The benefits of a good average

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In most areas of life, settling for average is not a strategy that reaps many rewards. But for the large majority of investors the reality is that they would do better just to accept the market’s average return.

After all, most investors have full-time jobs outside the financial markets with little time for stock picking, and few have the deep pockets needed for hedge fund investing. Meanwhile, even the professionals do not always beat the market. The exact statistic varies with the asset class and time frame in question, but it is not unusual to see 80 per cent of mutual funds fall short of their benchmark over a five to 10 year period.

One increasingly popular way to obtain these average market returns at low cost is through exchange-traded funds.

ETFs provide a way to own a share in a ready-made portfolio that tracks a specific benchmark index. Put simply, ETFs resemble index-tracking mutual funds but instead trade on exchanges like stocks. This means investors can gain exposure to a given sector with one trade and no minimum investment.

Sounds easy, doesn’t it? The problem is that ETF investing still presents a crucial challenge – how to choose the right market, or combination of market exposures, to suit an investor’s individual appetite for risk and to ensure that the portfolio is adjusted to reflect the changing performance of different markets over time.

In other words, investors may be better off with average market returns, but they still need to decide which market they think will have the highest average for the least amount of risk.

Studies have shown that asset allocation between different classes of stocks, bonds and commodities is the primary determinant of both risk and return, while market timing and specific security selection are much less important.

One company trying to address this challenge for the growing number of investors attracted to the $450bn ETF market is the New York-based asset management firm XTF.

In return for a management fee, XTF builds ETF portfolios for clients, using statistical models that track long-term trends across asset classes to produce the optimal “asset allocation” for a given investor’s needs over time.

Michael Woods, chief executive, says the long-term approach to this analysis is important because “wealth is built by time in the market, not timing the market”.

This principle has the added benefit of keeping trading costs down, Woods says, allowing XTF to charge less than 0.6 per cent a year, relative to mutual fund fees of about 1.6 per cent and hedge fund fees of 2 per cent plus 20 per cent of performance.

“We make tactical shifts in asset allocation about three times a year, so while hedge funds have around 100 to 200 per cent turnover, we have turnover of around 25 per cent,” Woods says.

Founded in 2000, XTF now has four different types of ETF portfolios – structured for different target dates, for diversification across country and sector exposures, and for different risk appetites. These portfolios rebalance if the long-term signals in XTF’s statistical model suggest one asset class will outperform another.

For investors looking for country exposures, for example, one portfolio equally weights 13 developed foreign countries and periodically shifts between each country’s ETF and an intermediate US Treasury bond. If, for example, the XTF model shows a country’s index will outperform the yield on the Treasury bond, the portfolio buys that country’s index ETF. If not, it sells the ETF and buys Treasuries.

For investors wishing to structure their portfolio according to risk appetite, XTF has 11 risk-based diversified ETF portfolios ranged to fit the most aggressive to the most conservative investment approaches. The equity exposures of the portfolios range in 10 per cent increments from 100 per cent equity and 0 per cent fixed income to 100 per cent fixed income and 0 per cent equity exposure.

The equity portion of each portfolio is divided between small-cap, mid-cap and large-cap stocks as well as international equities. The non-equity portion is generally composed of property assets, short- and long-term Treasuries, corporate debt and inflation-protected secur­ities.

This initial asset allocation is adjusted over time, with the proportion allocated to each asset class either reduced or expanded according to a series of fundamental, technical and risk factors. However, this so-called “tactical allocation” is conducted within strict ranges that mean over the long term the investor’s initial risk selections are, on average, maintained.

Thus far, the model has been remarkably successful. For XTF’s risk-based ETF with 80 per cent equity exposure, for example, the tactical allocation model produced first-year returns of 14.85 per cent, compared with 13.28 per cent if the fund had retained its initial allocations.

Not too bad for “average” market returns.

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