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ETFs ­ Spring 2017 yesterday

How to use ETFs in portfolio construction

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D iversification is investment 101. Having a diversified portfolio is what will help aninvestor bare times of lean returns in one sector or asset class while hopefully

picking up gains by being exposed to others.

So how do exchange traded funds fit into the mix? Simply put, by providing low costdiversification.

“Because ETFs come in many different flavours, they enable investors to construct theirportfolios in accordance with their asset allocation at a low cost,” Mark Fitzgerald,product manager for Vanguard, says.

Luis Rivera, chief executive and co-founder of robo-adviser ETFmatic, argues that ETFsETFmare so important to the modern portfolio construction process that even hedge fundsinvest significantly through them nowadays.

>The development of various ETFs have meant diversified portfolios of fundamentallydifferent risk premia can be constructed far more efficiently than in the past.---LuisRivera

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The overarching advantage, according to Mr Rivera, is that ETFs allow investmentmanagers to have what he calls “pure implementation” of a particular asset class - asopposed to using a third party fund manager that underweights or overweightsparticular sectors and companies.  

“The development of various ETFs have meant diversified portfolios of fundamentallydifferent risk premia can be constructed far more efficiently than in the past,” he says,“meaning uniquely tailored portfolios can be built for clients”.

What will these tailored portfolios look like?

According to Joe Parkin, head of UK wealth and retail sales at iShares, as investorsdemand both value and a premium service from their financial advisers and investmentmanagers, increasingly active portfolios will be built using ETFs and index fundsalongside high conviction alpha strategies.

“In essence investors will be blending active and passive strategies rather than investingin one or the other,” he says.

ETFs give retail investors access to low cost investing in assets it simply wouldn’t havebeen possible to buy as an individual before, such as gold or oil, James McManus,investment manager at Nutmeg, points out.

“The variety of ETFs available means there are now very few sectors, regions, factors orasset classes you can’t access through an ETF structure. 

“There are currently over 1,800 ETFs listed on the London stock exchange alone,meaning price competition is high (good for all investors), and choice is wide. 

“In many markets, there are not only competing product providers, but also differentunderlying index exposures from which we can choose.”

To benefit from the diversification they offer, there are four key ways ETFs can be usedin a portfolio, as Daniel Greenhough, investment manager at St Albans-based LuminWealth, points out:

tactical asset allocationadjusting style biasobtaining style performance without active manager fees

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providing market exposure for capital gains tax constrained clients

On tactical asset allocation, Mr Greenhough gives the example that many portfolioscontain a blend of active managers; blending value (low relative share price) and growth(capital appreciation over the long term) managers.

“ Buying and selling an ETF can be done at any time in the trading day and doesn’t upsetthe balance of a value/growth blend. For this reason, they are well suited to more shortterm tactical moves in asset allocation,” he says.

Next up, adjusting style bias

“For investors that want to adjust a style bias within a portfolio the development ofsmart beta ETFs that track a value or growth index provide a quick way to do this,” MrGreenhough points out.

He gives as a example a bias to growth funds led by the performance in recent years offunds like Fundsmith, and Lindsell Train UK Equity, where a value based ETF can helpbalance this bias out.

>By receiving market performance at a low cost, the ETF is an instrument they can buyand hold for a long time.---Daniel Greenhough

Using an ETF to obtain style performance without active manager fees is fairly selfexplanatory, but the example Mr Greenhough gives is if a value fund managerunderperforms a rules based value ETF, “this would suggest that the actual stockselection the active manager is doing detracts from performance”. 

Finally, clients with taxable portfolios that are constrained by capital gains can use ETFsto form the core of their portfolios. 

Mr Greenhough says: “They receive the performance of the market and don’t have toworry about fund manager changes possibly creating a requirement to sell. By receivingmarket performance at a low cost, the ETF is an instrument they can buy and hold for along time.”

ETFs also offer investors transparency in holdings and cost.

“Investors are able to understand portfolio risk in granular detail at all times, and thetransparent methodologies for rules driven approaches means that investors can

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understand how their portfolio will react to market changes,” Mr McManus says.

“In terms of the costs of trading - what we really like about ETFs is that we canunderstand the exact price at which we will purchase or sell the security, before thetransaction takes place (unlike mutual funds where the transaction typically takes placeonce a day at a set point).

“And in some asset classes, the secondary market that exists in the ETFs meansinvestors are able to quickly and efficiently gain access to assets that are expensive totrade individually - the cost of purchasing the ETF (the bid-ask spread) in the secondarymarket can often be lower than purchasing all of the individual securities themselves.”

With the demand for passive products on an upward trajectory and predictions byiShares that ETF assets will reach $1trn in Europe by 2019 are there any barriers tousing ETFs in portfolio construction?

Easily accessible

Joe Parkin, head of UK wealth and retail sales at iShares, reckons that for ETFs to reachtheir full growth potential investors need to be able to access and easily trade them.

“While we applaud those platforms which now offer ETFs to their clients, ETFs are stillnot universally available across all platforms,” he said.

iShares has been working with a number of investment platforms to help dvelop theirinfrastructure to enable them to offer ETFs to clients. 

“This is something we will continue to champion as platforms fundamentally need toadapt with the times and upgrade their infrastructure; otherwise they will eventuallylose all ability to compete in a changing world,” Mr Parkin says.

>While we applaud those platforms which now offer ETFs to their clients, ETFs are stillnot universally available across all platforms.---Joe Parkin

He believes investors wanting to use ETFs to better manage their portfolios are beingheld back by the inability of investment platforms to easily buy and sell ETFs.

He points out that retail investors have only been able to buy whole shares in a singlecompany stock or ETF on platforms and this has often left a proportion of cash un-invested. But this, he said, is changing.

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He gives the example of an investor having £100 to invest but the value of a share is £53,so this would leave them with £47 un-invested. 

“However this been revolutionised with the launch fractional shares, which allowsinvestors to buy a fraction of an ETF unit costing as little as one penny,” Mr Parkin says.

In the example above, fractional shares would mean that the remaining £47 could beinvested. 

“This ultimately means an investor is more likely to reach their investment goalsquicker,” Mr Parkin says, though he adds this is yet to be widely adopted across theindustry.

“We are working with third parties and platforms to make this widely available.”

laura.miller@ft.com

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Also in this guide

Guide to exchange-traded funds

How the ETF market has grown1ETFs vs index funds and the rise of smart beta2How to use ETFs in portfolio construction3

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ETFs ­ Spring 2017 yesterday

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ETF developments in 2017 and beyond4