Building an ETF portfolio

Every week at home, as a keen young portfolio manager, I would pore over the charts of all the stocks traded on the New York and American Stock Exchanges that were included in a binder with 12 charts to the page, 24 in total when open.

My pet cockatiel – named Dow Jones – would fly around the room as I worked. One day, he landed on my shoulder and walked down my arm onto the chart book. He shuffled around and showed his displeasure in a unique bird-like way on one of the charts. The next day that stock went down sharply! A humorous coincidence!

He did it the next week and the next. Each stock that received a “deposit” went down in price. Still a humorous coincidence, but I realized it represented a random key to how many people make investment decisions.

People do what they think worked for them in the past regardless of the method’s randomness. Sometimes their lottery ticket selection strategy is more systematic. No wonder so many investors end up with a portfolio of random securities with no plan or purpose.

There is less guesswork with exchange-traded funds (ETFs). These securities track broad indices, commodities, currencies, sectors and industries and allow investors to take leveraged long and short positions. They offer diversification, the ability to sell short, buy on margin, and trade like a stock during regular exchange hours.

There are only three basic ways to build portfolios with them – all others are variations. Over the next three issues, I will examine each of these.

Here is a brief overview of how ETF portfolio construction works:

Fundamental approaches

The fundamental approaches use some form of “top down” or “bottom up” analysis. Assessing views of global, region and local economies and their impact on sectors, industries and companies, ETFs lend themselves nicely to these strategies because they make country, regional, sector and industry investing simple.

Institutional managers can use ETFs to establish broad exposure before making specific securities investments and they can hedge existing exposure by shorting the relevant ETF. Portfolios for individual investors can similarly benefit from diversified exposure to elements identified by the portfolio manager.

“Bottom up” managers, or stock pickers who screen for superior growth, value a combination of both or other factors, have style ETFs as well as large, mid-cap, and small capitalization alternatives in different regions and sectors to choose from.

Many large portfolios and pension schemes employ “core” plus “satellite” or “tactical” approaches. They create a passive core cheaply and select active alpha-seeking strategies around that core.

ETFs offer flexibility and choice at a low cost so these traditional approaches can be applied to private client portfolios effectively. The tax efficiency of separately managed accounts combines nicely with ETFs so many firms will be encouraged to transition pooled and mutual fund assets to this format. Indeed, low costs contribute to better performance, so complacent product vendors should pay attention.

Market timing

Today, there are 1,000 ETFs available worldwide, with another 500 or so in registration, a fact attractive to many. Include currency; commodity; leveraged or enhanced; long and short; so-called “fundamental” and even Chinese real estate ETFs, and the possibilities grow.

Traders feed on volatility. So it’s good news that the dampened relative volatility of groups of securities – which counters traders’ need for action – is offset by better liquidity from the ETF structure.

Leveraged ETFs that offer the holder two times the daily price movement of an index are available; inverse versions go up two times the daily fall in price of an index. This is the type of action that traders want. But leveraged ETFs are not just for traders.

Trading has done much to democratize capital markets for individual investors; specialized education in financial analysis is not required. Technical analysis, the trader’s discipline, doesn’t care about companies, products, margins or market share. All that matters is price movement.

Within the movement of prices (and sometimes trading volume) lies all the necessary information needed to make buy and sell decisions. Anybody can apply these methods to the price of anything. This is pure market timing.

There are many other perks to using ETF products:

1. A free lunch: Lowering risk by using leveraged ETFs: If achieved, investors benefit from the higher return potential from leverage without assuming additional risk.

2. Risk budgeting through sophisticated portfolio construction: Only the most sophisticated institutions use this approach that optimizes diversification by assigning weights by risk.

3. Constant volatility: Consistent risk exposure for individuals can help avoid sharp market declines.

ETFs are neat little packages of diversified risk that make effective building blocks for many kinds of portfolios.

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Mark Yamada is president of PUR Investing Inc., a registered portfolio manager specializing in risk management using exchange-traded funds.

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