Why We Use ETFs

Posted by Andrew Gordon on September 7
simon-matzinger-320332-1.jpg

Exchange Traded Funds (ETFs) enable us to create a low cost, diversified and transparent portfolio for you. Here’s why we use them.

Diversification

There are thousands of different ETFs across many different asset classes such as shares, bonds, commodities and property.

Within these asset classes there are many subclasses further. For example, in equity (stocks and shares) ETFs there are ETFs that have exposure to different countries such as the UK or US. Within these countries there are ETFs that have exposure to smaller or larger companies or different sectors such as technology companies like Facebook or financial companies like Barclays. Within fixed income there are ETFs that provide exposure to bonds issued by governments or companies around the world. Within commodities you can get ETFs that provide exposure to gold, natural gas or oil just to name a few. Within property ETFs you can get exposure to real estate in different countries. By using ETFs we can easily create a diverse portfolio that has global exposure across many asset classes which we believe will help improve return and reduce risk.

Each ETF itself normally consist of a basket of underlying instruments, sometimes thousands, which helps again to increase diversification and reduce risk by “not putting all your eggs in one basket”. Using the iShares FTSE 100 UCITS ETF (ticker: CUKX LN) as an example. This ETF tracks the FTSE 100 Index. This index contains the 100 largest companies in the UK as measured by market capitalisation (the total value of all the shares they have issued).

By holding this ETF we gain small exposure to these 100 companies so if in any given day there are some companies’ stock that performs badly there should be others that perform better and this will smooth the overall return. Conversely some might perform very well and others less so and again this will smooth out returns.

 

Transparent

We only use physical ETFs. What this means is that the ETF provider typically holds all (or most) of the shares that are in the index that the ETF tracks so you know exactly what you are investing in when you purchase an ETF. This transparency allows us to accurately assess the risks associated with each ETF and the exposure you acquire by holding it. For equity ETFs, this allows us to see the exposure broken down by country, sector or market capitalisation. For fixed income ETFs, it allows us to see the maturity and credit rating of the bonds the ETF holds. The alternative to physical ETFs are synthetic ETFs or also known as swap based ETFs. In these ETFs the ETF provider enters into a swap with a swap writer to swap the return of a certain basket of instruments for the return of the index. We do not use these ETFs as in our view there are more risks associated with them.

 

Cost Effective

ETFs are extremely cost-effective instruments at getting you diverse exposure. In the example above of CUKX LN if you were to try go and individually buy all the stocks in the FTSE 100 you would incur a lot of trading expenses and it would require much more effort than buying the ETF for which you only do one trade and pay the expense ratio throughout the year.

The expense ratio is the management fee paid to the ETF provider for managing the fund throughout the year. The average expense ratio for the ETFs we use is typically between 20bps and 25bps. This is much cheaper than the fees on most actively managed funds which typically range from 1% to 2.5%.

Spreads are the main cost associated with trading ETFs, they are the difference between the bid (price people are willing to pay) and ask (price people are willing to sell) price of the ETF. Spreads for ETFs have declined signficantlyand will likely only get lower as the popularity of ETFs rise.

 

Liquidity

We aim to use ETFs that are very liquid. This means that there are a large number of people in the market willing to buy or sell them. ETFs trade on stock exchanges every day the market is open. This means that if you ever want to withdraw funds from your account or add new funds to be invested this can be done very easily on a daily basis. With actively managed funds it may not be this easy, you may only be allowed to buy or sell on a monthly or yearly basis and potentially incur extra fees for doing so. The other advantage of ETFs trading on exchanges is that while markets are open we will always know what the ETF is worth as prices are updated constantly throughout the trading day. Again, with some other actively managed funds prices may only be displayed at the end of the day/month/quarter.

 

Rebalancing

Because our portfolios are a portfolio of ETFs it means that rebalancing or adjusting the risk/return characteristics of the portfolio can be done easily. If, for example, the UK has been performing well and the US has not been performing well in recent months this could lead to the UK now being a higher weight in your portfolio and the US a lower weight that what was originally decided for your risk profile.

To bring it back to the correct weightings (rebalance) we can easily sell some of the ETF that tracks the UK and buy some of the ETF that tracks the US to bring us back to our original weighting and risk/return allocation. If you were however just invested in one fund that tracked the whole world this would not be so easily done.

Written by Andrew Gordon

Andrew is the Head of Algorithmic Trading at Moola. He previously worked on the ETF Desk for three and half years at Susquehanna International Group, a global quantitative trading firm. Andrew has a degree in Finance from Queen’s University Belfast.

Ready to see how your money could grow?

a month

Build a free example investment portfolio with no commitment.