Special Feature

The evolution of ETFs

In November 2012: more products and lower fees. In Mid-November 2012: ETF product innovation; plus portfolio construction. In December: fixed-income ETFs and lurking liquidity risks. Plus Barry Gordon discusses how to use ETFs in portfolio construction.

Although investors like traditional index-linked ETFs, they also want products that meet specific needs

By Dwarka Lakhan | Mid-November 2012

The crowded market for traditional, passively managed, index-linked exchange-traded funds (ETFs) has led to the emergence of new breeds of that product: actively managed and specialty ETFs.

"The number of opportunities in the indexing space is fast drying up," says Howard Atkinson, CEO of Horizons ETFs Management (Canada) Inc. in Toronto, "and the indexing space is starting to become saturated." But as the elbow room in the traditional market gets tight, he adds: "The growth potential for new ETF launches becomes almost limitless if you include active strategies."

Investors are looking to build ETF portfolios that can meet more defined investment objectives in one trade, says Oliver McMahon, director and head of product management with iShares Canada, a division of BlackRock Asset Management Canada Ltd. in Toronto. Actively managed ETFs, for example, seek to meet those objectives.

"These ETFs aim to outperform rather than replicate a particular index," says Kevin Gopaul, chief investment officer and senior vice president with BMO Asset Management, a division of Bank of Montreal, in Toronto. "[They] use a strict set of rules in their construction to provide objectives-based solutions."

Popular actively managed ETF strategies include those that use low-volatility, covered-call and customized "intelligent indexing":

- Low-volatility ETFs are meant to protect clients from wild market swings. They are designed, says McMahon, for investors who have become disillusioned with the broad stock market. He warns that this strategy is similar to traditional stock-picking and is based on the ETF manager's ability to pick the right stocks.

However, says Gopaul, ETF providers may use their unique methodology to construct portfolios.

Typically, low-volatility ETFs invest in a basket of stocks that have less volatility than the overall market. These stocks are selected based on their beta - their sensitivity to the broad market - says Vikash Jain, vice president, portfolio management, with archerETF Portfolio Management, a division of Oakville, Ont.-based Bellwether Investment Management Inc.

A stock with a beta of 1, for example, moves in sync with the market, whereas a stock with a beta of less than 1 is less volatile than the market.

"One would assume," says Atkinson, "these stocks will decline by less than the broad market during a pullback - and, presumably, they will rise less quickly during a growth market."

Jain says that these ETFs are relatively stable and, because they invest in stocks that pay dividends, they can be used to "smooth out your cash flow" to offer potentially stable returns.

- Covered-call ETFs use a strategy that involves writing (i.e., selling) call options contracts while owning the equivalent number of shares of the underlying stocks on which the call options are written. "Call options may be written on all or a portion of the underlying portfolio," says Atkinson.

These ETFs are designed to provide investors with two sources of income - dividends from the stocks held in the portfolio and premiums from writing the call options.

In a covered-call ETF, a call option is usually sold at a premium to the prevailing market price of the underlying stock. This premium is retained by the ETF, regardless of whether the option is exercised or allowed to expire. Says Atkinson: "Call writing on a security essentially creates additional income by selling away some of the upside price potential of the underlying securities."

These ETFs may reduce downside volatility, warns Jain: "But you do not necessarily get the best of the upside or the worst of the downside [of the market]."

Atkinson says that call writing historically has been found to generate returns with lower volatility and to outperform plain, long-only strategies during mild bull, bear and range-bound markets.

On the other hand, Jain adds: "This strategy works well if stock prices are heading up steadily and slowly, but does not necessarily work well when markets are choppy." That is because there is greater potential to earn premiums in a rising market.

- The use of customized intelligent indices to create ETFs gives investors access to certain areas of the market. "[This involves] the creation of products that target specific sectors of the market," McMahon says, "providing investors with a lot more opportunities to fine-tune their investment strategy."

These ETFs are not considered to be a core component of a portfolio and may replicate a sector within a broad index, such as the MSCI world index or the S&P 500 composite index. For example, says McMahon, an intelligent ETF can be based on the MSCI Thailand index or an index linked to silver or gold.

Customized intelligent indices also can be used to construct portfolios using specific variables such as stocks with the lowest 40 betas in a broad index such as the S&P/TSX 300, says Mark Raes, portfolio manager with BMO Asset Management in Toronto. With these ETFs, he says, there usually are "no copycats."

Arguably, your clients can construct a diversified portfolio using a combination of passive and active ETFs. Or clients can use ETFs in combination with products such as mutual funds.

Future ETF portfolios are likely to be a blend of actively managed and passive index strategies, Atkinson says, in which investors choose the strategies that are best for a given asset class. IE

Part 2 of a three-part series on exchange-traded funds

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