How to use ETFs in portfolio construction

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 development of various ETFs have meant diversified portfolios of fundamentally different risk premia can be constructed far more efficiently than in the past.Luis Rivera

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.

Next up, adjusting style bias

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

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

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

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

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

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

ETFs also offer investors transparency in holdings and cost.

“Investors are able to understand portfolio risk in granular detail at all times, and the transparent methodologies for rules driven approaches means that investors can 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 can understand the exact price at which we will purchase or sell the security, before the transaction takes place (unlike mutual funds where the transaction typically takes place once a day at a set point).

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

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

Easily accessible

Joe Parkin, head of UK wealth and retail sales at iShares, reckons that for ETFs to reach their 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 still not universally available across all platforms,” he said.

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

“This is something we will continue to champion as platforms fundamentally need to adapt with the times and upgrade their infrastructure; otherwise they will eventually lose 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 still not universally available across all platforms.Joe Parkin

He believes investors wanting to use ETFs to better manage their portfolios are being held 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 single company stock or ETF on platforms and this has often left a proportion of cash un-invested. But this, he said, is changing.

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 allows investors 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 be invested. 

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

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

laura.miller@ft.com