Incorporating ETFs into your portfolio
By Leo M. Zerilli, CIMA
Published on March 2016
"In discussing portfolio construction with financial advisors, we find that there are essentially three implementation approaches, each of which includes varying degrees of active and passive exposure."
Head of Investments at John Hancock Investments
Since their U.S. launch in 1993, exchange-traded funds (ETFs) have grown from a single S&P 500 Index-based ETF with $6.5 million in assets to a $2 trillion industry today. The investment vehicle’s devoted following is due in large part to its ability to offer a wide variety of investment objectives and risk profiles in a cost-effective manner. This flexibility is a key reason financial advisors and portfolio managers employ ETFs in the construction of portfolios alongside active strategies. At John Hancock Investments, our research working with financial advisors reveals that ETFs are typically allocated in one of three ways: as a minority position to achieve tactical exposure, as roughly half of a portfolio’s beta, or as the primary vehicle for market exposure. In this paper, we discuss the history and characteristics of ETFs and examine some common strategies for implementing them in a diversified portfolio.
The first ETF was launched in 1993 and tracked the S&P 500 Index. Over time, ETFs gained acceptance as investment vehicles that combine the simplicity and low cost of index mutual funds with the flexibility of individual stocks. Most ETFs in the United States are structured as open-end investment companies or unit investment trusts, and investors can buy or sell ETF shares through a brokerage account, just as they would shares of a publicly traded company.
As with mutual funds, an ETF must calculate its net asset value (NAV)—the value of its assets minus its liabilities—every business day, which it typically does at market close. However, approximately every 15 seconds throughout the business day, an ETF’s estimated NAV is calculated and distributed through quote services. Often, an ETF’s intraday value can be found by searching the ETF’s ticker symbol, just like a stock.
Since their debut more than two decades ago, ETFs have grown to become a staple of individual and institutional investor portfolios. Beyond the convenience of intraday trading, ETFs have also become significantly more diverse. Initially designed to closely track the performance of U.S. equity indexes, ETFs today number nearly 1,600, with countless varieties designed to match indexes in international, fixed-income, commodity, currency, and other specialty markets.
While the adoption of ETFs by do-it-yourself individual investors has been a fairly recent phenomenon, acceptance among investment professionals has a much longer record. Today, for the first time in their history, ETFs have become more highly recommended by professionals than mutual funds; they were recommended by a narrow 81% to 78% margin, respectively, in a 2015 survey.2 That finding indicates a rapid rate of acceptance since 2006, when just 40% of advisors indicated that they used or recommended ETFs. The most significant advantages that advisors cited for ETFs were lower costs, tax efficiency, trading flexibility, transparency of holdings, and diversification.
Passively managed ETFs and actively managed mutual funds have many similarities. They are both registered as investment companies under the Investment Company Act of 1940 and are regulated by the Securities and Exchange Commission. Both are constructed as a grouping of investments (stock, bonds, and/or derivatives), and new shares can be created or redeemed at any time. They both also follow the same valuation procedure and calculate their NAVs at the close of trading each day (although ETFs estimate a NAV throughout the day). However, passively managed ETFs differ from actively managed mutual funds in several ways that make them attractive to many investors.
In the second part of this paper, we detail how professional portfolio managers and financial advisors employ ETFs in the construction of client portfolios.
The debate over whether an investor should choose a purely active or purely passive approach is misguided, in our opinion, because investors can benefit greatly by combining both approaches in the same portfolio. Passive ETF strategies can achieve broad market exposure inexpensively and efficiently or enable tactical exposure to certain asset classes and markets. Active strategies can extend the reach of that portfolio—producing uncorrelated sources of return—or help mitigate risk and add performance alpha, depending on an investor’s goals. As a result of these complementary qualities, we believe blending active and passive management is most advantageous for investors, and we are not alone in our thinking. According to the “2015 Trends in Investing Survey,” 61% of financial advisors prefer a blend of the two asset management styles when overall portfolio cost was a consideration.2
As the variety of ETFs has grown beyond the category’s index-replication roots, so too has the potential for executing strategies that borrow from the ideas of active portfolio construction. Strategic, or smart, beta is a good example. Strategic beta investment strategies seek to improve on traditional market-capitalization-weighted indexes by pursuing many of the same goals as actively managed portfolios. But unlike active funds, strategic beta indexes and the portfolios that track them tend to follow rules-based, highly transparent, and lower-cost approaches to investing. For example, by altering the composition of the S&P 500 Index so that securities are weighted equally rather than proportionally by market capitalization, a strategic beta strategy can emphasize smaller-capitalization names without day-to-day active management. By definition, market cap weighting, the methodology used by the S&P 500 Index and many other traditional benchmarks, places greater emphasis on shares of larger, more expensive companies, which can produce unintended risk concentrations at particularly inopportune times (as happened during the 2000 tech bubble and the 2008 financial crisis). The goal of the equal-weighted strategic beta strategy in this case is to outperform the S&P 500 Index while maintaining the low-cost structure of a passive approach. In addition to specific portfolio construction rules, strategies can also be constructed to suit particular investor objectives.
Investors have allocated more than $400 billion to strategic beta ETFs globally across a wide range of styles, including returnoriented strategies that screen for attributes such as dividends, value, growth, momentum, buybacks, and quality. There are also risk-oriented strategies that attempt to minimize volatility, achieve a low or high beta, or use other risk-weighting methods.
From an asset allocator’s perspective, we believe it’s a good idea to blend both active and passive investment management styles by using passive strategies for low-cost beta exposure and surrounding them with the alpha opportunities that active strategies can generate.
The potential applications for combining active and passive strategies in a portfolio include:
The asset allocation team at John Hancock Asset Management has been blending active and passive strategies since 2005. Passive strategies are used as low-cost solutions to implement long-term structural, broad market, and strategic exposures, and are also sometimes used to achieve tactical exposures. Rather than gaining exposure and then removing it in the short term, passive strategies have the flexibility to tilt portfolios toward certain areas of the market.
The asset allocation team also makes portfolio construction decisions with a view toward the cyclical nature of performance.
For example, certain market conditions drive better relative performance in active management versus passive management, and vice versa. Having both active and passive strategies available can be beneficial because investment styles can move in and out of favor.
Almost two-thirds of financial advisors use some form of passive investment vehicle (usually ETFs) when constructing client portfolios. Allocations to ETFs range from a mere 3% in more active portfolios to a 73% ETF allocation, on average, in more passive portfolios.3
In discussing portfolio construction with advisors, we find that there are generally three implementation approaches: mostly active, partially passive, and mostly passive.4
Over the past 20-plus years, ETFs have grown in both variety and assets under management, and today they represent a key component of many investor portfolios. Most financial advisors recommend a blend of active and passive strategies when constructing portfolios for their clients, a sentiment echoed by our own view and that of the asset allocation team responsible for managing some of the largest asset allocation funds in the industry. When discussing specific portfolio construction ideas with financial advisors, we find that they implement ETFs in one of three distinct ways: to achieve tactical exposure, as part of the core market exposure, or as the main market exposure.