ETF Investing: Why and how?

In this article, we’ll unpack some of the ways that wealth managers use ETFs in their clients’ portfolios.

805
Michelle Noth, CFA, Client Coverage Executive, CoreShares Investment Managers

The Johannesburg Stock Exchange (JSE) announced in early September that actively managed exchange-traded funds (ETFs) will be allowed to list from October 2022. This is a notable milestone for the ETF industry in South Africa. ETFs are an efficient wrapper that can make a wide range of investments easily accessible to all types of investors. This news once again reminds us why we describe the rise of ETFs as “the democratisation of investing”.

The market for ETFs has exploded in recent years as institutional and retail investors seek to diversify their portfolios while keeping costs in check. However, given the wide range of funds available, many investors are apprehensive about how these funds work and where to start.

The Case for ETF's
Source: CoreShares Investment Managers

ETFs are simple, accessible and appropriate for all types of investors and can play a number of important roles in all portfolio types.

ETF use case 1: The multi-asset strategist

When constructing a portfolio with financial goals in mind, the first place to start is asset allocation – deciding how much to allocate towards different types of assets. In this case, ETFs focused specifically on the individual exposures can be used as building blocks to create a bespoke portfolio. These products offer a simple, efficient and cost-effective way to gain exposure to entire asset classes, sectors, themes or regions.

For example, an investor may choose to have a core exposure to South African equities while boosting yield income by adding South African property and bonds as satellite investments. They can then enhance diversification by including satellite investments into global equities, global property and global bonds. This example is illustrated below, however there are many more possible iterations. For example, an investor may want to have meaningful allocations towards Asian equities, the US tech sector or a theme such as electric vehicles.

The Multi-Asset Strategist - SA Equity Building Block
Source: CoreShares Investment Managers

ETFs are generally liquid funds, which means that multi-asset strategists can tilt their portfolios to express tactical views cheaply and easily. Broad market exposures can also be upweighted or replaced by sector-specific views and/or thematic ETFs as needed.

ETF USE CASE 2: Core-Satellite

Passive ETF in the core

Another common approach to using passive ETFs in a portfolio is the “core-satellite” model. By using ETFs in the “core” of their portfolio, an investor instantly achieves low-cost, broad-market exposure and diversification. This is a cost-effective and simple way to accurately implement asset allocation decisions, while avoiding any style drift that might creep in when using an active manager.

Once the core investment – or building block – is in place, the investor may seek outperformance by adding satellite investments – for example, high-conviction stock picks or even actively managed funds.

Core-Satellite - Passive ETF in the core
Source: Coreshares Investment Managers

Under this approach, the investor blends both active (stock picking) and passive investment strategies (ETFs) to build a lower-cost portfolio that can deliver outperformance (alpha) relative to pure market returns.

ETF USE CASE 3: Core-Satellite

Passive ETF in the satellite

By contrast, many portfolio managers find themselves managing a long-term basket of high-conviction stock picks for an investor; however, for a variety of reasons, the portfolio may not be entirely suitable for current market conditions or the immediate needs of the investor. In these situations, ETFs form handy satellite investments which are built around the long-term share portfolio in the core, to tweak the overall portfolio for the desired purpose. For example, an investor may require a higher yield than that currently offered by the long-term share portfolio, in which case the portfolio manager can add higher yielding asset classes such as bonds or property ETFs for example. Alternatively, the portfolio manager might have a high-conviction tactical market view on a particular asset class, sector or theme, which can easily be accessed via an ETF and added to portfolio as a satellite investment.

Core-Satellite - Passive ETF in the Satellite
Source: Coreshares Investment Managers

More ETF use cases

In addition to forming long-term holdings in the core, the satellite or as building blocks in a multi-asset global strategy (as seen in the use cases 1 to 3 in this series), ETFs can also be used very effectively as portfolio management tools for other purposes. For example:

  • Tactical tilting
  • Short-term equitisation of smaller cash flows
  • Transition management
  • Liquidity sleeve
  • Immediate and/or short-term access to theme or geography while completing the research to make high-conviction single stock or active manager selections
  • And many more…
ETF Investments
Source: Coreshares Investment Managers

In summary, ETFs are used by a wide variety of investors in many ways. Research shows that investors who start to use ETFs will, in almost all cases, go on to use them more extensively, in larger sizes and in more ways than one. They are efficient and cost-effective tools that “do what they say on the tin” and we will continue to see widespread adoption in South Africa, as we have globally.