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Combining active and passive strategies with ETFs

By James Dunn

Part of the explanation for the huge growth in exchange-traded funds (ETFs) in recent years is the fact that they offer investors cost-effective, simple, instant and liquid exposure to different markets, different asset classes and different strategies by buying one product, which is itself, a listed stock.

ETFs are very flexible investment tools, which allow investors to either instantly improve their portfolio’s diversification, or employ a range of investment strategies that were once too complicated or expensive for them to consider.

Investors can use ETFs to get market exposure very quickly and easily to implement their views and meet their investing objectives.

But ETFs can also work well with traditional investment tools, such as managed funds, and direct shares.

ETFs at the heart of “core/satellite” strategy

An increasingly common approach, which works in any asset class, is to use ETFs as the “core” of a portfolio – the foundation of your investment strategy – and then add some more specialised “satellite” investments around this core. In this approach, the core investments account for the main part of the overall portfolio: a typical allocation to the core investments would be about 70%.

The core is often held in a low-risk vehicle that offers low-cost, broadly diversified exposure to an asset class, market or index. ETFs are very well-suited to this role, which is to deliver a return in-line with the performance of the asset class, market or index you want to pick up. This is often referred to as the “beta” return – in a highly liquid form.

Around this core, the investor can add the satellite investments with the aim to earn returns above what the market generates. This is often referred to as “alpha”.

For example, an investor might hold a broad Australian equity ETF in the core portion of their portfolio, and add active managed funds to the satellite portion of the portfolio to seek to enhance performance. Using ETFs will help to keep the overall portfolio costs low, allowing the investor to choose unconstrained, high-conviction or absolute-return managers that represent the best chance for alpha. It’s important to ensure that the satellite funds generate a return that differs as much as possible from the market return.

This “blending” of a passive, low-cost indexed core and higher-cost active management can deliver market outperformance for less than a fully active portfolio would cost.

Using active strategies raises the risk, for chance of extra return

The satellite investments to an Australian equity core ETF can also be direct shares. This is a popular strategy given the prevailing low-interest environment, where franked dividends are a crucial source of income for yield-oriented investors. This is especially the case for self-managed superannuation funds (SMSFs) that are able to use the partial or full rebate of the unused franking credits (depending on whether the fund is in ‘accumulation’ or ‘pension’ phase, where the applicable tax rate is 15% and nil respectively.)

When using active managers as satellite holdings, make sure you do not get panicked out of the investment by short-term underperformance – which is the bane of active management. Make sure you hold the managers long enough – at least through a full economic cycle – to give each enough time to potentially generate positive active returns through their skills and insight.

Active managers give you the possibility of outperforming the index – which of course the traditional ETF cannot do – but the flipside is much higher return variability, and much higher management costs.

Even though ETFs are usually passive investment vehicles, they can be used actively, to make tactical tilts to certain markets and asset classes, based on the investor’s view of changing short-term market conditions, or to tap into a strong global investment “thematic” exposure in a precise manner.

A good example of this is the iShares S&P Global Healthcare ETF, which taps into the increased spending on healthcare as populations in many countries – developed and developing – age. Adding this exposure – which is difficult to achieve on the Australian Securities Exchange (ASX) – can provide a targeted investment while also improving the portfolio’s international diversification.

Factor-based ETFs combine active and passive investment

Within the equity asset class, the latest generation of ETFs provide exposure to fundamental factor-based or ‘style-based’ strategies, to allow more systematic investment allocation. These newer ETFs target particular “factors,” which are fundamental underlying drivers of equity return.

For example, “value” stocks – which have low prices relative to fundamental measurements (such as price/equity ratio, dividend yield or net asset value) – have historically out-performed the broad share market over the long term. Value stocks are those that are out of favour with the market, being priced low, relative to the company’s earnings or assets.

A value stock is usually considered to have a relatively low price/earnings (P/E) ratio and a low price-to-NTA (net tangible assets) value, but a high dividend yield (because its price has fallen). Value investors buy these stocks because they believe that the market will eventually recognise its true value and the stock will be re-evaluated (bid up in price). Cheap stocks – relative to these fundamental measurements – have tended to outperform in the past.

Other common factors include size (market capitalisation), company “quality” (as indicated by a range of fundamental criteria indicating financial health), “momentum” (trending stocks) and low-volatility i.e. the stocks that historically have fluctuated in price less than the overall index. Identifying these factors and creating rules-based indexes based on them can allow investors to seek improved returns, reduced risk or enhanced diversification, within the Australian or global shares asset class. For example, the iShares Edge MSCI World Multifactor ETF combines value, smaller size, quality and momentum stocks to seek outperformance compared to a traditional index of global shares.

These “smart beta” strategies combine elements of both passive and active investment, giving the investor the opportunity to make more targeted allocations to potential sources of risk and return at a lower cost.

Disclaimer: This is a sponsored article by BlackRock Investment Management. This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

Published on: Wednesday, March 01, 2017

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