Building an investment portfolio entirely with exchange traded funds remains relatively uncommon in Europe but this approach being adopted by a growing number of managers in the US.
A recent survey by Morningstar, the research group, identified 95 US groups using ETFs as their main portfolio building blocks (accounting for at least 50 per cent of a portfolio’s assets).
These companies had $27bn in assets under management at the end of September, but Morningstar estimates the total ETF “managed portfolio” universe is likely to range between $40bn and $100bn, making it one of the fastest growing segments of the fund management industry.
Morningstar has developed a new database to monitor ETF managed portfolio strategies as it expects interest in this sector to continue to grow. It is currently tracking almost 370 ETF managed portfolio strategies, with 30 per cent of these starting up in the past three years.
Windhaven, the investment advisory group, has developed into the largest player in the ETF managed portfolio universe. It started business in 1994 (under the name Windward) and was taken over by Charles Schwab in the fourth quarter of 2010.
Windhaven’s assets reached $8.6bn at the end of 2011, a rise of 87 per cent during the year, and rose further to $9.4bn at the end of January.
The group runs money for individual investors (with a minimum of $100,000 to invest), financial advisers and family offices, and is increasingly seeing interest from institutional investors.
Stephen Cucchiaro, Windhaven’s chief investment officer, says using ETFs has allowed it to deliver “sustainable” returns while controlling downside risk through diversification. He maintains that minimising losses in rough markets is essential to achieving superior long-term success.
Financial markets are “micro efficient” but “macro inefficient”, he argues; although individual securities are often priced efficiently within an asset class, making outperforming an index difficult, different asset classes can be frequently mispriced.
Windhaven complements tactical asset selection with a strategic asset allocation approach that is not based on fixed asset weightings but changes dynamically as the outlook for asset markets evolves.
“Tactical asset allocation is a very important component of our strategy and has contributed significantly to our investment performance over time,” says Mr Cucchiaro.
Windhaven offers just three strategies but invests in 40 different asset classes. It compares expected risk-adjusted returns over the next 12 months with cash. Any asset class with an expected return less than cash is excluded and that allocation is invested in three-month Treasury bills.
Portfolio rebalancing is carried out roughly three times per year but interim rebalancing is permitted if the outlook changes radically.
Mr Cucchiaro says Windhaven’s business is scaleable as its inflows could be 10 times larger and still remain small compared with the 40 asset classes he uses, which are the largest and most liquid in the world.
Scale also helps in portfolio rebalancing as it can be done through large block trades at better pricing than could be achieved by an individual investor.
“Because of our scale, we trade large blocks directly with authorised participants who create and redeem ETF shares from the underlying securities on a highly competitive basis, securing very favourable pricing on behalf of our clients,” says Mr Cucchiaro.
As well as considering costs before choosing an ETF, Windhaven also evaluates the quality of the provider, the ability of the ETF to track its underlying index and the ease of conducting large block trades with authorised participants.
Windhaven does not run short positions or use leveraged or inverse ETFs. Mr Cucchiaro is a fan of some of the fundamentally weighted ETFs, which he says can complement holdings in conventional market capitalisation-weighted ETFs. But he cautions that ETFs based on alternative weightings usually carry higher fees and it requires an experienced manager to assess whether they are truly cost effective within a broader portfolio.