Better Portfolios Through ETFs

Exchange traded funds have exploded in popularity in recent years, with assets listed globally in ETFs and exchange traded products reaching a record high of around £1.9 trillion ($3 trillion) in assets under management.

Advisers say it's not just the low costs that compel them to use ETFs but a host of other benefits, including their versatility and access to increasingly diverse areas of the market.

But how does an adviser go about constructing an ETF portfolio? ETF Report UK interviewed financial planners and industry experts to examine the key steps in portfolio construction and where ETFs fit into the plan.

Assessing Clients' Objectives

The first thing financial adviser at Edinburgh-based Dexterity and ETF champion Stephen Walters does is to meet clients for a consultation to assess his or her appetite for risk. Clients are then put into one of three categories: 'hesitantly hopeful,' 'eager learner' or 'confident self-starter.'

"There are no model portfolios; each person is bespoke," he said. "I don't run their portfolios; I help to choose them. I feel very safe having neither model portfolios nor risk questionnaires."

Kristopher Heck, managing partner and CIO of Tanager Wealth Management, also starts the portfolio-building process by interviewing prospective clients about their goals. Tanager then uses risk-profiling tools from FinaMetrica to make sure the quantitative assessment is taken into account and to bring up any discrepancies which may have not been spotted during the interview.

Choosing Asset Allocation

Once the IFA has understood the client's aims, the next step is asset allocation. Tanager Wealth Management, which deals exclusively with U.S. expatriates, begins asset allocation by considering the whole investable universe.

"We start with what the world looks like, then deviate away from that based on a medium-term view and what the client needs [regarding tax and currency] depending on residency," Heck said.

Another approach is illustrated by Andrew Whiteley, managing director of Provisio Wealth Management. His firm has five risk-rated portfolios, from defensive through to aggressive. They are built using strategic research, and the firm then employs a 'tactical tilt' for clients. For example, the balanced portfolio has a 6% underweight in government bonds, and a 6% overweight to corporate bonds.

At Dexterity, although Walters' clients are self-directed, he helps with asset allocation by offering an information service, for which he charges an annual fee.

Choosing ETFs

Step No. 3 is to implement your asset allocation decisions via investment instruments. ETFs can be used to form either a low-cost core to a portfolio, or offer a riskier or more specialised satellite component.

Mainstream ETFs investing in core markets have very low fees—often below 0.4% for main equity markets and 0.2% for bond investments. On the other hand, for the riskier part of the portfolio, there are ETFs available investing in a diverse range of specialist areas, from Asian equities to technology to precious metals.

Dexterity's Walters has a very rigorous and detailed process for selecting funds that he deems suitable for retail investors. He only chooses ETFs listed on the London Stock Exchange, and strips out complications by removing all exchange traded commodity products apart from gold, and any that are modelled in a currency other than sterling. This brings his universe of ETFs down from 1,800 to 450.

Heck at Tanager also tends to stick to large 'vanilla' ETFs and is not a fan of smart beta products, which he feels can work better in theory than in practice.

Low Costs For End Clients

The low cost nature of investing in ETFs means that passive fund-focused advisers can charge their end clients less in total.

For assets on the Provisio Wrap platform, clients are charged a 1% annual fee for portfolios worth up to £499,999. The average total expense ratio is 25 basis points plus the platform charge, while financial planning fees vary but typically range from £1,500 to £2,500 plus VAT.

Tanager Wealth Management, which has assets under advice of approximately $100 million, is entirely fee based with no entrance or exit charges. The firm charges 1% on assets up to $3 million, 0.75% on assets up to $10 million and 0.5% on assets of more than $10 million.

Blending ETFs With Other Asset Classes

Despite the ultimate benefit of low costs, there are some parts of the market where an ETF may not be suitable, and advisers may have to look further afield to execute their view.

Approximately 85% of Tanager's multi-asset portfolios are made up of ETFs, but they do use active managers within the fixed income space, particularly for multi-
currency bonds, which Heck says are the "largest challenge for an index-based portfolio."

When Provisio first started building ETF portfolios in 2008, it also struggled to find ETFs within the bond market.

"We could build a portfolio entirely from ETFs; the only problem we had was high yield bonds," Whiteley said. "We're still not sure about high yield bonds in an ETF; it's an example of where a manager can make a difference."

The Provisio team chose to gain exposure to that fixed income market across all five portfolios through the actively managed £1.6 billion Kames High Yield bond fund, due to its historically strong performance.

At Dexterity, Walters helps to build portfolios that are typically a combination of ETFs and investment trusts. The IFA uses trusts, which are actively managed funds traded on exchange, because they can access exotic areas of the market like derivatives and sell out of them again.

"I like the simplicity of them [trusts], as I like the simplicity of ETFs," he explained. "I like that they have low charges and are available to the public all the time. I like the versatility and also that managers can reach things you can't reach through an ETF."