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.

The flexibility of ETFs makes the opportunities for building low-cost portfolios almost limitless

By Dwarka Lakhan | Mid-November 2012

Whatever your client's risk profile, you can build a diversified portfolio using a mix of passive and actively managed exchange-traded funds (ETFs) or by using a combination of ETFs and other actively managed products, such as mutual funds.

The choice of using an ETF-only strategy vs one that involves a combination of ETFs and mutual funds in portfolio construction depends on several factors, the most important being performance, fees, suitability, accessibility and flexibility.

Regarding performance and fees, over the five-year period ended December 2011, only 3% of active Canadian equity funds were able to outperform their benchmark after fees, says Mary Anne Wiley, managing director and head of iShares Canada, a division of BlackRock Asset Management Canada Ltd., in Toronto.

This means your clients can "get a more predictable source of return," says Howard Atkinson, CEO of Horizons ETFs Management (Canada) Inc. in Toronto, "knowing that by investing in low-cost ETFs, they are enhancing their returns."

Whether clients choose a passive or an active strategy will depend largely on performance. "If an indexing ETF has a better long-term track record," Atkinson says, "investors will opt for that ETF. Or, if a certain active manager has a better track record, then investors will go with that ETF."

The flexibility that comes with ETFs makes construction opportunities limitless, Wiley says. ETFs cover just about every geographical region, industry sector and specialty category. However, she adds, unlike mutual funds, which may have similar coverage, ETFs are more accessible and simpler to use.

If you use only ETFs to construct a client's portfolio, all you need is "five or six ETFs," says Vikash Jain, vice president, portfolio management, with archerETF Portfolio Management, a division of Oakville, Ont.-based Bellwether Investment Management Inc. However, he cautions, some ETFs - such as those using futures contracts, leverage and inverse leverage - are designed for short-term trading and are not necessarily suitable for longer-term investing.

For example, Jain warns, investors may assume that investing in a crude oil-based ETF, which uses futures contracts as its underlying investment, will provide the same return as that of the commodity. But as a result of the pricing difference between the futures contracts and the spot price of oil, the ETF's return does not reflect the current price of oil.

Wiley says ETFs provide investors with a level of diversification that minimizes individual security risk. Your clients can obtain exposure to specific segments of the market and get in and out of these segments in a transparent and efficient manner, allowing your clients to combine actively and passively managed core positions effectively with satellite holdings.

These satellite positions could be rotated easily to adjust the risk of the portfolio or to enhance returns at different periods, depending on the outlook for the specific market segment or sector.

"This is important," Wiley says, "to address investor nervousness."

For example, you can build a diversified portfolio for an aggressive investor by using an asset mix comprising 70% equities and 30% fixed-income. The core equities component - say, 60% of total assets - can be invested in ETFs linked to the S&P/TSX composite index for Canadian exposure, to the S&P 500 for U.S. exposure and to the MSCI world index for global exposure. The remaining 10% of the equities (the satellite positions) can be invested in specialty ETFs that target a specific sector or country.

The fixed-income component of this portfolio can be invested in a combination of government, corporate and high-yield securities.

On the other hand, for a moderately aggressive investor, you could use the same core ETFs in combination with core fixed-income ETFs linked to investment-grade government or corporate bonds, then, for added torque, add a high-yield bond ETF or one linked to emerging-market debt. A covered-call ETF also could be added for more certainty in income; or use a low-volatility ETF for equities exposure with downside protection.

A conservative client's portfolio could be overweighted in primarily investment-grade and corporate bond ETFs, with some exposure to core equity ETFs.

Alternatively, actively managed equity or bond mutual funds could be used as the core component of a client's portfolio, then complemented with satellite ETFs linked to sectors that are favoured by the client.

"An active approach," Atkinson says, "particularly in income investing, might be the superior approach. If you can get active exposure at a low management fee, it's definitely worth investigating. There are some great low-cost, actively managed ETFs and mutual funds that complement indexing strategies in a portfolio."

As Mark Raes, portfolio manager with BMO Asset Management, a division of Bank of Montreal, in Toronto, says: "It all depends on whether you are taking a top-down or bottom-up approach to portfolio construction." ETFs can be used as building blocks, he adds, to fill the gaps in a more actively managed portfolio.IE

Coming in the December issue: ETFs and income; plus, ETFs and liquidity.

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