By Matthew J. Bartolini, Head of SPDR Americas Research.

Matthew J Bartolini, Head of SPDR Americas Research.

The more than 2,000 ETFs currently listed on US exchanges have provided investors democratized access to not only broad-based exposures, but more importantly, niche areas that are additive to the portfolio construction process.

This is true from both a risk/return and a diversification perspective. Combine that access with lower fees relative to other managed accounts (e.g. mutual funds) across many different strategy types – pure market cap weighted beta, smart beta, and active mandates – and one could argue that asset allocators have never had it so good.

At the turn of the century, ETF assets were small and there was little breadth of choice, with exposures limited primarily to just US large-cap equities. ETFs have since successfully withstood numerous tests during times of market volatility, and as investors have become more comfortable with their structure, the ETF selection menu has become more diverse.

Investors now have a deep toolbox of tools to wield within the portfolio construction process as they seek to construct custom strategies to meet their client goals: income, risk-based, alpha generating, or downside protection.

The ETF “kids” are all grown up

Fixed income is a prime example of the maturation of a market leading to more choice. In 2005, 43% of the assets were plain vanilla government bond exposures. Now government strategies only make up roughly 12% of the market as strategies focusing on EM debt, high yield, bank loans, and convertible bonds were launched.

This maturation is widespread, as the mainly equity market from the early 2000s has evolved to one where, out of the 2,000 ETFs today, the objectives range from:

Strategic asset allocation tools:

• Core: Strategies providing essential building block exposure to broad-based US, international, and emerging market equities as well as to traditional bond asset classes like treasuries and investment grade corporates
• Strategic non-core: Funds providing exposure to areas outside the core but strategic from a diversification and long-term risk and return perspective. This includes areas such as real estate, commodities, high yield bonds, and emerging market debt

Tactical asset allocation tools:

• Equity sectors/single countries: Funds that carve up broader segments into targeted exposures for use within tactical rotation models or to harness macro shifts in the market
• Targeted bond exposures: Duration and maturity focuses to actively tailor interest rate risk within a portfolio
• Thematics: Forward-looking exposures focused on harnessing innovation beyond the core in areas such as smart transportation or intelligent infrastructure
• Alternatives: Strategies seeking to harvest alternative risk premia or an uncorrelated return stream

With great power comes great responsibility

As the ETF market has evolved and new strategies have come to market, understanding the role they play in the portfolio construction process has become paramount. Investors are trying to answer the questions: “Where does this fit in my portfolio, and what role does it play?”

As the vast number of choices now stretches across different implementation options (e.g. active, smart beta, traditional beta) – all with different rules, constraints, and biases – it now requires more due diligence than just looking at the name of the fund. This leads to the next question of: “I’m sold on the investment case for the asset class, now what’s the best way to implement?”

In prior posts we have discussed core portfolio construction, the blending of active and passive strategies, using indexed based fixed income ETFs to create custom portfolios, as well as some of the key considerations for smart beta due diligence – leading to the creation of our smart beta checklist.

Those discussions were largely focused on trying to answer the second question. But we haven’t yet done the deep dive into specific non-core asset classes or tactical portfolio construction techniques. Nor have we covered why including them in a portfolio can have distinct advantages, one of which is improving the efficient frontier to find the optimal portfolio.

Expanding horizons for efficiency

The “Efficient Frontier” is a modern portfolio theory tool that shows investors the best possible return they can expect from their portfolio, given the level of risk that they’re willing to accept.

The first chart shows the most naïve form of the efficient frontier, covering basic broad asset classes, US equities, bonds, and cash. Holding just cash is not optimal from a risk/return perspective. Neither is holding just equities. Blending all three together will create a more optimal outcome. Let’s consider this the ETF efficient frontier from the early 2000s, when only a handful of ETFs was available.

Source: SPDR ETFs.

While the formation of the above efficient frontier takes a basic approach, the outcome of including non- or low-correlated assets, even at very small weights, can have a significant impact.

For instance, the below chart shows how a static 10% inclusion of a negatively correlated asset class (bonds) within an all-equity portfolio can lead to improved returns, both risk-adjusted and absolute. The cumulative return over the time frame below for the all-equity portfolio was 179%, while the 90/10 was 190%, even though bonds returned a lower figure at a cumulative 145% over this time frame (1998-2018).

The presence of this negatively correlated asset increased portfolio diversification by mitigating drawdowns. Bonds weren’t added to seek returns but to manage risk, underscoring some of the rationales on why certain asset classes are included in a portfolio.

Source: SPDR ETFs.

Bonds aren’t the only asset class or sub-asset class that can improve the risk and return profile of a portfolio. Broadening the scope of asset classes can push the efficient frontier higher, leading to a portfolio with the same risk level as one of just equities, bonds, and cash, but not with a higher return potential. The chart below shows the efficient frontier of an expanded asset allocation mix versus the basic mix mentioned above.

Source: SPDR ETFs.

Shining a spotlight on asset allocation tools

With the increase in the number of ETFs now at the asset allocator’s disposal, there’s greater potential to improve a portfolio’s risk and return profile by adding in more distinct sub-asset classes.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)