Portfolio Uses of ETFs

ETF Strategies

Most ETFs are used by asset and fund managers as well as financial advisers in many strategies serving diverse investment goals. This can be on a strategic, tactical, or dynamic basis. The ETFs serve the following purposes:

1. Portfolio efficiency: ETFs are used primarily for operational purposes. They include management of the transition of active managers, rebalancing of the portfolio, and management of the fund’s liquidity.
2. Managing asset class exposure: This involves the use of ETFs to deliver target returns to the asset classes.
3. Active and factor investing: For an active manager investing in illiquid securities, disclosure of holdings is less important. That is because not every strategy is fit for an ETF structure.

Efficient Portfolio Management

Management of portfolios is a vital aspect of an investment. Changes in cashflows and positions can be managed by using ETFs. The funds are useful for:

• Management of portfolio liquidity: This involves the management of cash flows. They reduce cash drag by ensuring that investors are consistent with the benchmark exposure. Moreover, ETFs can be used by issuers for transacting small cash inflows and outflows.
• Rebalancing of portfolios: Whenever the value of a portfolio diverges from its expectations, rebalancing is necessary. The ETFs required for rebalancing must be liquid and have a small bid-ask width. Such ETFs for rebalancing include domestic equity, international equity, and domestic fixed income.
• Portfolio completion: This involves the use of ETFs to fill gaps in strategic exposure to an asset class. Nevertheless, ETFs can be employed to adjust exposure to the target level. The ETFs used for portfolio completion include small international cap, real assets, among others.
• Transition management: ETFs can be used in transition management. This can happen, for instance, in the case of a newly hired manager. To maintain exposure while undergoing the process of selling unwanted securities from a management that has exited, an investor can invest in ETFs. This is because ETFs can be used to maintain benchmark exposure in case there is no external manager.

Management of Asset Class Exposure

The 2008 financial crisis reduced banks’ capital. Therefore, for core exposure, fixed income ETFs were used. Unlike other funds, fixed-income ETFs are more efficient and liquid. The applications for ETF asset class exposure include:

• Core index exposure to various asset and sub-asset classes: ETFs are used to meet the desired core exposures to asset classes. Based on ETF recommendations, financial advisers can utilize ETFs to create a diversified portfolio. Moreover, some ETFs such as domestic equities, international equities, and fixed incomes provide a tactical tilt to increase returns from an investment.
• Tactical strategies: ETFs are also used for delivering high returns and adjusting risks. For instance, thematic EFTs can be used instead of individual stocks or industry ETFs to ensure a representation of the investment view of the investor. Furthermore, ETFs are highly liquid, implying a high trading volume. Liquidity enables them to be suitable for tactical trading applications.

Active and Factor Investment

The ETF application for active and factor investment include:

• Factor exposure: A portfolio might have some missing risk factor allocations. Therefore, the risk factors can be added using factor ETFs. They can also be used for determining whether a factor meets its expectation as well as ascertaining the effectiveness of the selected factor in generating the benchmark return. Additionally, ETFs provide the excess profits from rebalancing as well as the risk premium for the risk factors.
• Risk management: Smart betas are constructed in diverse ways. Some generate a lower risk while others have a higher risk than that of the index class. ETFs that are less volatile reflect a portfolio with a lower volatility return profile. Moreover, ETFs are used in the management of equity beta, currency, and duration risks.
• Alternative weighting: Aside from being used for capitalization, ETFs can be used for the implementation of investment views. They seek outperformance and balancing of underlying security risks.
• Discretionary active ETFs: They include ETFs from reputational fixed income, and their purpose is to generate returns and diversify risks for stocks and bonds.
• Dynamic asset allocation and multi-asset strategies: Some ETFs are used to maximize returns from active allocations across the asset and sub-asset classes based on the risk profile, i.e., aiming at the investment view.

Question

ETFs are important tools for investors across markets. Which one of the following is least likely true about the applications of ETFs in portfolio management?

1. ETFs are used in portfolio rebalancing.
2. ETFs are used for portfolio liquidity management.
3. ETFs are used to measure tracking error.

Solution

The correct answer is C.

ETFs are not used in measuring tracking error.

Some of the uses of ETFs in portfolio management include:

1. Portfolio rebalancing.
2. Portfolio liquidity management.
3. Factor exposure.
4. Risk management.
5. Transition management.

Reading 39: Exchange Traded-Funds, Mechanics and Applications

LOS 39 (h) Identify and describe portfolio uses of ETFs.