[5 min read, open as pdf]
CPD Webinar: Is Active Management a Zero-Sum Game?
[3 minute read, open as pdf]
[3 min read, open as pdf]
[3 min read, open as pdf]
[3 min read, open as pdf]
On 4th August, the Bank of England raised rates by 0.5%, the largest single increase since 1995. This followed the US Federal Reserve raising rates by 0.75% at the end of July. While these rate rises may or may not bring inflation under control, the risk they pose to growth is considerable.
We consider the ways in which investors can use ETFs to build defensive resilience as an alternative to low-yielding cash or bonds.
[5 min read, open as pdf]
Even before the Russia/Ukraine war and sanctions, Covid policy stimulus, rapidity of the post-Covid restart, supply-chain disruptions and the energy crisis have stoked up inflationary pressure and we are in for a bumpy ride.
While we are not yet past the peak, it takes years, not months, to tame inflation, so it makes sense to adapt portfolios for an inflationary regime.
To understand asset class behaviour there is not much use looking at the last 10 or 20 years. That era has been characterised by falling interest rates and low inflation. Instead we have to go back to the history books and understand how asset classes behaved in the 1970s inflation shock and the subsequent period of rising interest rates and rising inflation.
From studying academic research on that era, we draw three key conclusions: firstly, inflation protection can be achieved by owning the assets that benefit, rather than suffer, from inflation. Secondly, that different asset classes have different inflation-protective qualities over time. Finally, that liquidity is key so that there is flexibility to alter and adjust your portfolio.
Equities: the long-term inflation hedge
Equities provide the ultimate “long-term” inflation hedge – companies that make things that you always need and have pricing power can keep pace with or beat inflation.
Within equities, studies show that a bias towards value, away from growth, outperforms during an inflationary regime. This is because of something known as “equity duration”, which basically means that companies that deliver earnings and dividends on a “jam today” basis, are more valuable than companies that are expected to deliver earnings and dividends in the very distant future on a “jam tomorrow” basis. You can access a Value ETF very simply by using factor-based ETFs, such as IWFV (iShares Edge MSCI World Value Factor UCITS ETF).
But given that investors are likely to have equities in their portfolios already and therefore have long-term protection in place, how do you achieve inflation-protection for the bumpy ride over the short- and medium-term?
Owning the problem
Inflation-hedging can be described as “owning the problem”. Worried about rising oil, gas and petrol prices? Own an Energy ETP like AIGE (WisdomTree Energy ETP). Worried about rising wheat prices? Own an Agriculture ETP like AIGA (WisdomTree Agriculture ETP). Worried about rising rail-fares? Own an infrastructure ETF like GIN (SPDR Morningstar Multi-Asset Global Infrastructure UCITS ETF). Worried about rising rents? Own a property ETF like IWDP (iShares Developed Markets Property Yield UCITS ETF). Worried about rising household bills? Own a Utilities ETF like UTIW (Lyxor MSCI World Utilities TR UCITS ETF).
By owning the assets that benefit, rather than suffer, from inflation, you can incorporate inflation-protection into your portfolio.
These assets are referred to as “liquid real assets” as their value is positively related to inflation. They can be accessed in liquid format by using exchange traded products (ETPs) keeping your portfolio flexible to enable future adjustments as time goes on.
Interestingly, real assets respond to inflation in different ways over different time frames. The study from the 1970s looked at the correlation of asset classes over time from the start of an inflation shock. It found that Commodities provided near-term inflation protection for the initial five or so years of inflation shock, but then moderated as supply-side solutions came-through. Infrastructure and Property provided medium- to long-term inflation protection but were vulnerable in the near-term to rising market risk associated with the break-out of inflation. Inflation-linked bonds – as the name suggests – provide inflation protection, if held to maturity. But in the short-term they can decline materially, as they are highly sensitive to increases in interest rates which are typically associated with inflation-fighting central bank policy. So while inflation-linked bonds like INXG (iShares GBP Index-Linked Gilts UCITS ETF) reduce inflation risk, they increase interest rate risk. By introducing some interest-rate hedging by owning assets whose interest rates go up when the Fed raises rates, like with FLOS (iShares USD Floating Rate Bond UCITS ETF GBP Hedged), this can be mitigated.
Gold is also a traditional real asset inflation-hedge: it preserves its value (purchasing power) over millennia, and is a classic “risk off” asset that can help protect a portfolio in times of market stress. Some critics of holding physical gold argue that is produces no income and therefore has no intrinsic value or growth. That may be so, but imagine you were a time-traveller – it’s the only money that you could use in any era going back to biblical times. It holds its value in inflationary and even in hyperinflationary times. From a portfolio perspective, it always makes sense to have some exposure both as a real asset, a shock-absorber and as an uncorrelated diversifier. Physical gold tends to outperform gold miners, in the long-run, and can be accessed at lower cost. There are plenty of low-cost physical gold ETPs to choose from.
Bringing it all together
We believe that a layered approach to inflation-hedging makes sense because of the different inflation-protection qualities of different asset classes over time.
Within equities this means pivoting equity exposure towards a Value/Income bias.
Within bonds, this means reducing duration and/or substituting nominal bonds with liquid real assets exposure as a potential alternative (subject to relevant risk controls).
We have incorporated a range of higher risk inflation-protective asset classes, such as commodities, gold, infrastructure and property, medium-risk like lower duration inflation-linked bonds and lower risk rate-sensitive assets, such as floating rate notes to create a diversified Liquid Real Assets Index strategy that aims to deliver exposure to inflation-protective asset classes, while delivering an overall portfolio volatility similar to Gilts. This makes the strategy a potential alternative to traditional (nominal) bonds exposure that will continue to struggle in an inflationary regime.
For those wishing to isolate and target specific inflation-protective exposures, there is no shortage of choice for highly targeted inflation-hedging strategies.
Adapting portfolios for inflation is key to ensure resilience in an inflationary regime. And while it may feel a bit late to get started, it’s better late than never.
Find out more about our All-Weather Portfolio of ETFs for UK investors.
Find out more about our Permanent Portfolio of ETFs for UK investors.
See all our Research Portfolios
[3 min read, open as pdf]
2021 in review
Our 2021 market roundup summarises another strong year for markets in almost all asset classes except for Bonds which remain under pressure as interest rates are expected to rise and inflation ticks up.
Listed private equity (shares in private equity managers) performed best at +43.08%yy in GBP terms. US was the best performing region at +30.06%.
Real asset exposures, such as Water, Commodities and Timber continued to rally in face of rising inflation risk, returning +32.81%, +28.22% and +17.66% respectively.
We are continuing in this “curiouser, through-the-looking glass” world. Traditionally you bought bonds for income, and equity for risk. Now it’s the other way round.
Only equities provide income yields that have the potential to keep ahead of inflation. Bonds carry increasing risk of loss in real terms as inflation and interest rates rise.
Real yields, which are bond yields less the inflation rate, are negative making traditional Bonds which aren’t linked to inflation highly unattractive. Bonds that are linked to inflation are highly sensitive to rising interest rates (called duration risk), so are not attractive either.
How to navigate markets in this context?
The big three themes for the year ahead are, in our view:
See full report in pdf
Attend our 2022 Outlook webinar
[5 min read, open as pdf]
Interest rates expected to rise
As the run up in inflation looks more persistent, than transitory, there is growing likelihood that Central Banks will raise interest rates in response.
Following an extended “lower for longer” near-Zero Interest Rate Policy following the 2008 Global Financial Crisis and the 2020 COVID Crisis, the market futures-implied expectations for the Fed Funds rate, points to a “take off” in 2022 in response to rising inflation, following COVID-related policy support, to an expected 1.01% interest rate level in Dec-23, from 0.88% last quarter.
Fig.1. Fed Funds Rate and implied expectations
Source: Elston research, Bloomberg data
The potential for increased interest rate volatility, as rate hike expectations increase, means that investors that are seeking to dampen interest rate sensitivity (“duration”) are allocating to shorter-duration exposures, such as ultrashort-duration bonds, and also to Floating Rate Notes (FRNs).
What is a Floating Rate Note?
Floating Rate Notes receive interest payments that are directly linked to changes in near-term interest rates and can therefore provide a degree of protection against interest rate risk, when interest rates are rising.
Issued for the most part by corporations, FRNs pay a periodic coupon – typically quarterly – that resets periodically in line with short-term interest rates.
This could be expressed as a premium or “spread” over a currency’s short-term risk-free rate, such as (in the UK) the 3 month SONIA rate (Sterling Overnight Index Average, and prior to that GBP LIBOR) in the UK, or (in the US) the 3 month SOFR (Secured Overnight Funding Rate, and prior to that USD LIBOR). These indices overnight borrowing rates between financial institutions.
The size of the premium or spread reflects the creditworthiness of the issuer: the higher the spread, the greater the rewarded risk for owning that security, and typically stays the same for the life of the bond and is based on the issuer’s credit risk as deemed by the market.
How can FRNs benefit investors?
Floating Rate Notes are a lower-risk way of putting cash to work and provide a useful direct hedge against interest rate fluctuations. When incorporated into a bond portfolio, they can help bring down duration given their reduced sensitivity to interest rate changes, as well as provide a return pattern that is directly and positively correlated with changes in interest rates.
Compared to nominal bonds, such as Corporate Bonds and UK Gilts, FRNs’ yield can increase as/when interest rates increase.
Relative to money market funds, FRNs may provide some additional yield pick-up, as well as very short <1 year duration.
Key considerations when investing in FRNs
Portfolio investors can access FRNs through funds and ETFs. Key considerations when investing in FRNs include, but are not limited to:
The expected timing of interest rate “lift off” in the US and UK will change as markets adapt to evolving growth and inflation outlook during the post-COVID recovery, and in response to the risk of further disruption from new virus variants. However, as interest rate rises become more likely, and incorporating an allocation to Floating Rate Notes for protection against interest rate risk makes sense within the bond allocation.
Watch the CPD Webinar: The Quest for Yield
 Data as at last quarter end
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“Suppose we define a passive investor as anyone whose portfolio of U.S. equities is the cap-weight market portfolio described above. Likewise, define an active investor as anyone whose portfolio of U.S. equities is the not the cap-weight market portfolio. It is nevertheless true that the aggregate portfolio of active investors (with each investor's portfolio weighted by that investor's share of the total value of the U.S. equities held by active investors) has to be the market portfolio. Since the aggregate portfolio of all investors (active plus passive) is the market portfolio and the aggregate for all passive investors is the market portfolio, the aggregate for all active investors must be the market portfolio. All this is obvious. It is just the arithmetic of the fact that all U.S. equities are always held by investors. Its implications, however, are often overlooked.”
What Bill Sharpe was saying to us was this: the performance of all active managers is, in aggregate [for a given asset class] that of the index less active fees. Which is a considerably worse deal than the charge often levelled against passive funds, namely that investors are paying for the performance of the index less passive fees.
CPD Webinar: Is active management a zero-sum game?
[Open as pdf]
Money market funds, and their exchange-traded equivalents “ultra-short duration bond funds”, are an important, if unglamorous, tool in portfolio manager’s toolkit.
They can be used in place of a cash holding for additional yield, without compromising on risk, liquidity or cost.
Money market funds are intended to preserve capital and provide returns similar to those available on the wholesale money markets (e.g. the SONIA rate that replace LIBOR).
How risky is a money market fund?
Money market-type funds hold near-to maturity investment grade paper. Their weighted average term to maturity is <1 year. They therefore have very low effective duration (the sensitivity to changes in interest rates).
Compare gilts which are seen as a low-risk asset relative to equities. The 10-11 year duration on UK gilts (all maturities) means they carry a higher level volatility compared to cash (which has nil volatility). On the flip side, their longer term also means they have higher risk-return potential relative to cash and ultra-short bonds.
By contrast, money market type funds have some investment risk as they hold non-cash assets, but given their holdings’ investment grade status, short term to maturity and ultra-short effective duration, they exhibit near-nil volatility.
Platform cash, fixed term deposit or money market fund
From a flexibility perspective and a value for money perspective, there's a clear rationale to hold money market funds, rather than platform cash or a fixed term deposit.
Our Money Markets fund research paper that looks at 4 low cost money market funds sets out why
Why does the fund structure make sense? Find out more in our CPD Webinar on Introduction to Collective Investment Schemes
Last week, the US Senate passed a $1.2trillion infrastructure bill that now awaits a House vote as part of the "build back better" campaign, and another part of the "bazooka" post-COVID policy stimulus.
Whilst there are plenty of infrastructure equity funds like INFR (iShares Global Infrastructure UCITS ETF) and WUTI (SPDR® MSCI World Utilities UCITS ETF) that benefit from infrastructure spend, for those not wanting to uprisk portfolio, we like GIN (SPDR® Morningstar Multi-Asset Global Infrastructure UCITS ETF) which invests in infrastructure equity and debt securities.
Infrastructure & Utilities forms a core part of our Liquid Real Assets Index, for the inflation-protective qualities (tariff formulae typically pass through inflation). The "hybrid" nature of infrastructure - with both equity and bond like components is why we place it firmly in the Alternative Assets category. Helpfully this can be accessed in a highly iquid and (relatively) low-cost format, compared to higher cost, less transparent and potentially less liquid infrastructure funds.
[3 min read, open as pdf]
Traditional indices weight companies based on their size. The resulting concentration risk and “the big get bigger” theory is a criticism levelled by many active managers who are critical of index investing.
Leaving aside the flaw in that argument (company's valuations determine their size in an index, not the other way round), it is important to remember that using traditional indices is a choice, not an obligation.
One alternative weighting scheme is to weight each share within an index equally, regardless of the size of the company.
Sounds simple? In a way, it is. But what’s interesting is understanding what an equal weight approach means from a diversification perspective, risk perspective and underlying factor-bias.
The curious power of equal weight is why some equal weight strategies have seen significant inflows over the last 6-12 months.
Register for our CPD event exploring this topic in more detail on Wed 23 June at 10.30am
[5 min read, open as pdf]
Commodity indices, and the ETPs that track them provide a convenient way of accessing a broad commodity basket exposure with a single trade.
What’s inside the basket?
Commodity indices represent baskets of commodities constructed using futures prices. The Bloomberg Commodity Index which was launched in 1998 as the Dow Jones-AIG Commodity Index has a weighting scheme is based on target weights for each commodity exposure.
These weights are subject to the index methodology rules that incorporate both liquidity (relative amount of trading activity of a particular commodity) and production data (actual production data in USD terms of a particular commodity) to reflect economic significance.
The index subdivides commodities into “Groups”, such as: Energy (WTI Crude Oil, Natural Gas etc), Grains (Corn, Soybeans etc), Industrial Metals (Copper, Aluminium etc), Precious Metals (Gold, Silver), Softs (Sugar, Coffee, Cotton) and Livestock (Live Cattle, Lean Hogs).
The index rules include diversification requirements such that no commodity group constitutes more than 33% weight in the index; no single commodity (together with its derivatives) may constitute over 25% weight); and no single commodity may constitute over 15% weight.
The target weights for 2021 at Group and Commodity level is presented below:
Owing to changes in production and or liquidity, annual target weights can vary. For example the material change in weight in the 2021 target weights vs the 2020 target weights was a +1.6ppt increase in Precious Metals (to 19.0%) and a -1.9pp decrease in Industrial Metals to 15.6%.
Traditional vs “Smart” weighting schemes
One of the drawbacks of the traditional production- and liquidity-based weighting scheme is that they are constructed with short-dated futures contracts. This creates a risk when futures contracts are rolled because for commodities where the forward curve is upward sloping (“contango”), the futures price of a commodity is higher than the spot price. Each time a futures contract is rolled, investors are forced to “buy high and sell low”. This is known as “negative roll yield”.
A “smart” weighting scheme looks at the commodity basket from a constant maturity perspective, rather than focusing solely on short-dated futures contracts. This approach aims to mitigate the impact of negative roll yield as well as potential for reduced volatility, relative to traditional indices.
This Constant Maturity Commodity Index methodology was pioneered by UBS in 2007 and underpins the UBS Bloomberg BCOM Constant Maturity Commodity Index and products that track it.
Illustration of futures rolling for markets in contango
An Equal Weighted approach
Whilst the traditional index construction considers economic significance in terms of production and liquidity, investors may seek alternative forms of diversified commodities exposure, such as Equal Weighted approach.
There are two ways of achieving this, equal weighting each commodity, or equal weighting each commodity group.
The Refinitiv Equal Weight Commodity Index equally weights each if 17 individual commodity components, such that each commodity has a 5.88% (1/17th) weight in the index. This results in an 18% allocation to the Energy Group, 47% allocation to the Agriculture group, 12% allocation to the Livestock group and 23% allocation to Precious & Industrial Metals.
An alternative approach is to equally weight each commodity group. This is the approach we take in the Elston Equal Weight Commodity Portfolio, which has a 25% allocation to Energy, a 25% allocation to Precious Metals, a 25% Allocation to Industrial Metals and a 25% Allocation to Agricultural commodities. This is on the basis that commodities components within each group will behave more similarly than commodity components across groups.
These two contrasting approaches are summarised below:
In 2020, the Equal Weight component strategy performed best +6.28%. The Constant Maturity strategy delivered +0.69%. The Equal Weight Group strategy was flat at -0.05% and the traditional index was -5.88%, all expressed in GBP terms.
Informed product selection
This summarises four different ways of accessing a diversified commodity exposure: traditional weight, constant maturity weighting, equal component weighting and equal group weighting. Understanding the respective strengths and weaknesses of each approach is an important factor for product selection.
[3 min read, open as pdf]
A “last resort” policy tool
Zero & Negative Interest Rate Policy are Non-Traditional forms of Monetary Policy is a way of Central banks creating a disincentive for banks to hoard capital and get money flowing.
Zero Interest Rate Policy (ZIRP) is when Central Banks set their “policy rate” (a target short-term interest rate such as the Fed Funds rate of the Bank of England Base Rate) at, or close to, zero. ZIRP was initiated by Japan in 1999 to combat deflation and stimulate economic recovery after two decades of weak economic growth.
Negative Interest Rate Policy (NIRP) is when Central Banks set their policy rate below zero. Japan, Euro Area, Denmark, Sweden are currently using a NIRP. US & UK are currently using a ZIRP, and are considering a NIRP.
Fig.1. Advanced economy policy rates
Whilst bond prices may imply negative real yield, or negative nominal yields, a NIRP impacts the rates at which the Central Bank interact with the wholesale banking system and is intended to stimulate economic activity by disincentivising banks to hold cash and get money moving. A NIRP could translate to negative wholesale rates between banks, and negative interest rates on large cash deposits, but not necessarily retail lending rates (e.g. mortgages).
Ready, steady, NIRP
Negative Interest Rates were used in the 1970s by Switzerland as an intervention to dampen currency appreciation. . It was the subject of academic studies and was seen as a last resort Non-Traditional Monetary policy during the Financial Crisis of 2008 and during the COVID crisis of 2020. Sweden adopted NIRP in 2009, Denmark in 2012, and Japan & Eurozone in 2014. The Fed started looking closely at NIRP in 2016.
According Bank of England MPC minutes of 3rd March 2021, wholesale markets are generally prepared for negative interest rates as have already been operating in a negative yield environment. By contrast, retail banks may need more time to prepare for negative interest rates to consider aspect such as variable mortgage rates.
There are arguments for and against NIRP. The main argument for is that NIRP is stimulatory. The main argument against is that NIRP failed to address stagnation and deflation in Japan and can create a “liquidity trap” where corporates hoard capital rather than spend and invest.
The hunt for yield
With negative interest rates, there will be an even greater hunt for yield. We look at the some of the options that advisers might be invited to consider.
Getting the balance right between additional non-negative income yield and additional downside risk will be key for investors and their advisers when preparing for and reacting to a NIRP environment.
[3 min read, open as pdf]
Focus on inflation
In our recent Focus on Inflation webinar we cited the study by Briere & Signori (2011) looking at the long run correlations between asset returns and inflation over time.
We highlighted the “layered” effect of different inflation protection strategies (1973-1990) with cash (assuming interest rate rises), and commodities providing best near-term protection, inflation linked bonds and real estate providing medium-term protection, and equities providing long-term protections. Nominal bonds were impacted most negatively by inflation.
Source: Briere & Signori (2011), BIS Research Papers
Given the growing fears of inflation breaking out, we plotted the YTD returns of those “inflation-hedge” asset classes, in GBP terms for UK investors, with reference to the US and UK 5 Year Breakeven Inflation Rates (BEIR).
Figure 2: Inflation-hedge asset class performance (GBP, YTD) vs US & UK 5Y BEIR
Source: Elston research, Bloomberg data, as at 5th March 2021
Winners and Losers so far
We looked at the YTD performance in GBP of the following broad “inflation hedge” asset classes, each represented by a selected ETF: Gilts, Inflation Linked Gilts, Commodities, Gold, Industrial Metals, Global Property, Multi-Asset Infrastructure and Equity Income.
Looking at price performance year to date in GBP terms:
So Inflation-Linked Gilts don’t provide inflation protection?
Not in the short run, no.
UK inflation linked gilts have an effective duration of 22 years, so are highly interest rate sensitive. Fears that inflation pick up could lead to a rise in interest rates therefore reduces the capital value of those bond (offset by greater level of income payments, if held to maturity).
So whilst they provide medium- to long-term inflation protection, they are poor protection against a near-term inflation shock.
In conclusion, we observe:
[5 min read, open as pdf]
Tech performance is skewing cap-weighted indices
The run up in technology stocks and the inclusion of Tesla into the S&P500 has increased both sector concentration and security concentration. The Top 10 has typically represented approximately 20% of the index, it now represents 27.4%.
The chart below shows the Top 10 holdings weight over time.
Rather than looking just at Risk vs Return, we also look at Beta vs Correlation to see to what extent each strategy has 1) not only reduced Beta relative to the market, but also 2) reduced Correlation (an indication of true diversification). Strategies with lower Correlation have greater diversification effect from a portfolio construction perspective.
Ironically, the last time the index was anything close to being this concentrated was back in 1980 when IBM, AT&T and the big oil majors ruled the roost.
From a sector perspective, as at end December 2020, Information Technology now makes up 27.6% of the index.
Increased concentration reduces diversification
This level of concentration is indeed skewing indices that rely on a traditional market capitalisation-weighted (cap-weighted) methodology, and does therefore reduce diversification.
But the issue of the best performing stocks getting a larger weighting in the index, is not an accident of traditional index design. It’s its very core. Cap-weighted indices reflect the value placed on securities by investors, not the other way round.
We should not therefore conflate the debate around “active vs passive” investment approaches, with the debate around index methodology.
If portfolio managers are concerned about over-exposure to particular company or sector within a cap-weighted index, they can either chose an active, non-index fund, that is not a closet-tracker. Or they can access the target asset class through an alternatively weighted index, which uses a security weighting scheme other than market capitalisation.
Using cap-weighted indices is an active choice
The decision to use a fund that tracks an cap-weighted index is an active choice. And for those seeking differentiated exposure, there is a vast range of options available.
We categorise these into 3 sub-groups: Style, Factor-based and Risk-based.
How have US equity risk-based strategies fared?
Risk-based strategies have been in existence for some time, so we are able now to consider 10 year data (to December 2020, in USD terms). In terms of risk-adjusted performance, Managed Risk index strategies have fared best, whilst Min Variance has delivered higher returns for similar levels of risk of a Max Diversification strategy. Meanwhile Equal Weight has actually exhibited greater risk than traditional cap-weighted approach.
In this respect, Equal Weight (Max Deconcentration), also disappoints delivering higher beta and >95% correlation. Likewise Min Variance, whilst delivering on Beta reduction, does not deliver on decorrelation. Max Diversification delivers somewhat on decorrelating the strategy from the S&P500, but only modestly, whilst Managed Risk achieves similar decorrelation, reduced beta and better returns. Finally Risk Parity 10% Volatility cap has delivered most decorrelation as well as beta reduction.
For more information about the indices and funds used to represent these different strategies, please contact us.
There are a broad range of alternatives to cap-weighted index exposures. But consideration of style-, factor- or risk-based objectives will necessarily inform portfolio construction.
Find out more
For more insights and information on research, portfolios and indices, visit:
www.elstonsolutions.co.uk or NH ETF<Go>
Compared to traditional retail funds, ETFs offer transparency, liquidity and efficiency
[7 min read, Open as pdf]
In this series of articles, I look at some of the key topics explored in my book “How to Invest With Exchange Traded Funds” that also underpin the portfolio design work Elston does for discretionary managers and financial advisers.
Indexes: the DNA of an ETF
An Exchange Traded Fund is an index-tracking investment fund that aims to track (perform exactly in line) with the benchmark index in the fund’s name. The index defines an ETF’s “DNA”.
An index is a collective measure of value for a defined group of securities, where criteria for inclusion and weighting within that group are defined by a systematic set of rules. Indices can represent a basket of equities like the FTSE 100 Index (the “Footsie”) or a basket of bonds like the FTSE Actuaries UK Conventional Gilts All Stocks Index (the “gilts” index). Indices can be used as benchmarks to represent the performance of an asset class or exposure. ETFs aim to track these benchmark indices by holding the same securities in the same weights as the index.
Whilst ETFs can be an equity fund or bond fund (amongst others) with respect to its underlying holdings and the index it tracks, the shares in those ETFs trade on an exchange like an equity.
This means ETFs combine the diversification advantages of a collective investment scheme, with the accessibility advantages of a share, all at a management fee that is substantially lower than traditional active funds. These features make ETFs easy to buy, easy to switch and easy to own, revolutionising the investment process as well as reducing investment costs.
Indices enable transparency
ETFs are regulated collective investment schemes (often UCITS schemes) that can be traded on a recognised exchange, such as the London Stock Exchange.
Whereas the manager of a traditional active fund aims to outperform an index such as the FTSE 100 by overweighting or underweighting particular securities within that index or holding non-index securities, an ETF aims to deliver the same returns as the index by holding within the fund the same securities as the index in the same proportion as the index.
If the index represents a basket of securities weighted by their respective size, it is a “Capitalisation-weighted index”: this is the traditional index approach.
If the index represents a basket of securities weighted by a criteria other than their respective size, it is an “Alternatively-weighted” index. For example, an equal weighted index means all the securities in an index are given an equal weight.
 UCITS: Undertakings for Collective Investment in Transferable Securities (the European regulatory framework for retail investment funds)
ETFs track indices, and indices have rules. Index rules are publicly available and set out how an index selects and weights securities and how frequently that process is refreshed. Indices therefore represent a range of investment ideas and strategies, but codified using a rules-based approach. This makes ETFs’ investment approach transparent, systematic and predictable, even if the performance of securities within the index is not.
Furthermore, ETFs publish their full holdings every day so investors can be sure of what they own. This makes ETFs’ investment risks transparent.
The investment risk-return profile of an ETF is directly link to the risk-return profile of the index that it tracks. Hence ETFs tracking emerging market equity indices are more volatile than those tracking developed market indices, which in turn are more volatile than those tracking shorter-duration bond indices.
As with direct shares, traditional active mutual funds and index-tracking funds, when investing in ETFs, capital is at risk, hence the value of investments will vary and the initial investment amount is not guaranteed.
ETFs vs traditional funds
An ETF is different to other types of investment fund in the following ways:
The primary advantage of ETFs is the additional liquidity that a “secondary market” creates in the shares of that ETF (meaning the ability for investors to buy or sell existing shares of that ETF amongst themselves via a recognised exchange). However it is important to note that ultimately the liquidity of any ETF is only as good as its underlying assets.
Traditional mutual funds can be traded once a day and investors transact with the fund issuer who must buy or sell the same amount of underlying securities. Fund issuers have the right to “gate” funds and refuse to process redemptions to protect the interests of the broader unitholders of the fund. If this happens, there is no secondary market for shares/units in the fund. Recent examples of “gating” include UK property funds after the Brexit vote and strategic bond funds as interest rates expectations rose.
By contrast, Exchange Traded Funds can be traded throughout the day and investors generally transact with each other via the exchange. If necessary the fund issuer must create (or redeem) more units to meet demand and then buy (or sell) the same amount of underlying securities. Whilst, the liquidity of the fund is ultimately only as good as the underlying assets, there is, however, additional liquidity in the secondary market for shares in the fund which can be bought or sold amongst investors. For example, there have been circumstances when some markets have closed, and the underlying shares aren’t traded, the ETF continues to trade (albeit a premium or discount to Net Asset Value (NAV) may appear owing to the inability of the ETF to create/redeem units when there is no access to the underlying shares) and indeed becomes a vehicle of price discovery for when the market eventually reopens.
As regards fees, whereas funds have different fee scales for different types of investor based on share classes available, the fees on ETFs are the same for all investors meaning that the smallest investors benefit from the economies of scale that the largest investors bring.
Whilst the active/passive (we prefer the terms non-index/index) debate grabs the headlines, it is this targeted acces to specific asset classes, fee fairness and secondary market liquidity that makes ETFs so appealing to investors of any size.
A summary of similarities and differences of ETFs to other types of fund is presented in the table below:
From the table above, we see how, ETFs offer the combined functionality of a collective investment scheme with the flexibility and access of an exchange traded instrument.
Ways to use ETFs
We see three key applications for ETFs in portfolio construction: “core”, “blended” and “pure”.
Using ETFs for a core portfolio means creating and managing a core asset allocation constructed using ETFs, with satellite “true active” fund holdings for each of the same exposures in an attempt to capture some manager alpha at a fund level. This enables a portfolio manager to reduce partially the overall client costs without forsaking their hope of higher expected returns from “true active” non-index fund holdings for each exposure.
Using ETFs for a blended portfolio means creating and managing an asset allocation constructed using ETFs for efficient markets or markets where a portfolio managers may lack sufficient research or experience; and active funds for asset class exposures where the manager has high conviction in their ability to deliver alpha from active fund or security selection. For example, a UK portfolio manager with high conviction in UK stock picking may prefer to access US equity exposure using an ETF that tracks the S&P500 rather than attempting to pick stocks in the US.
Use of ETFs for a pure ETF Portfolio means creating and managing an asset allocation constructed using ETFs entirely. For example, a portfolio manager looking to substantially reduce overall client costs without compromising on diversification is able to design a portfolio using ETFs for each asset class and risk exposure.
Fig.3. Illustration representing core, blended and pure approaches to ETF adoptio
Who uses ETFs and why?
ETFs are used by investors large and small to build and manage their portfolios. As well as providing low cost, diversified and transparent access to a market or asset class, the liquidity of ETFs namely that 1) they only invest in liquid securities that index-eligible and 2) the ETF can itself be bought or sold between market participants means that investors can adapt their portfolio in a timely basis, if required.
Put differently traditional funds are one of the few things in the world that you can only sell back to the person you bought it from (the fund issuer), and that fund issuer has the right to say no.
Furthermore, the dealing cycles for traditional funds are long. If you want to sell one to buy another, it could take 4-5 days to sell and 4-5 days to buy. An 8-10 day round trip is hardly timely. In the meantime you may be out of the market, which could dramatically impact performance, particularly in periods of extreme volatility.
By contrast, ETFs are designed to be tradable on a secondary market via an exchange, and can be bought and sold between market participants on the same day without the fund manager’s involvement. This means that if investors want to alter their risk posture to respond to changing events, they can do so instantly and effectively if required.
ETFs have therefore grown in popularity as a core part of institutional and retail investor’s toolkit for portfolio and risk management.
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