ETF’s – Top 5 portfolio strategy considerations

SH Hisock &

Strategy Steps

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 Strategy Steps

May 2013

PortfolioConstruction Forum Symposium 2013 Research Paper

1

.au

SH Hisock &

Strategy Steps

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

.au

SH Hisock &

Strategy Steps

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

.au

SH Hisock &

Strategy Steps

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

.au

SH Hisock &

Strategy Steps

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

.au

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download