Multi-assetOct 17 2019

Attractive option for portfolios

Supported by
Fidelity
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Supported by
Fidelity
Attractive option for portfolios

The popularity of exchange-traded funds has exploded in recent years.

In 1998, there were only 29. By the end of 2018, there were more than 1,900 ETFs investing in a wide of range of stocks, bonds, and other securities and instruments, according to data from the Investment Company Institute.

And since the Retail Distribution Review there has been a gradual reduction in the overall costs of multi-asset portfolios as advisers demand that fund managers be more transparent and reduce their costs, driving up the use of these products even more.

Justin Onuekwusi, a multi-asset fund manager at Legal & General Investment Management, says: “More and more ETFs are becoming in vogue, more mainstream, and importantly they are starting to compete on cost with the big index players or the big index mutual funds.

“The other things ETFs give you is real-time performance. You can effectively align your ETF with the pricing point of the overall funds, which makes them very attractive.”

ETFs, which are a type of index fund, offer shares in a pool of investments designed to pursue a specific investment goal. 

Key points

  • ETFs in multi-asset funds can keep costs down
  • Passive investing is not necessarily the best during falling markets
  • A combination of passive and active is the better option

ETFs cover a broad range of asset classes and can give exposure to specific markets, sectors or investment strategies.

The types of ETFs in the market have also evolved in recent years, and now cover everything from mainstream asset classes to niche investments or particular portions of a given market.

Fund manager Fidelity notes that ETFs can provide exposure to a variety of asset classes such as equities or fixed income by:

• Following the performance of a market index, such as the FTSE 100 or the S&P 500;

• Following the performance of a smart beta index, such as the S&P 500 Minimum Volatility or MSCI Europe Value;

• Being actively managed by an experienced and dedicated manager.

Smart beta refers to a methodology of index construction that seeks to achieve better risk-adjusted returns compared with traditional market capitalisation-weighted benchmark indices. 

Actively managed ETFs

Lately, the market has also seen the emergence of active ETFs. 

Actively managed ETFs invest in a portfolio of securities that is chosen by a fund manager on their own, rather than being based on a rules-based index. The idea is to perform better than a benchmark through flexible active management.

As ETFs have continued to grow in popularity, they have become a key part of multi-asset portfolios, not least because they help keep costs down.

In the case of the largest, most liquid equity markets, such as those in the US or UK, ETFs tracking these indices can cost as little as 0.05 per cent.

However, an investor should always understand what is in the underlying index. Additionally, as cost is important, so too is risk and return. 

Core and satellite approach

Caroline Baron, head of ETF EMEA sales at Franklin Templeton, explains that the products can be useful in a multi-asset portfolio as part of a core-satellite strategy.

On this point, Morningstar explains: “Your multi-asset fund, ETFs or mix of more general funds will provide the core of your portfolio – the bit that should deliver steady returns and is unlikely to change much over time. 

“But around this you can incorporate smaller investments in more specific funds that you might have a strong belief in. This is known as a ‘core and satellite’ approach.”

Ms Baron says: “There are a lot of different applications. We see a lot of multi-managers using futures, and they are actually using ETFs as a replacement as they can be more cost-efficient.”

Passive investing has had a few good years, but Ryan Hughes, head of active portfolios at AJ Bell, notes it is important to remember that markets can go down as well as up, even if it feels so long since that happened.

Mr Hughes says: “Acknowledging that passive investing doesn’t have an ability to protect capital when stock markets are falling is vital, and this is where some of the best active managers over the years have earned their reputations. 

“Additionally, it’s important to recognise that the indices that passive investments follow can change. 

“For example, an investor in an emerging markets tracker five years ago had about 15 per cent exposure to technology companies, whereas today it is more like 30 per cent in technology companies. This can change the risk profile of the passive investment significantly over time.”

To mitigate the risks, Mr Hughes says advisers should never invest in something they do not understand.

He adds: “Just because it is passive doesn’t mean it is any less risky, and therefore it is just as important to stay on top of your investments and do your research so you understand what you have bought. Diversifying your portfolio is a strong method of reducing risk.”

Ms Baron also cautions against all ETFs being seen as the same. “You need to look under the hood to understand the structure and the cost,” she says. 

Howie Li, head of ETFs at LGIM, says there is still a huge amount of education to do on the ETF market, adding that they should be viewed in the same way as mutual funds.

He says: “Are you comfortable with the [practice of] securities lending? Do you need to have a lot of liquidity?

“Looking at the liquidity in the ETF, there are a lot of different layers you need to consider, because one ETF will not suit everyone. A lot of people assume that all ETF risks are the same. The risk here is that we are tracking the market and buying just the largest companies. 

“ETFs are doing the same thing as an index fund is. You are buying the largest 500 companies in the ETFs and you are buying the largest 500 companies in the funds. The risk here is how well they are buying and selling those stocks.”

Mr Li continues: “What I would ask in terms of risk is: are we buying all 500 of the stocks in a fund or ETF, or are we buying some of it?

“Are we buying it and then lending it out to generate some additional return? If so, you have then got counterparty market risk there.”

James Burns, head of the Smith & Williamson managed portfolio service, says that in a multi-asset portfolio there should be a mix of passive and active funds.

“I do not believe that investing in the cheapest base makes sense in the longer term,” he says.

“There have been enough years for journalists to extol the virtues of passive investing and the markets going up, but at some point that will change and that is where active management will have to come to the fore and prove its worth again.”

Ima Jackson-Obot is deputy features editor of Financial Adviser and FTAdviser.com