Rethinking core equity in modern portfolios

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Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Greg Gipson, managing director and head of ETFs, CIBC Asset Management 

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ETFs can really act as the foundation of a core equity portfolio. And what they offer is the benefits of instant diversification and a cost-effective ability for an investor to truly customize that portion of their portfolio, which acts as the engine, if you will, that drives the long-term performance of their investments. 

ETFs as a portion of the core equity portfolio offer an ability to really have a liquid and flexible component of the portfolio, and really then allows investors to use satellite exposures to tilt their portfolio to those areas of the market where they see opportunity on a risk-adjusted basis. 

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Small ETF tilts, if you will, have the opportunity to meaningfully improve outcomes over the long term. 

If you look at the past six years in equity markets, just having a small tilt towards, say, growth stocks or the Nasdaq in U.S. equities could add material benefit to the portfolio, as we’ve seen upwards of a 60% outperformance of this area of the market — the Nasdaq — relative to the broad S&P 500. 

These small tilts really offer a number of different advantages. One is the potential for enhanced return. The other is for risk management, or perhaps adding exposures that can act as a shock absorber to the overall market portfolio, so something like a dividend strategy or a low-volatility strategy. It also allows an investor to really fine-tune their portfolio to meet their unique investment objective — so that ability to curate a more bespoke solution for each investor’s needs. 

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Valuations or factor cycles can really impact an investor when they are looking to build out their core ETF portfolio. Now, most research will show you that market timing is extremely challenging, factor timing is extremely challenging. But certainly, if you look over time, different areas of the market will outperform or underperform. And having the ability to, again, use these tilts or this satellite exposure is a good way to capture exposure to those areas of the market that are being rewarded. 

In building the core ETF portfolio, valuations can also play a factor in how one allocates capital to different areas of the market, whether that’s geography — so U.S. equities versus Canadian equities versus international equities — or in looking to allocate to different sectors — so as I mentioned earlier, something like technology or healthcare or financials. Depending on an individual investor’s view of the investment landscape, they’re then able to really use ETFs as a way of gaining exposure to those areas that they believe will benefit. 

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An interesting aspect of building a core ETF portfolio is addressing tax concerns, as well as any home bias. Investing in Canadian-listed ETFs can offer greater tax efficiency than, say, investing abroad. The home bias is obviously strong anywhere in the world. If you look at investors, whether they be in Canada, the U.S. or Japan, you’ll always see that a portfolio typically has a greater proportion of assets invested locally. 

Now for Canadians, this has been great. If you look at since, again, that same time period from the last six years, you see that the S&P/TSX composite has actually performed in line with the U.S. S&P 500 in Canadian dollar terms. Having that home bias to Canadian equities hasn’t materially impacted the performance relative to a global portfolio. 

From a tax perspective, depending on which investments you make, there are different vehicles that can be more tax efficient. One of the main ones in the market now certainly are covered-call ETFs. Being able to realize that distribution, or component of that distribution that comes back in the form of capital gains can be efficient. 

It’s also important to balance the investment portfolio really against the totality of assets that an investor has. Getting back to home bias, one could imagine that an investor who has investments in domestic real estate, or investments in private assets, private equity, venture capital domiciled in Canada, that it might actually make sense for them on the public market side to take advantage of international diversification. 

For any investor, ensuring that the totality of a portfolio — not just public market investments, not just this core ETF strategy — is efficient from a tax perspective and meets the overall investment goals is paramount to building an optimal approach to managing the investments. 

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When implementing a core ETF strategy, first and foremost is to ensure that that core holding — that core position in the portfolio — aligns with an individual client’s goals and risk tolerance. This could lead to a difference, say, one investor relative to another, where that core is more defensive. So perhaps more focused on dividends, or cash flow, or low volatility. Or, in contrast, it could be perhaps a younger client who has a longer investment timeframe that may want more exposure or greater exposure to equity markets, or to growth assets, or growth areas of equity markets. 

It’s also important to do your due diligence on every product. Not every product with the same name has the same potential outcome or same cost. It’s really important that one assesses the liquidity — the tradability, the volume — of those ETFs they’re looking to invest in and really understands how to implement ETF trading. So, whether it’s executing in the market using limit orders or trading at a day and price, understand how each portfolio of ETFs is implemented. 

On an ongoing basis then, it’s important to continue to monitor performance, ensuring that the return or the outcome of that investment is consistent with expectations, [and] maintaining a disciplined rebalancing schedule, so ensuring that the portfolio is meeting the evolving needs. 

Disciplined rebalancing of a portfolio is extremely important, both to ensure that the portfolio is delivering on the expectations of how it was built, as well as adapting to the evolving needs of investors over time. Ensuring that risk management, risk oversight and diversification are properly addressed when building a portfolio for investors is extremely important. 

When implementing a core ETF strategy, it’s really important to think of that portion of the portfolio as being the engine of the overall investment. It’s the big moving ship that charts a course from where you are today to where you want to be. So ensuring that the investment made, the risk allocated, the geographical diversification, the risk management, all of these features are really designed to drive the portfolio forward. 

Outside of that core piece then, one can almost think of the tilt, so to speak, as value add. So again, with a car example, you can think of these as perhaps getting a slightly more advanced GPS that can help chart a smoother course. It could also be something — again, the car analogy — of using improved shock absorbers. This could be something like a dividend strategy, a low-volatility strategy that really helps to absorb the volatility or variability in markets, and provide perhaps a smoother ride for the portfolio over time. 

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Often, when people think of ETFs, there’s a certain mystique around them. But in my opinion, ETFs are really just an efficient way of gaining exposure to some area of the market. Think of an ETF merely as a delivery mechanism of exposure. And, in some ways, almost a continuously priced mutual fund. 

The benefit of the ETF relative to a fund is that it’s continuously traded on the market. There’s the ability, perhaps, on a cost-effective basis, [and] greater liquidity on an intraday basis. ETFs really offer that flexibility for investors to implement a decision when they make a decision. 

When you think about an overall portfolio, I would go back to basic first principles. What is the objective of the portfolio? Any investment, whether it’s public or private markets, can be broken into one of two categories. It can be listed as something that is expected to go up over time — so capital appreciation — or something that will pay some sort of cash flow or income. 

So, at the top of the house, really ensuring that there’s that balance of growth, or capital appreciation and income then drives how one allocates across public and private markets. And ultimately, deciding on an ETF really is the last decision because it’s, as I mentioned, just a delivery mechanism of the desired exposure.

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