Comments from Christian Tomaszewski for the FT Advisor. Article written by Simoney Kyriakou.

Diversification is king; at least, so it should be.

The importance of having a properly diversified investment portfolio has been expounded by so many for so long that it ought to be a mantra that is seared onto every investor’s consciousness.

The core tenet is simple: avoid concentration risk in any one asset class, sector or country by diversifying your investments across asset class, sector and geography.

Understandably, this can lead to higher portfolio fees as investors patched together do-it-yourself portfolios of bits of this and that and whatever takes their fancy after reading their latest client newsletter.

The question of how to maintain a well-diversified portfolio without retaining the high management or transaction costs involved has led, over the past few decades, towards the use of passive funds within a portfolio.

‘Investors who favour fully active funds may use passive for exposures where active management generally doesn’t make sense.’ Seager-Scott

Pierre Debru, head of quantitative research and multi-asset solutions for WisdomTree Europe, said as exchange-traded funds are listed on market exchanges, they “regroup” all the characteristics of classic open-ended mutual funds, as well as other features.

He lists these as:

High liquidity.
Intra-day trading.
Low fees.

He says ETFs as a wrapper are an “incredible improvement for investors” and the high growth of the European exchange-traded products market is testament to this.

This has been evident in the institutional space, such as default pension funds, where the focus is as much on keeping costs low as it is about driving investment performance. Take the National Employment Savings Trust, the government’s flagship auto-enrolment scheme.

Nest does offer access to active fund managers, when there is need to expose members to a particular type of asset or market that cannot be gained through passive investing.

But in its 36-page investment approach document, called Looking after members’ money, Nest also states: “Investing passively is generally better value than paying a premium for a fund manager to actively select individual securities.

“Active management can be expensive and, on average, active managers in many asset classes tend to underperform passive benchmarks in the long term.”

‘Investors use ETFs in every corner of their portfolios.’ – Debru

This approach is being replicated in the world of retail investing, too, and not just among those using a DIY approach.

Advisers and wealth managers are also keen on integrating passive funds within a multi-asset strategy, as Barry Cowen, senior fund manager, collectives and model portfolio solutions at Sanlam Wealth, explains.

He says the use of passives – whether straightforward index trackers, smart beta or ETFs – is a great “tactical tool” for constructing a model portfolio. He gives the following three reasons for Sanlam’s use of passives in this way:

Lower cost.
Provision of core beta.
Creating a core-satellite approach.

How multi-asset portfolios of passives are constructed along these three lines will be considered in more detail further in the article; but for Christian Tomaszewski, financial adviser at Timothy James & Partners, part of the reason why advisers and wealth managers have been using passives has been a regulatory one.

He explains: “Since Mifid II and the requirement to have conversations with clients surrounding costs, certain frailties within the financial construct have been exposed, specifically in regard to transaction costs of actively managed funds.

“IFAs have to disclose the costs of all fund managers, as well as their transaction costs, which has caused some surprise to both advisers and clients, in terms of the size of the percentage figure.”

This has led to a wider use of passive investment vehicles to reduce costs of overall portfolios. Tomaszewski adds: “To gain exposure to some of the more ‘efficient’ stock markets, where information is ubiquitous and widely known, advisers have been using passive investments as the additional value of using actively managed funds can be relatively small.”

To him, this is why the use of US, UK and European passive investment vehicles has increased, while the use of actively managed funds in stock markets and economies in historically more “opaque nations” is still popular.

And while some people still argue for active management, Debru counters the active versus passive argument by explaining how ETFs can work well in a multi-asset portfolio. He says: “Some people view ETFs as a vehicle to deliver only delta-one exposure to large market cap indices.

“This erroneous view creates this fake debate between ETFs as the passive investment and mutual funds as the active investment. This is no longer the case.

“Nowadays, ETFs offer a full spectrum of market exposures, from market-cap-weighted investment to active or thematic strategies that used to be the sole preserve of mutual funds through the halfway house of factor investing.

“Therefore, investors use ETFs in every corner of their portfolios.”

Keeping it low cost

Lower cost is the first and foremost argument put forward for the use of passive funds within a multi-asset portfolio approach. Sanlam’s Cowen explains: “There are times when macro dominates and bottom-up selection is drowned. In this situation, few active managers outperform.

“Why pay up for active at such times, when the chances are high that detailed analysis may be unrewarded in the short term? At other times stock selection can add a lot of alpha. At such times we dial down exposure to index.”

David Hsu, senior equity index and ETF product specialist for passive fund giant Vanguard, says the company believes investors have the best chance of success through holding broadly diversified portfolios, at a low cost, for the long term.

And as a foundation stone, he says: “ETFs are a great tool for constructing these kind of portfolios.”

Ben Seager-Scott, head of multi-asset funds for Tilney Group, says there are lots of different ways to build multi-asset portfolios incorporating passives/ETFs and related funds.

‘Having core beta allows something of a core-satellite approach.’ Cowen

But he adds: “Much of it depends on the investment strategy or preferred style of the investor. One way to think of it is as a bit of a spectrum between fully active and fully passive.

“Even those investors who heavily favour fully active funds may end up using passive for exposures where active management generally doesn’t make sense, for example for physical gold exposure or simple gilt/US Treasury exposure.”

Then again, there are some fully passive portfolios, at the far end of the passive spectrum, which he says come in several varieties; some using simple, static allocations, some using tactical asset allocation and some using more sophisticated passive/ETF options, such as factor ETFs.

He explains: “Investors in these types of portfolios may have a focus on minimising costs, or perhaps they simply don’t want to be exposed to the dispersion of returns you get with active funds and simply opt not to play that game.

“I hope that gives you some idea of a few different passive portfolio set-ups that spring to mind, I’m sure there are others.”

Style tilt

Cowen’s second reason, providing core beta to a benchmark component, essentially means allowing for some style tilt while navigating and managing risk.

He says: “For example we can combine a corporate bond tracker to give core rates and investment-grade credit exposure and combine it with a tactical macro bond manager.

“We can then size the respective positions to deliver the degree of benchmark risk we are comfortable with, and vary this as the backdrop becomes more or less suitable to active management.”

And the growth of more flexible and tailored ETFs, or smart beta funds that do not track a traditional market-cap-weighted index such as the FTSE 100 or the S&P 500 means managers can create more bespoke portfolios of passive funds for clients that can help create that tactical tilt.

Such flexibility can also help provide an environmental, social and governance overlay, for example, as more cleverly structured ETFs are brought to market that avoid simple ‘deselection’ strategies but actively include companies with strong ESG credentials that are accredited independently by ratings agencies such as Sustainalytics.

Core-satellite approach

Again a borrowing from the institutional world, where the core-satellite approach was taken by many pension funds at the turn of the new millennium.

This essentially allows a large, centralised holding of a passive fund or series of passive funds, with the flexibility to add different asset classes into the mix around the edges.

It is a way of keeping risk and costs low, while allowing better diversification and exposure to slightly more esoteric asset classes or emerging markets.

As Cowen puts it: “Having core beta allows something of a core-satellite approach, enabling us to use active managers with more focused and stronger factor biases.

“Such funds, such as concentrated deep value or high growth and their underlying stocks, may trade at a discount as they are too ‘non-core’ for many.”

Seager-Scott says there are several ways of creating a portfolio with a core holding or set of holdings, with funds added around it. By moving further down the passive portfolio spectrum, some investors may choose to have a core of active funds looking to add alpha in a particular market.

However, they could supplement that with passive/ETF exposure that can be used for portfolio liquidity or to help express more tactical views.

He adds: “Another step along the spectrum might be using a core and satellite approach with a core of passive funds and minority of active funds.

“Often, this approach aims to take advantage of broad characteristics of risk assets (market or beta exposure) with relatively low costs using passive exposures.

“It complements this with active funds that tend to be a little more aggressive and unconstrained to provide an alpha ‘kicker’ without exposing the rest of the portfolio to what can be returns that deviate significantly from the benchmark.”

Why it might work for clients

Vanguard’s Hsu explains: “An ESG ETF enables investors to construct these kind of balanced portfolios, in a manner that also aligns with investors’ values. Physically replicated ETFs also have the advantage of being simple and transparent.

“Investors are able to know at any time what their portfolio is invested in, and importantly, via exclusionary screening, which companies they are not invested in.

“While fund companies continue to innovate, there are already a wide choice of ESG investment vehicles out there in the market, and investors can look to find products that best suit their needs and values.”

The table below from Hargreaves Lansdown shows the popularity of ETFs. Over October, the following were top sellers on the DIY platform (listed alphabetically).

Top ETFs bought on Hargreaves Lansdown platform: October 2021 (by net buy, alphabetical)
Invesco Markets II Plc Invesco Elwood Global Blockchain Ucits ETF (Acc)

iShares II plc Global Clean Energy UCITS ETF (Dist)
iShares III plc Core MSCI World (Acc)
iShares Physical Metals plc Physical Gold ETC
iShares Physical Metals plc Physical Silver ETC
iShares plc Core FTSE 100 UCITS ETF (Dist)
iShares plc S&P 500 UCITS ETF (Dist)
iShares V plc S&P Commodity Producers Oil & Gas UCITS ETF USD Ac

Legal & General ETF Hydrogen Economy UCITS ETF USD (GBP)
Legal & General UCITS ETF Cyber Security UCITS(GBP)
Vanguard Funds Plc FTSE All World High Dividend Yield UCITS ETF
Vanguard Funds plc FTSE All-World UCITS ETF (USD) Accumulating
Vanguard Funds plc FTSE All-World UCITS ETF (USD) Distributing – GBP

Vanguard Funds plc S&P 500 UCITS ETF USD ACC (GBP)
Vanguard Funds plc S&P 500 UCITS ETF USD(GBP)
WisdomTree Carbon ETC
WisdomTree S&P 500 VIX Short-Term Futures 2.25x Daily Lev
Moreover, with more structured ETFs being launched that track the performance of more esoteric asset classes, or the performance of a synthetic basket of stocks that mirrors the performance of other asset classes such as commodities or cryptocurrencies, it might also be possible to add diversification from these products.

Hsu comments: “It’s certainly possible to package a wide variety of different exposures into an ETF vehicle. However, the key benefit of ETFs is that they enable investors to put together low-cost portfolios in a transparent, democratically priced manner.”

“Investors should be aware of any lack of transparency in a product, and ensure they remain diversified at the portfolio level. Investors should always review the ETF’s prospectus and ask the provider any questions they have before investing.”

It is also worth considering the potential that passive strategies can bring to an overall portfolio, given the flexibility of the investment product. While traditional passive funds have simply tracked an index, with all the underlying concerns this has for market cap concentration and sector risk, things have changed over recent years.

Clients who want an ESG overlay or want to invest in less liquid or more esoteric investments, such as infrastructure or cryptocurrencies, can now potentially do so by using ETFs.

‘A key benefit of ETFs is that they enable investors to put together low-cost portfolios in a transparent, democratically priced manner.’ Hsu

Product manufacturers can work with index providers or active managers to create versions of an index or basket of stocks that play to a certain theme (such as climate change) or can replicate the performance of an underlying asset (such as crypto) by using synthetics.

That said, Tomaszewski says the popularity of passive investment vehicles is “rather cyclical”, so although creating a passive-based portfolio can work in some economic cycles, it might not work in others.

He explains: “From 2012 to 2020 global stock markets generally trended upwards, particularly developed markets. The recovery following the banking liquidity crisis and the presence of world leaders who correlated stock market valuations as an indication of a thriving economy and their ‘reign’ saw the popularity of passive investments increase significantly.

“When stock markets generally trend upwards, it would seem that the overarching ‘common’ consensus is to question paying fund managers to target capital growth while cheaper passive investments are achieving very similar outcomes.”

Developments lead to broader diversification

Such developments can help investors match their money with their morals as well as providing the low-cost diversification they need to spread the risk.

But Tilney’s Seager-Scott says while there can be plenty of diversification and transparency with passive funds, advisers will still need to help clients manage their investment portfolios.

He cautions: “It’s worth remembering that in a multi-asset portfolio you will generally have quite a spread of passives. If you’re using broad market passive funds, this generally means you will have a great deal of diversification at the stock level and a pretty reasonable spread of sectors and geographies.”

This comes with responsibilities, though. “One element to remember with passive investing, though, is that it puts greater onus on you as the investor or portfolio manager to fully understand what your exposures are.”

“These are index or rules-based investments and you have a high degree of certainty what you’ll be holding, so you can’t blame this one on the underlying active manager.”

In terms of sectors, for broad, market-cap-weighted indices, he says most investors should already know where the exposures tend to be – the US has a lot in technology, the UK has a lot in financials and basic materials, for example.

‘In a multi-asset portfolio you will generally have quite a spread of passives.’ Seager-Scott

And this is where using an adviser to find ETFs that provide a different level of diversification comes into play, he adds.

“These can be supplemented, for example, with dedicated sector ETFs to control overall sector exposure.”

This goes some way to answering the correlation/concentration conundrum, according to WisdomTree’s Debru. He comments: “Can ETFs be structured/selected to help avoid concentration risk in any one sector?

“Looking at global equity markets, there is no denying that market-cap-weighted indices have gone through a period of concentration. US equities represent almost 70 per cent of developed, equity market-cap-weighted indices.

“The top five stocks in the S&P 500 represent north of 20 per cent of the index. However, not all ETFs are passive; not all ETFs are market-cap weighted.”

Because many ETF providers specialise in strategies that seek to outperform the market or products that unlock new or hard-to-access exposures.

Debru highlights Factor ETFs (also called smart beta) as one solution for the “concentration risk conundrum”. He explains: “Such ETFs provide exposure to diversified research-grounded strategies with a focus on long-term outperformance.

“By construction, those ETFs select stocks based on differentiated factors, like companies’ profitability or their growth potential and therefore tend to offer differentiated exposure to investors, away from the largest stocks in the world.”

Furthermore, many of those ETFs have inbuilt sector and country caps leading to less concentrated exposures. Thematic ETFs are also a very good way to avoid concentration in mega caps, he adds, as these aim to harness long-term growth by turning mega-trends into investment opportunities, breaking out of traditional silos, such as countries, sectors, factors, or regions.

Client centric

It might be worth advisers reminding clients that some of the non-market-cap-weighted indices (not all) can change the sector mix as well.

For example, since it is often the mega-cap stocks that dominate sector weights, using an equal-weighted index (effectively giving them exposure to size factor effects) will often also reduce some of the high sector exposures.

Back in 2013, Cass Business School ran an extensive study, commissioned by Aon Hewitt, to explore the make-up of indices and whether alternative approaches to index creation would be better for passive investors.

Cass developed an algorithm based on the ‘infinite monkey theorem’ to study whether 10m ‘monkeys’ (random computer-based managers) could beat a standard market-cap-weighted index over a 43-year period.

They did. Every single one over every single year, as the article “Meet your new stockbroker” explains.

This research helped set the groundwork for product manufacturers to work with index providers to create non-traditional indices, whether equally weighted or screened or inclusive, as a basis for passive investors to track an index but not necessarily the performance of a few index giants.

And ETFs, with their greater flexibility and ability to track a basket of physical or synthetic stocks, as traditional or esoteric as a client’s risk profile allows, can provide clients with a lower cost way of getting diversification without ramping up the risks or at the mercy of sector giant performance.

Therefore, building a multi-asset portfolio using passive funds such as ETFs can make a lot of sense for investors. Certainly the choice is there, although, as always, it depends on the client and their needs.

Tomaszewski adds: “An interesting trend with my clients has been the desire to start investing small amounts of money under their own leadership/jurisdiction.”

According to him, the pandemic and thus the consequential lockdowns provided inexperienced investors with more time to conduct their own research into investment opportunities.

“Although the additional time provided these people with the ability to research areas or themes which interest them, it did not necessarily lead to specific active fund research.

“I found this specifically with clients who tilted towards a ‘sustainable’ mindset with their investments and a noticeable increase in clients who bought passive investments from their own research.”

And, with the volatility seen in stock markets over the past 18 months, which has permeated into their passive investments, Tomaszewski says this has “materialised into many clients discussing the possibility of translating their passive investments into more actively managed portfolios, once they realise the passive investments may not align with their financial tolerance towards risk but to their short-term emotional tolerance to volatility.”