The benefits of blending index funds, ETFs and active funds

Jun 24th, 2016 | By | Category: ETF and Index News

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Investors have historically had to choose between passive or active management, but in recent years they have been offered a combination of the two, or – blending – as it is often referred to, an approach that has seen good results.

Mike Mount

Mike Mount, Director of Intermediary Solutions at JM Finn

The evolution of this investment strategy is unsurprising –  an increasing amount of data shows that active managers are increasingly failing to outperform their benchmarks. In March, data from the Year End 2015 Europe S&P Indices Versus Active Funds (SPIVA) Scorecard found that more than 85% of active equity funds in Europe underperformed their benchmark over the last ten years. This, combined with an influx of flows into the passive space, which includes exchange traded funds and index funds, has been a boon for this new investment strategy.

One such firm offering this ‘blended’ service is discretionary investment management firm JM Finn. Founded in 1945 by John M Finn it has grown organically and through acquisition. The firm has total assets under management of £7.7bn (as of March) and this year was awarded Best Discretionary Service at the City of London Wealth Management Awards.

It offers a core satellite managed portfolio service (MPS), which has been running for five years and has £150m in AUM. The service uses ETFs, index funds and active funds for varying reasons and the team building and managing these is headed up by Mike Mount, Director of Intermediary Solutions. Currently available via wrap platform only, the firm is about to launch its own in-house core satellite MPS.

Rebecca Hampson, Associate Editor at ETF Strategy talks to Mike Mount about how they use ETFs and why the firm has adopted a blended approach to investing.

What does the core satellite MPS include?

MM: For the core satellite MPS we start with an asset allocation approach and populate the portfolios with ETFs and index funds. We then look to active funds based on where they can add value, or access a market that we can’t in other ways. Generally we take a 70% passive approach and 30% active.

What does your team do and why has it taken a blended approach?

MM: We focus on building solutions for clients of intermediaries and offer various services, one being a core satellite approach, with passive at the core and active funds as the satellite. We have been using ETFs for around five years. The blend of active and passive works for us and we believe the [passive or active] debate on this is over now.

This approach works for us for two reasons.  Firstly, it enables us to keep an eye on costs and keep them down. Secondly, it allows us to manage risk better as manager risk is reduced.

We are now in a market whereby most financial planners we speak to know what ETFs are. The IFA’s underlying clients also have some familiarity with them. When they don’t, we are able to explain to them how having a core exposure to the market using ETFs works. This concept is easy to follow, but we find that those clients will ultimately make a decision based on what works for them – financial planners are increasingly asking for Core-Satellite solutions.

What are the costs for this service?

MM: The costs on our core satellite range run at around 0.6%+VAT, with the underlying funds costing around 0.35%. This includes access to our platform and all our services. However, there will be financial planner fees on top of this so investors should be aware of this.

There is a minimum investment level of £100,000.

Why do you use ETFs?

MM: We find ETFs particularly useful for certain markets. Notably, fixed interest is something where ETFs are an attractive option. This is because there are few active managers who are consistently outperforming in this sector. This ability to use ETFs to get a specific exposure is very useful.

Similarly, ETFs can perform a useful service of maintaining exposure to a certain underlying asset class while we look for a suitable active manager, if this is the type of investment vehicle we want. Most recently we did this with an emerging market fund. It had a soft close and we spent nine months finding the right actively managed fund. In the interim we used an ETF to maintain our exposure.

How do you choose your ETFs?

MM: We choose our ETFs by firstly performing due diligence with the provider. We will go and meet them on site, asses the team and their offering. Following this we discuss the benefits of using certain providers. We look at their business model – and whether they include things like securities lending, how their ETFs are structured (physical or synthetic) and so on. If we like them and they have a particular exposure we want or need, then we may choose that ETF.

How do you choose between ETFs and index funds?

MM: For long term strategies we perhaps favour index funds over ETFs, dependent on costs and for shorter term holdings we may use ETFs. The ability to trade ETFs intraday is not a function we need particularly because our portfolios available on platforms would only trade once, at the end of the day, which is what an index fund does. But our choice over ETF or index fund is at our discretion.

Are there any exceptions to the 70/30 passive/active split?

MM: While the split of our portfolios is generally 70% passive and 30% active here are exceptions. For example, our income portfolio is split 50/50.

We also like smart beta, although we do not like the term. We were asked recently to perform some due diligence on smart beta and concluded that smart beta for us falls within the definition of active management as the strategies tend to veer away from the market cap benchmark.  We like smart beta because it can be appropriate when looking for yield at a low cost.  At present we favour SPDR’s Aristocrat’s ETF range for this.

You are due to launch your core satellite portfolios next month. How will this new offering differ to the existing one available on wrap platforms?

MM: These new portfolios are based on the WMA’s Private Investor Indices:  The Conservative index, the Income index, the Growth index, the Balanced index and, the Global Growth index.

These will be going live on our own platform, as opposed to wrap platforms where we also offer our core satellite services, next month. We populate the portfolios with passive and active products and have discretion on what balance this is. We will be rebalancing the portfolios twice a year minimum, and more if required based on changes in the WMA indices. The portfolios are risk rated with the help of risk profiling firm Dynamic Planner and investment risk house E-Value.

In addition to this the firm offers a bespoke portfolio service which allows individuals or financial planners to access a range of portfolio construction options, including core-satellite.

We also work with financial planning firms looking to build a portfolio offering for their investors via their chosen wrap platform.

Why did you launch this service in the first place?

MM: Since RDR came into force we have seen an uptick in financial planners using our services. They focus on cost and the blend of active and passive. They are now looking at the entire fund universe, so we source from across the whole universe.

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