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Deconstruction site: Building an ETF portfolio

By Rolf Agather, managing director, North America research 

I recently spoke to a room full of financial planners and advisors at the Inside ETFs industry conference in Florida. Based on my experience with market indexes—which form the basis of exchange traded funds, or ETFs—I offered some ideas on portfolio construction, or rather deconstruction.

Deconstruction may conjure images of taking something apart. Actually, it enables us to rebuild a process or approach from the ground up. In the process, we can refine our approach by learning what we’re currently doing right and pinpointing those areas where we might improve. We also learn more about where we personally add value in the process and where we might benefit from leaving a task to someone—or something—else.

As a hypothetical example, let’s consider your investment portfolio. You may be a very hands-on investor, managing all aspects of the client portfolio. Depending on what unique qualities you have, you may be able to beat the market. But in many cases you can’t, or the costs to do so may be prohibitive. In the last three decades, with the rise of index-based ETFs, much of the market exposure covered by an active strategy can now be replicated more efficiently and methodically by an index-based strategy.

Originally, investment products based on indexes gave us a way to invest in broad asset classes. Rather than investing directly in individual US large- or small-cap stocks, you could now put that allocation into an index-based investment product like a mutual fund or ETF based on the US large-cap Russell 1000® Index or US small-cap Russell 2000® Index, which automatically gave you efficient portfolio exposure to these asset classes. For active strategies that consistently beat the performance of these broad asset classes, perhaps index-based investments were not the way to go. But for those that could not, indexing fit the bill.

In the last 30 years, this trend has been extended to many areas of the market previously considered solely within the realm of active managers. When Russell introduced its Growth and Value indexes in 1987, for example, it enabled investors to identify growth- or value-oriented stocks in a more methodical and efficient way.

And the trend has continued as index providers have continued to develop clever ways of efficiently mimicking certain investment styles and factors. Today, investors can use index-based ETFs to gain access to a full range of portfolio allocation objectives. In addition to style, we can use index-based ETFs to allocate portions of our portfolio toward specific sectors, themes and even market factors.

I am not implying that we have lost the ability to actively manage investment portfolios. Portfolio construction will always require active decisions. And an investor with a unique approach, skill or information advantage has the potential to beat the index. The difference now is that we can express our active decisions more efficiently and cost-effectively using index-based investment products.

As advisors and investors we should deconstruct everything we do and rebuild from the bottom-up. In the process, we need to honestly ask ourselves, “where do I add value?” Are you a more holistic financial planner, an asset allocator, an investment strategist or none of the above? Which areas of your portfolio would be better outsourced to a low-cost provider and which areas require unique information, insight or connections only you can provide?

At the end of the day, active management works when the manager possesses unique skill or information. However, if active elements of the strategy can be produced with relatively static index-based exposures, you may be better off using one or a combination of index-based ETFs. Deconstructing our portfolios—and our process—will lead to greater insights and a more efficient investment process.

 

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