Why consider funds of ETFs?

Head of Barclays Wealth funds David Dalton-Brown comments on the advantages of funds of exchange traded funds.

At Barclays Wealth we believe funds of exchange traded funds (ETFs) are great alternatives to traditional funds of funds (FoFs) for investors looking for multi-asset solutions but without the cost of active stock selection.

FoF structures have been rising in popularity since their first retail appearance in the 1980s. The Investment Management Association (IMA) reported that last year £1 in every £8 invested in retail funds was placed in a fund of funds.

Steady improvement

There is increasing reason for investors to look at these products. Lipper data shows that in the three IMA Managed sectors as well as its Global classification, there has been a steady improvement in the outperformance of funds of funds over single manager funds. During the decade to the end of 2010, funds of funds in the four sectors outperformed the aggregate sector, on average by 7.2%.

Despite their current popularity, FoFs have not had it all their own way. Performance was weak in 2008 when the financial crisis played havoc. In short, many FoFs held both equity and bond funds, across multiple managers and strategies that could not escape market directionality, leaving investors disappointed by returns.

As a result, we believe it is time to reconsider what a FoF is for and how best to construct it. The question is: what generates returns and how can they be achieved efficiently and at lower cost?

Tactical asset allocation

A number of academic studies over the years have indicated that asset allocation is the primary determinant of portfolio returns. However, a caveat to this is that asset mixes must be revisited regularly. This is a stumbling block traditional FoFs may encounter, as switching in and out of funds regularly to make quick asset allocation calls adds cost, which then drags down their performance. This is why in recent years FoF managers themselves use ETFs as a tactical asset allocation tool, helping them to quickly get 
in and out of regions and 
asset classes where they see opportunity.

If the key to superior returns is asset allocation, a fund of ETFs offers an elegant solution, providing the asset allocation is well constructed and managed on an ongoing basis. When it comes to asset allocation, funds of ETFs have a growing palette to work from. Worldwide, there are more than 2,600 products on close to 50 different exchanges. Asset allocators can access all the major domestic and global investment markets as well as more specialised markets.

The due diligence process to invest in an ETF is also less time consuming than for an active fund in the same market once due diligence has been performed on the ETF provider. Following due diligence with selected ETF providers and on reaching comfort in relation to the structure of the individual ETFs, we can be a little more dispassionate when it comes to replacing one ETF with another, making it easier to make quick asset allocation calls.

Whole of market

In a traditional FoF portfolio, underlying managers are unlikely to provide as pure an exposure to a market as an ETF. This is because actively managed funds are often run with a style towards either growth or value plays with managers selecting those companies they believe will do well.

ETFs, on the other hand, provide whole of market exposure, enabling access to all the companies within a set index or sector, or close to all depending on the index replication methodology. The key advantage of course is the removal of the cost of selection and monitoring of which companies to invest in. So what you give up in terms of opportunity to outperform through active stock selection, you gain through loss of opportunity to underperform plus reduced cost of investment.

Consistent returns

While FoF managers will drop funds that fare poorly, they do not do so lightly, and rightly so, as reacting to short-term performance is generally not a good idea. However it does mean they can suffer through extended periods of underperformance before a manager is replaced.

A fund of ETFs in contrast removes the opportunity for underperformance through poor stock selection, meaning returns will be more consistent with the markets being tracked. In short, the cost of investing is directed towards the asset allocation decision making process, asset allocation being the most important driver of returns, while markets are accessed cheaply and efficiently through passive funds.

At Barclays we absolutely believe that identifying the most appropriate asset mix for each client based on their objectives and needs is the key to successful investing. We offer clients a choice of solutions that are either constructed with active funds or passive funds such as ETFs. Some clients are happy to pay extra for the opportunity to outperform through active stock selection, while others prefer more consistent returns and a lower cost strategy.

This is especially relevant in the run-up to the implementation of the retail distribution review (RDR) in the UK, where charges and fees are under increased scrutiny and value-for-money propositions are being championed.

Passive future

Looking ahead, we believe there will be a fundamental shift towards passive and pseudo-passive solutions as a core part of investors’ portfolios. These will be overlaid with a number of core satellite solutions such as actively managed funds as we approach the implementation of RDR.

Advisers should consider funds of active funds, and funds of passive funds (such as ETFs), and provide their clients with choice.

This article first appeared in Professional Adviser.