Eight ways institutional investors use ETFs
29 January 2018 | Portfolio construction
Commentary by Andreas Zingg, head of ETF distribution management at Vanguard Asset Management.
Exchange-traded funds are growing in popularity as more investors use them for long-term investment strategies and not just for tactical investing. Let me outline eight ways we are seeing investors use ETFs.
1: Investing in tactical opportunities
This is probably the best known use of ETFs. They can be an ideal tool for tactical investment opportunities. Maybe an investor expects US equities to outperform over the next few months. They can take advantage of this opinion by holding, for example, an S&P 500 ETF for that period. In one trade, the ETF gives the investor immediate exposure to a diversified portfolio of US large cap stocks.
2 and 3: Two ways to minimise performance mismatch
There are two short-term uses that help solve the same issue. Investing unexpected cash flows and transition management can be disruptive and lead to a performance mismatch.
Perhaps a portfolio manager has a large temporary cash position due to large unanticipated cash flow. The longer the manager holds the cash, the greater the potential for the portfolio's return to deviate from its benchmark. Buying an ETF that gives broad-based exposure to the benchmark or asset class reduces this risk. It also gives the manager breathing space to implement their chosen investment themes in the portfolio.
Transitioning between active investment managers also runs the risk of a performance mismatch. Any change in manager will, most likely, lead to a change in the underlying portfolio. Again, using ETFs in the transition period reduces the likelihood of a performance mismatch, or shortfall.
4: Managing a portfolio's risk profile
The different returns from different markets and asset classes mean a portfolio's asset allocation will drift away from its initial target over time. Periodic rebalancing helps make sure the portfolio maintains the long-term asset allocation that suits its risk and return profile. The trading flexibility of ETFs and the instant exposure they give makes them convenient and easy-to-use tools for rebalancing a portfolio back to its strategic asset allocation.
5: Addressing liquidity concerns
Since the financial crisis, liquidity has become a source of concern for many investors. One way to deal with liquidity concerns is simply to hold cash. Of course, that could result in a significant, and most likely undesirable, change to a portfolio's risk and return characteristics.
An alternative option is overlay management. Instead of reducing exposure and allocating to cash, investors can invest in an ETF that matches the asset class in which there are liquidity concerns.
Arguably, this ETF use is tactical if liquidity concerns are short term. If they persist, overlay management may be a strategic tool for the long-term investor. Moreover, if these worries are broad-based, investors could use a selection of ETFs that mirror the portfolio's strategic asset allocation. This ensures the portfolio is fully invested but with liquidity options from the ease and accessibility of trading ETFs.
6: Plugging the gaps
Another use that can be both tactical and strategic is portfolio completion. This is associated with institutional portfolios, usually those that use several managers across different mandates. While the portfolio may be invested according to its long-term strategic asset allocation, there could be gaps. Perhaps a risk budgeting exercise revealed a lack of large-cap value stocks across the portfolio's aggregate global equity exposure. This can be remedied by reducing a portion of the assets allotted to each manager and buying a global large-cap value ETF.
7: Implementing strategic asset allocation
With the couple of exceptions mentioned above, the list of ETF uses so far are generally more short term. There is however, an increasing trend for long-term uses, notably to implement strategic asset allocation positions.
The range of ETFs available to European investors makes them ideal building blocks for portfolios. Investors can chose single market ETFs that track the S&P 500 or FTSE 100 for example, or regional exposure like the EuroStoxx 50 or the broader FTSE Developed Europe. Bond indices are also well represented by ETFs with country, regional and global exposure available.
8: Combining active and passive
ETFs are most often associated with passive investing. Typically, they reflect the risk and return characteristics of a particular market or asset class. Active investing, on the other hand, offers the opportunity to outperform. But it does bring greater relative risk and unpredictability. Combining lower-cost active funds with index-based ETFs can achieve a balance between the two approaches. One way to do this is with a core-satellite strategy that uses indexing at the core of the portfolio and actively managed funds as the satellites. An indexed core provides a risk-controlled, low-cost way to capture market returns (beta) over the long-term, while actively managed satellites provide an opportunity for market outperformance (alpha).
Not every use I've described is suitable for every institutional portfolio. Investors should always consider how their choice of investment instrument fits with their long-term investment objectives. And of course, they should weigh up the costs against the benefits.
But these eight tactical and strategic uses underscore the versatility of ETFs. They give investors flexible, low-cost access to a wide range of asset classes, highlighting why demand for ETFs is growing.
Head of ETF distribution management, Vanguard Asset Management
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