It’s no secret that investors have been favoring low-cost passive investments that track a specified
index, whether the investment is in
the form of an exchange-traded fund
or a passively managed mutual fund.
According to EPFR Global, ETFs have
attracted more than $1 trillion in net
inflows, while actively managed funds
have experienced over $1 trillion in net
outflows, between June 1, 2009, and
June 26, 2019.
Despite the popularity, investing in
ETFs is not simply selecting a particular
low-cost ETF that tracks a benchmark
to which your client wants exposure.
Financial practitioners should implement a comprehensive strategy when
incorporating ETFs into a client portfolio. Below are the steps that should be
considered when incorporating ETFs
into an investment portfolio and what
metrics are useful when searching for
the appropriate ETF.
Like building any type of investment
portfolio, the first step is to create an
asset allocation mix that will meet your
client’s investment objective. There are
different ways one can create an asset
allocation; however, using a tool that
produces an efficient frontier that can
be used to build an optimized portfolio
ALL ETFS OR A MIX?
Next, an advisor should determine what
portfolio strategy to employ. There are
advantages to both active and passive
investments, and deciding between the
two should not be exclusive, but rath-
er, inclusive of one another. The two
types of investment philosophies can
play well together. However, some may
disagree, so it’s important to determine
if you are going to build a portfolio
consisting of 100% ETFs or a portfolio
including both ETFs and actively man-
aged mutual funds.
If it’s decided a portfolio should
adopt both styles, then the next step
is to determine which asset classes
are the most efficient and which ones
provide the best opportunity to locate
alpha. In our recent studies, we have
found that small-cap equities, foreign securities, high-yield bonds and
funds with a growth tilt tend to offer
more opportunities to locate outperforming managers.
DUE DILIGENCE AND FILTERING
Next, screen for ETFs that fit into each
slice of the asset allocation. Filtering
for appropriate ETFs is much different than filtering for actively managed mutual funds. Actively managed
due diligence is typically quantitative,
whereas filtering for ETFs is traditionally qualitative.
ETF investors focus primarily on size,
trading volume, expense ratio and the
culture of the sponsoring firm. However,
it’s important to take a quantitative look
also, and make sure you select ETFs
that behave as their objective states, so
the individual investments work well
together and the entire portfolio has a
greater chance of meeting its objectives.
Outside of lowering investment costs,
the primary reason to invest in an ETF
is to track a particular benchmark. To
determine how well a manager tracks
a specific benchmark, advisors consider the manager’s tracking error, which
measures how consistently a manager outperforms or underperforms the
benchmark. Tracking error also is useful
in determining just how “active” a manager’s strategy is. The lower the tracking
error, the closer the manager follows the
benchmark; conversely, the higher the
tracking error, the more the manager
deviates from the benchmark.
Investing in ETFs is a low-cost way
to gain exposure to a particular asset
class when building an investment portfolio that meets your client’s objectives.
However, investing in an ETF is not
and should not be a simple solution.
The growing number of available ETFs
with complex styles is making it more
difficult for investors to locate an ETF
that fills a specified role within a diversified portfolio. It is important to set
clear guidelines and objectives for the
portfolio and find ETFs that consistently
follow their stated objectives.
Ryan Nauman is a market strategist at
Informa Financial Intelligence. His primary
focus is providing value-added market and
investment insight along with educating
buy-side participants on investment analytics and portfolio management concepts.
By Ryan Nauman
How to Size Up ETFs for Client Investing
Growth in number of ETFs means advisors must be careful how they
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