Building a low cost portfolio with ETFs

ETFs have transformed retail investing, their growth riding the trends of passive investing and ‘smart beta’, in the process earning a justified popularity thanks to their low cost. ETFs are traded on an exchange like stocks. And they benefit from low spreads and (usually) considerable liquidity. All of these features mean ETFs show considerable potential for building a low cost, long-term investment portfolio, particularly for equity investors. Though they are not without critics, these complaints tend to focus on the ‘other’ side of the market – their impact on capital allocation – rather than claims they are bad for investors.


Why are costs important?


There is considerable debate over the merits of active versus passive investing. With some portfolio managers harshly criticising passive investing for its overall effects on the market and inability to outperform. While passive managers attack their active counterparts for wasting client money and underperforming the market. One thing that can be agreed on by everyone is that high fees eat into overall performance.

Consider a skilled active manager who is able to consistently beat the overall index by 1.5% per year. This is a remarkable achievement. But if his management fees are 2% clients will end up underperforming the index. In order to provide value after fees, the active manager has to beat the index plus fees, a tall order for even the most dedicated portfolio managers.

Many institutional and retail investors have turned towards passive investing. Rr targeted risk methods such as smart beta, in order to avoid this problem. This style of investing emphasises low cost, and instead of aiming to beat the index tries to replicate it as closely as possible. With smart beta approaches trying to find subtly different risk exposures that are more rewarding. To do this passive investors needed a new tool: the ETF.


Exchange traded funds


In an ETF, a large portfolio is held by the ETF provider, who uses this to track the returns of the index. Investors in an ETF buy a share in that fund, giving them participation in the returns of the fund. Because these are exchange-traded products, they can be bought and sold throughout the trading day. Unlike mutual funds which are only traded once per day after market close. Unlike a mutual fund, you cannot redeem your holdings for cash, nor do you technically hold the underlying assets. Although ETF investors normally receive payments or added reinvestment for dividends. Holding an ETF does not give you voting rights for the constituent shares.

These features of ETFs give several advantages, including favourable tax status in some jurisdictions. However, the real reason investors use ETFs is to lower costs: they are far cheaper than comparable mutual funds.


How to use ETFs in a portfolio


For a retail investor looking for an entirely equities portfolio, because they have a high risk appetite and a long time till retirement, ETFs offer several opportunities. One is simply to buy a tracker fund for world equities, and benefit from the global return of this index. This maximises diversification (within equities). It can offer returns without exposure to specific geographic risks (remember that world equity indexes will skew towards the US market, as this is by far the largest global stock market).

Another very common holding is an S&P500 tracking fund, allowing you to share in the performance of the 500 largest American traded companies. You can afford some protection to either of these holdings by assigning a smaller portion of your portfolio to a risk-off ETF. Such as one tracking the price of gold. Thematic ETFs exist. Such as US Consumer Goods or Chinese Manufacturers, that track an index based on a specific sector. These allow you to be more creative and create a targeted portfolio. This notion of using targeted passive investing to select for certain risks is sometimes called smart beta.


Smart beta


Smart beta is an investment philosophy where investors use low-cost, passive products to recreate an index. But then optimise it for certain metrics such as volatility or value. To do this, investors use thematic ETFs or similar products. ETFs like S&P500 value will either only hold companies which meet certain value requirements, or include all companies but overweight those.

Critics of smart beta say it is just a rebranding of active investing. But it is true that smart beta funds are normally much cheaper than their active equivalents. These strategies can be easily replicated by retail investors, as the same ETFs are accessible to everyone. So they are a good choice for the retail investor looking for more targeted market exposure.


Problems with ETFs and criticisms


From the perspective of retail investors, ETFs are pretty unambiguously good. They are cheap, and so don’t eat into your overall returns. They have also driven down the fees of both passive and active mutual funds in order to remain competitive. Some market analysts warn that ETFs and passive investing more generally is damaging the value discovery aspect of the market. And though these concerns don’t impact their suitability for your portfolio, they are worth understanding.

The traditional explanation of why active fund management is good goes something like this: In the stock market, there are good companies and bad. Bad companies may outperform good ones in the short term for various reasons, but in the long run shrewd fund managers will identify them through their reports and other research, and assign their portfolios to the better (in terms of value for money) companies instead. This will then lead the market price of the worse companies to decline, forcing them to change their business model or else struggle to raise funds, and eventually close.

In practice it doesn’t work quite like that, at least not anymore, although many analysts still claim that there is an important capital allocation role for active management. The problem with passive investing is any company in the index will now see huge outward investment. So if you become one of the largest 500 companies in the US, immediately you will see massive inward investment in order to make sure all the S&P500 tracker ETFs are reflecting the index. This is completely divorced from the actual quality of the underlying business, which is essentially being rewarded for inclusion on a list.

Critics of passive investing fear we will end up with a static list of large companies that benefit from an increasing stock price. And the opportunities this brings for financing or acquisition, thanks to the sheer volume of passive funds. Whether this will really happen remains to be seen, and whatever your thoughts on the issue. The fact remains that low-cost passive funds outperform. But it is something to think about.

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Passive investing is slowly becoming the dominant method for retail investors, a fact that is welcomed by some and lamented by others. Whatever funds you choose, making sure you limit costs as much as humanly possible is a good idea. ETFs are perhaps the most powerful tool we have for doing just that. And it is a rare retail portfolio that wouldn’t see lower fees if they used more ETFs. The traditional methods of diversification, alongside newer concepts like smart beta. It can all work using these products, which have multiplied to meet investor demand for new and innovative investment solutions.

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