah, I think I would answer that question, if you don't mind for me to answer it this way, I'm going to speak to my book a bit here. So, in my role and responsibility at Fidelity, the 2 big areas of emerging products that we're really focused on, and I'm working very closely with are active ETFs and alternatives. And those are two areas that are growing exceedingly quickly. And I can put some numbers around that. When you think about total ETF assets and ETF business overall, that's a big and mature business, right? The ETF business has been around for a couple of decades, and now it's a nearly 10 trillion dollar business. But active ETFs, those are products or vehicles that are really growing quickly right now and really have proliferated just over the last couple of years. So put some numbers around that just through October of this year, 2024, we've seen about $230 billion of net inflows into active ETFs.

That's on pace to double the record flow of any calendar year that we've ever seen in the history of active ETFs. We're now at about an 800 billion dollar AUM standpoint from active ETFs, and they're growing at a 3 year compounded annual growth rate around 40%. That said, it's super early innings for active ETFs.

When you think about total active mutual funds and total ETF AUM, active ETFs only make about 5 percent of the assets. Not surprising given all that growth in assets. We're seeing lots of new products come to the market and lots of new managers. Other asset managers, including Fidelity, other asset managers come into that space.

So a couple of interesting facts from that perspective. We now have 59 asset managers that manage over a billion dollars in active ETFs. That's up from 32 just about a year and a half ago. So a lot of growth there. And fun fact, within there is there's actually more asset managers that have at least a billion dollars in active ETFs then passive ETFs which is pretty surprising, I think for a lot of folks, given the size of the passive space. And then just from a new product standpoint that I'll switch gears and talk to alternatives just briefly. From new product standpoint, we've seen 390 new active ETFs get launched here in 2024. And only 126 new passive products and only 107 new mutual funds.

So the active ETF launches that we've seen in 2024 already exceed what we saw all of 2023. All right, so a lot of growth in the active ETF space. And I can talk a little bit about more about kind of the details within there. But just very quickly, the other big emerging product and trend that we're seeing is in the alternative space and more specifically within alternatives, alternatives that are being driven through intermittent liquidity products.

So think non listed BDCs, interval products, things like that. So I won't go through all the numbers of what the fundraising is look like in that space. But just some new product numbers, 32 new interval funds launched since the start of 2022. That's more than the previous two years combined. We saw 13 new launches of BDC products in 22 and 23 versus just three in 20 and 21.

And why, you know, again, this is a hypothesis in a sense, but why we're seeing so much growth in that space is, it has a lot to do with this trend that people are referring to as kind of the democratization of alts. Right? This idea of a vehicle like an intermittent liquidity product, whether it's a non listed BDC or an interval fund, allows, typically, an investor to get access to alts with lower eligibility requirements, lower minimums, intermittent liquidity, hence the name.

So often you have access to liquidity potentially on a quarterly basis and simplified tax reporting. So kind of a more attractive vehicle to get access to private markets.

[00:05:46] Doug Heikkinen: Let's get back to the active ETF as a growing segment. How should advisor be thinking about them? How are they different from Index ETF and how are they different from active mutual funds?

[00:05:59] Ryan McKee: Yeah, thanks so much, Doug. It's a great question. I think how advisors should be thinking about them is really as a new tool or an additional tool in their toolbox to solve whatever the needs are that their clients potentially have, or whatever the needs of a specific portfolio are, right?

So I think it's expanded the instruments that they could potentially use to help solve portfolio challenges or meet the needs of their clients. When you think about what the differences are between an active ETF and an index ETF, an active ETF allows you to take advantages of the benefits of active in take advantage of simultaneously of the kind of attractive features of the ETF chassis or the ETF vehicle. Now I mentioned up front that the majority of the assets within ETFs overall today are still passive, right? That's where the majority of the assets have been. In fact, up until just a couple of years ago, north of 95 percent of all ETF assets were passive ETFs, right? So passive ETFs tend to fall into two big categories, right?

Cap weighted or issuer weighted ETFs. So they're tracking a cap weighted benchmark or an issuer weighted benchmark. And if you just focus on cap weighted benchmarks, what is a passive ETF tracking a cap weighted benchmark supposed to do or typically do? Well, it's typically going to be low cost, hopefully have low tracking error to that cap weighted benchmark, hopefully closely mirror their underlying benchmark.

But you're going to take the good with the bad when you buy that passive ETF, meaning that you're typically not going to outperform the underlying benchmark, right? Just by nature of tracking error. And then you have the risk of potential underperformance relative to that benchmark driven by things like transaction costs and expenses.

And when you buy a passive index ETF. What do you get within that passive index ETF? You, you get the good companies potentially, but you also potentially could get exposure to the bad companies. And what I mean by bad companies, I mean, companies that aren't necessarily growing top line, that might not have necessarily attractive valuation, that might have too much leverage potentially on their balance sheet, that might not have the right leadership team for whatever that next environment is.

And by investing in an active ETF, you have potentially driven by quantitative investment management or quantitative research or fundamental research. You have a active portfolio management team who is looking to identify who the potential good underlying companies would be to invest in. So the potential winners of tomorrow, if you will, while not necessarily sacrificing the positive traits or the positive attributes of the ETF. So you still get the tax efficiency, the intraday trading, the transparency, the potential for low cost, the things that are hallmarks of that ETF vehicle, but now with active management.

[00:09:13] Doug Heikkinen: You see so many advisors and how they're implementing these solutions. What are you seeing?

[00:09:19] Ryan McKee: Yeah, well, I mean, I mentioned already a number of statistics around how we've seen growth in this space and all the product proliferation that we've seen in the space.

And I think that's affording advisors to think creatively and innovatively on how they solve clients challenges. Or, you know, mitigate risks that a client may be looking to mitigate within their portfolio. So, as we have more innovative products, I think we're going to see more innovation around how we solve some of these challenges that clients are interfacing with on a day in and day out basis.

That said, you know, as we think about portfolio construction and using investment vehicles, including ETFs, a couple of different things, I think, that we would think about. Number one, if you were ever to interact with Fidelity's portfolio construction guidance team, which is a team of CFAs, investment professionals, that consult with financial advisors on their portfolios, what they tend to do in a consultant framework is they tend to look at a client's portfolio through different time horizons.

So a secular time horizon, a cyclical time horizon, which is often, you know, through the business cycle lens, Or a tactical time horizon, and we spend the majority of our time and energy in that cyclical time horizon. When you're in a cyclical time horizon, you're thinking about things like the business cycle. Active ETFs, or in some cases, factory ETFs as well can help you lean in and lean out of things that have historically done well in different parts of the business cycle.

So an early, mid, late recession. And so that's one lens that we'd see advisors often look through. Hey, where are we in the business cycle? What type of active ETFs or factory ETFs or other investment vehicles should I be thinking about employing to take advantage of where we are? Another thing that we've been thinking quite a bit about and, it's coming up more and more in some of our interactions is this idea of a budget within a portfolio. What is my budget for expenses? What is my budget for risk? What is my budget for active share? What am I looking to capture on the upside? Or, you know, what am I worried about on the downside? And now through new vehicles and an active ETF chassis, you have the ability to do that.

And what I mean by that is, you're seeing product proliferation in kind of lower cost, quantitatively driven products that have really tight tracking error, sector and security bets, active share and might have less variability relative to an index on the upside and the downside. Then you're seeing products come into the market that use maybe some quantitative, but some fundamental analysis and have slightly wider term sheets, and then you have your traditional kind of fundamental managers, very similar to what people would see traditionally in a mutual fund.

And those managers may have more latitude. And depending on what you're trying to accomplish within the portfolio within an area of the portfolio, maybe one of those three styles, if you will, of investing makes sense. And then last thing I would say thinking about the different use cases, you think about the needs of a client. Often clients can have lots of needs, right?

They could be looking to simply diversify within their portfolio. They could be looking for Hey, how do I create income? They may be thinking about geopolitical events and say, how do I manage risk or how do I manage downside? And some of the innovation that we've seen in ETFs are specifically targeted towards those areas, producing income, managing volatility, often through things like option strategies, or potentially just offering additional diversification opportunities.

[00:13:00] Doug Heikkinen: You mentioned alternatives earlier, and there's been a lot of discussion around them this year. How are advisors using these solutions and why do you think they are?

[00:13:10] Ryan McKee: Maybe I'll start with the second part first. There's a couple of different use cases that we hear from advisors and they can be radically different.

So first off, when we survey advisors about why are they using alts, why would they consider using alts. A lot of them actually start by talking about why from a practice standpoint. And the things that we hear are, they are using alternatives to enhance their service offering or differentiate their practice.

They see alternatives as a way to move up market and attract maybe new high net worth clients, enhance their ability to raise assets, increase client retention, develop deeper client relationships. So, you know, some of those things have an investment angle to them, but they're really practice oriented.

The other big reason in the center at Fidelity and some of the conversations that we have on a day to day basis are the potential for investment benefits. So, so number 1, alternative investments and really specifically alternative investments that are targeting private markets, give advisors and their clients the ability to expand the investment universe.

So I'll give an example. The U. S. middle market. You know, again, in this country, in the United States, which by definition is privately owned enterprises with annual revenue of, you know, somewhere between 10 million and billion dollars, right? So these are private companies. There's 200, 000 of those companies here in the U. S. That's a, that's a third of the U. S. GDP. That's the third largest economy all by itself in the world. And that's a part of the market that is private, right? And if you aren't using alternatives to access that part of the market, that's a part of the market that you're simply not getting exposure to.

You think about just kind of broad equities and public companies. The number of public companies have almost dropped in half over the past 25 years, right? We're hearing about all of these stories about various companies that are staying private longer for all sorts of reasons and including things like, you know, private exposure through alternatives into a client's portfolio gives you access to those companies.

And just one last statistic, and then I'll just mention quickly from a portfolio standpoint, and this was something that one of the individuals on our team shared with me recently, and I just hadn't realized that is that 85 percent of the companies in this country right now that have over 100 million in revenue are private.

So when you're only investing in public securities, whether that's equities or bonds, you're not getting exposure to any of those things that I just mentioned, right? So there's a big, wide world out there to potentially invest in. From portfolio's standpoint, without getting too into the weeds here, the reasons that we see advisors using alternatives are some of the same reasons I spoke to a few moments ago around active ETFs.

There are different alternatives for different use cases. So some alternatives are designed or targeted to try to help a client enhance their return profile. Some are designed to help them protect on the downside. Some are designed to help them diversify from some of those public asset classes that I just mentioned.

And some are designed to help provide income. So lots of different use cases, lots of reasons, but practice benefits, investment universe benefits, and then outcome benefits, if we can describe it that way.

[00:16:34] Doug Heikkinen: Fidelity as an organization does a lot of work within portfolio construction and consulting with advisors.

What trends have you seen with the emerging products here?

[00:16:45] Ryan McKee: It's some of the same things that we've spoke to so far. So put some numbers around this again. In a given year, Fidelity's Portfolio Construction Guidance team will do something like 12, 000 portfolio reviews with financial advisors. And just speaking to the same theme that we've talked about here, ETFs and specifically active ETFs and alternatives Maybe I'll give you a couple of numbers of where we're seeing things today.

So if you look within U. S. equities, 63 percent of the portfolios that are coming into Fidelity, so that means an advisor has already constructed them his or herself, are using ETFs. About 78 percent of the portfolios have mutual funds. So you, you see that we're seeing ETFs and mutual funds being used more equally than maybe we saw just a couple of years ago.

The average ETF allocation was about 31%, which is a, you know, big part of the equity sleeve. With international, though, we haven't seen as, as high use of ETFs, and part of that is kind of the limits on what we can do sometimes within ETFs, and we can come back to that if time permits. And then with fixed income, pretty similar trends.

 The one thing that I would know is in 2022, only about 13 percent of advisors had an allocation to active ETFs. Thinking about our portfolio experiences, right? So not broad industry, but just what we're seeing in portfolio reviews. This year, nearly 30 percent of advisors have some exposure to active ETFs specifically.

So a big uptick. On the alternative side you know, historically speaking from an investment standpoint, when you have a higher inflation environment, the correlation of stocks and bonds tends to go up, right? Inflation has come down here recently measured by some of the metrics that the Fed uses to measure inflation. But people still have that kind of 22 view in the rear view where you had a really, really difficult year for both stocks and for bonds. And as a result, we saw kind of an increased usage or increased interest in alternatives. Now, typically, when we're doing portfolio reviews, were primarily focused on liquid alts.

So not semi liquid or illiquid kind of LP products, but primarily liquid products that are being delivered through mutual fund or chassis. And about 18 percent of incoming portfolios, at least, include some alts, some liquid alts. In quarter over quarter, Q3 over Q2, we saw about a 2 percent increase. And the average weight of alternatives within the portfolios that we see is around 8%, which is still a bit higher than we saw last year.

So the 60/40 portfolio has actually done pretty fantastic here over the past year. But as clients have more access to alternatives through some of the vehicles that we've talked about here we have seen increased interest and increased usage within client portfolios.

[00:19:44] Doug Heikkinen: Are emerging products addressing the demand for more portfolio customization?

[00:19:49] Ryan McKee: Yeah. I mean, I, I think so. I mentioned lots of statistics so far already. And you talk about all the new products that are coming to market, whether they're alternatives or ETFs and other vehicles.

 And what are they allowing us to do is they're allowing us to get kind of more and more specific with our exposures and with our allocation and more and more specific to a unique clients needs. That said, when I think about portfolio customization. I actually don't often think quite as quickly about ETFs and alternatives.

I actually think about something that we haven't really talked about at all here yet today which is custom SMAs and, and direct indexing. You know, for those of you who are, are not familiar with custom SMAs or direct indexing, it essentially allows you to buy the individual securities within a separately managed account rather than buying just a passive ETF or active ETF or index or mutual fund. So buy the individual security. So when you buy the individual securities rather than the package product, well, now you can get really customized with your exposure and the kind of accelerated rate at which we've seen technology and innovation there has allowed us, I think, as an, as an industry and as an organization to scale our capabilities to offer things like custom SMAs and custom SMA and direct indexing for clients.

And again, some numbers behind it, probably not growing quite as quickly here as active ETFs, but as of the end of last year, I think custom SMAs direct indexing made up about 615 billion dollars of AUM. That's nearly a 20 percent 3 year compounded annual growth rate. And if I'm remembering correctly, I think Cerulli expects that number to approach close to a trillion dollars as we get into 2027.

Despite that also, pretty new business overall, when I think about penetration across advisors, so only about 1 and 5 advisors. I think the industry statistics are are currently using custom SMAs or direct index products, and that's pretty concentrated by by channel. So I think when I think about portfolio customization, yes, product proliferation around ETFs and alts are helping us to do it. Technology and product through something like a custom SMA or direct indexing is definitely helping us do that with lots of other potential benefits, including specific exposures, tax management et cetera, et cetera.

[00:22:26] Doug Heikkinen: Yeah. That's the last thing I wanted to ask you. What role do you see FinTech playing in the development and distribution of new financial products?

[00:22:33] Ryan McKee: So one of the things that financial advisors, I don't want to say that they, struggle with, but it is a constant challenge, and ongoing challenge, is to figure out how they can scale their business. And the reason why they need to scale their business is when you look across the industry, 2 things are happening.

Advisor practices are getting bigger, right? And advisors are being asked to do more on a day in and day in day in and day out basis. And so we can talk about all these great things that active ETFs and alternatives and custom SMAs and, you know, things like that, what they can do for your practice.

But if they're not scalable, well, it actually just becomes one more challenge for an advisor. And so one of the, the kind of exciting things, enter kind of the FinTech space, is the ability to use technology to scale all of these things we've been talking about. And if you can scale it, well, then you enable usage.

We see accelerated development, and we see kind of accelerated distribution of all of these products. So, yeah, I mean, there's lots of different ways that we're seeing that. We're seeing the advent of the UMA platform, the unified managed account platform, which allows an advisor to maybe have a custom SMA, a mutual fund, an ETF, and an alternative, all in one portfolio all in one account, if you will, and kind of trade reasonably seamlessly between those positions. So that's all been developed by kind of FinTechs and technology overall. We just talked about direct indexing and custom SMAs and the FinTech and, and technology kind of behind the enablement of, that investment solution.

And then in the alts space, I think where we've seen the most development is, or where we're seeing the most current development, I should say, is how do we make it easier for advisors, and therefore their clients to access alternatives, implement alternatives, and then manage alternatives on an ongoing basis.

And can we take products like semi liquid products and illiquid products and use technology to allow an advisor to manage them potentially even within something like a model, right? Allowing them to scale something that historically wasn't really scalable. And that's really exciting, because we can talk about all these great things, but if you can't do this component of it you know, I don't think that we'll see the penetration really significantly pick up.

So really excited about what we're seeing out of the FinTech space.

[00:25:17] Doug Heikkinen: Ryan, there's a lot of great information that you just covered here. How does a financial advisor get started?

[00:25:24] Ryan McKee: Yeah, it's a good question. Again, I know it's a lot and I just mentioned a moment ago, the importance of scale and efficiency in an advisors practice, right? Because without scale and efficiency in a practice all of this just quickly becomes overwhelming. This is what, or at least in part, what we see is our value proposition in partnering with advisors, right? So we have a team of strategists, a team of specialists across all of these different disciplines that can help go deep for an advisor, help them understand kind of the intricacies around some of the specific products that we've addressed here today.

And if they would like to have a more comprehensive conversation thinking about their client portfolios and how or where or if some of these solutions potentially could fit, the best way to engage with us is simply go to i.fidelity.com/portfolio. And again, that's i.fidelity.com/portfolio.

And you can simply click request a consult, which would give you access to the Fidelity team, including our portfolio construction guidance team, which consults with financial advisors to help them understand exactly what I was just referring to a moment ago.

[00:26:37] Doug Heikkinen: Ryan, thanks so much for joining us.

[00:26:40] Ryan McKee: Thanks for having me.

[00:26:41] Doug Heikkinen: To learn more about Fidelity's Portfolio Construction Strategies, please visit i.fidelity.com/portfolio. Please follow us for timely updates on X, LinkedIn and Facebook. all @Advisorpedia. For everyone at Advisorpedia, our producer Julia Smollen, our engineer Tory Miller, and the Power Your Advice podcast team, this is Doug Heikkinen.