ETFs provide low-cost diversification that allows investors to construct portfolios according to their asset allocation. They enable exposure to assets that were previously difficult to access individually, like gold and oil. While ETFs are increasingly used in portfolio construction, some platforms have not fully adapted to offering fractional trading that would allow investors to fully allocate all available funds.

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ETFs ­ Spring 2017 yesterday
How to use ETFs in portfolio construction
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Diversification is investment 101. Having a diversified portfolio is what will help an
investor bare times of lean returns in one sector or asset class while hopefully
picking up gains by being exposed to others.
So how do exchange traded funds fit into the mix? Simply put, by providing low cost
diversification.
“Because ETFs come in many different flavours, they enable investors to construct their
portfolios in accordance with their asset allocation at a low cost,” Mark Fitzgerald,
product manager for Vanguard, says.
Luis Rivera, chief executive and co-founder of robo-adviser ETFmatic, argues that ETFsETFm
are so important to the modern portfolio construction process that even hedge funds
invest significantly through them nowadays.
>The development of various ETFs have meant diversified portfolios of fundamentally
different risk premia can be constructed far more efficiently than in the past.---Luis
Rivera
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The overarching advantage, according to Mr Rivera, is that ETFs allow investment
managers to have what he calls “pure implementation” of a particular asset class - as
opposed to using a third party fund manager that underweights or overweights
particular sectors and companies.
“The development of various ETFs have meant diversified portfolios of fundamentally
different risk premia can be constructed far more efficiently than in the past,” he says,
“meaning uniquely tailored portfolios can be built for clients”.
What will these tailored portfolios look like?
According to Joe Parkin, head of UK wealth and retail sales at iShares, as investors
demand both value and a premium service from their financial advisers and investment
managers, increasingly active portfolios will be built using ETFs and index funds
alongside high conviction alpha strategies.
“In essence investors will be blending active and passive strategies rather than investing
in one or the other,” he says.
ETFs give retail investors access to low cost investing in assets it simply wouldn’t have
been possible to buy as an individual before, such as gold or oil, James McManus,
investment manager at Nutmeg, points out.
“The variety of ETFs available means there are now very few sectors, regions, factors or
asset classes you can’t access through an ETF structure.
“There are currently over 1,800 ETFs listed on the London stock exchange alone,
meaning price competition is high (good for all investors), and choice is wide.
“In many markets, there are not only competing product providers, but also different
underlying index exposures from which we can choose.”
To benefit from the diversification they offer, there are four key ways ETFs can be used
in a portfolio, as Daniel Greenhough, investment manager at St Albans-based Lumin
Wealth, points out:
tactical asset allocation
adjusting style bias
obtaining style performance without active manager fees

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providing market exposure for capital gains tax constrained clients
On tactical asset allocation, Mr Greenhough gives the example that many portfolios
contain a blend of active managers; blending value (low relative share price) and growth
(capital appreciation over the long term) managers.
“ Buying and selling an ETF can be done at any time in the trading day and doesn’t upset
the balance of a value/growth blend. For this reason, they are well suited to more short
term tactical moves in asset allocation,” he says.
Next up, adjusting style bias
“For investors that want to adjust a style bias within a portfolio the development of
smart beta ETFs that track a value or growth index provide a quick way to do this,” Mr
Greenhough points out.
He gives as a example a bias to growth funds led by the performance in recent years of
funds like Fundsmith, and Lindsell Train UK Equity, where a value based ETF can help
balance this bias out.
>By receiving market performance at a low cost, the ETF is an instrument they can buy
and hold for a long time.---Daniel Greenhough
Using an ETF to obtain style performance without active manager fees is fairly self
explanatory, but the example Mr Greenhough gives is if a value fund manager
underperforms a rules based value ETF, “this would suggest that the actual stock
selection the active manager is doing detracts from performance”.
Finally, clients with taxable portfolios that are constrained by capital gains can use ETFs
to form the core of their portfolios.
Mr Greenhough says: “They receive the performance of the market and don’t have to
worry about fund manager changes possibly creating a requirement to sell. By receiving
market performance at a low cost, the ETF is an instrument they can buy and hold for a
long time.”
ETFs also offer investors transparency in holdings and cost.
“Investors are able to understand portfolio risk in granular detail at all times, and the
transparent methodologies for rules driven approaches means that investors can

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understand how their portfolio will react to market changes,” Mr McManus says.
“In terms of the costs of trading - what we really like about ETFs is that we can
understand the exact price at which we will purchase or sell the security, before the
transaction takes place (unlike mutual funds where the transaction typically takes place
once a day at a set point).
“And in some asset classes, the secondary market that exists in the ETFs means
investors are able to quickly and efficiently gain access to assets that are expensive to
trade individually - the cost of purchasing the ETF (the bid-ask spread) in the secondary
market can often be lower than purchasing all of the individual securities themselves.”
With the demand for passive products on an upward trajectory and predictions by
iShares that ETF assets will reach $1trn in Europe by 2019 are there any barriers to
using ETFs in portfolio construction?
Easily accessible
Joe Parkin, head of UK wealth and retail sales at iShares, reckons that for ETFs to reach
their full growth potential investors need to be able to access and easily trade them.
“While we applaud those platforms which now offer ETFs to their clients, ETFs are still
not universally available across all platforms,” he said.
iShares has been working with a number of investment platforms to help dvelop their
infrastructure to enable them to offer ETFs to clients.
“This is something we will continue to champion as platforms fundamentally need to
adapt with the times and upgrade their infrastructure; otherwise they will eventually
lose all ability to compete in a changing world,” Mr Parkin says.
>While we applaud those platforms which now offer ETFs to their clients, ETFs are still
not universally available across all platforms.---Joe Parkin
He believes investors wanting to use ETFs to better manage their portfolios are being
held back by the inability of investment platforms to easily buy and sell ETFs.
He points out that retail investors have only been able to buy whole shares in a single
company stock or ETF on platforms and this has often left a proportion of cash un-
invested. But this, he said, is changing.

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He gives the example of an investor having £100 to invest but the value of a share is £53,
so this would leave them with £47 un-invested.
“However this been revolutionised with the launch fractional shares, which allows
investors to buy a fraction of an ETF unit costing as little as one penny,” Mr Parkin says.
In the example above, fractional shares would mean that the remaining £47 could be
invested.
“This ultimately means an investor is more likely to reach their investment goals
quicker,” Mr Parkin says, though he adds this is yet to be widely adopted across the
industry.
“We are working with third parties and platforms to make this widely available.”
laura.miller@ft.com
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Also in this guide
Guide to exchange-traded funds
How the ETF market has grown1
ETFs vs index funds and the rise of smart beta2
How to use ETFs in portfolio construction3
CPD 60min
ETFs ­ Spring 2017 yesterday

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Bank CPDFinished reading all (4) articles in this guide?
ETF developments in 2017 and beyond4