ETFs - Spring 2017 

How to use ETFs in portfolio construction

This article is part of
Guide to exchange-traded funds

How to use ETFs in portfolio construction

Diversification is investment 101. Having a diversified portfolio is what will help an investor 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 cost diversification.

“Because ETFs come in many different flavours, they enable investors to construct their portfolios 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 ETFs are so important to the modern portfolio construction process that even hedge funds invest significantly through them nowadays.

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

“The development of various ETFs have meant diversified portfolios of fundamentally different 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 investors demand both value and a premium service from their financial advisers and investment managers, increasingly active portfolios will be built using ETFs and index funds alongside high conviction alpha strategies.

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

ETFs give retail investors access to low cost investing in assets it simply wouldn’t have been 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 or asset 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 different underlying index exposures from which we can choose.”

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

  • tactical asset allocation
  • adjusting style bias
  • obtaining style performance without active manager fees
  • providing market exposure for capital gains tax constrained clients

On tactical asset allocation, Mr Greenhough gives the example that many portfolios contain 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 upset the balance of a value/growth blend. For this reason, they are well suited to more short term tactical moves in asset allocation,” he says.