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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 growing popularity, investing in ETFs is not simply selecting a particular low-cost ETF that tracks a benchmark that your client wants exposure to. Financial practitioners should implement a comprehensive strategy when incorporating ETFs into a client portfolio. Below are the steps that should be considered when a client wishes to incorporate low-cost investments into their 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 is recommended (Figure 1).

Risk vs. Return Figure 1 – Source: Informa Financial Intelligence’s Zephyr

Next, one 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 rather, 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 managed mutual funds. If you and your client conclude that a portfolio that includes both styles meets your client’s objectives, then you must determine which asset classes are the most efficient, while 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 for financial professionals to locate outperforming managers.

Asset allocation Figure 2- Source: Informa Financial Intelligence’s Zephyr

Next, you will want to screen for ETFs that fit into each slice of the asset allocation. Filtering for an appropriate ETF is much different than filtering for an actively managed mutual fund. Conducting due diligence on an actively managed mutual fund is typically quantitative in nature, whereas filtering for an ETF is traditionally qualitative in nature. Investors looking for an ETF focus primarily on the ETF’s size, trading volume, expense ratio and the culture of the sponsoring firm. However, I believe it is 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, believing that it is hard for active managers to consistently beat the benchmark. When determining how well a manager tracks a specific benchmark, one should consider looking at the manager’s tracking error. Tracking error measures how consistently a manager outperforms or underperforms the benchmark. Tracking error is also 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.

Tracking Error Figure 2- Source: Informa Financial Intelligence’s Zephyr

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.