While it’s safe to say that most advisers know what exchange-traded funds (ETFs) are now, how to actually incorporate them into a portfolio is not yet fully understood. Krystine Lumanta reports.
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Exchange-traded funds (ETFs) have now been around for more than a decade – ample time for financial planners to have worked out what they are. But now, planners are grappling with the how question: How to use ETFs constructively in developing investment portfolios.
Robyn Laidlaw, head of product develop- ment and management at Vanguard, says that if planners already understand the benefits of ETFs, they will quickly grasp the “context of where they might play a role in portfolios”.
“Being low-cost, they offer diversification, there’s a liquidity of the ASX trading – they have that secondary market trading to them – and they give advisers access to overseas markets,” Laidlaw says.
She says they can be used as “building blocks” to implement strategic decisions, both for long-term and short-term uses, such as “equitising” cash.
“If somebody has a cashflow that’s going to be invested in Australian equities…an ETF can be a great solution because they’re simply bought in one trade on the ASX, giving you market exposure from the day you’ve acquired the ETF and [avoiding the] drag of holding that money in cash,” Laidlaw says.
Vanguard recently launched three new ETFs, expected to be available from May 26: the Vanguard Australian Shares High Yield ETF, Vanguard MSCI Australian Large Companies Index ETF and Vanguard MSCI Australian Small Companies Index ETF. The diversity of ETFs across the broad market now means that planners not only have more products to consider, but they can plan for different results in return, according to the type of portfolio that will be generated.
A CORE ETF PORTFOLIO
Laidlaw says that if ETFs are thought of as being the index funds in the portfolio construction process, they can really play a role in forming the core ingredient. Having a main core component will allow returns to be delivered in line with the market’s performance.
“Therefore advisers can get a core exposure – for example, an Australian shares ETF – that gives them a diversified core [exposure] to the Australian equity market,” she says.
Michael Molloy, certified financial planner at Charter Financial Planning, has had more than five years’ experience in applying ETFs to portfolios.
He says that from a financial planning perspective, he can see that the majority of Australian portfolios will have ETFs incorporated into them in the coming years.
“It’s fair to say you’d have a proportion in there, whether it ends up being five per cent, or 25 or 30 per cent.
“If I look at my portfolios, most of my clients do have an exposure to an ETF at some level, but the extent to which that occurs is the variable.
“Certainly, I can see that there’s a role to play to have these types of funds in there. “Our practice has about 35 advisers and at a practice level, they’re starting to look at it as a legitimate part of the portfolio.”
Molloy says there are a number of ways to use ETFs to achieve low-cost beta exposure to the market.
“One way to look at it is as a core exposure,” he says.
“Up [until] recently, it’s predominantly been the Australian exposure where you may use an ETF to represent a core component of your portfolio and that may represent 50 per cent or 40 per cent.
“You have that as a core, low-cost exposure where basically, you get the broader market. Given the fact that the majority of fund manager soften struggle to outperform, that’s sort of a decent way to get your overall exposure.”
CORE PLUS SATELLITE
This traditional strategy uses index-based ETFs as the core component of a portfolio, but also includes actively managed funds or assets around that. The aim is to potentially increase the overall portfolio return, without deviating too far from the benchmark. The actively managed component will have a higher risk profile than the core component, but will generally be much smaller in size.
Laidlaw says that the core-satellite approach is a strategy that Vanguard has been talking about with financial planners for the past few years. “It’s not a question of, ‘Do I use index funds or do I use active funds?’ But it’s really a question of how do both play a role in my portfolio?” she says.
Molloy says that planners can “put in some direct stocks where you’ve got a higher alpha or more risk on the table” but potentially, you can “outperform comfortably with your stock- picking skills”.
“Or you may decide to choose a couple of active fund managers, which historically have added value, so you may put [in] one or two direct active managers to complement the index style from an ETF,” he says.
“You may also add a small cap manager – so again, there’s potentially more risk, potentially more alpha…to complement the broader return from an ETF.”
As more ETF products evolve due to the availability of sector-type funds, they can be used to tilt a portfolio into specific sectors, such as gold or commodities. If planners can get their heads around what’s available and the differences between each product, Molloy says they will be able to use ETFs in a more sophisticated way when constructing portfolios.
