ETFs what, when and how much to buy? These are the key questions

By Jeffrey F. Black, CIM, FCSI
Principal, Portfolio Manager
CRESTRIDGE ASSET MANAGEMENT INC.

Typical of most innovations, early iterations of ETFs were simple and focused on passive equity index exposures. As with anything Bay Street and / or Wall Street derived, however, passive asset class ETFs have morphed into all manner of offerings ranging from passive and active, to single asset class and multi asset class, levered and unlevered and more.

For investors, the continuing evolution and proliferation of ETF products naturally means increasing choice and complexity, and a rising onus to pay close attention to the role and types of ETFs to consider including in a portfolio.

Consider this: In some asset classes, there are now more ETF offerings than actual constituent holdings from which to include inside the ETF. Beyond core passive equity index exposures, ETFs now offer exposure to numerous other asset classes such as Bonds, Commodities and Preferred shares.

All investors, whether Institutional or Private Client, have to address a number of key questions to determine the suitability and inclusion of ETFs in portfolio construction and design. The three main questions to consider are:

1. What to buy
2. How much to buy and
3. When to buy.

First and foremost, among other considerations an asset mix decision has to be made bearing in mind the investor’s investment objectives, risk tolerance, time horizon and liquidity needs . These decisions are part and parcel of an Investment Policy Statement (IPS). Secondly, a decision to pursue an “Active” or Passive” approach is inherent in developing a Strategic Asset Allocation (SAA) and or a Tactical Asset Allocation (TAA).

The “Active” versus “Passive” debate has been well documented over the years and the initial ETF products served to provide low-cost and transparent exposure to primarily capitalization weighted Indices or Sub Indices. Clearly passive, this so-called “Beta” exposure was quite diversified with arguably the most recognized Index example being the S&P 500 equity index in the U.S. 

The current debate has seen indices created and weighted not on capitalization, but with fundamental, factor and other considerations. No surprise then that ETF offerings have followed suit with further slicing and dicing of asset classes, markets and other groupings now described as “smart beta.” By definition this term is an oxymoron and more akin to smart marketing versus a discernable difference to active management. The use of screens and factor-based rules and criteria for security selection has long been the essence of active portfolio management.

Enter Mutual Fund organizations

Numerous traditional Mutual fund management organizations have now entered the ETF product space either through acquisitions of existing ETF product firms or the creation of their own products. For the most part, their approach and philosophy is not materially different from their actively managed mutual funds. The underlying structure is of course different and some cost efficiencies will be achieved and by extension passed on to the benefit of investors. Recent announcements pertaining to ETF intentions include the likes of firms such as AGF, CI, Mackenzie, TD and Templeton.

Portfolio design considerations

Financial products in and of themselves – whether an ETF or a mutual fund – are not generally complete one-stop solutions or portfolios in the broadest sense. For most investors an approach to including the best of both product worlds into portfolios is a prudent and logical way to proceed. A core and satellite approach to portfolio construction and design can and should include both active and passive products. In many asset classes, it has become much more efficient and economical to gain exposure through the use of an appropriate ETF.

I lean towards the core of certain asset class exposures being represented by a suitable representative low-cost, liquid ETF offering.

Within the equity index arena, costs are now in the 3-4bps range which equates to $3 to $4 for every $10,000 invested. Tracking errors to the underlying index are also very low and correspondingly liquidity is quite high. For the ubiquitous S&P 500 U.S. large cap equity index, which very few active portfolio managers succeed in outperforming over the long term, a passive ETF is an attractive value proposition.

When you have exposure to 500 companies in one equity index such as the S&P 500, you by definition have position stock holdings to the good the bad and the ugly companies simultaneously. This trade off can be offset with the inclusion of more focused or active management whether via an ETF or other structure.

As the maxim goes, in a Bull market “a rising tide floats all boats.” To this end, an ETF with broad passive Index exposure will capture and optimize the benefits of market gains. Conversely in Bear markets the opposite occurs, and some active management can be more defensive and selective when warranted. Hence, the logic of integrating both approaches in an optimal portfolio built not just for optimal return performance, but inherently coupled with optimal risk controls and management.

With most things in life there is some value in keeping things simple. Many ETFs allow investors to do just that by offering core asset classes exposures at competitive low cost. As a product group they are much more than a current fad and going forward should continue to play an integral role as positions in optimally managed investment portfolios.

Jeffrey Black is President and CIO of Crestridge Asset Management, a member firm of the Portfolio Management Association of Canada (PMAC) and a Portfolio Manager member of the Canadian ETF Association (CETFA).