ETPs: Core portfolio building blocks, tactical tools

Ben Johnson, director of ETP Research at Morningstar looks at the investment opportunities provided by Exchange Traded Products

At Morningstar’s second annual Investment Conference, held in London on 10-11 May, Morningstar’s global director of Exchange Traded Products and Alternatives Research, Scott Burns, gave investors insight into how Morningstar’s global ETF research team assesses the suitability of exchange-traded products (ETPs). ETPs’ low costs, liquidity, and generally stable, transparent portfolios have made them an increasingly popular choice for a wide variety of investors, who have implemented them in any number of different ways within their own portfolios and on behalf of their clients.

At the highest level, Morningstar’s ETF research team categorises ETPs as being suitable for use as either core portfolio building blocks or as tactical tools.

A matter of cost
ETPs have a number of attributes that make them ideal candidates for use as core portfolio building blocks. First and foremost amongst these attributes is their low cost relative to traditional funds and index trackers. Countless studies have shown that one of the factors exhibiting the greatest predictive power of future fund performance is a fund’s expense ratio.

This is intuitive, while no-one can predict the future performance of a market or a fund with any degree of certainty, investors know with full confidence that they will always be leaving management expenses on the table, regardless of performance.

In addition to low expenses, ETPs generally stable, passive portfolios also make them suitable for use as core portfolio building blocks. Given that the odds are stacked against active managers when it comes to besting the market, using passive building blocks as the foundation of a portfolio allows portfolio managers to spend more time and energy on asset allocation decisions. Furthermore, the stable nature of most index-tracking products in turn ensures the stability of the chosen asset allocation.

In general, the ETPs that are most suitable for use as core portfolio building blocks are those that track large, liquid, and broad equity, fixed income, and commodity benchmarks. Examples would include those products linked to the FTSE 100 index, the FTSE UK All Stocks Gilt index, or the DJ-UBS Commodity Index. These indices are all representative of the investable opportunity set available to investors within their respective markets. Furthermore, each of these markets is very large, liquid, and generally efficient. Active managers have tended to have difficulty adding value on a sustainable basis within such markets. Furthermore, combining multiple active managers in constructing a balanced asset allocation will further diminish one’s odds of building a market-beating portfolio.