4 reasons to say yes to ETFs

Highly specialized ETFs are dominating headlines, but that’s not what should be driving short-term investment decisions. Think back to the late ’90s when many investors jumped on the bandwagon just before the dot-com bubble burst.

More recently, in the spring of 2009, many investors who couldn’t stand the volatility abandoned the market right before it started rebounding.

How big was the rebound? On March 10, 2010, the MSCI Canada index finished more than 50% higher for the year.

The lesson: Don’t overreact to the news of the moment. Yes, some commodity, single-country, narrow sector, and other such ETFs look good now. But a more staid group of ETFs—those that track broadly diversified market segments—are quietly helping financial advisors meet client investment goals by reducing risk and dampening volatility in portfolios.

Globally, the majority of investor assets in ETFs are held in broadly diversified core products. This reflects a trend of investors embracing ETFs to reduce risk and lower costs in their investment portfolios. Advisors, too, are using ETFs to reduce risk, including:

• as substitutes for portfolios of individual stocks;
• to offset active manager risk;
• to hedge exposure to a particular market segment;
• to temporarily equitize cash.

Let’s examine each.

1. Offsetting single-stock risk

Some advisors may try to build portfolios of individual stocks or bonds, but cannot achieve the proper level of diversification with only a handful of securities. An ETF may contain hundreds or thousands of stocks or bonds—more than many actively managed mutual funds. Broader diversification, of course, reduces the risk of any single security having a negative impact on portfolio performance.

2. Reducing manager risk

Active management—whether at the individual level or through an actively managed fund—may also introduce unintended risk into a portfolio.

Add it up

Combining active and passive holdings can mitigate relative downside risk

Note: 15 years ending December 2010. Source: Vanguard calculations, using data from Morningstar

Note: Past excess returns are not indicative of future results, which may vary. The excess returns reflect the reinvestment of dividends and distributions, but don’t reflect the deduction of any fees or expenses that would have reduced returns.

Our firm’s analysis shows that, on average, active management reduces a portfolio’s returns and increases volatility compared with a static index implementation of a portfolio’s asset allocation. This is partly due to the higher costs, and because security-selection and market-timing strategies require a very high amount of skill.

A passive-management approach cuts exposure to active-manager risk. ETFs may underperform benchmarks because of real-world operating costs, but the margins are usually narrow.

Used together, actively managed funds and ETFs can complement each other by moderating swings between the extremes of relative performance.

A combined strategy can help avoid the pangs of regret an investor might otherwise experience when one approach trumps the other (see “Add it up”).

3. Diversifying concentrated portfolios

Some advisors may have clients with a portfolio concentrated in a particular stock or sector; such as an executive who owns a large block of her company’s stock. Or clients may hold stocks in a particular sector they don’t wish to sell.Advisors can short an ETF to hedge this exposure.

For example, an advisor with a client who has a large position in an energy company stock can short energy ETFs to hedge the overall exposure to that sector, thus dampening portfolio volatility. However, this strategy carries its own risks and costs, and is not appropriate for all investors.

4. Equitizing cash after a portfolio change

Finally, some advisors may fire a fund manager or decide to leave a particular mutual fund due to disappointing performance, manager change, or a change in the portfolio’s investment philosophy. Or, perhaps a client has bonds that have matured, or has received a large cash allocation from an inheritance.

Unfortunately, cash can introduce portfolio risk by altering the asset allocation. If clients are under-invested in equities due to this cash allocation, it could risk their retirement goals.

ETFs can help reduce this risk by temporarily equitizing cash to maintain a strategic allocation, while looking for an appropriate home for those assets.

ETFs are an efficient, low-cost way to diversify. That said, diversification isn’t a panacea that allows you to garner positive returns in all situations. Instead, it helps you weather the bad times a little easier by truncating some of the downside risk. Atul Tiwari is Managing Director, Vanguard Investments Canada.