Delta one decisions

Noland Carter, chief investment officer at Heartwood Wealth Management, talks to Emma Dunkley about product selection and how ETFs compare with other investment vehicles

What are the different ways in which you use ETFs?

We use them as a means of implementing tactical asset allocation changes quickly and efficiently. If you have made a decision and want to move fast you can do so with ETFs. Second, it is a way of gaining exposure to markets where there is no proven evidence that active managers can outperform indices. We also use them to gain access to themes, sectors or concepts in a targeted fashion, when we cannot find an appropriate active vehicle or when it would be too expensive to put a product together. So for example, we currently own the iShares S&P North America Technology-Semiconductors Index fund as a way of playing semiconductor stocks. 

Would you opt to use an active manager over an ETF, in markets where you believe alpha can be gained?

More likely yes, but this is not always the case. When selecting which product to use, we look at what level of return we think we are going to get, and the duration of the investment. This helps determine how much cost we are prepared to incur.

Also, we look at whether it is a highly speculative call, or whether we have enormous confidence. This would determine, for example, whether we buy protection through a structured product or whether it has leveraged potential.

Then we look at the underlying structure of the market and the ability for active managers to outperform passive managers. All of these aspects help us come to a conclusion, given the asset class, region, theme or the sector you want to play. 

Do you use ETFs as a building block to overweight certain asset classes?

We have a very heavy overweight exposure to technology and we have split it equally between a global active manager who has an orientation to software networking, which is an area where there is evidence of active management outperforming. The other half we wanted to place in semiconductors, so that is why we bought the iShares ETF. 

We have been overweight in Pacific and Asia equity on a structural basis for a while, but in addition, we have had at times thematic bias towards sustainable income and high yield. We have owned the iShares Dow Jones Select Dividend ETF, and the Asia Pacific Dividend ETF, which pick the highest yielding equities in the region – there aren’t that many active managers who can do that. With the emerging markets, we have the db x-trackers MSCI Emerging Markets fund, which is the lowest cost product looking at this area. 

How do you think ETFs compare with other delta one products? Do you use swaps and futures? What are the benefits and downfalls of these?

We have been pretty absent in the structured products market for a while, although that is not to say we will not go back into it. We look at cost, fees, dealing expenses, and taxes. We then look at liquidity to see if it is continuous, daily, weekly, and if there is a secondary market if it is a structured product. 

Then we look at convenience of settlement and also transparency, which depends on how much asset information there is and how much counterparty risk underlies the products. This also depends on who the client base is, how sophisticated they are, and what we are trying to achieve. 

We consider price behaviour as often with structured products you have the issue of whether the delta stays fixed to the holding period or the life of the structure, or whether it is subject to conditional changes. So there is a whole range of things you look at and it depends on what you are trying to achieve. Quite often the more esoteric the opportunity is, the less likely you are to have transparency on all these issues. 

Why did you decide to opt out of the structured products market? Is it due to issues such as counterparty risk and a lack of transparency?

Yes, as well as pricing and the ability to capture what you want when you want. We went through 2008 and raised an enormous amount of cash, so we hit the economic downturn sitting in big cash positions. The exposures we had to risk assets were in very liquid vanilla-type assets.

But if you had looked at our portfolios in 2007, we had massive exposure to private equity, commercial property, hedge funds, and structured products. Part of the decision to take money out of these areas was to get liquidity and to create a much more transparent and easy-to-trade situation. As you go back into markets when things become more stable, it is possible we will go back to looking at structured products.

We have always seen ETFs as a core building block to portfolio construction, or we have at least for the last two to three years. They have just as good a place in a portfolio, depending upon what you are trying to achieve, as an active manager or any other product such as a derivative. 

What are your views on the ETF industry as a whole?

We are seeing many interesting innovations in this area of low-cost, passive investment products and are closely watching the emergent hedge fund index replicators, which might offer similar returns to hedge funds at lower cost. 

In contrast, we are not comfortable with the leveraged, short and more esoteric instruments. There has been a huge proliferation of these, especially in the US, and we believe that many may prove inappropriately constructed and so may be unable to pay investors’ anticipated returns.