Exchange traded funds (ETFs) are an increasingly important feature of the investing landscape, particularly as the focus on investment fund costs has intensified.  Determining how and when ETFs are most effectively and appropriately used is dependent upon the purpose of the investment, the asset class in question, the time horizon of the investment, liquidity considerations and last but not least, the investor’s needs and expectations.

Deploying ETFs for asset allocation purposes

Passively-managed funds are an efficient way in which to execute strategic (long-term) asset allocation policies.  Asset allocation decisions at the broadest level – cash, bonds, equities - are typically the most important drivers of an investor’s returns and there are valid reasons for applying these strategic decisions in the purest possible manner, through the use of passively-managed vehicles.

ETFs are sometimes thought to be the cheapest passive options but this is not necessarily the case; indeed, when taking into consideration bid/offer spreads and brokerage commission, they can be more expensive than index-tracking mutual funds.  These transaction costs suggest that ETFs are better utilised for lump sum investments rather than regular savings, thereby avoiding the repetition of one-off costs associated with purchases.

One of the key benefits of ETFs is the ability to buy and sell them throughout the stock market trading day.  This facility is highly appealing for investors who wish to express short-term, tactical views.  It is also very useful for those who need to deploy cash into the market quickly, or to raise cash quickly, thus they can be an ideal portfolio rebalancing tool.

Opportunities in core and specialist areas

Today, there is a breath-taking range of ETFs available to all types of investors, replicating the most mainstream of indices as well as highly specialist areas that have historically been the preserve of sophisticated institutional investors.

There are strong arguments for utilising ETFs for some asset classes and for particular segments of the markets.  Looking at the UK market by way of example, active managers in aggregate have a poor record of delivering outperformance in large-cap stocks with any consistency.  Therefore, if you wish to express a positive view on large caps, a FTSE 100 tracker in one form or another is likely to be a good option.

The picture is less clear when looking at active managers who invest more broadly in UK equities, although consistency remains problematic.  Choosing an ETF for FTSE All-Share index exposure is therefore a valid and defensible choice, although there are good reasons to include active managers who have a record of investing successfully across the market cap range.  A mix of active and passive funds may well be a solid choice.

This example highlights that less efficient markets bring greater opportunity for active managers.  Statistically, active managers tend to fare better in mid and small caps and also when investing regionally, for example across Europe.  The record for regional managers in Asia and emerging markets is more mixed, but this speaks not only to investment capability, but also to issues such as liquidity, ethical and governance considerations.  It may well be that these issues are more important to investors than pure index performance, potentially rendering passive vehicles inappropriate.

The US market is rightfully cited as the most efficient market and the most difficult market to outperform; therefore, there is a strong case for using a passive vehicle here.

The case for investing passively in fixed income markets is not as strong, in our view.  This is particularly true of corporate bonds and high yield bonds, where index replication is more problematic and market liquidity can be extremely challenging.  At a more basic level, it is important to remember that a key success factor in credit investing is the avoidance of deteriorating and defaulting companies.  With this in mind, we think it is worth paying a (reasonable) fee to access a manager who is adept at applying this skill, rather than being passively exposed to highly indebted companies.

Investors who wish to gain exposure to specific sector indices or access specialist asset classes can do so using ETFs.  If you have a particular view on the US consumer staples sector, you can buy an ETF to express it.  If you are bearish on the direction of the FTSE 100 index, you can access a ‘super short’ strategy, which, through swap contracts, provides twice the inverse of the daily percentage change in the index. If you think lean hogs are the way forward, you can buy an exchange traded commodity vehicle (ETC) that provides exposure to the total return of a lean hogs index.

These vehicles are highly specialised and, in order to appreciate the risks involved, they demand an understanding of the liquidity and dynamics of the underlying market, the liquidity of the ETF or ETC itself, pricing/spread analysis and counterparty risk assessment where ETFs are synthetically backed.

In summary

ETFs can be used to satisfy different investment needs and can be the mainstay of a portfolio or used primarily at the margins.  There is no correct answer with regard to whether, or the extent to which, ETFs are used but we think they have advantages in some areas and in some circumstances.

Article written by Gill Hutchison, Head of Investment Research

This article featured in Professional Adviser Magazine, June 2014.