Using ETFs for portfolio building: Part 1

Reader Alert: This is the first of a three-part series on how ETFs can help control costs when constructing core portfolios.

Fundamental analysis is the stuff of cocktail parties, water-cooler gossip, and 24-hour financial news networks. Based on business facts, the main allure of fundamental analysis is the intellectual satisfaction it provides: it is logical. Most professional money managers use fundamental analysis in some form of top-down or bottom-up analysis. Regardless of portfolio size, controlling costs is important, and ETFs can help.

Top-down

Starting with global, regional and local economies, this approach assesses the impact of the economy on sectors, industries and companies. ETFs lend themselves nicely to these strategies because they make country, sector and industry investing simple. For example, institutional managers can use ETFs to establish broad exposure before making specific investments and they can hedge existing exposure by shorting the relevant ETF. During the banking crisis in 2008, shorting financial stocks was prohibited, but there was no such restriction on ETFs. Institutions used ETFs to maintain liquidity in the face of uncertainty. Portfolios for individual investors can similarly benefit from diversified exposure. Just remember, sector and industry ETFs tend to be more expensive than broad-based ETFs.

Bottom-up

Bottom-up managers, also known as stock pickers, screen for superior growth, value, a combination of both and other factors. Investors have “style” ETFs as well as large, mid-cap, and small-capitalization alternatives in different regions and sectors from which to choose. There are even two value-focused Canadian equity ETFs.

Many institutions and pension funds use a core-and-satellite approach. They select active alpha-seeking strategies around a passive core. ETFs are an obvious choice for core portfolios because of their low cost. In Canada, some ETF sponsors offer a prêt-á-porter core portfolio: Claymore’s Balanced Growth CoreportfolioTM ETF (CBN) – consisting of other Claymore ETFs – has approximately 62% equities, with bonds, real estate and gold making up the balance. The “listed” MER for CBN is 0.25% per annum, but a recent prospectus shows the cost in 2009 was 0.70%, so MERs for individual holdings make this choice more expensive. iShares’ Growth Core Portfolio Builder Fund (XGR) also offers a group of iShares ETFs bundled with an MER of 0.60%, all in. These may be a good solution for investors with less than $10,000 to invest.

Investors who can afford to purchase at least five $2,000 positions may be better off buying individual ETFs – if they have the inclination to do so. Five positions cost about $100 in commissions to set up and about 0.30% per annum in MERs. Assuming two rebalancing trades a year ($40), the $10,000 investor, with annual costs of about 0.34%, makes back the initial commission costs in three-and-a-half years.

It just doesn’t matter

Fundamental stock picking can be detailed. Let’s use Research in Motion as an example. A growth manager, viewing earnings and revenue growth over the year ending March 31, 2010 of 29.8% and 35.1% respectively, may conclude that the 17 PE ratio is low, based on current interest rates and prospects for double-digit growth for several years.

A value manager may be concerned that because gross margins fell from 46.1% to 44.0%, the rapidly growing 37% of sales from developing countries is cannibalizing margins, meaning the average BlackBerry selling price may fall below $300, eroding profitability. Hence the dilemma of fundamental analysis: no one knows when or if the market will recognize one view or the other.

Guess what? If you are looking to build a diversified portfolio, it doesn’t matter. Here’s why. Ioulia Tretiakova, Director of Quantitative Research for PUR Investing says, “When buying RIM shares, company-related factors account for about 85% of total return, the market only 15%. But in a 50-stock portfolio, fully 85% of the return from this portfolio comes from the broad market and only 15% from company-specific elements.” Recognizing the fallacy of hindsight, one could have purchased iShares Technology ETF (XIT), got a 22% exposure to RIM and not been as exposed to a schizophrenic view about short-term results.

ETFs offer low-cost flexibility, so fundamental approaches can be effectively used to benefit individual investors. Broad diversification reduces the need for company-specific research and allows for all the benefits of mutual funds without the costs. Indeed, low costs contribute to better performance, so complacent product vendors should pay attention.