Incorporating ETFs into your portfolio

By Leo M. Zerilli, CIMA

Published on March 2016

 

Key takeaways

  • In little more than 20 years, ETFs have become a staple in many investor portfolios, and for good reason: They provide intraday liquidity, transparency, tax efficiency, and access to specific markets at a relatively low cost.
  • Investors have allocated more than $400 billion to strategic beta ETFs globally across a wide range of styles, including return-oriented strategies that screen for attributes such as dividends, value, growth, momentum, buybacks, and quality.1
  • Financial advisors generally approach ETF implementation in one of three ways, and with varying degrees of active and passive exposure in each portfolio.

"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."

Leo M. Zerilli, CIMA

Head of Investments at John Hancock Investments

Executive summary

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 allure of ETFs: blending the low-cost exposure of indexes with the intraday trading convenience of stocks
 

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.

Net assets and total number of ETFs have grown over the years

Comparison with actively managed mutual funds
 

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.
 

Passively managed ETFs are typically less expensive than actively managed mutual funds
 

  • Most ETFs track indexes, and tracking an index is inherently less expensive than daily active management.
  • ƒƒ ETFs are traded through a brokerage account, and the ETF sponsor does not need to account for the expense of shareholder recordkeeping.
     

Passively managed ETFs are structurally more tax efficient than actively managed mutual funds
 

  • ETFs generate tax savings from their structure. When dealing with fund flows, especially redemptions, ETFs can minimize the likelihood of generating taxable capital gains by exchanging securities in kind (not through a monetary transaction).
  • ƒƒETFs have a much lower turnover than mutual funds because most ETFs passively track an index.
     

Passively managed ETFs are transparent due to the daily disclosure of assets
 

  • ETFs make their holdings available on a daily basis, while mutual funds generally do so only monthly or quarterly, with semiannual updates.
  • ETFs disclose whether they lend out securities and give detail of the collateral they hold, while mutual funds are not required to do so.
     
ETFs vs. mutual funds: Key differences

Implementing ETFs: real-world examples
 

In the second part of this paper, we detail how professional portfolio managers and financial advisors employ ETFs in the construction of client portfolios.
 

Most financial advisors recommend a blend of ETFs and active strategies
 

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
 

"61% of financial advisors recommend a blend of active and passive approaches for their clients."
 

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.

Financial advisors have increasingly recommended ETFs

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.
 

An asset allocator’s perspective
 

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:
 

  • Using active management as a core, flexible holding and passive management as a low-cost source of beta in efficient markets
  • Using active management to provide noncorrelated sources of return and passive management to provide precise, tactical exposure to certain asset classes
  • Using active management to mitigate risk and/or produce performance alpha and passive management to reduce the overall cost of the portfolio
     

Our experience combining active and passive strategies
 

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.

John Hancock's retirement portfolios blend active and passive strategies

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.
 

"It’s important to have both active and passive strategies available in the toolkit when managing portfolios over the long term."
 

Our work with financial advisors reveals three widely used approaches to ETF implementation
 

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

Incorporating ETFs into your portfolio: Examples of implementation styles employed by financial advisors
ETFs: advisor sample portfolios

Conclusion
 

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.

1 “Are Strategic Beta ETFs a Threat to Active Fund Managers?” Hortense Bioy, CFA, Morningstar.com, 4/23/15.

2 “2015 Trends in Investing Survey,“ Financial Planning Association, Research and Practice Institute, Journal of Financial Planning, 2015.

3 Ignites, May 2015.

4 John Hancock Asset Management, July 2015.

ETFs are subject to trading costs, and frequent trading of ETFs may accrue significant expenses that outweigh the benefits of a lower expense ratio.

Active investment strategy regularly takes investment positions that clearly differ from those of the portfolio’s performance benchmark, with the objective of outperforming the benchmark over time.

Passive strategies are designed to mimic market benchmark indexes and minimize trading costs.

Alpha is typically used to represent the value added or subtracted by active investment management strategies.

Alternative investments are not categorized as stock, bond, or cash investments.

Beta measures the volatility of a security or portfolio in comparison with the market as a whole.

Correlation measures the relationship between two investments—the higher the correlation, the more likely they are to move in the same direction for a given set of economic or market events.

Market cap weighting generally refers to an index whose individual components are weighted according to their market capitalization.

Niche alpha refers to concentrated active investment exposure.

The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index.

Strategic beta—along with multifactor investing, smart beta, fundamental indexing, and a few other related expressions—broadly refers to a diverse and growing category of rules-based approaches to investing in various markets.

Tracking error measures the divergence between the price behavior of a portfolio and that of a benchmark index.
 

Diversification does not guarantee a profit or eliminate the risk of a loss.

Past performance does not guarantee of future results.
 

Large company stocks could fall out of favor. The stock prices of midsize and small companies can change more frequently and dramatically than those of large companies, and value stocks may decline in price. A portfolio concentrated in one sector or that holds a limited number of securities may fluctuate more than a diversified portfolio. ETF shares are bought and sold through exchange trading at market price (not NAV), and are not individually redeemed from the fund. Shares may trade at a premium or discount to their NAV in the secondary market. Brokerage commissions will reduce returns. A fund’s holdings and returns may deviate from those of its index due to various factors. This deviation may be greater when markets are volatile or subject to unusual conditions.
 

John Hancock Retirement Living Portfolios’ performance depends on the advisor’s skill in determining asset class allocations, the mix of underlying funds, and the performance of those underlying funds. The portfolio is subject to the same risks as the underlying funds and exchange-traded funds in which it invests: Stocks and bonds can decline due to adverse issuer, market, regulatory, or economic developments; foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability; the securities of small companies are subject to higher volatility than those of larger, more established companies; and high-yield bonds are subject to additional risks, such as increased risk of default. Each portfolio’s name refers to the approximate retirement year of the investors for whom the portfolio’s asset allocation strategy is designed. The portfolios with dates further off initially allocate more aggressively to stock funds. As a portfolio approaches and passes its target date, the allocation will gradually migrate to more conservative, fixed-income funds. The principal value of each portfolio is not guaranteed, and you could lose money at any time, including at, or after, the target date. Certain market conditions, including reduced trading volume, heightened volatility, and rising interest rates, may impair liquidity, the ability of the portfolio to sell securities or close derivative positions at advantageous prices. Hedging and other strategic transactions may increase volatility and result in losses if not successful. Please see the portfolio’s prospectus for additional risks.
 

A fund’s investment objectives, risks, charges, and expenses should be considered carefully before investing. The prospectus contains this and other important information about the fund. To obtain a prospectus, contact your financial professional, call John Hancock Investments at 800-225-5291, or visit our website at jhinvestments.com. Please read the prospectus carefully before investing or sending money.