How portfolio managers use ETFs

For many portfolio managers, second thoughts about using ETFs are a thing of the past.

Traditionally, generating alpha meant being a great stock-picker, says Tyler Mordy, president and CIO of Forstrong Global Asset Management in Kelowna, B.C. A competing philosophy maintains that outperformance lies in picking asset classes—a macro-thematic approach. That’s where managers have been influenced by ETFs.

“ETFs have colonized the world’s asset classes,” says Mordy. “We can now buy ETFs that track Chinese bonds or the price of gold—a whole host of different asset classes.”

The result is the ability to cost-effectively build a global portfolio exclusively with ETFs. “The toolbox is so much larger now,” he says.

Robert Armstrong, vice-president, associate portfolio manager and investment strategist, multi-asset solutions at BMO Global Asset Management in Toronto, also refers to accessing a broad set of tools that includes ETFs. “Asset allocation is probably one of the most important factors to win in investment management in the long run,” he says. “ETFs today are giving us, portfolio managers, access to markets that were previously not available to investors.”

The shift in asset class availability means active decisions are changing as managers assess their processes and consider adding macro-thematic components, says Mordy. Instead of picking one stock over another, managers decide whether they need to allocate more to Japan, for example, or to ETFs that protect against inflation.

Stocking-picking might be here to stay, but “a new breed of money manager is coming up—more in the style of traditional macro managers,” Mordy says.

Getting active with ETFs

ETFs are often cited for their efficiency in particular markets, such as for high-yield bonds, where transaction costs are relatively high.

Managers also use ETFs to get specific exposure, such as emerging markets, the U.S. and EAFE (Europe, Australasia and the Far East). To reduce U.S. exposure and increase emerging markets exposure, for example, using ETFs is less disruptive to the underlying manager, who would otherwise have to sell and buy individual securities, increasing transaction costs.

ETFs also allow portfolio managers to be nimble in fast-moving markets. For example, managers might want to increase their cash positions when volatility increases, says an AGF blog post. With ETFs, that move can be done with minimal cost, less time and fewer trades compared to selling individual stocks.

Even managers who mostly use stocks will hold ETFs to enhance liquidity or as a stopgap to fulfil short-term tactical adjustments, says the AGF post.

“For instance, if the outlook for a particular country or sector improves, an ETF can be purchased to add weight to that position until such time that one or more individual stocks is properly assessed and deemed a buying opportunity,” it says. Alternatively, an ETF could be used to reduce exposure if the outlook for a country or sector worsens, but the manager continues to like his individual holdings.

Precision call

ETFs can also be used to enhance a call on a market segment.

For example, with persistent low interest rates, managers must look beyond Canada to generate income, says Mordy, who manages a global yield fund. That means looking to emerging market debt, global REITs and global dividend-paying equities, among other options. All are available via ETFs listed on Canadian and U.S. stock exchanges.

“Ultimately, we can deliver an income stream that’s higher than what we have at home, without compromising on diversification,” he says.

This means managers no longer have to move up the risk curve in search of yield. “It’s a very different way to run money these days,” says Mordy.

Armstrong describes achieving a more precise call in some of BMO’s portfolios using a core-satellite investing approach. For example, for a core portfolio holding stocks for the long term, he could buy an ETF, which would offer long-term, cost-effective exposure, with low turnover for tax efficiency.

The satellite would make up the strategic side of the core holding, where a specialty manager could add alpha, says Armstrong.

He also uses this approach for fixed income, in a context of rising rates. In the past, investors would buy the bond universe, he says, but ETFs allow for precision.

“We can still hold that active manager who gives us the universe exposure to fixed income, but in the satellite sleeves, we can use individual ETFs,” he says, such as ones that track short-term federal or provincial bonds to reduce portfolio duration. As a result, “we are less at-risk should there be rising interest rates.”

When to avoid ETFs

Where markets are inefficient, Armstrong leans toward an active approach.

For example, research indicates that small- and mid-cap managers generally outperform large-cap managers in U.S. equities, so active managers have the potential to add value in that space. Likewise, within corporate credit.

Armstrong also notes that portfolio requirements should be assessed first and foremost, before determining which investment vehicle to use to satisfy that requirement in the most effective way.

Mordy says he doesn’t generally consider ETFs in terms of when they shouldn’t be used. Overall, he sees the ETF as “financial technology” that has facilitated a shift in active management, allowing the creation of modern, global portfolios. “It’s a good news story for clients,” he says.

Also read:

How to invest in currency ETFs

European investment managers increase use of ETFs, bonds

When ETFs get active—in the boardroom