Investment for all seasons

Much has been made of exchange-traded funds (ETFs) lately – easily traded, diversified, low cost, low risk investments. Their success and popularity with investors is reflected in their phenomenal growth, both in the US and increasingly across Europe. Amidst uncertain markets, the take up of ETFs has been spectacular. Worldwide, there is now more than e125bn in ETFs compared with less than e10bn as recently as 1997, according to Morgan Stanley’s research. The amount of assets in European ETFs increased by 23 per cent in the first quarter of 2002, indicating the phenomenal growth is not being limited to the US alone. With all this growth, in what ways are investors using ETFs? Because of their inherent transparency and cost efficiency, ETFs are ideal tools for a wide array of investment strategies, be they long or short-term. Long term One of the catch phrases in the world of portfolio building these days is “core-satellite” investing. This is where the bulk of one’s portfolio is invested in a stable, lower risk “core” vehicle, whilst the remainder is allocated across a number of riskier “satellite” investments, which aim to make the portfolio outperform. ETFs provide an ideal vehicle for the “core” component of this strategy. They provide broad, diversified exposure to a wide variety of industry benchmarks, sectors, countries, and regions. This is a relatively simple way of using ETFs, but one that growing numbers of retail investors are adopting as a cost efficient, “buy and hold” portfolio strategy. Similarly, ETFs have emerged as ideal products for tactical asset allocation, and are increasingly being used by personal investors to implement specific strategies including risk diversification and sector/style plays. Short term It is in relation to short-term investment strategies that ETFs really come into their own. Because ETFs can be sold short, they can be used to hedge a portfolio of stocks or funds, and to make specific bets on market direction. For example, the highly volatile Nasdaq 100 Index offers frequent money making opportunities if one can pick the market swings. ETFs tracking this index can be sold short, cheaply and simply and quick gains can be made. As a hedging vehicle, ETFs have also proven an effective alternative to futures. Depending upon the availability of the futures contract for a given benchmark, the anticipated holding period, and the overall expense ratio of a given fund, ETFs can enable investors to avoid the quarterly rolling costs of futures. The ease with which they can be bought and sold, combined with their very high liquidity has seen growing numbers of asset managers turn to ETFs as a means of equitising short-term cash balances. Fund managers frequently use ETFs to easily and cheaply maintain equity market exposure prior to making specific stock or sector asset allocation decisions. This is increasingly being used in portfolio transition management. If an investor wants to move his assets from one manager to another, this transition can often be time consuming, with market exposure being difficult to maintain at reasonable cost. ETFs provide the perfect way of maintaining cheap market exposure while this often lengthy process is taking place. Again, the overall liquidity of ETFs has seen the most successful of them benefit as a result of index arbitraging. Despite their closeness to respective indices, which is a key attraction with ETFs, arbitrage opportunities do present themselves when the value of the ETF slips from its tracked index. Because of their efficiency, these arbitrage opportunities are usually only very brief windows of opportunity for large investors, but their high liquidity enables the alert investor to capture these incremental differences between the ETF and the market. It could almost be claimed that ETFs are the “investment for all seasons”. They offer simplicity, diversification and ease of access – key selling points for risk risk-averse retail investors. To claim that they are simplistic and unsuited to more complex portfolio building or trading strategies, is to do ETFs a disservice. They can be used as key tools for securing or enhancing one’s portfolio. As the man with the 50 ice-cream flavours said, “there is something for everyone”.