The unique attributes and benefits of ETFs appeal to both institutional and individual investors. Typically structured like managed funds, but listed and traded on an exchange like stocks, ETFs are flexible trading and investment vehicles that can be used to help satisfy a number of critical investment needs. These include:
- Asset Allocation
- Risk Management
- Transition Management
ETFs are ideal for realising both long-term strategic asset allocation strategies, and short-term tactical responses for capturing market opportunity, and avoiding unnecessary risk.
Savvy investors are discovering what institutional investors have known for some time: asset allocation, not security selection, is a dominant driver of long-term investment results. However, advanced asset allocation strategies have been difficult for many individual investors to implement, given the costs and asset size required to achieve proper levels of diversification. The introduction of ETFs now offer investors a sophisticated tool to efficiently gain exposure to broad market segments, encompassing a wide range of asset classes, equity market capitalisations and sectors.
This enables investors to build customised investment portfolios consistent with their financial needs, risk tolerance and investment horizon. It’s important to remember that diversification and asset allocation do not ensure a profit or guarantee against loss. Three examples of asset allocation and ETFs include: strategic asset allocation, core-satellite strategies, and tactical asset allocation.
Sample Uses of ETFs in Asset Allocation Strategies
Strategic Asset Allocation: Research shows that a properly allocated portfolio is the most critical factor in explaining the difference in returns across portfolios. The value of asset allocation has been witnessed at extremes during and after the Global Financial Crisis. After an investor decides what their long-term asset allocation will be—for example, equities vs. fixed income vs. commodities—they can then deploy passive investment vehicles like index ETFs to build easily managed, low cost portfolios that reflect the combined performance of the selected market indices.
Core-Satellite Strategy: Investors can also use ETFs to implement a core-satellite strategy. A core-satellite strategy seeks the broad market return as the “core” portion of a portfolio, and seeks additional diversification and returns in a “satellite” strategy which adds non core market exposures. Broad-based ETFs can be used as the core of an investment strategy. Sector, commodity-based, or other ETFs can be used to add a cost-effective and efficient satellite portfolio to complement the “core” broad market portfolio exposures.
Such a strategy has the additional benefit of blending the general market risk of the core portfolio with the potentially riskier or more concentrated satellite portfolio exposures. This helps diversify risk as investors seek other forms of return beyond the broad market.
Tactical Asset Allocation: In today’s ever-changing macro and geo-political environment, investors often need to make real-time adjustments to their long-term asset allocation to reflect changing views on short-term asset class performance. They may also wish to deviate from long-term asset allocation to take advantage of tactical, short-term opportunities provided by the market.
ETFs provide a fast, low-cost and efficient vehicle with which to make tactical adjustments to portfolios. This can include tactical allocations to markets and sectors that have become more attractive. It might also include reducing or unwinding exposures to less
attractive markets and sectors. Investors can also easily reverse these tactical moves once the opportunities and risks have run their course.