Laying the foundations

Charles MacKinnon, chief investment officer who runs over £200m at Thurleigh Investment Managers, talks to Emma Dunkley about understanding index construction and the risks associated with different ETFs

Do you use ETFs to access any specific asset classes or areas in particular?

We use ETFs to gain our market exposure across asset classes. We are using them for exposure to real estate at present. We tend not to use them for exposure to credit, although we do use them for government bonds, so we are quite specific in our allocation to fixed income. In terms of regions, we have the iShares MSCI Emerging Markets fund which provides our main emerging markets exposure, but we also use the iShares FTSE Xinhua China 25 ETF for our China exposure. 

The reason we do not use ETFs for credit is because they essentially follow an index, as opposed to a manager making an active stock selection. So when you are buying an ETF, the construction of the index is really important. For equity indices, such as the FTSE 100, there is a well-developed process to work out the construction of the index; in essence, it is the market capitalisation of the companies that are in the FTSE. 

However, there is no natural index for bonds. There are some companies that are very large issuers of bonds and others that are small issuers. A company with lots of bonds outstanding, and therefore the company that has had to borrow the most, is the one you least want to give money to. So the construction of an index on credit is very important. 

It is not that these indices are bad or unsuitable, but it is really a question of understanding what it is you are buying. The risk is people may not want to lend money to those who have issued the most bonds and are therefore the most in debt, in case of the risk of default. 

What role do ETFs have in your portfolio?

It is the core of our portfolio. The proportion that we allocate to ETFs is around 40%. However, it could be more. For certain portfolios and strategies this allocation is 100%. It is a question of what we are trying to achieve for the client. 

Why do you opt for ETFs over other investment vehicles?

We opt for ETFs to get exposure to any large liquid markets. Statistics show us that 97% of all active managers fail to beat an index over a three-year period. If we are giving a mandate to an active manager, we know that 97% of the time active managers will fail to beat the benchmark.

Are there any issues or hindrances obstructing the development of the ETF landscape and your use of them?

The major issue in the UK is most people involved in managing money are paid by commission on transactions and by fees from fund producers and so they have an economic disincentive to buy an ETF, as they make less money. 

We have also frequently been in pitch meetings with prospective clients where they have got a portfolio consisting of 200 to 300 stocks in some cases, with around 100 UK-based names. We propose a portfolio of around 20 positions, of which five are ETFs. However, we are then told by the accountant, trustee or lawyer that they cannot have their portfolio that concentrated, even though they have all of their assets in the FTSE 100, for example. 

So it is down to education. Although we say we have ETFs on the S&P 500, MSCI World and FTSE 100 indices, which actually represents over 1,000 shares, some clients say there is only one fund manager. This misunderstanding is the issue. 

Do you think the Retail Distribution Review  will favour ETFs more?

In theory it does. It will absolutely have an effect in the IFA community, because IFAs in theory will now be paid for advice, so what they are being paid to do is subtly different. 

Would you use more ETFs in your portfolio or do you think your current weighting is enough?

Our allocation is not driven by the ETF vehicle itself, it is driven by what we are trying to achieve for our clients. If all we wanted to do was have mainstream long only exposure, we would gain this through ETFs. If we wanted to have exposure to obscure asset classes, I do not think ETFs would provide this. If we decided that we just wanted active managers, then by definition we would not be using ETFs. 

Do you prefer to use traditionally replicated or synthetic ETFs? 

I prefer traditionally replicated funds and I mostly use iShares. In times of crisis there was a sense traditionally replicated funds were better, but we tend to use ETFs for our mainstream exposure anyway, where there is no need for synthetics. We are not big buyers of new types of ETFs, such as any of the weighted or inverse funds. 

People need to be careful that they understand exactly what they are buying. Investors need to really concentrate on understanding what they have when they buy, for example, an enhanced dividend European ETF and how it will move in certain circumstances. I do not think a lot of people have the education to work this out and I am not sure all IFAs understand what happens if certain events occur. Our clients start at £2m, and they tend to be high-net worth financial investors.