Money market funds, and their exchange-traded equivalents “ultra-short duration bond funds”[1], 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

• What would be in your ETF’s?
• What goes inside your fund?
• What an ETF would cost to an investor?

[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]

• We look at Commodity Index basket weighting schemes
• Compare Traditional vs “Smart” weighting schemes
• Contrast equal weighted approaches

 
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:

​Performance
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]
​

• Negative Interest Rate Policy (“NIRP”) is a “last resort” policy tool
• The UK is getting ready for “NIRP”
• The hunt for yield and alternatives to cash

 
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.

• Foreign Exchange: This is what drove many Japanese retail investors to open savings accounts in foreign currencies that – despite the exchange rate risk – paid a greater interest rate.
• Structured Retail Products may offer high headline yields, these typically involve a complex return pay-off or conditionality linked to an index level such as the FTSE 100.  Return and risk cannot be created or destroyed.  Structured Products simply re-distribute the pay-offs between issuer and investor and – in aggregate – represent market returns less product costs and commissions.  We do not consider these as appropriate alternatives to Cash in a NIRP environment, or at all.
• Mini-Bonds that offer too-good-to-be-true interest rates that lure investors in to speculative investment schemes have, thankfully, been banned for promotion to retail investors.
• Up-risking: Alternative yield options necessarily require a modest “up-risking” relative to the zero-volatility and guaranteed (if paltry) return on cash deposits.  This up-risking could include money market funds (which will also come under interest rate pressure), longer dated bonds, and ultimately equities.

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]

• We look at the YTD performance of “inflation-hedge” asset classes in GBP terms, with reference to US and UK 5Y BEIR
• Commodities & Industrial metals have provided best defence, Gold and Inflation-Linked Gilts have provided least protection
• A layered approach to portfolio protection makes sense with Liquid Real Asset ETFs for the near- and medium-term, and inflation-linked bonds and equity income for the long-term

 
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:

• The best protections thus far have been Broad Commodities +7.4% and Industrial Metals +4.8%
• The worst protections thus far have been Gold -11.5% and Inflation Linked Gilts -6.3%.

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.
 
Conclusion
In conclusion, we observe:

• To integrate an inflation-protection strategy within a portfolio, a layered approach to inflation-hedge assets makes sense to mitigate inflation risk over different time frames.
• Inflation-linked gilts, owing to their long duration, will not respond well near-term to fears of potential interest rate increases and or interest rate volatility.
• Each inflation-hedging asset class is available through liquid, transparent and cost-efficient ETFs, or as a portfolio of Liquid Real Assets ETFs.

[5 min read, open as pdf]

• Tech performance is skewing cap-weighted indices
• Increased concentration reduces diversification
• Using cap-weighted indices is an active choice

 
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.

1. Style-based: for example: Value, Growth, Income.  This is the classical style-based approach.  Value investing traces back to Graham & Dodd’s research in the 1930s.
2. Factor-based: for example: Value, Size, & Quality.  Factor-based investing weights securities by their internal fundamental characteristicss that relate to their expected drivers of returns: for example securities included in a Quality index would be included based on profitability and/or Return on Equity metrics.  Min Volatility (lowest and Momentum relate to the performance of the security rather than its fundamentals.  Our recent CPD webinar explores factor-based investing in more detail.
3. Risk-based: probably the least developed area.  Risk-based investing weights securities by their relationship to each other in order to target a particular target risk characteristic.  Examples include: Max Deconcentration (aka Equal weighted); Max Diversification; Max Decorrelation; Max Sharpe; Min Variance, Risk Parity (aka Equal Risk Contribution) and Managed Risk.  Our recent CPD webinar explores risk-based investing in more detail.
4. Min Volatility or Min Variance? What’s the difference? Semantics, but for differentiation, we refer to Min Volatility when a strategy ranks securities by their volatility, to include only those lowest volatility stocks (hence used when referring to Factor-based strategies).  We refer to Min Variance when a strategy looks at risk and correlation structure between stocks to target a “minimum variance portfolio” of those securities (hence used when referring to Risk-based strategies).  So similar, but different.

With that array of index methodologies for US equities to choose from, there’s no excuse for complaining about being fed-up with the traditional cap-weighted approach.  Index selection, depends, of course, on portfolio construction objectives, and index methodology due diligence remains key.

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.
​
Summary
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.

• Fiscal and policy support should keep growth shock short and sharp
• Inflation looks bottled – for now, but this is the key focus
• Asset price recovery was welcome but vigilance now required

 
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[1] 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. 
[1] 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:

• A traditional active fund has shares or units that are not traded on an exchange and typically has an objective to outperform a particular benchmark index.
• An index-tracking fund has shares or units that are not traded on an exchange and typically has an objective to track the performance of a particular benchmark index.
• An investment trust has shares that are traded on an exchange and typically has an objective to outperform a particular benchmark index.
• An Exchange Traded Fund has shares that are traded on an exchange and typically has an objective to track a particular benchmark index.

 
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[1] and strategic bond funds as interest rates expectations rose[2].
 
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[3].
 
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:

[1] https://seekingalpha.com/article/3986464-investors-u-k-property-etfs-affected-9b-fund-lock
[2] https://www.ft.com/content/a007d563-4454-3c92-aeaa-4d0dc64e425b
[3] https://www.cnbc.com/id/41354109

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.

[2 min read, open as pdf]

• Momentum has been the best performing factor
• Can factors get crowded, but can they be timed?
• Will we see a persistent rotation to value?

 
A Factor-based approach to investing
Factor-based investing means choosing securities for an inclusion in an index based on what characteristics or factors drive their risk-return behaviour, rather than a particular geography or sector.
Just like food can be categorised simply by ingredients, it can also be analysed more scientifically by nutrients.  Factors are like the nutrients in an investment portfolio.
​
What are the main factors?
There is a realm of academic and empirical study behind the key investment factors, but they can be summarised as follows
The different factors can be summarised as follows:

• Size: smaller capitalisation companies
• Momentum: companies with upward price trend
• Quality: companies with strong and stable earnings
• Value: companies that are undervalued relative to their fundamentals
• Min Volatility: companies with lower volatility performance characteristics

 
Which has been the strongest performing factor?
Momentum has been the best performing factor over the last 5 years.  Value has been the worst performing factor.
 
Fig.1. World equity factor performance

Source: Elston research, Bloomberg data

A crowded trade?
Data points to Momentum being a “crowded trade”, because of the number of people oerweighting stocks with momentum characteristics.  This level of crowdedness can be an indicator of potential drawdowns to come.
​
Fig.2. Momentum Factor is looking increasingly crowded

Source: MSCI Factor Crowding Model

The best time to buy into a Momentum strategy has been when it is uncrowded – like in 2001 and 2009, which is also true of markets more generally.  MSCI’s research suggests that with crowding scores greater than 1 were historically more likely to experience significant drawdowns in performance over subsequent months than factors with lower crowding scores.
​
Fig.3. Factors with higher crowding score can be an indicator of greater potential drawdowns, relative to less crowded factors

Source: MSCI Factor Crowding Model

Rotation to Value
The value-based approach to investing has delivered lack lustre performance in recent times, hence strategists’ calls that there may be a potential “rotation” into Value-oriented strategies in coming months as the post-COVID world normalises.  But can factors be timed?

Marketing timing, factor timing?
Market timing is notoriously difficult.  Factor timing is no different.  To get round this, a lot of fund providers have offered multi-factor strategies, which allocate to factors either statically or dynamically.  Whilst convenient as a catch-all solution, unless factor exposures are dynamically and actively managed, the exposure to all factors in aggregate will be similar to overall market exposure.  This has led to a loss of confidence and conviction in statically weighted multi-factor funds.

Summary
Factors help break down and isolate the core drivers of risk and return.

• Factor investing looks at the “nutrients” of investment
• Static “catch-all” approach to multi-factor investing has clear constraints, so a more dynamic approach makes sense
• Factors can get crowded, but factor allocation is hard to time

 
For more on Factor investing, see
https://www.elstonsolutions.co.uk/insights/category/factor-investing  
​https://www.msci.com/factor-investing 

[7 min read, open as pdf]

Whether or not investors enjoy creating and managing their own ETF portfolios, ready-made portfolios and funds of ETFs and index funds offer a convenient alternative

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.

Who needs or wants a ready-made portfolio?
Individual investors of all wealth levels may find the prospect of engaging with their investment daunting, time-consuming, or both.
 
This is heightened by the high number of investment products and services available.  In the UK, there are over 70 discretionary management firms, and over 3,000 investment funds and ETFs.
 
For this reason, DIY investors may want ready-made portfolios that are an easy-to-buy and easy-to-own investment.  Not only do these solutions look like a simple alternative but they can also address and can potentially mitigate behavioural mistakes.
 
We look at three alternative ways of delivering ready-made portfolios for DIY investors in more detail: multi-asset funds, ETF portfolios and multi-asset ETFs.

Multi-Asset Funds
Multi-Asset Funds (also known as Asset Allocation Funds or Multi-Manager Funds) are the most established type of ready-made portfolios.  By owning a single fund (or in some cases an investment trust), investors get exposure to a diversified portfolio of underlying funds to reflect a specific asset allocation.  This means that having selected a strategy, the investor does not need to worry about asset allocation, or about the portfolio construction to achieve that asset allocation, or about security selection within each asset class exposure.
 
We categorise Multi-Asset Funds into different categories by investment strategy:

• Managed Balanced Funds are the “original” multi-asset funds and represent an unfixed asset allocation between equities and bonds that the fund manager will adapt based on their view of the markets.  These funds may hold direct equities and bonds, or used collective equity and bond funds that are typically actively managed.

 

• Relative Risk Funds (also known as Risk Profiled Funds) target a risk (volatility) that is relative to equity risk and are designed for a group of investors that share a risk-return objective.

 

• Target Risk Funds: target a risk (volatility) band in absolute terms

 

• Target Date Funds target a date in the future when withdrawals are expected to commence and are designed for a group of investors that share a time-based objective.

 

• Target Absolute Return Funds target a return objective and are unconstrained in their investment approach.

Despite the cost of wrapping underlying funds within a fund structure, economies of scale mean that Multi-Asset Funds can be delivered to investors at highly competitive price points with very low minimums.  However, the disadvantage is that Multi Asset Funds have a one-size-fits-all approach that means there is little scope for customisation to the individual needs and characteristics of the investor’s objectives and constraints.

ETF Portfolios
ETF Portfolios are basket of individual ETFs providing an asset allocation.  Rather than wrapping an investment strategy within a fund, a model portfolio is made available as a basket of ETFs that can be bought individually to create the strategy.  Model portfolios may be “strategic” (rebalanced to fixed weights of the same securities) or “tactical” (rebalanced to changing weights of the same or different ETFs).  Model portfolios are research portfolios meaning that the model portfolio provider has no control of client assets so it is up to a portfolio manager, adviser or DIY investor to implement any changes should they wish to follow a given model portfolio strategy.​

The advantages of ETF Portfolios include: firstly, potentially lower fees owing to removal of a fund wrapper to hold the strategy; secondly greater flexibility and specificity with regards to asset allocation design; and lastly agility as strategies can be launched or closed with ease.
 
An example of an ETF Portfolio could be as simple as a classic global 60/40 Equity/Bond strategy constructed with ETFs.

The ability to design and create ETF Portfolios with an increasing number of ETF building blocks means that both traditional (asset managers, stock brokers) and non-traditional providers (e.g. trade publications, investment clubs, industry experts) can create investment strategies that can be “followed” by investors.  However, the usual due diligence rules for any investment provider should be applied as regards their investment process.
 
Whilst the rise of more bespoke ETF strategies is welcome, the convenience of having a single strategy delivered as a single security from a portfolio construction perspective is attractive.  This is where Multi-Asset ETFs could have a role to play.
 
Multi-Asset ETFs
Multi-Asset ETFs are an emerging way of delivering the returns of a managed ETF Portfolio using a single instrument.  Whereas multi-asset funds are often funds of index-tracking funds, Multi-Asset ETFs can be viewed as an “ETF of ETFs”.
 
In the US, there are a number of multi-asset ETFs available providing a ready-made allocation within a single trade.  In the UK, there are currently only two ranges of multi-asset ETFs available.
 
Multi-Asset Infrastructure (launched April 2015)
SPDR® Morningstar Multi-Asset Global Infrastructure UCITS ETF
 
ESG Multi-Asset ETFs (launched September 2020)
BlackRock ESG Multi-Asset Conservative Portfolio UCITS ETF (MACG)
BlackRock ESG Multi-Asset Moderate Portfolio UCITS ETF (MAMG)
BlackRock ESG Multi-Asset Growth Portfolio UCITS ETF (MAGG)
 
We expect multi-asset funds, constructed with ETFs and index funds, to gain more traction than multi-asset ETFs because as a “buy and hold” ready-made portfolio multi-asset funds do not need the intraday dealing availability that ETFs provide.
 
Multi-asset funds (constructed with index funds/ETFs), ETF Portfolios, and Multi-asset ETFs provide a ready-made one stop for delivering a multi-asset investment strategy for all or part of an investment portfolio, whether defined by a multi-asset index or not.

The advantages of a multi-asset fund of ETFs as a ready-made portfolio
The advantages of a “one and done” approach include collectivisation, convenience and consistency.
 
Firstly, is collectivisation of investor’s by objective which creates cost efficiency from the economies of scale.  Adopting a collectivised approach, can be done where each group of clients shares the same goal (as defined by, for example, a target risk level or income objective, or volatility objective or target date).  This can help achieve economies of scale and lower the cost of offering professionally managed asset allocations in at least three different ways. Firstly, each cohort becomes a multi-million pound ‘client’ of an asset manager who can deploy institutional-type bargaining power on the pricing of the underlying funds within their asset allocation. Secondly, the collective scale reduces frictional trading costs of implementing the asset allocation decisions: one managed investment journey is more efficient to manage and deliver than thousands of individual ones. Finally, by focusing on actively managing the asset allocation as the main determinant of the level and variability of returns[1] the asset allocation can be implemented with index-tracking ETFs to keep costs down.
 
Secondly is convenience.  Rather than focusing solely on building optimal multi-asset class portfolios that need monitoring, the proposition of investment offerings can be engineered to eliminate poor behavioural tendencies that prevent effective management. Engineering funds so that they offer a single investment journey which investors do not necessarily need to monitor regularly in order to reach their goals can help reduce the perceived hassle of investing.  This can motivate individuals to invest. Such professionally managed funds prevent investors from either not rebalancing the portfolio or doing it in an improper fashion due to behavioural tendencies such as status quo bias[2] and disposition effect[3]. Furthermore, a professionally managed strategy can respond to other risks aside from market risk such as shortfall, concentration or longevity risks which lay investors can overlook. An additional advantage of offering managed diversified funds is that it automatically curtails the number of products offered, thereby reducing cognitive load of making an investment decision and can prevent decision deferral.[4]
 
Finally is consistency.  Investors in each strategy experience the same time-weighted investment returns thereby reducing the likely dispersion of returns that a group of investors would experience through an entirely self-directed approach.  This consistency is why multi-asset funds have also been adopted by some financial advisers as a core or complete holding within a centralised investment proposition.
 
The disadvantage of a ready-made portfolio are not secret.  They are designed as a “one-size-fits-all” product with no scope for customisation.
 
The respective features of the various types of ready-made portfolio are set out below.  Whereas multi-asset funds of ETFs, and multi-asset ETFs can be accessed via a single trade, their scope for customisation is low.  ETF Portfolios have the highest degree of flexibility for creating custom strategies, but are not accessible via a single trade.

Summary
Ready-made portfolios are easy to buy and easy to own.  They enable a “set and forget” approach to investment management which can help design out key behavioural risks, or provide a useful core holding to a broader strategy.​

Obviously the primary choice is which strategy an investor must choose, or their adviser should recommend depending on their risk-return objectives and suitability considerations.

High risk, complex Exchange Traded Products that amplify (with “leverage”) index’ moves in the same (“long”) or opposite (“short”) direction are designed for sophisticated investors who want to trade and speculate over the short-term, rather than make a strategic or tactical investment decisions.  Whilst they can have a short-term role to play, they should be handled with care.  If you think you understand them, then you’ve only just begun.

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.

For more speculators and or more sophisticated risk managers there are a range of inverse (short) and leveraged (geared) ETPs that can rapidly add or remove upside or downside risk exposure in short-term (daily) market movements.
 
The difference between speculating and investing should be clearly defined.

• Investing implies a disciplined, rational approach to seeking a commensurate level of expected return for a given level of risk using the investor’s own capital.
• Speculating implies an unstructured, emotional approach to seeking outsize levels of possible return at any level of risk using the speculator’s own or borrowed capital.

 
Owing to the higher degree of risk management and understanding required to use these products,  they may not be suitable for DIY or long-term investors.  However a degree of knowledge is helpful to identify them within a managed portfolio or amongst research sites.
 
Defining terms
Unlike their more straightforward unleveraged ETF cousins, leveraged and inverse or “short” ETNs should be for sophisticated investor or professional use only. So hold onto your seat.  Shorting and leverage are important tools in a professional manager’s arsenal.  But first we need to define terms.
 
Going long: means buying a security now, to sell it at a later date at a higher value. The buyer has profited from the difference in the initial buying price and final selling price.
 
Going short: means borrowing a security from a lender and selling it now, with an intent to buy it back at a later date at a lower value. Once bought, the security can be returned to the lender and the borrower (short-seller) has profited from the difference in initial selling and final buying price.
 
Leverage: means increasing the magnitude of directional returns using borrowed funds.  Leverage can be achieved by:

• Borrowing (on a secured or unsecured basis) from lender to invest in risk assets, in the expectation that the returns are greater than the interest rate charged for borrowing those funds. Use of borrowing within ETNs to create Leveraged ETNs introduces interest costs into the overall cost of the ETN.

 

• Options: leverage can be achieved synthetically by buying call options (the right to buy a stock (including ETFs on whole markets) at a certain strike price in the future.  As markets move further away from the strike price, the value of that option increases exponentially. A leveraged short position can be achieved by selling call options.

 

• Contracts for Difference (CFD): leverage can be achieved synthetically by entering into a contract for difference (where one party contracts to pay the other party the difference between a current value and the value at the start of the contract).  The buyer can use current cash and trade on margin that is based on the size of the trade. Effectively, it means buyers of CFDs only need a small amount of capital to access a much larger position.

 
Underlying index: is the underlying index exposure against which a multiplier is applied.  The underlying index could be on a particular market, commodity or currency.
Potential applications
Managers typically have a decision only whether to buy, sell or hold a security.  By introducing products that provide short and/or leveraged exposure gives managers more tools at their disposal to manage risk or to speculate.  Going short, and using leverage can be done for short-term risk management purposes, or for speculative purposes.  Leverage in either direction (long-short) can be used either to amplify returns, profit from very short market declines, or change the risk profile of a portfolio without disposing of the underlying holdings.
 
 
Short/Leveraged ETPs available to DIY investors
The following types of short/leveraged ETPs are available to implement these strategies.
 
Fig.1. Potential application of inverse/leveraged ETPs

The ability to take short and/or leveraged positions was previously confined to professional managers and ultra-high net worth clients.  The availability of more complex Exchange Traded Products gives investors and their advisers the opportunity to manage currency risk, create short positions (profit from a decline in prices) and create leveraged positions (profit more than the increase or decrease in prices).
Risks
Leveraged and short ETPs have significantly greater risks than conventional ETFs.  Some of the key risks are outlined below:

• Complexity: short and leveraged products are complex products making them harder to understand and deploy.

 

• Counterparty risk: furthermore short/leveraged ETPs carry bank counterparty risk as they are swap based agreements unlike traditional ETFs which are physical and own the underlying asset.

 

• Decay: leveraged products exhibit decay (their ability to perfectly track an index with leverage) diminishes over time from the combined effects of fees and expenses, rebalancing costs and volatility decay[1].

 
If concerned regarding risk of deploying short/leveraged ETPs, set a capped allocation i (eg no more than 3% to be held in leveraged/inverse ETPs, and a holding period for leveraged/inverse ETPs not to exceed 1-5 days). 
 
US Case Study: Inverse Volatility Blow Up
VelocityShares Daily Inverse VIX Short-Term ETN (IVX) and ProShares Short VIX Short-Term Futures ETF were products created in the US for professional investors who wanted to profit from declining volatility on the US equity market by tracking the inverse (-1x) returns of the S&P VIX Short-Term Futures Index.  The VIX is itself an reflecting the implied volatility of options on the S&P 500.  As US equity market volatility steadily declined the stellar performance of the strategy in prior years not only made it popular with hedge funds[2], but also lured retail investors who are unlikely to have understood the complexity of the product.  By complexity, we would argue that a note inversely tracking a future on the implied volatility of the stock market is hardly simple.
 
On 5th February, the Dow Jones Industrial Average suffered its largest ever one day decline.  This resulted in the VIX Index spiking +116% (from implied ~12% volatility to implied ~33% volatility).  The inverse VIX ETNs lost approximately 80% of their value in one day which resulted in an accelerated closure of the product, and crystallising the one day loss for investors[3].  The SEC (US regulator) focus was not on the product itself but whether and why it had been mis-sold to retail investors who would not understand its complexity[4].

Summary
In conclusion, on the one hand, Leveraged/Inverse ETP are convenient ways of rapidly altering risk-return exposures and provide tools with which speculators can play short-term trends in the market.  Used by professionals, they also have a role in supporting active risk management.  However, the risks are higher than for conventional ETFs and more complex to understand and quantify.

​RISK WARNING! Short and/or Leveraged ETPs are highly complex financial instruments that carry significant risks and can amplify overall portfolio risk.  They are intended for financially sophisticated investors who understand these products, and their potential pay offs.  They can be used to take a very short term view on an underlying index, for example, for day-trading purposes. They are not intended as a buy and hold investment.

[1] https://seekingalpha.com/article/1457061-how-to-beat-leveraged-etf-decay

[2] https://www.cnbc.com/2018/02/06/the-obscure-volatility-security-thats-become-the-focus-of-this-sell-off-is-halted-after-an-80-percent-plunge.html

[3] https://www.bloomberg.com/news/articles/2018-02-06/credit-suisse-is-said-to-consider-redemption-of-volatility-note

[4] https://www.bloomberg.com/news/articles/2018-02-23/vix-fund-blowups-spur-u-s-to-probe-if-misconduct-played-a-role

[5 min read, open as pdf]
​

• In June 2018 we launched a Zero Carbon Portfolio for a university endowment fund
• The objective was to deliver the performance of a global equity index whilst fully excluding companies with exposure to fossil fuels and positively including Socially Responsible Investments
• In addition to a successful back-test, the live portfolio has delivered on objectives

What is Zero Carbon investing
The Zero Carbon Society at Cambridge University is one of many campaign groups calling for university endowment funds to divest from all fossil fuels.  This has been termed “Zero Carbon” investing.
The divestment trend started in the US in 2012 when the city of Seattle divested from fossil fuels.  In 2014, Stanford University followed suit.  Campaigns across the US and UK led to other universities following suit.  Some of the reasons universities found it hard to ensure that their investments were “fossil free” is because:

• Collectives: Use of collective investment schemes meant it was hard to pressure fund houses to change investment style, on something that would affect all clients
• Alternatives: Use of hedge funds and alternative strategies meant it was hard to vouch for full exclusion on a look-through basis
• Trackers: Use of low-cost tracker funds meant indirect exposure to energy stocks
• Definitional uncertainty: if you invest in a FTSE 100 future does that create “exposure”?
• Opportunity Set: Concern about a narrowing of the investment opportunity set
• Methodology: low carbon and ESG funds could nonetheless include energy companies with strong green credentials and substantial investment in renewable energy

The challenge
When set this challenge by a university college, we proposed to do two things.  Firstly to create a Zero Carbon SRI benchmark to show how Zero Carbon investing could be done whilst also focusing on other ESG considerations.  Secondly, to create a Zero Carbon portfolio to deliver on the primary aim of full divestment.
 
Creating a Zero Carbon SRI benchmark
We wanted to create a benchmark for the endowment’s managers that not only screened out fossil fuels, but went further to screen out one of the main consumer of fossil fuels, the Utilities sector, as well as other extractive industries – namely the Materials sector.  We also wanted to screen in companies with high ESG scores and low controversy risk and cover the global equity opportunity set.  We worked with MSCI to create a custom index, the catchily-named (for taxonomy reasons) the MSCI ACWI ex Energy ex Materials ex Utilities SRI Index (the “Custom Index”, please refer to Notice below).

Creating a Zero Carbon portfolio
The second part of the project was to create an implementable investment strategy that maintained a similar risk-return profile to World Equities, but fully excluded the Energy, Materials and Utilities sectors.  Rather than creating a fund which introduces additional layer of costs, this was achievable using sector-based ETF portfolio.

This portfolio meets the primary objective of creating a Zero Carbon, fully divested, world equity mandate.  In the absence of ESG/SRI sector-based ETFs, it is not yet possible to create a sector-adjusted ESG/SRI ETF portfolio.  But we expact that to change in the future.

Custom Index Performance
The back-test of both the custom index could deliver similar risk-return characteristics to global equities.  The concern was would those back-test results continue once the index and portfolio went live.  The answer is yes.  Whilst the custom index has shown outperformance, that was not the objective.  The objective was to access the same opportunity set, but with the fossil-free, ESG and socially responsible screens in place.

Fig.1. Custom Index performance simulation from June 2012 & live performance from June 2018

Zero Carbon Portfolio performance
Similarly, the Zero Carbon portfolio has delivered comparable performance to MSCI World – hence no “missing out” on the opportunity set whilst being fully divested from fossil fuels.  Although not intentional, the exclusion of Energy, Materials & Utilities has benefitted performance and meant that the performance, net of trading and ongoing ETF costs, is ahead of the MSCI World Index.

Fig.2. Zero Carbon ETF portfolio performance from June 2018

Summary
Whatever your views on the pros and cons of divestment, Zero Carbon investing is not an insurmountable challenge, and the combination of index solutions and ETF portfolios solutions creates a range of implementable options for asset owners and asset managers alike.

IMPORTANT NOTICE ABOUT THE CUSTOM INDEX
With reference to the MSCI ACWI ex Energy ex Materials ex Utilities SRI Index (“Custom Index”). Where Source: MSCI is noted, the following notice applies.
Source: MSCI.  The MSCI data is comprised of a custom index calculated by MSCI, and as requested by, Queens’ College Cambridge.  The MSCI data is for internal use only and may not be redistributed or used in connection with creating or offering any securities, financial products or indices.  Neither MSCI nor any third party involved in or relating to compiling, computing or creating the MSCI data (the “MSCI Parties”) makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and the MSCI Parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to such data.  Without limiting any of the foregoing, in no event shall any of the MSCI Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.

​Which asset classes are not indexable; what proxies do they have that can be indexed; and why it can make sense to blend ETFs and Investment Trusts for creating an allocation to alternative asset classes

​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.
 
Non-indexable asset classes
Whilst Equities, Bonds and Cash are readily indexable, there are also exposures that will remain non-indexable because they are:

• Illiquid in nature (inaccessible markets, for example infrastructure contracts (toll roads, power contracts, wind-farms, aircraft leasing, railway operating contracts))
• Require or reward subjective management and skill (“true active”, for example high conviction long only funds, or long/short hedge funds)
• Difficult to hold (for example commodities)

On the face of it, alternative assets seem less suitable to indexing: for example property, infrastructure, private equity, and hedge funds.

It is however possible to represent some of these alternative class exposures using liquid index proxies.  Index providers and ETF issuers have worked on creating a growing number of indices for specific exposures in the Liquid Alternative Asset space.

Some examples are set out below:

• For property as an asset class, exposure can be achieved via an index of listed property companies. This is a more liquid way to obtain exposure to that asset class than traditional property funds that own direct property, and means there is less liquidity risk (as we saw in 2016 Brexit and 2020 Covid market dislocations) compared to traditional open-ended property funds.  Unlike traditional funds, property ETFs saw no suspensions or gatings.
• For infrastructure, exposure can be achieved via an index of listed infrastructure equities, or a multi-asset infrastructure index that has both equities and bonds (reflecting infrastructure’s bond-like characteristics).
• For private equity, there are listed private equity firms which benefit from returns in that sector.
• For commodities, exposure can be achieved via diversified basket of commodities held via an exchange traded product that tracks a broad commodity index
• For gold, exposure can be either to gold-producers, or synthetic exposure to gold, or to a physical fund that tracks the gold price whose underlying holding is gold bullion.

These liquid index proxies for alternative assets have broadened the range of asset classes investable via ETPs.

​Alternative asset index proxies
Whilst these liquid proxies for those asset classes are helpful from a diversification perspective, it is important to note that they necessarily do not share all the same investment features, and therefore do not carry the same risks and rewards as the less liquid version of the asset classes they represent.

While ETFs for alternatives assets will not replicate holding the risk-return characteristics of that exposure directly, they provide a convenient form of accessing equities and/or bonds of companies that do have direct exposure to those characteristics.
​
Using investment trusts for non-index allocations
Ironically, the investment vehicle most suited for non-indexable investments is the oldest “Exchange Traded” collective investment there is: the Investment Company (also known as a “closed-end fund” or “investment trust”).  The first UK exchange traded investment company was the Foreign & Colonial Investment Trust, established in 1868.
​
Like ETFs, investment companies were originally established to bring the advantages of a pooled approach to the investor of “moderate means”.

For traditional fund exposures, e.g. UK Equities, Global Equities, our preference is for ETFs over actively managed Investment Trusts owing to the performance persistency issue that is prevalent for active (non-index) funds.  Furthermore, investment trusts have the added complexity of internal leverage and the external performance leverage created by the share price’s premium/discount to NAV – a problem that can become more intense during periods of market stress.
​
However, for accessing hard-to-reach asset classes, Investment Trusts are superior to open-ended funds, as they are less vulnerable to ad hoc subscriptions and withdrawals.

The Association of Investment Company’s sector categorisations gives an idea of the non-indexable asset classes available using investment trusts: these include Hedge Funds, Venture Capital Trusts, Forestry & Timber, Renewable Energy, Insurance & Reinsurance Strategies, Private Equity, Direct Property, Infrastructure, and Leasing.

A blended approach
Investors wanting to construct portfolios accessing both indexable investments and non-indexable investments could consider constructing a portfolio with a core of lower cost ETFs for indexable investments and a satellite of higher cost specialist investment trusts providing access to their preferred non-indexable investments.  For investors, who like non-index investment strategies, this hybrid approach may offer the best of both world.

Summary
The areas of the investment opportunity set that will remain non-indexable, are (in our view) those that are hard to replicate as illiquid in nature (hard to access markets or parts of markets); and those that require or reward subjective management and skill.  Owing to the more illiquid nature of underlying non-indexable assets, these can be best accessed via a closed-ended investment trust that does not have the pressure of being an open-ended fund.
ETFs provide a convenient, diversified and cost-efficient way of accessing liquid alternative asset classes that are indexable and provide a proxy or exposure for that particular asset class.  Examples include property securities, infrastructure equities & bonds, listed private equity, commodities and gold.

[5 minute read, open as pdf]
Sign up for our upcoming CPD webinar on Real Assets for diversification

• As Real Asset funds AUM increased, so too has their usage of ETFs and index-tracking funds to ensure good underlying liquidity
• Combining liquid real asset ETFs into a model portfolio enables access to similar performance characteristics, greater liquidity & transparency, at lower overall cost
• We contrast the performance of the Elston Liquid Real Asset index portfolio of ETFs to the largest Real Assets funds

 
What are “Real Assets”?
Real Assets can be defined as “physical assets that have an intrinsic worth due to their substance and property”[1].  Real assets can be taken to include precious metals, commodities, real estate, infrastructure, land, equipment and natural resources.  Because of the “inflation-protection” objective of investing in real assets (the rent increases in property, the tariff increases in infrastructure), real asset funds also include exposure to inflation-linked government bonds as a financial proxy for a real asset.

Why own Real Assets?
There are a number of rationales for investing in Real Assets.  The primary ones are to:

• Diversify a portfolio away from just equities and bonds
• Generate an income stream supported by the underlying asset’s cashflows
• Protect against expected and unexpected inflation

For these reasons there has been substantial allocation to real asset by both institutional and retail investors.

Accessing Real Assets
Institutional investors can access Real Assets directly and indirectly.  They can acquired direct property and participate in the equity or debt financing of infrastructure projects. Directly.  For example, the Pensions Infrastructure Platform, established in 2021 has enabled direct investment by pension schemes into UK ferry operators, motorways and hospital construction projects.  This provides funding for government-backed project and real asset income and returns for institutional investors.  Institutional investors can also access Real Assets indirectly using specialist funds as well as mainstream listed funds such as property securities funds and commodities funds.

Retail investors can access Real Assets mostly indirectly through funds.  There is a wide range of property funds, infrastructure funds, commodity funds and natural resources funds to choose from.  But investors have to decide on an appropriate fund structure.

• OEICs have the advantage of convenience and pooled scale, but have the risk of a liquidity mismatch (the daily liquidity of the funds is not reflected by the liquidity of the underlying assets
• Investment Trusts have the advantage of being able to borrow to invest, but have the disadvantage of a volatile premium or discount to NAV based on demand/supply for the shares
• ETFs have the advantage of transparency, liquidity and cost, but the disadvantage of being restricted to owning only listed or tradable securities.

For this reason, there has been a risk in the use of Real Asset funds to outsource these decisions to professional managers.

The rise of real asset funds
The first UK diversified real asset fund was launched in 2014, with competitor launches in 2018.  There is now approximately £750m invested across the three largest real asset funds available to financial advisers and their clients, with fund OCFs ranging from 0.97% to 1.46%.

Following the gating of an Equity fund (Woodford), a bond fund (GAM) and several property funds for liquidity reasons, there has – rightly – been increased focus by the regulator and fund providers (Authorised Corporate Directors or “ACDs”) on the liquidity profile of underlying assets.

As a result, given their increased scale, real asset fund managers are increasingly turning to mainstream funds and indeed liquid ETFs to gain access to specific asset classes.

Indeed, on our analysis, one real assets funds has the bulk of its assets invested in mainstream funds and ETFs that are available to advisers directly.  Now there’s no shame in that – part of the rationale for using a Real Assets fund is to select and combine funds and manage the overall risk of the fund.  But what it does mean is that discretionary managers and advisers have the option of creating diversified real asset exposure, using the same or similar underlying holdings, for a fraction of the cost to clients.
 
Creating a liquid real asset index portfolio
We have created the Elston Liquid Real Asset index portfolio of ETFs in order to:

• Gain exposure to real asset classes using the same or similar exposures to a real assets fund
• Have full transparency as regards underlying holdings and assured ETF liquidity
• Deliver a systematic, diversified exposure at a lower cost to clients

We have built the index portfolio using the following building blocks

• Liquidity: exposure to ultrashort duration bonds to provide ballast and stability
• Inflation protection: exposure to UK and government inflation-linked bonds
• Property & Asset backed securities: exposure to the capital value and income stream of property using property securities ETF, as well as being on the receiving end of mortgage payments using a mortgage backed securities ETF.
• Clean Energy & Infrastructure: clean energy means owning within an ETF the listed securities in providers of clean energy such as wind farms and solar farms.  Infrastructure means owning within an ETF the listed equity and bond securities of infrastructure providers.
• Gold & Commodities: direct exposure to Gold using a physical ETC, and indirect exposure to a broad commodities basket using a synthetic ETC.
• Natural Resources: owning ETFs with exposure to listed global water companies as well as listed global timber and forestry companies.

As regards asset allocation, we are targeting a look-through ~50/50 balance between equity-like securities and bond-like securities to ensure that the strategy provides beta reduction as well as diversification when included in a portfolio.  For the index portfolio simulation, we have used an equal weighted approach.
Fig.1. Performance of the Liquid Real Asset Index Portfolio (.ELRA)

Source: Elston research, Bloomberg data. Total returns from end December 2018 to end September 2020 for selected real asset funds.
Since December 2018, the Sanlam Real Assets fund has returned 19.99%, the Elston Real Asset Index Portfolio has returned +19.76%.  This compares to +5.86% for the Architas Diversified Real Asset fund and +0.16% for the Waverton Real Assets Fund.
What about Beta
Our Real Asset Index Portfolio has a Beta of 0.75 to the Elston 60/40 GBP index so represents a greater risk reduction than Waverton (0.86) and Sanlam (0.84), which are all higher beta than Architas (0.53).
Fig.2. Real Asset strategies’ beta to a 60/40 GBP Index

Source: Elston research, Bloomberg data. Weekly data relative to Elston 60/40 GBP Index, GBP terms Dec-18 to Sep-20.
Finally, by accessing the real asset ETFs directly, there is no cost for the overall fund structure, hence the implementation cost for an index portfolio of ETFs is substantially lower.
Fig.3. Cost comparison of Real Asset funds vs index portfolio of ETFs

Source: Elston research, Bloomberg data 

Fund or ETF Portfolio?
The advantage of a funds-based approach is convenience (single-line holding), as well as having a a manager allocate dynamically between the different real asset exposures within the fund.
The advantage of an index portfolio is simplicity, transparency and cost.  Creating a managed ETF portfolio strategy that dynamically allocates to the different real asset classes over the market cycle is achievable and can be implemented on demand.
​
Summary
The purpose of this analysis was to note that:

1. Real Asset Funds available to retail investors do not have any special access to an opportunity set of funds that cannot be accessed directly
2. The liquidity requirements on real asset funds is driving them more to the use of index funds and ETFs
3. It is possible to create a diversified, liquid real assets portfolios using ETFs and index funds.
4. There is a trade off between cost and convenience between having an index portfolio of ETFs and a unitised fund.
5. An equal-weight strategy can prove effective given the overall allocation to real assets within a portfolio.  A managed dynamic-weight strategy would be an interesting enhancement.

​[1] Source: https://www.investopedia.com/terms/r/realasset.asp

​There’s no such thing as passive.  Index investors make active decisions around asset allocation, index selection and index methodology.

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.

If indices represent exposures, what is index investing and what are the ETFs that track them?  Does using an index approach to investing mean you are a ‘passive investor’?

I am not comfortable with the terms “active” and “passive”.  A dynamically managed approach to asset allocation using index-tracking ETFs is not “passive”.  The selection of an equal weighted index exposure over a cap weighted index is also an active decision.  The design of an index methodology, requires active parameter choices.  Hence our preference for the terms “index funds” and “non-index funds”.

Indices represent asset classes.  ETFs track indices.  Index investing is the use of ETFs to construct and manage an investment portfolio.
​
The evolution of indices
The earliest equity index in the US is the Dow Jones Industrial Average (DJIA) which was created by Wall street Journal editor Charles Dow. The index launched on 26 May 1896, and is named after Dow and statistician Edward Jones and consists of 30 large publicly owned U.S. companies.  It is a price-weighted index (meaning the prices of each security are totalled and divided by the number of each security to derive the index level).

The earliest equity index in the UK is the FT30 Index (previously the FN Ordinary Index) was created by the Financial Times (previously the Financial News).  The index launched on 1st July 1935 and consists of 30 large publicly owned UK companies.  It is an equal-weighted index (meaning each of the 30 companies has an equal weight in the index).

The most common equity indices now are the S&P500 (launched in 1957) for the US equity market and the FTSE100 (launched in 1984) for the UK Equity market.  These are both market capitalisation-weighted indices (meaning the weight of each company within the index is proportionate to its market capitalisation (the share price multiplied by the number of shares outstanding)).

According to the Index Industry Association, there are now approximately 3.28m indices, compared to only 43,192 public companies .  This is primarily because of demand for highly customised versions of various indices used for benchmarking equities, bonds, commodities and derivatives.  By comparison there are some 7,178 index-tracking ETPs globally.

The reason why the number of indices is high is not because they are all trying to do something new, but because they are all doing something slightly different.

For example, the S&P500 Index, the S&P500 (hedged to GBP) Index and the S&P 500 excluding Technology Index are all variants around the same core index.  So the demand for indices is driven not only by investor demand for more specific and nuanced analysis of particular market exposures, but also for innovation from index providers.
 
What makes a good index benchmark?
For an index to be a robust benchmark, it has to meet certain criteria.  Indices provided a combined price level (and return level) for a basket of securities for use as a reference, benchmark or investment strategy.
Whilst a reference point is helpful, the use of indices as benchmarks enables informed comparison of fund or portfolio strategies.  An index can be used as a benchmark so long as it has the following qualities (known as the “SAMURAI” test based on the mnemonic based on key benchmark characteristics in the CFA curriculum).  It must be:

• Specified: The benchmark is specified in advance - prior to the start of the evaluation period.
• Appropriate: The benchmark is consistent with the manager’s investment style or area of expertise.
• Measurable: The benchmark’s return is readily calculable on a reasonably frequent basis.
• Unambiguous: The identities and weights of securities are clearly defined.
• Reflective: The manager has current knowledge of the securities in the benchmark.
• Accountable: The manager is aware and accepts accountability for the constituents and performance of the benchmark.
• Investable: It is possible to simply hold the benchmark.

 
Alternative weighting schemes
Whereas traditional equity indices took a price-weighted, equal-weighted or market capitalisation weighted approach, there are a growing number of indices that have alternative weighting schemes: given the underlying securities are the same, these variation of weighting scheme also contributes to the high number of indices relative to underlying securities.
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The advent of growing data and computing power means that indices have become more granular to reflect investors desire for more nuanced exposures and alternative weighting methodologies .

Whether indices are driven by investor needs for isolated asset class exposures or by other preferences, there is a growing choice of building blocks for portfolio constructors.
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Index investing
Whilst indices have traditionally been used for performance measurement, if the Efficient Markets Hypothesis holds true, it makes sense to use an index as an investment strategy.  A fund that matches the weightings of the securities within an index is an index-tracking fund.  The use of single or multiple funds that track indices to construct and manage a portfolio is called “index investing”.
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We define index investing as 1) using indices (whether traditional cap-weighted or alternatively weighted) to represent the various exposures used within a strategic or tactical asset allocation framework, and 2) using index-tracking ETFs to achieve access to that exposure and/or asset allocation.
 
The advantages of index investing with ETFs are:

• Consistency: By using an ETF, the performance and risk-return characteristics of that ETF match those of the index they track and asset class they represent.
• Predictability: given long run asset class analyses are based on indices, by using an ETF the expected risk-return characteristics are more predictable than an active fund which depends on manager skill, style and behaviour.
• Diversification: rather than holding a portfolio of 30 stocks, or an active fund with 100 stocks, a (full replication) ETF will hold all the stocks in an index thereby providing maximum diversification at an asset-class level.  Of course the diversification is only as good as the underlying index: an ETF tracking the S&P500 is more diversified than an ETF tracking the CAC40, for example.

 
As index investors we have a choice of tools at our disposal.  The primary choice is to whether to use Index Funds or ETPs to get access to a specific index exposure.

Index funds and ETPs
Exchange Traded Products (ETPs) is the overarching term for investment products that are traded on an exchange and index-tracking.  There are three main sub-sets:

• Exchange Traded Funds: funds are structured as companies listed on an exchange, where the target return is to match an index
• Exchange Traded Notes: notes are debt securities issued by a bank, where the return is linked to an index. Notes carry that bank’s counterparty risk.  ETNs are used for leveraged and inverse strategies
• Exchange Traded Commodities: these are debt securities issued by a bank and either backed (“collaterised”) by the underlying security or are uncollateralised relying instead on a swap agreement.

 
Individual investors are most likely to come across physical Exchange Traded Funds and some Exchange Traded Commodities such as gold.

Professional investors are most likely to use any or all types of ETPs.  Both individual and professional investors alike are using ETPs for the same fundamental purposes: as a precise quantifiable building block with which to construct and manage a portfolio.
 
Index investors have the choice of using index funds or ETFs.  Index funds are bought or sold from the fund issuer, not on an exchange.  ETFs are bought or sold on an exchange.  For individual investors index funds may not be available at the same price point as for institutional investors.  Furthermore, the range of index funds available to individual investors is much less diverse than ETFs.  Trading index funds takes time (approximately 4-5 days to sell and settle, 4-5 days to purchase, so 8-10 days to switch), whereas ETFs can be bought on a same-day basis, and cash from sales settles 2 days after trading reducing unfunded round-trip times to 4 days for switches. If stock brokers allow it, they may allow purchases of one transaction to take place based on the sales proceeds of another transaction so long as they both settle on the same day.  The ability to trade should not be seen as an incentive to trade, rather it enables the timely reaction to material changes in the market or economy.
 
For professional investors, some index funds are cheaper than ETFs.  Where asset allocation is stable and long-term, index funds may offer better value compared to ETFs.  Where asset allocation is dynamic and there are substantial liquidity or time-sensitive implementation requirements, ETFs may offer better functionality than index funds.  Professional investors can also evaluate the use of ETFs in place of index futures .  For significant trade sizes, a complete cost-benefit analysis is required.  The benefit of the ETF approach being that futures roll can be managed within an ETF, benefitting from economies of scale.  For large investors, detailed comparison is required in order to evaluate the relative merits of each.
 
The benefits of using ETFs
There are considerable benefits of using ETFs when constructing and managing portfolios.  Some of these benefits are summarised below:

• Access & Applications: ETFs are listed on a stock exchange and can be traded any time the market is open to get access to entire markets for both strategic and tactical asset allocation.
• Breadth & Depth: ETFs represent many different sectors and subsectors for equities, bonds, commodities and other exposures. For example, for equities: domestic and international equities, as well as industrial sectors and thematic approaches.  For bonds, domestic and international government and corporate bonds, as well as sub-sectors of the bond market by credit quality, and/or duration.
• Convenience: for investors wishing to make allocations to entire markets, for example Global Equities, ETFs offer a convenient way of accessing an entire market through a single trade .
• Cost & Control: ETFs provide a cost-effective way of accessing an asset class relative to actively managed funds, and relative to buying all the underlying securities for that market.  Additionally, the larger that ETFs get, issuers can decide whether to pass on economies of scale to investors via fee reduction.
• Diversification: like funds, ETFs provide access to a broad range of holdings for each asset class. In the case of ETFs this represents all or most of the securities that make up the index.
• Liquidity: ETFs are as liquid as the underlying securities they represent.  Unlike funds which can be only bought or sold from the issuer, buyers and sellers of ETFs can trade on an exchange.
• Risk management: in addition to the elimination of stock-specific idiosyncratic risk, the use of targeted index exposures enables greater control around expected risk and return in portfolio construction
• Transparency: ETFs’ objectives are clearly articulated, the underlying securities are disclosed on a daily basis, often on the issuer’s website.  Investors therefore know exactly what they are buying and all the underlying holdings and respective weights.

 
Summary
There’s no such thing as “passive investing”.  There is such a thing as “index investing” and it means adopting a systematic (rules-based), diversified and transparent approach to access target asset class, screened, factor or strategy exposures in a straightforward, or very nuanced way.  It is the systematisation of the investment process that enables competitive pricing, relative to active, “non-index” funds.  This is a trend which has a long way to run before any “equilibrium” between index and active investing is reached.
Most investors, automatically enrolled into a workplace pension scheme are index investors without knowing it.  The “instutionalisation of retail” means that a similar investment approach is permeating into other channels such as discretionary managers, financial advisers, and self-directed investors.
© Elston Consulting 2020 all rights reserved

[5 minute read, open as pdf]
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Summary

• Dividend concentration risk is not new, just more visible
• Quality of income, not quantity of yield, matters most
• The advantage of a multi-asset approach

​Dividend concentration risk is not new, just more visible
A number of blue chip companies announced dividend reductions or suspensions in response to financial pressure wrought by the Coronavirus outbreak. This brought into light the dependency, and sometimes over-dependency, on a handful of income-paying companies for equity income investors.
For UK investors in the FTSE 100, the payment of dividends from British blue chip companies provides much of its appeal.  However a look under the bonnet shows a material amount of dividend concentration risk (the over-reliance on a handful of securities to deliver a dividend income).
On these measures, 53% of the FTSE 100’s dividend yield comes from just 8 companies; whilst 22% of its dividend yield comes from energy companies.  The top 20 dividend contributors provide 76% of the dividend yield.
We measure dividend concentration risk by looking at the product of a company’s weight in the index and its dividend yield, to see its Contribution to Yield of the overall index.

Fig.1. FTSE 100 Contribution to Yield, ranked

Source: Elston research, Bloomberg data, as at June 2020

Quality of Income
More important than the quantity of the dividend yield, is its quality.
As income investors found out this year, there’s a risk to having a large allocation to a dividend payer if it cuts or cancels its dividend. 
Equally, there’s a risk to having a large allocation to a dividend payer, whose yield is only high as a reflection of its poor value.
Screening for high dividend yield alone can lead investors into “value-traps” where the income generated looks high, but the total return (income plus capital growth) generated is low.
Contrast the performance of these UK Equity Income indices, for example.
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Fig.2. UK Equity Income indices contrasted

Source: Elston research, Bloomberg data. Total returns from end December 2006 to end June 2020 for selected UK Equity Indices.  Headline Yield as per Bloomberg data as at 30th June 2020 for related ETFs.

​The headline yield for the FTSE UK Dividend+, FTSE 100 and S&P UK Dividend Aristocrat Indices was 8.10%, 4.44%, and 4.07% respectively as at end June 2020.
However, the annualised long-run total return (income plus capital growth) 1.03%, 4.29% and 4.82% respectively.
Looking at yield alone is not enough.  The dependability of the dividends, and the quality of the dividend paying company are key to overall performance.
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Mitigating dividend concentration risk: quality yield, with low concentration
The first part of the solution is to focus on high quality dividend-paying companies.  One of the best indicators of dividend quality is a company’s dividend policy and track record.  A dependable dividend payer is one that has paid the same or increased dividend year in, year out, whatever the weather.
The second part of the solution is to consider concentration risk and make sure that companies’ weights are not skewed in an attempt to chase yield.
This is evident by contrasting the different index methodologies for these equity income indices.
The FTSE 100 does not explicitly consider yield (and is not designed to).  The FTSE UK Dividend+ index ranks companies by their dividend yield alone.  The S&P UK Dividend Aristocrats only includes companies that have consistently paid a dividend over several years, whilst ensuring there is no over-dependency on a handful of stocks.
A look at the top five holdings of each index shows the results of these respective methodologies.
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Fig.3. Top 5 holdings of selected UK equity indices

Put simply, the screening methodology adopted will materially impact the stocks selected for inclusion in an equity income index strategy.
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What about active managers?
A study by Interactive Investor looked at the top five most commonly held stocks in UK Equity Income funds and investment trusts.
For funds, the most popular holdings were GlaxoSmithKline, Imperial Brands, BP, Phoenix Group & AstraZeneca.
For investment trusts, the most popular holdings are British American Tobacco, GlaxoSmithKline, RELX, AstraZeneca and Royal Dutch Sell.
Unsurprisingly, each of the holdings above is also a constituent of the S&P Dividend Aristocrats index, hence ETFs that track this index simply provide a lower cost way of accessing the same type of company (dependable dividend payers with steady or increasing dividends), but using a systematic approach that enables a lower management fee.
Understanding what makes dividend income dependable for an asset class such as UK equities, is only part of the picture of mitigating income risk.  Income diversification is enabled by adopting a multi-asset approach.
 
The advantage of a multi-asset approach
The advantage of a multi-asset approach is two-fold.
Firstly the ability to diversify equity income by geography for a more globalised approach, to benefit from economic and demographic trends outside the UK.
Secondly the ability to diversify income by asset class, to moderate the level of overall portfolio risk.
For investors who never need to dip into capital, have a very high capacity for loss, and can comfortably suffer the slings and arrows of the equity market, equity income works well – so long as the quality of dividends is addressed, as above.
But for anyone else, where there is a need for income, but a preference for a more balanced asset allocation, a multi-asset income approach may make more sense.  The rationale for a multi-asset approach is therefore to capture as much income as possible without taking as much risk as an all-equity approach.

Value at Risk vs Income Reward
There is always a relationship between risk and reward.  For income investors, it’s no different.  To be rewarded with more income, you need to take more risk with your capital.  This means including equities over bonds, and, within the bonds universe, considering both credit quality (the additional yield from corporate and high yield bonds over gilts), and investment term (typically, the longer the term, the greater the yield).
This overall level f risk being taken can be measured using a Value at Risk metric (a “worst case” measure of downside risk).
If you want something with very low value-at-risk, shorter duration gilts can provide that capital protection, but yields are very low.
Even nominally “safe” gilts, with low yields, nonetheless have potential downside risk owing to their interest rate sensitivity (“duration”).
UK Equities offer a high yield, but commensurately also carry a much higher downside risk.
The relationship between yield and Value-at-Risk (a measure of potential downside risk) is presented below.
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Fig.4. Income Yield vs Value at Risk of selected asset classes/indices

Source: Elston research, Bloomberg data, as at 30th June 2020.  Note: an investment with a Value at Risk (“VaR”) of -10% (1 year, 95% Confidence) means there is, to 95% confidence (a 1 in 20 chance), a risk of losing 10% of the value of your investment over any given year.  Asset class data reflects representative ETFs.

Our Multi-Asset Income index has, unsurprisingly, a risk level between that of gilts and equities, and captures approximately 65% of the yield, but with only 52% of the Value-at-Risk.
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Summary
How you get your income – whether from equities, bonds or a mix – is critical to the amount of risk an investor is willing and able to take, and is a function of asset allocation.  Understanding the asset allocation of an income funds is key to understanding its risks (for example, Volatility, Value at Risk and Max Drawdown).

The dependability of dividend income you receive - whether from value traps or quality companies; whether concentrated or diversified – is a function of security selection.  This can be either manager-based (subjective), or index-based (objective).

For investors requiring a dependable yield, a closer look at how income is generated – through asset allocation and dividend dependability – is key.

Investors should prefer the certainty of index funds which track the index less passive fees, than the hope and disappointment of active funds which, in aggregate, track the index less active fees.

​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.
 
Clarifying terms
We believe that typically an index fund or ETF can perfectly well replace an active fund for a given asset class exposure.  As with all disruptive technologies, many column inches have been dedicated to the “active vs passive” debate.  However, with poorly defined terms, much of this is off-point.
If active investing is referring to active (we prefer “dynamic”) asset allocation: we fully concur.  There need be no debate on this topic.  Making informed choices on asset allocation – either using a systematic or non-systematic decision-making process – is an essential part of portfolio management.
If, however, active investing refers to fund manager or security selection, this is more contentious, and this should be the primary topic of debate. 
Theoretical context: the Efficient Market Hypothesis
The theoretical context for this active vs passive debates is centred on the notion of market efficiency.  The efficient market hypothesis is the theory that all asset prices reflect all the available past and present information that might impact that price.  This means that the consistent generation of excess returns at a security level is impossible.  Put differently, it implies that securities always trade at their fair value making it impossible to consistently outperform the overall market based on security selection.  This is consistent with the financial theory that asset prices move randomly and thus cannot be predicted .
Putting the theory into practice means that where markets are informationally efficient (for example developed markets like the US and UK equity markets), consistent outperformance is not achievable, and hence a passive investment strategy make sense (buying and holding a portfolio of all the securities in a benchmark for that asset class exposure).  Where markets are informationally inefficient (for example frontier markets such as Bangladesh, Sri Lanka and Vietnam )  there is opportunity for an active investment strategy to outperform a passive investment strategy net of fees.
Our view is that liquid indexable markets are efficient and therefore in most cases it makes sense to access these markets using index-tracking funds and ETFs, in order to obtain the aggregate return for each market, less passive fees.
This is because, owing to the poor arithmetic of active management, the aggregate return for all active managers is the index less active fees.
The poor arithmetic of active management
Bill Sharpe, the Nobel prize winner, and creator of the eponymous Sharpe Ratio, authored a paper “The Arithmetic of Active Management” that is mindblowing in its simplicity, and is well worth a read.
We all know the criticism of passive investing by active managers is that index fund [for a given asset class] delivers the performance of the index less passive fees so is “guaranteed” to underperform.  That’s true, but it misses a major point.
The premise of Sharpe’s paper is that the performance, in aggregate, of all active managers [for a given asset class] is the index less active fees.
Wait.  Read that again.
Yes, that’s right.  The performance of all active managers is, in aggregate (for a given asset class) the index less active fees.  Sounds like a worse deal than an index fund? It’s because it is.  How is this?
Exploring the arithmetic of active
Take the UK equity market as an example.  There are approximately 600 companies in the FTSE All Share Index.
Now imagine there are only two managers of two active UK equity funds, Dr. Star and Dr. Dog.
Dr. Star consistently buys, with perfect foresight, the top 300 performing shares of the FTSE All Share Index each year, year in year out, consistently over time.  This is because he avoids the bottom 300 worst performing shares.  His performance is stellar.
That means there are 300 shares that Dr. Star does not own, or has sold to another investor, namely to Dr. Dog.
Dr. Dog therefore consistently buys, with perfect error, the worst 300 performing shares of the FTSE All Share Index each year, year in year out, consistently over time.  His performance is terrible.
However, in aggregate, the combined performance of Dr. Star and Dr. Dog is the same as the performance of the index of all 600 stocks, less Dr. Star’s justifiable fees, and Dr. Dog’s unjustifiable fees.
The performance of both active managers is, in aggregate, the index less active fees. It’s a zero sum game.
In the real world the challenge of persistency – persistently outperforming the index to be Dr.Star – means that over time it is very hard, in efficient markets to persistently outperform the index.
So investors have a choice.
They can either pay a game of hope and fear, hoping to consistently find Dr. Star as their manager.  Or they can be less exciting, rational investor who focus on asset allocation and implement it using index fund to buy the whole market for a given asset exposure keep fees down.
Given this poor “arithmetic” of active management, why would you ever chose an active fund (in aggregate, the index less active fees) over a passive fund (in aggregate the index less passive fees)? Quite.
Monitoring performance consistency
The inability of non-index active funds to consistently outperform their respective index is evidenced both in efficient market theory, and in practice.
Consistent with the Efficient Market Hypothesis, studies have shown that actively managed funds generally underperform their respective indices over the long-run and one of the main determinant of performance persistency is fund expenses .  Put differently, lower fee funds offer better value for money than higher fee funds for the same given exposure.  This is a key focus area from the UK regulator as outlined in the Asset Management Market Study.
In practice, the majority of GBP-denominated funds available to UK investors have underperformed a related index over longer time horizons.  Whilst the percentage of funds that have beaten an index over any single year may fluctuate from year to year, no active fund category evaluated has a majority of outperforming active funds when measured over a 10-year period.  This tendency is consistent with findings on US and European based funds, based on the regularly published “SPIVA Study”.
The poor value of active managers who “closet index”
“Closet indexing” is a term first formalised by academics Cremers and Petajisto in 2009 .  It refers to funds whose objectives and fees are characteristic of an active fund, but whose holdings and performance is characteristic of a passive fund.  Their study and metrics around “active share” and “closet indexing” caused a stir in the financial pages on both sides of the Atlantic as active fund managers started to watch the persistent rise of ETFs and other index-tracking products.  The issue around closet index funds is not simply about fees.  It’s as much about transparency and customer expectations.
Understanding Active Share
Active Share is a useful indicator developed by Cremers and Petajisto as to what extent an active (non-index) fund is indeed “active”.  This is because whilst standard metrics such as Tracking Error look at the variability of performance difference, active share looks at to what extent the weight of the holdings within a fund are different to the weight of the holdings within the corresponding index.  The higher the Active Share, the more likely the fund is “True Active”.  The lower the Active Share, the more likely the fund is a “Closet Index”.
How can you define “closet indexing”?
There has been some speculation as to what methodology the Financial Conduct Authority (FCA) used to deem funds a “closet index”.  In this respect, the European Securities and Markets Authority (ESMA), the pan-European regulator’s 2016 paper may be informative.  Their study applied a screen to focus on funds with 1) assets under management of over €50m, 2) an inception date prior to January 2005, 3) Fees of 0.65% or more, and 4) were not marketed as index funds.  Having created this screen, ESMA ran three metrics to test for a fund’s proximity to an index: active share, tracking error and R-Squared.  On this basis, a fund with low active share, low tracking error and high R-Squared means it is very similar to index-tracking fund.
Based on ESMA’s criteria, we estimate that between €400bn and €1,200bn of funds available across the EU could be defined as “closet index” funds.  That’s a lot of wasted fees.
Defining “true active”
We believe there is an essential role to play for “true active”.  By this we mean high conviction fund strategies either at an asset allocation level.
True active (asset allocation level): at an asset allocation level, hedge funds which have the ability to invest across assets and have the ability to vary within wide ranges their risk exposure (by going both long and short and/or deploying leverage) would be defined as “true active”.  Target Absolute Return (TAR) funds could also be defined as true active given the nature of their investment process.  Analysing their performance or setting criteria for performance evaluation is outside the scope of this book.  However given the lacklustre performance both of Hedge Funds in aggregate (as represented by the HFRX index) and of Target Absolute Return funds (as represented by the IA sector performance relative to a simple 60/40 investment strategy), emphasises the need for focus on manager selection, performance consistency and value for money. 
True active (fund level): we would define true active fund managers as those which manage long-only investments, either in hard-to-access asset classes or those which manage investments in readily accessible asset classes but in a successfully idiosyncratic way.  It is the last group of “active managers” that face the most scrutiny as their investment opportunity set is identical to that of the index funds that they aim to beat.
True active managers in traditional long-only asset classes must necessarily take an idiosyncratic non-index based approach.  In order to do so, they need to adopt one or more of the following characteristics, in our view:

• Conviction: the ability to show high conviction by allocating to securities with substantial deviation from benchmark weights (high active share)
• Concentration: the ability to create and manage a concentrated portfolio that includes sufficient securities for diversification purposes (for example, a minimum of 30 securities to create the possibility of a normal distribution), but not as many as the index they are trying to beat.
• Cash Limits: the ability and willingness to allocate up to the maximum level of cash allowed to dampen volatility in a risk off environment.

 
Their success, or otherwise, will depend on the quality of their skill and judgement, the quality of their internal research resource, and their ability to absorb and process information to exploit any information inefficiencies in the market.
True active managers who can consistently deliver on objectives after fees will have no difficulty explaining their skill and no difficulty in attracting clients.  By blending an ETF portfolio with a selection of true active funds, investors can reduce fees on standard asset class exposures to free up fee budget for genuinely differentiated managers.
Summary
In conclusion, “active” and “passive” are lazy terms.  There is no such thing as passive. There is static and dynamic asset allocation, there is systematic and non-systematic tactical allocation, there is index-investing and non-index investing, there are traditional index weighting and alternative index weighting schemes.  The use of any or all of these disciplines requires active choices by investors or managers.

What kind of investor are you: a stock selector, a manager selector or an index investor?

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.
 
In previous articles, we looked at things to consider when designing a multi-asset portfolio.  Let’s say, for illustration, an investor decides on a balanced portfolio invested 60% in equities and 40% in bonds.  The “classic” 60/40 portfolio.

You now have a number of options of how to populate the equity allocation within that portfolio.
We look at each option in turn.

Equity exposure using direct equities: “the stock selectors”
This is the original approach, and, for some, the best.  We call this group “Stock Selectors”: investors who prefer to research and select individual equities and construct, monitor and manage their own portfolios.  To achieve diversification across a number of equities, a minimum of 30 stocks is typically required (at one event I went to for retail investors I was slightly nervous when it transpired that most people attending held fewer than 10 stocks in their portfolio).  Across these 30 or more stocks, investors should give due regards to country and sector allocations.

Some golden rules of stock picking would include:

1. understand the macroeconomic factors that impact a company and its trading and reporting currency
2. understand what drives a company’s future earnings, and the risks to that earnings
3. evaluate the management to understand their strategy for the company

 
The advantage of investing in direct equities is the ability to design and manage your own style, process and trading rules.  Also by investing direct equities there are no management fees creating performance drag.  But when buying and selling shares, there are of course transactional, and other frictional costs, such as share dealing costs and Stamp Duty.
The most alluring advantage of this approach is the potential for index-beating and manager-beating returns. 
But whilst the potential is of course there, as with active managers, persistency is the problem.
The more developed markets are “efficient” which means that news and information about a company is generally already priced in.  So to identify an inefficiency you need an information advantage or an analytical advantage to spot something that most other investors haven’t.  Ultimately you are participant in a zero-sum game, but the advantage is that if you can put the time, hours and energy in, it’s an insightful and fascinating journey.
The disadvantage of direct equity is that if it requires at least 30 stocks to have a diversified portfolio, then it requires time, effort and confidence to select and then manage those positions. 
The other disadvantage is the lack of diversification compared to a fund-based approach (whether active or passive).  This means that direct investors are taking “stock specific risks” (risks that are specific to a single company’s shares), rather than broader market risk.  In normal markets, that can seem ok, but when you have occasional outsize moves owing to company-specific factors, you have to be ready to take the pain and make the decision to stick with it or to cut and run.

What does the evidence say?
The evidence suggests that, in aggregate, retail investors do a poor job at beating the market.
The Dalbar study in the US, published since 1994, compares the performance of investors who select their own stocks relative to a straightforward “buy-and-hold” investment in an index funds or ETF that tracks the S&P500, the benchmark that consists of the 500 largest traded US companies.
The results consistently show that, in aggregate, retail investors fare a lot worse than an index investor.
Reasons for this could be for a number of reasons, including, but not limited to:

• Information asymmetry: retail investors dabbling in stocks do not have the same access to information as professional investment managers and therefore may be late on to news, developments, or turning points that affect a share price.
• Behavioural biases: retail investors are subject to a range of behavioural biases that means they may be reluctant to sell winners (confirmation bias), and/or not quick enough to sell losers (status quo bias)
• Over-trading: retail investors may be tempted to “tinker” with their portfolio.  Some studies show that the more frequently investors trade their portfolios, the worse the performance can get.

So whilst it may be in the interest of some brokerages who rely on dealing costs for income to encourage investors to trade frequently, it may be in investors’ best interests to “buy and hold” their chosen 30 stocks and review them just once or twice a year.
But selecting the “right” 30 or more stocks is labour-intensive, and time-consuming.  So if you enjoy this and are confident doing this yourself, then there’s nothing stopping you.
Indeed, you may be one of the few who can, or think you can, consistently outperform the index year in, year out.  But it’s worth remembering that the majority of investors don’t manage to.
For most people, a direct equity/direct bond portfolio is overly complex to create, labour intensive to manage and insufficiently diversified to be able to sleep well at night.  Furthermore owning bonds directly is near impossible owing to the high lot sizes.  So why bother?
Investors who want to leave stock picking to someone else have two options to be “fund” investors selecting active funds.  Or “index” investors selecting passive funds.

Equity exposure using active funds: the “manager selectors”
A fund based approach means holding a single investment in fund which in turn holds a large number of underlying equities, or bonds, or both.
Investor who want to leave it to an expert to actively pick winners and avoid losers can pick an actively managed fund.  We call this group “Manager Selectors”.  But then you have to pick the “right” actively managed fund, which also takes time and effort to research and select a number of equity funds from active managers, or seek out “star” managers who aim to consistently outperform a designated benchmark for their respective asset class.  And whilst we all get reminded that past performance is not an indicator of future performance, there isn’t much else to go by.
In this respect access to impartial independent research and high quality,unbiased fund lists is an invaluable time-saving resource.
The advantage of this approach that with a single fund you can access a broadly diversified selection of stocks picked by a professional.  The disadvantage of this approach is that management fees are a drag on returns and yet few funds persistently outperform their respective benchmark over the long-run raising the question as to whether they are worth their fees.  This is evidenced in a quarterly updated study known as the SPIVA Study, published by S&P Dow Jones Indices, which compares the persistency of active fund performance relative to asset class benchmarks.  For efficient markets, such as US & UK equities, the results are usually quite sobering reading for those who are prefer active funds.  Indeed many so-called active funds have been outed as “closet index-tracking funds” charging active-style fees, for passive-like returns.
So of course there are “star” managers who are in vogue for a while or even for some time.  But it’s more important to make sure a portfolio is properly allocated, and diversified across managers, as investors exposed to Woodford found out.
In my view, an all active fund portfolio is overly expensive for what it provides.  Whilst the debate around stock picking will run and run (and won’t be won or lost in this article), consider at least the bond exposures within a portfolio.  An “active” UK Government Bond fund has the same or similar holdings to a “passive” index-tracking UK Government Bond fund but charges 0.60% instead of 0.20%, with near identical performance (except greater fee drag).  Have you read about a star all-gilts manager in the press? Nor have I.  So why pay the additional fee?
What about hedge funds? Hedge funds come under the “true active” category because overall allocation exposure can vary greatly, and there is the ability to position a fund to benefit from falls or rises in securities or whole markets, and the ability to borrow money to invest more than the fund’s original value.  But most “true active” hedge funds are not available to retail investors who are more limited to traditional “long-only” retail funds for each asset class.

Equity exposure using index funds: the “index investor”
Investors who don’ want the time, hassle or cost of picking active managers, or believe that markets are “efficient” often use passive index-tracking funds.  We call this group “Index Investors” (full disclosure: I am a member of this group!).  These are investors who want to focus primarily on getting the right asset allocation to achieve their objectives, and implement and actively manage that asset allocation but using low cost index funds and/or index-tracking ETFs.
The advantage of this approach is transparency around the asset mix, broad diversification and lower cost relative to active managers.  The disadvantage of this approach is that it sounds, well, boring.  Ignoring the news on companies’ share prices are up or down and which single-asset funds are stars and which are dogs would mean 80% of personal finance news and commentary becomes irrelevant!
On this basis, my preference is to be a 100% index investor – the asset allocation strategy may differ for the different objectives between my parents, myself and my kids.  But the building blocks that make up the equity, bond and even alternative exposures within those strategies can all index-based.

A blended approach
Whilst my preference is to be an index investor, I don’t disagree, however, that it’s interesting, enjoyable and potentially rewarding for some retail investors and/or their advisers to spend time choosing managers and picking stocks, where they have high conviction and/or superior insight.  Traditionally the bulk of retail investors were in active funds.  This is extreme.  More and more are becoming 100% index investors: this is also extreme.  There’s plenty of ground for a common sense blended approach in the middle.
For cost, diversification and liquidity reasons, I would want the core of any portfolio to be in index funds or ETFs.  I would want the bulk of my equity exposure to be in index funds, with moderate active fund exposure to selected less efficient markets (for example) small caps, and up to 10% in a handful of direct equity holdings that you follow, know and like.

What would a blended approach look like for a 60/40 equity/bond portfolio?
60% equity of which
                Min 70% index funds/ETFs
                Max 20% active funds
                Max 10% direct equity “picks”/ideas
40% bonds of which
                100% index funds

Summary
For most investors, investing is something that needs to get done, like opening a bank account.  If you are in this group then using a ready-made model portfolio or low-cost multi-asset fund, like a Target Date Fund, may make sense.
For some investors, investing is more like a hobby – something that you are happy to spend time and effort doing.  If you are in this group, you have to decide if you are a Stock Selector, Manager Selector or Index Investor, or a blend of all three, and research and build your portfolio accordingly.

 

• Focus on index methodology
• Looking at concentration risk
• Index selection is an active choice

 
Focus on index methodology
Methodology is the genetic code of an index.  The rules that govern how an index is constructed determines what’s in it, at what weights, and therefore how it will perform in relation to the performance of all its components.
A handful of (mainly older) indices are price-weighted indices (such as the DJIA (in the US, since 1896), FT30 (in the UK, since 1935), and Nikkei 225 (in Japan, since 1950).  This means the weight of each stock in the index is determined by its price relative to the summed prices of all the constituents of the index.
The bulk of the most familiar, and most tracked, indices are capitalisation-weighted indices.  This means the weight of each stock in the index is determined by its (often free-float-adjusted) market capitalisation relative to the aggregated market capitalisation of all the constituents of the index.
This leads to one of an oft-cited critique of mainstream indices that they become “pro-cyclical”: namely, they allocate an increasing weight to the best performing stocks, and a decreasing weight to the worst performing stocks.  This is true, but is coloured by your view as to which comes first, the stock performance chicken, or the index performance egg.
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Looking at concentration risk
What is certainly true is that changes in company capitalisation can create significant stock concentrations in mainstream indices.  For example, the top 5 holdings in the S&P 500 (Apple, Microsoft, Amazon, Alphabet and Facebook) currently represent 21.6% of that index.  The top 30 stocks represent 44.6%, and the top 100 stocks represent 69.9%.  The remaining 400 stocks are a long tail of relatively smaller companies whose individual change in value will not materially impact the overall index performance.

Fig.1. S&P500 Concentration

Size-bias is a choice not an obligation
Index concentration, and related “size-bias”, the relative over-weighting of the largest companies, is however a choice, not an obligation for index investors.
The existence of equal-weight indices enable a less concentrated exposure to the same components of an index.  Whilst this solves the stock concentration risk, it creates a “Fear of Missing Out risk” when those large stocks are doing well.
So, if choosing to use an equal-weighted index to reduce dependency on a concentrated index, communication is key.
Reducing stock-specific risk may be welcome with end clients in theory, but clear messaging is required to explain that investment performance will not be comparable to the performance of funds (whether active or passive) using traditional capitalisation weighted benchmarks.
End investors may feel they miss out when sentiment in the largest names is strong.  But will be relieved when the reverse applies.  On the basis that many investors are asymmetrically loss-averse, the more evenly distributed stock risk of an equal-weighted index could be something to consider.  But only once any potential “Fear of Missing Out” has been discussed and addressed.

Fig.2. S&P 500 vs S&P 500 Equal Weight, YTD Performance (USD terms); Fig.3. & FTSE 100 vs FTSE 100 Equal Weight, YTD Performance (GBP terms)

Source: Elston Research, Bloomberg data, as at 18-Sep-20
 
Index selection is an active choice
There’s no such thing as passive.  Index investing is about adopting a systematic, rules-based approach to stock selection.  There is an active choice to be made around methodology and index selection.  If you don’t want to always hold the largest stocks, then don’t use a cap-weighted index.  If you want to hold stocks based on other criteria – their earnings, their dividends, their style, or just equally weighted – there are plenty of other indices to choose from.  It’s up to the index investor to make that active choice.