ETFs make for tactical trading tools

We've seen a flurry of news in the GCC financial press about exchange traded funds (ETFs). Here we seek to demystify what is a relatively simple but powerful product category and how you can use it to augment your portfolio.

An ETF is an investment vehicle which is constructed like a mutual fund but trades like an individual security on a stock exchange. Essentially, an ETF combines many of the benefits of traditional mutual funds, but are not to be confused with close-ended mutual funds that also trade on an exchange. ETF units can be created or redeemed by Authorised Participants as required and as ETFs are listed on stock exchanges just like a share, they can be traded whenever the exchange is open. There is no fund manager picking the underlying stocks but the investor is given exposure to whichever companies make up the index that the ETF is tracking. The value of a holding in ETFs could go down as well as up and an investor may not get back the amount invested.

How many people are actually using ETFs Globally, ETFs have seen a tremendous uptake since they were first introduced to the market in 1993 with three products covering $0.8 million (Dh2.93m) assets under management (AUM).

At the end of Q2 2009 the Global ETF industry had 1,707 ETFs with 3,066 listings, assets of $789.04 billion, from 93 providers on 42 exchanges around the world with plans to launch an additional 777 new ETFs. Globally, iShares is the largest ETF provider in terms of number of products – 386 ETFs – and assets of $380.23bn, reflecting 48.2 per cent market share.

Active fund mangers typically maintain a cash buffer of between one per cent and three per cent of a fund's total assets in order to effectively meet client redemptions. Conversely, new investments into a fund can generate a cash balance that might exceed the desired weighting. In both instances, an efficient way to minimise the 'cash drag' effect or the loss of performance could be by holding an ETF.

Core investments

Many investors use core-satellite investing to meet very specific risk and return requirements. The core investments account for the main part of the overall portfolio, a typical allocation to the core investments would be 70 per cent. The core usually takes the form of a lower risk, pooled investment vehicle. This is typically an index tracking fund, such as an ETF, that offers low cost, broadly diversified exposure to a market or index. The aim is to deliver a return in line with the market's performance – this is often referred to as the beta return.

One of the most important factors in implementing such a strategy is cost, as pursuing a variety of investment strategies runs up management fees that erode the portfolio's returns. ETFs mitigate this cost problem, with funds that track major indices like the S&P 500, FTSE 100 and Euro Stoxx50 making ideal core components of the overall portfolio. ETFs charge no sales or redemption fees and annual fund expenses can be as low as 0.09 per cent.

The second segment of a core-satellite portfolio is made up of the satellites. These are typically more specialised investments which the portfolio manager believes will deliver additional returns. This can be achieved through exposure to specific markets, actively managed funds, investment themes, individual securities and ETFs. Satellite investments typically carry higher risk and fees than core investments.

While broad-based ETFs make ideal core holdings, more specialised funds also make excellent satellite investments where managers are expressing their views on the market at the periphery of the portfolio to generate additional returns. The range of ETFs available offers significant choice with large and smaller companies, as well as value and growth market segments covered.

Buying into an appropriate ETF would provide a solution as security specific risk is eliminated. As ETFs are extremely liquid and inexpensive to trade, they make efficient hedging tools as well. ETFs can be traded real time through a stock exchange rather than the once-per-day trading that many other types of funds typically offer. Developed markets have seen an unprecedented volatility over the past year, and investors are no longer content to wait for end-of-day pricing provided by traditional mutual funds, when they know they can implement investment decisions with ETFs immediately.

ETFs are frequently used as a means to gain immediate exposure to a market. Instead of investing new cash flows in money market funds or government bond futures while making investment decisions or waiting for new issuance, a portfolio manager can now buy diversified exposure to the corporate or government bond market through a number of recently launched ETFs.

Irregular and unforeseen events offer tactical short-term opportunities to add value. One route to implementing such a short-term view, before the opportunity is arbitraged away, would be to select a basket of individual securities. However, this would require a number of security specific decisions and trades. Therefore, in many instances, using an ETF to express this type of view is a more effective option.

ETFs in the GCC

Generally, professional investors (Wealth Advisors) view ETFs as liquid, transparent and low-cost investment tools that help construct portfolios. Accordingly, GCC-based investment professionals are using ETFs in multiple ways. One of the key uses for ETFs is combining different asset classes in the "core" of investment portfolios with actively managed funds or single stock selections. The result is a blend of active and passive management that can be tailored to best fit an optimal asset allocation and a client's risk profile. GCC-based professional investors are also significant users of ETFs for tactical trading strategies, which typically include specific sector, single country or emerging market ETFs.

- The writer is Vice-President and Regional Business Director, GCC for BlackRock

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