ETF s Top 5 portfolio strategy considerations ETFs have grown substantially in size, range, complexity and popularity in recent years. This presentation and paper provide the key issues and portfolio strategy considerations relating to ETFs that can form part of the client conversation. These considerations are not often discussed but should influence whether and how ETFs may be used by clients relative to alternative structures. By May 2013 PortfolioConstruction Forum Symposium 2013 Research Paper 1
Introduction Over the last decade globally and more recently in Australia and New Zealand, there has been an explosion in the use of exchange-traded products and, more specifically, exchange-traded funds (ETFs) by both institutional and retail investors. Investors have been attracted to the relatively low cost of ETFs as well as their ability to enable time-efficient diversification and their simple, transparent and flexible investment features. Furthermore, the shift towards a fee-for-service model has meant that more portfolio construction practitioners have expanded the universe of structures that they recommend to clients to include ETFs. However, as the ETF market has evolved, so too has the complexity of the various ETF products and it is now more important than ever that practitioners be informed about ETFs and their suitability to the client s specific needs and circumstances. This paper provides details on some of the key issues relating to ETFs that can form part of the client conversation and, where suitable, how ETFs can be used in a client portfolio. PortfolioConstruction Forum Symposium 2013 Research Paper 2
Overview of exchange traded funds There has been much confusion over what constitutes an exchange-traded product and what does not. Exchange-traded products can be broadly broken down in three types: exchangetraded funds (ETFs), exchange-traded commodities and currencies (ETCs) and exchange-traded notes (ETNs). This paper focuses on ETFs. An ETF is an open-ended index fund, listed on an exchange, which invests in shares, fixed income, cash, alternative assets, currencies and commodities across global regions, sectors and asset classes. Typically, ETFs invest in a range of shares that replicate an index, either physically or synthetically. Investors can buy units in the listed fund and obtain an index exposure that is, ETFs have been designed to track the return of the relevant index with the ease of trading normal shares. PortfolioConstruction Forum Symposium 2013 Research Paper 3
Major considerations when investing in ETFs The aim of this section is to overview some issues to be aware of when developing recommendations to clients who are thinking of investing in equity ETFs (80% of the ETF market is equity-based ETFs). Some of the issues to consider when determining whether to recommend a client invest in equity ETFs are: Whether actively managed funds that use a fundamental stock picking approach can consistently outperform the relevant index. How the degree of market concentration affects the performance of the index relative to other investment styles. The type of market conditions in which ETFs are likely to outperform actively managed funds. How the inclusion of equity ETFs into a client s portfolio may impact on the diversification at the asset class and total portfolio level. How the underlying features of the ETF match the client s circumstances. The following issues will be discussed in more detail: 1. Market capitalised portfolios may not be the most efficient portfolio. 2. Market efficiency. 3. Selecting and combining best of breed fund managers with ETFs. 4. Active versus passive management in different market conditions. 5. Complexity of the various ETF structures. 1. Market capitalised portfolios may not be the most efficient portfolio Market capitalisation weighted indices involve the total market capitalisation of the companies weighted by the size of the overall market. Larger companies would have a higher weighting in the index and their performance would have a greater impact on the performance of the overall index. The proportion of a company held in an index is based on the market capitalisation of the company. As the share price of a company increases by more than the rest of the share market, its market capitalisation will increase and it will comprise a larger portion of the overall index. The reverse applies to companies whose share prices falls relative to the average market returns. An ETF that replicates an index will buy the companies that have been outperforming the broader share market and reduce exposure to companies that have been underperforming. In this way, ETF portfolios are linked to changes in the relevant index. Therefore, the ETF may be buying PortfolioConstruction Forum Symposium 2013 Research Paper 4
increasingly expensive companies. On the flip side, as a company s share price falls (relative to the index) and becomes cheaper, ETFs will sell down their holding in the company. In other words, an ETF may at times overweight the fund with overvalued companies and underweight the fund with undervalued companies. This may cause a performance drag on the client s overall portfolio. The performance drag may be prevalent in highly concentrated share markets. On the other hand, actively managed funds have the ability to take advantage of this mispricing by overweighting the portfolio with companies the manager believes are undervalued and represent better investment merit and underweighting the portfolio with companies the manager believes are overvalued. Where a best of breed active manager has the staff and capability to successfully pick companies that outperform an index, the net return (total return less costs) from investing in ETFs may be lower than that of actively managed funds even after taking into account the lower costs of an ETF. Practitioners should recognise that a number of studies have shown that market-weighted portfolios are not the most efficient risk and return portfolio and therefore may not be the most optimal way to access the various investment markets. Arnott, HSU & Moore (Fundamental Indexation, 2005, p15) found that fundamental indexing is materially more mean-variance efficient than standard cap-weighted indexes and flagged a number of problems with market cap weighted indexing. Cap weighted indices may not be mean-variance optimal if markets are not perfectly efficient. Theoretically, it is possible to construct a more optimal portfolio. Furthermore, capweighted indexes have traditionally become more heavily concentrated in growth stocks (high price/earnings (P/E) stocks) during periods of P/E multiple expansion, making capweighted indexes particularly vulnerable to market bubbles. Goltz and Le Sourd (Does finance theory make the case for capitalisation-weighted indexing, 2010, p6) found in relation to US-based indices that only under very unrealistic assumptions would such indices be efficient investments. In the presence of realistic constraints and frictions, cap-weighted indices cannot, according to the academic literature, be expected to be efficient investments. 2. Market efficiency Investors who implement an index-type portfolio strategy whereby the portfolio is constructed to replicate an index are inherently taking a view that active fund managers cannot add any value to PortfolioConstruction Forum Symposium 2013 Research Paper 5
stock selection net of the active fee levels. This is because they believe that all the publicly available information has already been incorporated into the price of the listed shares. Active managers tend to add value when there is imperfect information in share markets. Stocks included in ETF portfolios are usually weighted by their market capitalisation in the underlying index. Many advocates of these types of indices argue that they provide the most efficient riskreturn portfolio and most attractive investments. Conventional wisdom suggests that market efficiency tends to be greater in the large cap segment of equities due to greater research coverage and greater publicly available information. The higher efficiency implies that it may be more difficult for active managers to add value from stocks selection tilts in the large cap segment. On the other hand, mid and small caps are one area where active managers may find greater pricing inefficiencies and opportunities to add value due to relatively low research coverage and lower levels of liquidity. Therefore, ETFs that have a greater exposure to large cap segments of the share market may be considered more efficient and warrant the use of an ETF while ETFs that track the mid-small cap segment of the market may underperform capable active managers that invest in the same market segments. Therefore, a practitioner needs to be aware that investing in some types of equity ETFs may not be the most efficient way to maximise net returns. 3. Selecting and combining best-of-breed fund managers with ETFs When building an investment portfolio, a practitioner seeks to construct a portfolio that has a high probability of achieving the client s overall risk-return objectives. As a part of this process, they rely on investment specialists such as research houses, asset consultants and multi-manager funds to select best-of-breed fund managers and build efficient investment portfolios. In many cases, the argument for including ETFs in a portfolio includes that the median active fund manager, after fees, is unlikely to outperform the relative index. However, some investment specialists have shown that they can consistently select active fund managers and build portfolios that outperform their peers and relative indices after fees. If this is the case, ETFs may not form a core or satellite part of the client s portfolio. Following are some of the factors to be aware of when considering the inclusion of an ETF in a diversified portfolio that may include actively managed funds and/or direct shares: PortfolioConstruction Forum Symposium 2013 Research Paper 6
A portfolio may include too many fund managers, ETFs and/or funds with a similar investment process and portfolio which results in over-diversification. For example, one fund may be overweight BHP and another fund in the portfolio underweight BHP and therefore the overall portfolio may have a similar weighting to BHP as to the index. This would result in a lowering of the portfolio s risk and more than likely generate benchmark-like returns. Another consideration is the weight and composition of the different fund styles and attributes in the portfolio. When combining fund managers and ETFs, it s important to consider a number of factors, some of which include style bias (i.e. growth or value), market capitalisation, sector exposures, stocks held and weightings in the portfolio, and the manager s contribution to the portfolio s overall risk profile. This is important when considering the inclusion of ETFs that have a style bias or market cap bias, such as value ETFs or small cap ETFs in a portfolio that includes actively managed funds with distinct styles or biases. A further consideration is the complementarity of an ETF within a portfolio of direct shares that includes any overlap between the direct shares and the shares represented in the ETF. A client with a portfolio of direct shares that mostly constitute the largest shares by market capitalisation may need to look at the extent of the overlap of the shares held in a broad-market ETF with the direct shares already held. In such a case, it may be more appropriate for the client to consider ETFs that have a style bias, smaller market cap bias or international share exposure to provide greater diversification. Active versus passive management in different market conditions The investment environment can affect the ability of active fund managers to outperform their benchmark or underperform. Active fund managers have a greater ability to outperform at times when the performance and valuations of companies and sectors have a high level of variability. A capable and skilled active fund manager can use this dispersion to apply their research and process to select companies and sectors that are likely to outperform the relevant index. Where such an environment exists, a capable and skilled active fund manager who takes big positions relative to the index is likely to produce higher levels of outperformance. PortfolioConstruction Forum Symposium 2013 Research Paper 7
When the investment environment is undergoing a period when there is a lower level of variability in the performance and valuation of companies and sectors, there is less opportunity and ability for active fund managers to outperform the index. This may take place when there is a bull market and most investments experience strong returns and are more highly correlated. Skilled active managers can take greater active underweight and overweight positions in parts of the market by market capitalisation, as discussed above. Also, active fund managers can consider macro-economic factors in their decision making and adjust their portfolio accordingly. In this case, they can account for any unexpected events or an event whose probability of occurrence has been discounted. Active fund managers can also take advantage of capital raisings. At times, fund managers have been able to add significant value through participation in discounted placements and rights issues. 5. Complexity of the various ETF structures As the ETF market has evolved, so too has the complexity of ETF structures. Two structures used by ETF issuers include physical replication and synthetic replication. Physical replication ETFs hold the assets physically and therefore invests directly into the shares. Alternatively, synthetic replication ETFs invest in derivatives that give the investor the opportunity to generate similar returns without physically buying those shares. Clients need to be aware of the various structures and understand how the various ETFs gain exposure to the various indices. These two ETF structures are discussed further below. Physical replication The physical replication structure is further categorised into full replication and sample replication: Full replication - These ETFs aim to generate the same total return as the index they are tracking by investing in all securities that comprise the index, in proportion to their particular weight in the index. Sample replication - These ETFs invest in a sample basket of the underlying index. Their aim is to preserve the risk and return characteristics of the underlying index. The degree of sampling varies and will typically entail employing statistical techniques to derive the optimal sample to hold. Sampling is particularly popular with ETFs that track indices with PortfolioConstruction Forum Symposium 2013 Research Paper 8
a very large number of shares denominated in different currencies across countries and exclude some securities that are difficult to obtain or parts of an index that may not be highly liquid. Synthetic replication Synthetic ETF structures differ from physical ETF structures in that, instead of holding stocks directly, they use derivatives to generate the same total return as the index. There are four types of synthetic structures - total return swaps, forward contracts, futures contracts and options. Typically, forward and futures contracts are used when providing exposure to commodities because in these markets, a lack of sufficient diversification of assets in the index makes it difficult to use a physical replication structure. Although physical replication of some commodity indices such as gold and copper is used by issuers, synthetic replication using futures or forward contracts is more common. PortfolioConstruction Forum Symposium 2013 Research Paper 9
ETFs and portfolio construction Once the strategic asset allocation (SAA) has been determined for a portfolio, the next step is to consider how to implement the portfolio for each asset class within the SAA. In regard to the Australian equities component of an SAA, the aim may be to achieve a number of different outcomes. Some of the outcomes or objectives for the Australian equity portion may be: Index (beta) returns (i.e. returns in line with the market index) Active returns (beta plus active) (i.e. overall returns that exceed the market returns) Active (alpha) (i.e. concentrate on achieving a nominal return that does not have regard to the index return).c These different risk-return objectives are represented in Figure 1 below. It demonstrates how the ETF can be included as part of the portfolio and whether the ETF can form part of the core and/or satellite component of the portfolio under the different client objectives illustrated above. Figure 1 Index (beta) return If the client s objective is in line with achieving market-like returns, the asset class - such as Australian equities - may consist of a broad-based ETF. This decision may be driven by lower fees, a belief that little value can be added from actively managed Australian share funds and the PortfolioConstruction Forum Symposium 2013 Research Paper 10
client s unwillingness to take on any active risk. In this case, the SAA to Australian equities could consist largely of a broad-based equity ETF and the core component will constitute 100% of the portfolio and no satellites are needed to increase the portfolio s risk profile. Active (alpha) return Active return is simply the returns in excess of the relevant index returns. The client may believe that certain investment strategies after fees will result in performance above the benchmark, and amy look to use more specialised products such as absolute strategies (i.e. hedge funds, such as long-short or market-neutral strategies) in order to generate a positive active return. Index (beta) plus active (alpha) return A core plus satellite approach involves anchoring the core part of a portfolio with one broadranging ETF or/and actively managed diversified investment product that provides diversification and will approximate the index returns (beta). The satellites comprise smaller allocations to multiple ETFs, active managed funds, direct shares, absolute strategies and/or strategy specific products. Investments that are made to complement the core portfolio may be specialised, concentrated and/or country specific. These satellites can be chosen to allow the portfolio to tilt towards a certain bias or to include investments that suit the client s specific requirements or preferences. The satellite products are added or their weighting is increased up to a point where they give the highest probability of the client achieving their risk-return objectives. This approach is represented in Figures 2 and 3 below. A strategy-specific example would be a client seeking to generate an income return from their portfolio for example, retirees and pre-retirees planning for their income needs and intending to generate income from superannuation money investments as well as accumulators who need to generate a level of income from their non-superannuation (ordinary money) investments. These clients may use ETFs with an income focus. PortfolioConstruction Forum Symposium 2013 Research Paper 11
Figure 2 Australian equities ETF investment portfolio Figure 3 International equities ETF investment portfolio Using ETFs to implement Tactical Asset Allocation ETFs may be used as an efficient and effective means of implementing tactical asset allocation (TAA) shifts because they can provide the client with exposure to an asset class or sector through undertaking a few trades. For example, if the client believes that equities are undervalued relative to bonds and wishes to take advantage of a market downturn by increasing their exposure to PortfolioConstruction Forum Symposium 2013 Research Paper 12
equities, this can be implemented easily and efficiently by entering the secondary market and buying a broad-based market ETF. At an asset class level, the client may wish to take advantage of thematic or market views. For example, if the client believes that small cap stocks are substantially undervalued relative to large cap stocks, they can sell down some of the broad-based market ETFs and buy a small cap ETF. Other possibilities include the inclusion of a commodities, sector, country or absolute strategy ETF. Rebalancing the portfolio Within the core plus satellite approach, the investor may wish to rebalance the portfolio weights back to the strategic benchmarks. This can be done by trading the relevant ETFs. Adding new types of investments to the portfolio ETFs can be used as a means of adding new types of investments to the portfolio - for instance, absolute return strategies may provide uncorrelated returns (diversification benefits), particularly with equity markets. Absolute return strategies typically attempt to deliver positive returns in both a falling and rising market. Pre-retirees and retirees may be seeking income to meet certain essential needs. The equities portfolio may be biased to an income product by investing in high-dividend ETFs. Accessing investment products that would otherwise be difficult to access ETFs allow clients to access investment products that would otherwise be difficult to access, such as emerging market countries, currencies, commodities, style and themes. Portfolio gearing Clients who are thinking of borrowing funds to invest in equities (a gearing strategy) may invest in ETFs as a means of implementing the gearing strategy. Some ETFs (just like equities) can be used to gear into the share market. Processes and compliance procedures need to be considered PortfolioConstruction Forum Symposium 2013 Research Paper 13
when deciding on a gearing strategy for clients. This strategy may be more appropriate for accumulator and pre-retiree clients who have the following objectives and circumstances: They wish to increase their wealth and can commit to at least a five- to seven-year investment horizon (e.g. provide for retirement or their children s education). They wish to benefit from the tax-effectiveness of negative gearing arrangements - however, this should never be the primary reason for gearing. They have an appropriate risk tolerance (i.e. they understand that gains as well as losses are magnified when gearing is undertaken). They have excess income and are able to fund the extra interest repayments associated with a negatively geared arrangement or margin calls for any margin-lending facilities. Post-retirement portfolios ETFs can form part of a client s post-retirement strategy. One strategy that may be used for the pension portfolios of retired clients is the bucket approach. It is typically used by retirees as a means of addressing both longevity and investment risk. In this strategy, two to three years worth of income required from the portfolio is placed in a cash portfolio that is not affected by market downturns and is secure in nature. The required income drawdown is made from this cash portfolio. The remainder of the portfolio is invested in a diversified growth-based portfolio to generate the potential for capital growth over the longer term. The income generated from this growth portfolio is reinvested in line with the diversified asset allocation. A broad based share ETF comprises the growth component of this portfolio strategy. Another iteration of this strategy is to place two to three years worth of essential income needs in the cash portfolio as above, with the remainder in the diversified growth-based portfolio. The difference here is that the essential income needs represent a portion of the client s total income needs and hence a smaller amount is invested in the cash portfolio and a larger portion in the growth portfolio. The growth portfolio includes growth assets that have an income bias, such as the income strategy Australian equity ETFs. The income generated from this growth portfolio is then used to meet the client s discretionary income needs. The use of ETFs allows the investor to quickly and efficiently rebalance the strategy during times of high market volatility and prolonged periods of downturns and upturns. PortfolioConstruction Forum Symposium 2013 Research Paper 14
Conclusion There are a number of key issues to be aware of when investing in ETFs and how they can affect the client s portfolio. Importantly, it s important the client understands the implications of potentially investing in an ETF in terms of their specific circumstances and objectives. PortfolioConstruction Forum Symposium 2013 Research Paper 15
Disclaimers The information contained in this publication is based on the understanding Pty Ltd (ABN 14 130 045 242, AFSL 333649) has of the relevant Australian legislation as at March 2013. This information contains general information and may constitute general advice. Any advice in this communication has been prepared without taking account of individual objectives, financial situation or needs. It should not be relied upon as a substitute for financial or other specialist advice. Before making any decisions on the basis of this communication, you should consider the appropriateness of its content having regard to your particular investment objectives, financial situation or individual needs. We recommend that you see a registered tax agent or legal adviser prior to implementing any recommendations that you may make based on the information contained in this publication. PortfolioConstruction Forum Symposium 2013 Research Paper 16