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Five ways professional advisers are using ETFs
The exchange traded fund sector moved from strength to strength in 2020, seeing massive flows from retail and professional investors alike. They have also been among some of the best performing investments for the year. Yet with such a great diversity of opportunities available to even the most inexperienced investors, it has never been more important to understand the purpose and role of each investment in your portfolio.
One of the key benefits of engaging with a financial adviser is that a formal relationship tends to bring with it a more formal and disciplined approach to investing. Typically coming in the form of an Investment Policy or Investment Strategy document, these should outline your preferred asset allocation, investment vehicle, tolerance to risk and areas of interest.
At times it feels like a new ETF is being issued every other week. In one week it may be a new ‘thematic’ production, the next a ‘market cap’ based passive option and another an actively managed fund offered in ETF form. So how do they all fit in portfolios? In the sections that follow I attempt to summarise the five ways that professional investors tend to use productions.
Core
For many investors, ranging from financial advisers to large super funds, the primary focus is on keeping the fees levied on their clients to an absolute minimum. This could be for several reasons, but in the case of large super funds, it is based on a ‘fee budget’ that they must meet. With the traditionally higher performing investments like private equity and unlisted property charging significantly higher fees, using lower cost, passive share ETFs or index funds allows them to spend more elsewhere. On the other hand, those willing to accept the performance of the index, for better or worse, also tend to use ETFs as their core exposures.
An important consideration for investors, however, is that these core holdings tend to focus on only one factor, being size, when many factors have influenced performance over time. In this context, size refers to market capitalisation which determines the weightings within traditionally sharemarket indices. For those willing to dive deeper, many ETFs now offer access to other factors ranging from momentum, to quality, value and volatility.
Thematic
Long identified as the most likely source of long-term investment returns, thematic investing has yet to be fully embraced by the self-directed and financial advisory space. Thematic investing simply involves identifying what one believes to be the most powerful societal, economic or demographic themes in the decades to come, and seeking to invest into them in the most efficient way.
One theme that has been common in Australia for several decades has been the search for income or franking credits. More recently though thematic investing has taken on a decidedly growth focus. Some of the fastest growing and most important themes for Australian investors at the current time include the commercialisation and expansion of the battery and electric vehicle sector, the digitisation of the global economy with sub themes ranging from e-commerce to cyber security. Another important theme has been the growth in demand for more sustainable and socially aware investments whether that involve investments in clean energy, the avoidance of fossil fuels, advanced materials and the like.
Geographic weighting
Similar to the thematic weighting, is geographic spread. The pandemic offered a first-hand experience into why it is no longer sufficient to rely on ASX-listed companies with exposure to say the US or Chinese markets as a ‘proxy’ for a direct exposure; Treasury Wine being a perfect example. The economic shutdowns throughout 2020 also evidenced the huge difference emerging in the growth and investment opportunities throughout Asia and other less popular parts of the world.
Professional investors are increasingly utilising country or region specific exposures in order to both diversify their ‘core’ portfolios but also gain access to faster growing and more attractive companies. These could be as simple as buying a Chinese or Indian sharemarket ETF, of stepping back further and seeking consumer-facing businesses across the Asian region.
Sector weightings
Whilst among the least common and least available ETFs in Australia, an increasing number of options are being made available that offer exposure to a single sector of the economy. One of the biggest issues facing investors who use ETFs as their core exposure to sharemarkets, is the fact that these indices are actually higher concentrated. For example, has 27% invested into financials and 21% into mining companies, which is clearly not great diversification.
For those seeking to increase their exposure to individual sectors ranging from resources, to smaller companies and infrastructure, as well as potentially expanding into other asset classes like bonds, ETFs can play an important role.
Hedging
In an environment where both bond and equity markets are near all-time highs, diversification has never been more important. Yet for those focused on investing via ETFs or direct markets only the options can be somewhat limited at times. Gold bullion remains the most popular alternative asset or hedge available via ETFs, but there is a growing suite of investments being made available to direct investors.
The ultimate purpose of a hedge is simple, to find assets that will not fall when sharemarkets fall. This offers the option for the investor to sell their hedge to purchase further shares at depressed prices or when ‘blood is on the streets’. In 2021 a diverse range of opportunities is now available ranging from traditional commodity exposures like gold, silver and platinum, to less traditional, derivative driven strategies or ‘bear funds’. These funds tend to offer an exposure to something like the Volatility or VIX index, which tends to increase as markets fall, or alternatively, use options to ensure the investment moves in the opposite direction of the sharemarket.
There are clearly many options available, offering substantial power and opportunity for investors of all types. As a financial adviser by trade, however, I must provide a warning. Every investment should form part of a disciplined and organised investment strategy. If not, investors risk constructing portfolios that carry significantly more risk than the alternative.
