On balance: weighing up ETFs against other options in portfolio management

When it comes to portfolio construction and asset allocation, which areas do ETFs tend to have the advantage? Peter Sleep, Senior Investment Manager, Seven Investment Management (7IM) gives his opinion on how advisers can seek the best value approach for clients.

A perennial question facing many advisers is how they might put together an investment portfolio for clients and use active funds or ETFs.  Most advisers will agree that this is a bit like asking how long a piece of string is. It certainly doesn’t have to be an either/ or scenario – as our own portfolios testify.

But frustratingly, the answer is not easy and it inevitably involves a lot of tooth sucking and head scratching. We do this because it is a difficult question and there is no clear answer, not because I want to be enigmatic or evasive.

Client first

Advisers will know all too well that putting together a portfolio is a very personal thing. It will depend on your client’s time horizon and whether they are willing to accept losses in exchange for long term returns – even then there is a high degree of uncertainly to build in. This is why advisers spend so much time with risk tolerance questionnaires. It is also where they can really add a lot of value. Perhaps one of the great conundrums facing advisers is the fact that whilst past performance is absolutely no guide to future returns, we can still draw on the past to try to gauge how that might inform the future. Some of the best mathematical and computer science people in the world work in the savings and finance industry and I think they will all agree that there are no absolute correct answers for any investor or their adviser.

For the purposes of this article, I shall assume that you have had a long hard think about your client’s personal situation and that they have a very long time horizon, but that they do not really want to take a great deal of risk. A “balanced” investor might invest 50% of their portfolio in bonds and 50% in equities. Even though this sounds conservative, nearly all the ups and downs you suffer will probably come from the equities in the portfolio. The risk experts at 7IM tell me that about 85% of the volatility you will experience will probably come from the equity components of your portfolio.  An adviser can really add value in this area by explaining the risks upfront and by guiding their clients through the market downturns.

Active funds or ETFs?

Whether you should use active funds or ETFs seems to be the next question.  Here I think personal preference is again key. Whilst with any age-old debate, there’s always that element of ‘six of one and half a dozen of the other’, there is much evidence to suggest that as a group, active managers find it difficult to add value. However, on the other hand, some might argue that you are guaranteed to underperform by the fees with an ETF. At least with an active manager you have the chance of outperforming and there is some value in that option.

Advantage ETFs?

At 7IM we tend to sit on the fence on the active versus passive argument.  It is very hard to find an active manager who consistently outperforms in areas like government bonds, so it seems like a good idea to save your time and reduce fees by selecting ETFs in these areas. A holding in high grade, developed market global bonds is a key component of most portfolios, despite their low yields.  Not always, but usually, when equity markets go down, high grade bonds generally go up and act as a bit of a cushion for your portfolio.

I say this knowing that this has not always been the case. In the bad old, high inflation days of the early 1970s, when bonds were known as “certificates of confiscation”, bonds were not great for balanced portfolios. Expect to pay between 0.1% and 0.2% for a government bond ETF and if there is an overseas component you may decide to look for a hedged ETF.  To hedge or not to hedge is not clear cut, as hedging removes exposure to some of the world’s safe haven currencies like the US dollar and the Japanese yen, but on balance we believe that bonds are low risk assets and removing currency volatility through hedging can be a good thing.

When it comes to corporate bonds we think ETFs tend to win out.  Generally, it is very hard to find an active manager in this area and an adviser might prefer to spend their efforts in other areas with greater added value. An ETF will cost around 0.2%, whereas an active fund will cost twice that.

Advantage active funds?

High yield, Emerging Market bond and convertible bond ETFs are generally priced at levels close to the active managers and these are areas where good fundamental research by an active manager can really pay off, so an adviser might want to spend some time trying to find a good active manager.

Equities are an area where an adviser can add value by trying to find active managers. This can be done by selecting a global equity manager or by a series of UK and country / regional portfolio managers. Historically investors have struggled to find active managers in the US – the argument being that the markets are “too efficient” for active managers to outperform. The reality may be that the market has been led higher by a few very large tech companies, whereas portfolio managers tend to prefer smaller stocks with room to grow. If you think that the large tech companies may have had their day in the sun, then it could be worthwhile looking for a US active manager who invests in smaller US stocks. The same is true for the other major markets like Europe, Japan and the Emerging Markets. We think it is generally worth spending time to find an active manager in these areas.

I have given a personal outline of how I think an adviser might combine ETFs and active funds. There is a lot of room to be creative within this outline by perhaps including some of the ethical or gender equality ETFs that are now emerging and gaining traction. However, perhaps the greatest added value comes from the adviser’s relationship with their clients. By ensuring that they are in the correct risk category and keeping those clients invested in the market through thick and thin, ensures that they can benefit from the long term returns they need, in order to meet the all-important objectives of their financial plan.

Peter Sleep – Senior Investment Manager, Equities
Peter joined 7IM in 2007. Having qualified as a chartered accountant, Peter audited company accounts, before joining Citibank as an internal auditor. After three years in that role, he worked for 11 years in Citibank/Citigroup as fund manager and analyst. Prior to joining 7IM he worked as an analyst at Man Group. Specialist areas/responsibilities: portfolio strategy, quant funds, investment auditing, alternative assets/methodologies and Japanese equities.