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.
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.