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How to Use ETFs in Your Portfolio

ETFs have grown in popularity as investors cotton on to the impact of cost on real returns - and now passive funds can be used to build a diversified a profitable portfolio

Emma Wall 7 October, 2016 | 12:00PM

This article is part of Morningstar's Guide to Passive Investing, helping investors make smart choices to meet their long-term investment goals.

 

Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Ursula Marchioni Chief Strategist for iShares.

Hi, Ursula.

Ursula Marchioni: Hi, Emma.

Wall: So, we're here today to talk about how people use ETFs in their portfolios and how they can best use ETFs in their portfolios. I thought we'd start by going back a bit and seeing how people have used ETFs in the past and how that's changed in recent years as passive investing has gained in popularity.

Marchioni: Absolutely. So, my first answer would be that there is no one use for ETFs in investors' portfolios. So over the years we have seen the classic core/satellite approach where index investing, also known as passive, has been a very popular choice for core strategic long-term holdings, which were then coupled with alpha strategies which tend to be allocated to the satellite and that's where investors tend to take bets in terms of the good mangers that they believe will generate extra returns. That is certainly one aspect of it.

But over the years we've seen appearance of other solutions, for example, the reverse core satellite where active strategies have been put in the core and used as strategic long-term holdings and ETFs and index funds have been used as a liquidity sleeve or a liquidity tool to manage inflows and outflows without having to disturb the active managers' strategy with inflows or outflows.

In general, I would say one theme that runs across both solutions is the fact that over the last few years we have seen the breadth of solutions. The strategies that you can actually access through these vehicles really grow exponentially. If you think about the rise of fixed income ETFs, the industry in Europe has now exceeded $150 billion in size. iShares is over $100 billion of that. So it's been a massive journey for investors and that's just one of the many examples. Smart beta or strategic beta is certainly another. So, I think we are at the very exciting time in terms of how ETFs can now play a role in portfolios.

Wall: I think what you said there is very interesting and certainly true of our readers and investors sort of in the U.K. They may first come to passive strategies, to ETFs with the idea of investing in a very liquid equity market such as the S&P 500 or the FTSE 100. But then actually you see that growth then move into bonds, to commodities, gold obviously being a firm favorite this year, and indeed, these alternative non-market cap weighted strategies, strategic beta or smart beta. Should we expect this trend to continue and people to be increasingly diversified in their passive investing?

Marchioni: Absolutely. I'm a firm believer that that is the case. I think the trend that we have seen will continue for a variety of reasons. One is the fact that index strategies in general deliver diversification and cost-efficient access to the underlying. So as the industry evolves, investors will certainly embrace the opportunity to access new parts of the financial markets with these two great benefits.

A third benefits that I would definitely mention is the fact that index investing has proven to be very flexible over the years. To your point, absolutely. The first index was born couple of centuries ago to access the U.S. large-cap sector, railways companies, in particular. And if you think about the journey since then across all the exposures and the innovation that you've mentioned has been great and it will continue because, again, these big benefits that investors can enjoy and harness through index investing are here to say and will continue to resonate going forward.

Wall: And is there anything that investors should consider before investing in ETFs? They may not have done before in the past because they have only been active strategy investors.

Marchioni: Yes. So, I would mention two main things. The first one might be slightly surprising. But at BlackRock, we are firm believers that due diligence is needed for index investing as well. So not all managers are created equal, not all products were created equal and there is a bit of a myth in the industry that indexing is commoditised and ultimately you are just replicating a benchmark.

But in fact, there are a lot of active choices that the portfolio manager has to make in terms of when the index rebalances and when sampling might be needed. So I would definitely say number one, perform due diligence and think about the manager's track record in terms of his or her ability to deliver a result that is actually close to what the benchmark stands for.

Number two, I would recommend to go beyond simple TER-based approach. TER is certainly an important point. We live in a lower for longer environment. So everybody is much more cost focused. Everybody needs and wants to be efficient and that should be embraced but should be, I would say, applied in a holistic manner. There are certainly costs attached to the holding period of an instrument. So the TER is one of those but it should be considered together with potential securities' lending revenues or tax rebates or withholding tax effects that might come through.

And then equally, the cost of accessing and exiting from the instruments should be considered. So from an ETF perspective, the bid/offer spread. So, I would say, look at the manager, look at their track record, number one; and two, look at how closely you get to the index thinking about a holistic approach to costs through TER and other holding related affects but also the trading aspect.

Wall: Ursula, thank you very much.

Marchioni: Thank you, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Emma Wall

Emma Wall  is Senior Editor for Morningstar.co.uk