Clients who want or need to increase their equity exposure these days may be unwilling or unable to follow the traditional paths. Some will resist committing to mutual funds, with the industry still reforming its way out of recent transgressions. Others may not be able to achieve adequate diversification or customized sector exposure in a portfolio of individual stocks. Exchange-traded funds (ETFs), which combine some of the benefits of both mutual funds and stocks while removing certain drawbacks, offer an attractive third alternative.
ETFs are among the fastest-growing sectors of the capital markets. Created just 10 years ago, there are now more than 100 ETFs listed on the American Stock Exchange. Assets committed to these instruments, which today exceed $150 billion, are forecast to reach upward of $500 billion by the year 2007, according to The Financial Research Corporation.
While ETFs initially gained favor among institutional investors who use them in sophisticated hedging strategies, their applications for individual portfolios are becoming increasingly popular. In December 2003, investors poured a record $12.57 billion into ETFs, according to the Investment Company Institute. Analysts attributed the sharp rise to higher equity markets and the inclination of some investors to avoid mutual funds in the face of the industry scandals over market timing and late trading.
ETFs combine the mutual fund benefits of affordable diversification with the convenience and transparency of an exchange-traded share. Each share of an ETF represents an interest in a basket of stocks constructed to replicate a large market index such as the S&P 500, a “style” index such as the Russell 2000 Value, a sector index such as the S&P Utilities Index, or a bond index such as the Lehman Aggregate. International ETFs may be based on a broad regional index or a specific country. Whatever your client’s asset allocation or risk appetite, chances are there’s an index and corresponding ETF to match.
ETF shares are bought and sold on an exchange–the American Stock Exchange is the clear leader with the most ETF listings–and priced throughout the day. Their performance tracks the index they replicate, before expenses, typically with minimal tracking error. The cost of buying and selling the shares depends on your arrangement with your custodian or broker/dealer.
Core or Explore
Within a client portfolio, ETFs can play a variety of roles. A broad-market ETF can serve as the core equity holding. Even if you prefer actively managed instruments, in the large-cap space particularly it is very difficult for managers to outperform broad index benchmarks significantly or consistently. With a client’s core allocation invested in a broad-market ETF, the smaller and more specialized allocations–small cap or international, for example–can be invested in actively managed funds or in the ETF that corresponds appropriately to the need.
Another option is to use a combination of sector ETFs to construct a portfolio that overweights certain sectors and underweights others to reflect the client’s investing profile and risk tolerance. Conservative, income-oriented investors could allocate more to energy and utility sector ETFs, for example, while more aggressive investors with longer time horizons might emphasize technology and financial sector ETFs.
Table 1 provides examples of how to allocate this way.
To see how the allocation might work when international stocks, bonds, and cash equivalents are added to the overall asset allocation, see Table 2.
From another perspective, a sector or style ETF can also be used as an “explore” tool to complement core holdings in the form of a stock portfolio or mutual fund and as a means of increasing the client’s exposure to a particular sector or style in a manner consistent with his or her goals.
However you choose to use them, ETFs give you the flexibility to accommodate preferences specific to your client. Perhaps you’re working with a technophile who wants to take a personally active approach to the technology sector. You can use individual stocks for that portion of the allocation and round out the portfolio with the eight other sector ETFs that will effectively cushion the technology risk with broader diversification.