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 is recommended.
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 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 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.