This article was originally published in November 2011.
ETFs are primarily associated with indexed or passive products, so the idea of combining them with active management seems as logical as U.S. Tea Party Republicans working with Democrats in Congress.
But institutional portfolio managers are pragmatic. They’re always looking for ways to improve performance, and ETFs offer an expanding arsenal.
Opportunities to improve portfolio function come under two categories: liquidity and diversification.
Liquidity
ETFs are changing the rules of portfolio management, and have added a dictum of their own—“it’s all about the underlying.” ETFs are a function of their underlying holdings. If these holdings trade well, the ETF should be liquid, which should be reflected in a lower bid-ask spread from market makers and a lower tracking error from the index it follows.
However, ETFs also offer a unique creation and redemption feature that allows market makers to create more ETF units if demand exceeds supply, and vice versa. This boosts liquidity beyond the traditional daily trading volumes that are reported.
To portfolio managers, this means an added element of liquidity for moving into or out of markets or sectors quickly with minimal trading impact. This function is useful if a manager has portfolio exposure to individual holdings that may not be liquid and wants to gain or shed exposure quickly. Exposure to other assets can be realigned later.
During the financial crisis of 2008-2009, when financial stocks could not be shorted, financial sector ETFs could be, adding liquidity to a market that desperately needed it. The sidebar “How U.S. asset managers use ETFs” shows institutions use ETFs primarily for the liquidity they provide.
Trend-following strategies (formerly known as market timing) have become increasingly sophisticated with the aid of computers. Some of these strategies form part of the algorithmic trading subculture. Traders need volatility to make money. Theoretically, because traditional ETFs dampen volatility, they are only useful for hedging.
However, leveraged ETFs are popular because of their added risk and often account for over 50% of all daily ETF trading volumes on the TMX. If active management involves aggressive trend following, leveraged ETFs can offer the needed juice.
Diversification
Diversifying to manage risk can be problematic, as the tech wreck of 2000-2001 and the financial crisis of 2008-2009 proved. Nevertheless, identifying the next uncorrelated asset class occupies the time of many professionals.
ETFs offer fertile ground for prospecting. Domestic and international equities draw the most institutional interest. In a 2011 Greenwich Associates study of asset managers using ETFs in the U.S., 89% used ETFs in their domestic equity portfolios and 94% accessed international equity exposure in whole or in part using ETFs.
Given recently elevated levels of market volatility, there is increasing buzz around exchange-traded products that represent volatility, like the iPath S&P 500 VIX Short-Term Futures Exchange Traded Note (VXX), the Horizon Betapro S&P 500 VIX Short-Term Futures ETF (HUV) and leveraged version (HVU). Because volatility tends to expand in declining markets, buying these ETNs can partially offset losses. Caveat: Extended periods of volatility may mean that shorting leveraged versions would be preferred, so seek expert advice first.
Advisors
Advisors can use ETFs for all the liquidity functions listed in the chart, like cash equitization and transitioning from an old to a new portfolio. Portfolio completion involves finding assets that round out a portfolio based on the manager’s criteria. They may include hard-to-access regions like emerging markets or a particular maturity segment of the yield curve. Some tools allow advisors to enter an existing portfolio of mutual funds and/or stocks and bonds, and yield a list of ETFs that can replace the funds or improve the diversification properties of the portfolio.
Building a passive core using ETFs that represents the client’s long-term goals can also combine passive with active. Individual stocks, bonds, ETFs or funds can be chosen that represent active satellite bets. The core will reliably deliver the return of the long-term asset mix while the tactical pieces can be alpha-seeking, with costs optimized for the investor.
Money management is evolving to accommodate changing capital market demands. Passive buy-hold-rebalance strategies, while still defensible for pension and institutional portfolios with long investing time horizons, are proving to be inappropriate for individuals who face perpetually shortening horizons.
ETFs offer institutions, advisors and individual investors an effective and economical way to shift assets to tactically adjust for these evolving circumstances.