Portfolio Review: Aldous Bullish On China, India

In an interview recently conducted with IndexUniverse.eu, Aldous described his firm's business approach as a pioneer in ETF-only investment management, before sharing his current market views.

IU.eu: Christopher, your company is known for only using ETFs in its client portfolios - could you explain why you've chosen this route?

Aldous: We are unusual in that we've never used anything but ETFs. So we don't come with any of the baggage usually associated with active managers - we've always advocated indexation. We're not wedded to ETFs as the magical solution - it just so happens that they are cheaper, safer, more transparent and easier to use than other forms of indexation We regularly review other indexing solutions to compare them to ETFs in terms of cost and tracking error, for example.

I'd add that we see our mission as trying to add value through asset allocation, rather than through stock picking, so ETFs are the natural instrument for us to use. The range of asset classes available has also improved dramatically. Three years ago, for example, we wouldn't have been able to get access to listed private equity, listed global property, water, forestry. Anything that the Yale Endowment can invest in, with the possible exception of hedge funds, we can do via ETFs.

Aldous: No - our default hedge is cash. We don't invest in an asset class unless we expect it to beat cash on a tactical and strategic basis, and this year we've done well by having high cash balances.

IU.eu: There has been a lot of debate this year about the relative merits of physical and swap-based replication of indices by ETFs. What are your views on the matter?

Aldous: It comes back to the "easier, safer" comment I made earlier. We feel most comfortable using ETFs that employ full replication, since there is no structural or counterparty risk. Having said that, we're happy with synthetic replication, but we do have risk guidelines that limit the amount we can hold in any portfolio in any particular structure. Like most ETFs, synthetically-replicated funds tend to be part of an umbrella structure, where there is always the risk of cross-contamination, even though theoretically funds are protected cells. One has to be aware of that. But we're broadly happy with the risks involved, as UCITS III guidelines limit swap counterparty exposure to 10% of NAV. Bear in mind though that there is also an asset mismatch risk in swap-based ETFs, in addition to the counterparty risk. All these factors give us a certain amount of concern, and we try to have as much as we can in fully-replicated ETFs as we can without compromising our asset allocation views. We don't like structured products - we prefer very simple access to asset classes. And for the same reasons of concerns about counterparty risk we haven't used ETNs or ETCs, though I'm not saying there's anything wrong with them, and we are comfortable with the new, collateralised ETCs on offer.

IU.eu: How is your asset base split by client type, and how much do you have under management?

Aldous: We have roughly a third each represented by charities, family offices and high net-worth private clients, though we're now actively pursuing the pensions market as well. We've only been going a year, and have around £100 million under management, though we very much expect to have doubled this, at least, by this time next year.

Aldous: We regard the ETF fee as the tracking error. Of course we disclose the [underlying ETFs'] total expense ratios, but these are not so relevant if the use of stock lending or dividend optimisation reduces the tracking error to a few basis points. Incidentally, this is another great thing about the ETF market, in that it is competitive, and fund issuers do have an incentive to compete to bring costs down, track indices more closely, and reduce inherent risks - they're unlike many other investments, in this sense. On top of that we apply a sliding fee scale, based on funds under management. For a £3-5 million private client we often find we can shave at least 0.5% per annum off the fees they'd typically be paying by investing in a range of actively managed funds - this compounds to 5.1% over ten years.

IU.eu: What are your current market views, given that it's been a traumatic year for anyone invested in equities?

Aldous: We think that the full extent of the debt crisis is still to be seen. Many of the problems may be priced in, but the continuing ramifications of the structured debt market may hold things back for some months to come. It's not clear that the change of US President will have much of an effect. Bearing in mind that there has been a lot of good news in terms of fiscal and monetary stimulation, it's remarkable that markets haven't responded more. We're expecting massive dividend cuts throughout most of the Atlantic countries. One of our big themes is Pacific-centric investment, and while everything depends on the US starting to recover, Pacific markets are a geared play on that, as well as having their own, internal dynamism.

Aldous: Longer-term we are positive on commodities, but we have avoided them this year, in other words, since we launched, as we felt that their recent rise was overdone. When we decide to invest in them we'll use a diversified ETF or some of the physically-backed commodity products.

Aldous: We're still underweight across the board. When we do decide to go back in it will probably be initially into Far Eastern property ETFs. UK property, we think, will be in a very difficult situation for some time. In fact we're heavily underweight all UK assets.

IU.eu: What about the fixed income markets, where we've seen an incredible bull run in government bonds, but where corporate bonds have been struggling?

Aldous: One question I'd like to ask through you to the ETF product providers is why there isn't an ETF covering the short end of the gilt market, since it's been an incredible place to be! In longer duration bonds we feel that there may be a reappearance of inflation concerns, especially given the amount of debt governments have to issue. We think there will be great opportunities in inflation-linked bonds, especially in the US, though maybe not just yet - perhaps by the middle of next year? As far as corporate bonds are concerned, it's only because of some slight nervousness that we haven't become more heavily invested already. The great thing about corporate bond ETFs is that you can see what you've got, whereas if you employ an active corporate bond manager you run the risk of turning round and finding he's put the lot into Woolworths, for example. Plus a lot of the holdings in the corporate bond ETFs are issues from banks, many of which are now quasi-governmental organisations. So the yields are looking quite attractive, and it's very easy to put together a basket of ETFs covering US, UK and European corporate bonds.

Aldous: Our big message is that China represents a large part of the world economy, yet you would have no weighting at all if you just bought the MSCI World Index. I would argue that you should want to have a decent exposure to China in your portfolio at the moment. Chinese equities are on a trailing P/E ratio of 9 and a yield of around 3%. The China FTSE Xinhua 25 ETF is one of the most amazing growth stocks there are. India also attracts us, among the emerging markets. There are 2.5 billion people in the two countries, combined, and we feel the underlying dynamism of these economies is still there, despite the stock market falls of the last year. So for a more aggressive portfolio we'd be quite happy holding 10% in Chinese stocks, for example.