ETFs For Advisors
By Agustin Fleites

Introduction

The explosion in the number and size of exchange-traded funds (ETFs) confirms that institutional and individual investors are increasingly more comfortable investing in these products. Recognized as a valuable addition to the securities markets, there are now more than 250 ETFs worldwide with $115 billion in assets. ETFs cover a wide spectrum of investment options across domestic and global markets, market capitalization, investment styles and sectors.

Exchange-traded funds are an effective tool for financial advisors who wish to design customized investment solutions for their clients. ETFs are simple to use and have low inherent costs. They offer a powerful combination of benefits flexibility, broad diversification, and tax efficiency which make them attractive investment vehicles relative to other options that are available, such as mutual funds, separately managed accounts or even single stocks.

One method for introducing ETFs to your clients is to start with the concept of asset allocation. A well thought out asset allocation strategy lays the proper foundation for structuring a tailored portfolio for your client. It also provides the framework to make investment decisions that support your clients' objectives. Once the broad allocation decisions are made, ETFs can be used to establish equity exposure across asset classes, manage risk in the portfolio and enhance performance.

We will examine the importance of asset allocation and how ETFs fit into this frame work by introducing the concepts of asset class efficiency and risk budgeting. We have found ETFs o be an effective complement to active management, helping achieve a more efficient, optimal portfolio. It is within this context that we will illustrate how ETFs can add value.

The allocation of assets across equities, fixed income, alternative investments and cash is the most important step when building a client's portfolio. Research has shown that asset allocation explains over 90% of a portfolio's variability in returns. As a result, it is the asset allocation decision that should drive the investment process, not which stocks to own or when to invest.

A clearly defined asset allocation strategy will also help manage client expectations through times of market volatility. When investors become either overconfident or panicked, as experienced over the last three years, sticking to the strategy as dictated by their own needs and objectives becomes paramount to avoiding the perils of market timing and stock picking.

If you look at compounded annual returns over the last ten years, the S&P 500 returned 11.43%. However, if you were out of the market for the 10 best days, the return drops by approximately 40% to 6.72%. If you missed the 30 biggest days, the return drops even further to under 1%. The investor would have missed out on over 95% of the return generated over the last ten years. Predicting when these 'best days' will occur is difficult to do. Even the best money managers are rarely successful on a consistent basis in timing the market.

Once the client understands the importance of establishing an asset allocation policy, you can then begin to discuss what investments are appropriate within each asset class. One approach is to look at the efficiency in asset classes to determine whether the investments should be actively or passively managed. The objective is to build the best possible portfolio for your client by maximizing return for a given level of risk. After your clients have defined their risk / return objectives, it is up to you to determine how best to allocate the assets. The introduction of ETFs at this time becomes less of a product discussion and more of an investment process discussion.

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