Tools of choice for tactical and strategic exposure

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Morgan Stanley says assets managed in exchange traded funds are expected to exceed US$2,000bn (£1,014bn, €1,289bn) in 2011, at least partly as a result of the increasing use of ETFs as tools for tactical and strategic exposure to assets and indices.

Few investment markets have expanded as fast as ETFs in the past year or so.

Hedge fund managers are beginning to use the instruments as a hedging tool, either to short an index while catching the upside of a particular stock or short a stock while keeping exposure to the sector. The advantage is they are cheap, relatively transparent and available in almost every size and shape from commodities, fixed income to emerging markets.

Other equity fund managers use them to give them market exposure to a sector or an equity index, often while waiting to invest more actively in specific investment opportunities, says James Oates, marketing director of Spa ETF.

Private bankers, wealth managers and fund of funds managers are also starting to look at more actively managed ETFs or even the new breed of enhanced ETFs promising a higher return than pure index trackers. These are still lower cost than most actively managed mutual funds, say Mr Oates, whose firm trades them.

Pension funds are turning to ETFs to increase their exposure to chosen assets as part of a core-satellite approach. This is one of the most common investment strategies. ETFs form the core of an investment portfolio alongside other index trackers and low-cost passively managed investments. This core gives investors exposure to efficient asset classes such as large-cap stocks and investment grade bonds. The portfolio manager then picks a series of actively managed satellite funds to boost returns.

But there is a band of ETFs coming to the market that are no longer purely passive or track indices, stocks or sectors. In the US a number of actively managed ETFs are coming on to the market.

A few investment consultants advising pension fund trustees have also begun to advocate using ETFs. Andrew Tunningley, head of UK investment consulting at Hewitt, acknowledges that the investment consulting sector has been slow to catch on to the idea but says his firm increasingly advises clients to use ETFs to achieve medium-term shifts in asset allocations.

Thomas Anderson, vice-president at State Street Global Advisors and head of SSgA’s strategy and research group, outlines a number of other ways investors use ETFs.

Some investors use ETFs to plug holes in a portfolio, he says. “ETFs can be used as ways to fill out or complete the portfolio. If it was missing energy and technology exposure, for example, a manager might complete the asset allocation by adding exposure to energy and technology sector funds. An emerging approach is ‘reverse’ core satellite, in which wealth managers use ETFs as the satellites to get efficient exposure to satellite asset classes such as commodities, international real estate, international bonds, or emerging markets,” Mr Anderson says.

ETFs are also increasingly used to manage tax liabilities, he adds.

“For instance, an investor with a loss in a technology stock sells the stock to harvest the loss and then purchases an ETF with a high correlation to the sold position. The investor maintains exposure to the sector while harvesting a tax loss.”

And then there is so-called “transition management”.

“An investor is no longer satisfied and decides to terminate a manager or liquidate an actively managed mutual fund. Until a new active manager can be identified, ETFs can be used as a temporary investment to maintain exposure to an asset class and limit cash drag. Once a new manager is selected, the ETF can be easily sold and the proceeds can be used to fund the new active manager.”

John Davies, director at Standard & Poor’s, says: “ETFs are now part of a broad investment tool box for investors”. And both investors and the range of available ETFs, as well as the way they are designed, are becoming increasingly sophisticated. Where, for example, an ETF would in the past fully replicate an index, now they use derivatives and swaps to replicate the returns from indices.

Mr Davies adds one caveat. “The question is what investors are gaining access to? If they use swaps, they should know they are also gaining exposure to the credit risk of a swap issuer”.

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