ETFs - A clever way to build portfolios?

 

”The global ETF/ETP industry had 5,632 ETFs/ETPs, with 10,902 listings, from 245 providers listed on 63 exchanges in 51 countries.”

ETFGI, March 2015

 

The number of Exchange Traded Funds (ETFs) now available is staggering.

Listed on stocks exchanges around the world, ETFs give investors access to investment strategies previously available only to sophisticated investment houses as well as offering an alternative way to mutual funds, SICAvs, OEICs and other collective investment schemes of gaining access to passively managed investments. For the moment, at least, actively managed investment products, by which we mean investment products relying on the expertise of a fund manager at any particular time, remain largely outside of ETFs.
Just because the investment strategies are sophisticated, it doesn’t mean they are any more risky than buying a few of your favourite shares or funds, or even managing your savings as cash. Indeed some of the more sophisticated strategies are in place to reduce risk rather than increase it.
Globally, ETFGI counts 5,632 ETFs as at the end of March 2015 with more being launched on some exchange or another every month. So why are ETFs so popular today? And is this really a lasting trend or, as the title proposes, just a fad?

Why ETFs will last

It’s easy to look back a couple of decades and see how markets have arisen to meet the needs of the moment. Traded options in the 1980s means that short-term “bets” could be made for relatively low outlay and very high returns (nor not). Hedge funds from the 1990s offered a degree of risk management as well as large performance-related fees for their managers. But they were not entirely safe and the collapse of LTCM in 1998 showed us that not only could some of the best brains in the business get it wrong but also that financial markets and national economic interests were interdependent, given the $3.6 billion bailout organised by the Federal Reserve.
It is also easy to say that anything that can be done in an ETF can also be done by a manager of a mutual fund, SICAV, OEIC or whatever. But what the ETF structure has done is to uncouple the investment technology from the trading of the resulting strategy. This means that the investment technology, basically an index, is run by a company unconnected with the ETF such as S&P or FTSE and the trading is done by participants in the financial markets. The job of the ETF provider in the middle of all of that is to turn the theoretical calculation into an actual one by mimicking the index using investments. And how they do that is set out clearly in unambiguous rules.
The last ten years or so have seen more and more curious beasts join the ETF ark. I wonder who would have thought at the dawn of ETFs that we would now see commodities and currencies offered, let alone products which benefit from tightening of credit spreads and the ideas from the world’s top investment gurus. The point is that now there is a well-beaten path from idea to listing, ETF providers can push through more and more innovative products with economies of scale. iShares launched fifteen new ETFs in the first quarter of 2015 alone.
The recent ETF trend is for “smart beta” strategies. Simply put, this means investing according to a model which defines their relative size in the investment portfolio and which isn’t based on the size of the company or a manager’s own personal view. Smart Beta models include various low risk approaches such a low volatility and minimum variance, fundamental weighting using data from companies’ financial statements, and methods based on dividend payments. There is no real suggestion that these strategies will perform better than the underlying index on which they are based, although claims by academics are often used to show there is empirical evidence of premiums to be gained. But if an investor believes that a certain kind of company will benefit in a forthcoming economic climate, then it is more and more likely that there is an ETF out there that already offers that approach.
This is why I believe that ETFs will prosper. The innovation they have unlocked means there is something for everyone. Yes, the original attraction of a low fee and continuous trading is still there, but with the choices now available, the ETF market has matured quickly and competitively.

Clever portfolios

Having argued that ETFs are not a fad, here’s why they help with clever investing.

Access to a variety of assets

Investing into shares and bonds has always been easy for the individual. Gold and silver, commercial property and currencies a little less so. Oil and gas, agricultural commodities and intellectual property have been pretty much inaccessible. Now, packaged as ETFs, these and many other assets can be bought and sold in bite-size morsels even for those with big hungry mouths. I wrote about investing in food and oil as part of a strategy for retirement savings a few weeks ago. And anyone worried about the value of their national currency might see gold and silver as an alternative to money.

A portfolio that represents your objectives

It might be that there is a single ETF out there that does everything you need regarding your investment goals. But it is more likely that you might, for example, have the view that you need to invest 40% into your national equity market, 30% into international equities, 20% into government debt and 10% into precious metals. The old way would be to find an investment intermediary to organise all of that for you, or to find one or more investment managers offering funds investing in those four sectors. Now, in keeping with the spirit of the 21st century, all the information you need is available online. For US-listed ETFs, try ETFDB. For a global perspective, the Financial Times has a good selection tool.

A way of managing risk

To avoid the historically risky equities, there are many ETFs which use only stocks or combinations of stocks with low volatility. There are also “risk control” ETFs where part of the investment is in cash when the market is volatile, the amount of cash being set by equation rather than by manager opinion. For those who want more risk, there are leveraged ETFs which, for example, return twice the increase (or decrease) in the price of gold. And there are ETFs which strip out the safe (interest rate) part of a credit portfolio leaving only the risky (credit spread) part.

Hedging your ignorance!

Warren Buffett speaks about ignorance as that which is being diversified away when opting for a diversified investment strategy. On the other hand, most of us are indeed more ignorant than Warren Buffett so this is what we do. But we might know a thing or two about a part of the market which we want to manage directly. Real Estate, for example. Not wanting to invest 100% into one asset, we would feel our wealth is safer if we put some part of it into one or more other assets about which we know little other than that if we did we would manage our money there too. ETFs provide such a way of diversifying.

Lower cost

Finally, let us not forget that ETFs have lower charges associated with them than managed funds. Some might say that it is not worth getting bothered about a 0.30% annual charge than a 0.35% annual charge. On the other hand, that’s what those with higher charges want you to think, and if you are really not bothered about 0.05% then still buy the ETF and put the balance into a charity donation.
Also be aware that ETFs incur a transaction fee for buying and selling, which is levied by the broker. The managed fund will also have fees – often loaded onto the buy side in the form of two-way pricing – to take into consideration. Those who expect to frequently buy and sell their investments will notice the effect of these fees more than those who trade less frequently.

Any downsides?

Actively managed funds

Although we have been considering indices and systematic, formulaic ways of investing up to now, there is still a place for the star fund manager. There really are people out there who know their way round their parts of the market. They will likely have no presence at all in the ETF world. So anyone wanting high-conviction managed funds will need to deal directly with the management company or one of their intermediaries.

Taxation

To be frank, I don’t even know the full tax implications of holding ETFs even in my own jurisdiction (the UK) although I imagine they are treated like an equity investment. But I have come across stories of people running into difficulties selling US-listed ETFs from outside of the US. There is no substitute for educating one’s self, or speaking with someone who can advise.

Finally

This post has hopefully described the world of ETFs. Clearly with over 5,000 ETFs out there, no blog post can do much more than scratch the surface of this huge market. I suggest everyone interested in investing takes a few minutes to explore the vast array of investments and strategies now available, if only for inspiration on what to do next.

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