Joseph Ho of Credit Suisse looks at how investors can use ETFs within the core and satellite parts of their portfolio, and in particular at using them tactically during volatile market conditions.

Date: Nov 2011

Tags: ETFs, Asset allocation, Portfolio construction

• It’s not the ETF which drives the decision, but rather investors need to determine their investment strategy – and then they can find the right ETF to execute this
• ETFs can exist in both the core and satellite parts of an investor’s portfolio
• ETFs are playing a bigger role in portfolios in volatile markets, as investors change their investments and do tactical investing via ETFs to implement strategies
• Do need to understand some of the more specific products better, for example with leveraged and short versions, performance might be a bit unexpected because they are rebalanced daily

When looking at the role of ETFs within the broader asset allocation process, Joseph Ho said in an interview that it’s not the ETF which drives the decision, but rather investors need to determine their investment strategy – and then they can find the right ETF to execute this.

At the same time, however, product innovation does expand the horizon of the types of strategy which investors can come up with.

Core or satellite

According to Ho, ETFs can exist in both the core and satellite parts of an investor’s portfolio.

For example, a lot of people would agree that an S&P portfolio should be part of a core holding – given that the S&P ETFs available are cost effective, at less than 10 basis points.

And when it comes to gold or emerging market ETFs, for instance, Ho said these could be part of the satellite portfolio.

Impact of volatile markets
 
According to Ho, ETFs are playing a bigger role in portfolios in volatile markets, and this is evident from many stock exchanges around the world reporting a jumping trading volume in August and September 2011.

This is because people are changing their investments, he said, for example from equities to bonds or from bonds to commodities.

In addition to this, tactical investing by some investors has made certain ETFs into favourable tools to implement strategies.

In a fast-moving market, Ho said investors want to have many as tools as they are available. And the ETF market includes over 3,000 products globally, covering geographical areas, markets, sectors, commodities and even strategies such as long and short, or leveraged.

With the additional ability to trade ETFs live, this allows investors who are following the market very closely to use them as implementation tools, whatever their investment strategy might be, added Ho.

Pitfalls of ETFs in uncertain markets

Given that ETF are the tools, whether an investor succeeds or fails will depend on the strategy that is being implemented, said Ho.

However, investors do need to understand some of the more specific products better, he added, explaining that with leveraged and short versions, performance might be a bit unexpected because they are rebalanced daily.