Asset allocation: A quick and easy way

Andrea Morresi explores how ETFs can help investors tap into the less accessible and more esoteric markets

In the correct hands, asset allocation can be an important driver of returns. Anyone who has had consistent exposure to the commodities market over the past few years will vouch for that. But the more esoteric end of the investment market – for example, commodities or property – can be difficult and expensive to access. Exchange traded funds (ETFs) can be a cost-effective and liquid way to tap into those markets.

Academic reports have suggested that asset allocation can dictate up to 90 per cent of investment returns. Specifically, an article in the Financial Analysts Journal by Gary Brinson in 1986, stated: “Data from 91 large US pension plans over the 1974-83 period indicates that investment policy dominates investment strategy (market timing and security selection), explaining on average 93.6 per cent of the variation in total return.”

If anything, this has become even more widely recognised over the past few decades.

With this in mind, how do investors go about handling asset allocation? They could try standard pooled investments like unit trusts or investment trusts, but this can be relatively expensive.

There has also been much controversy about larger investors trading in and out of funds for asset allocation purposes. For smaller, specialist funds, the addition and removal of large amounts of money can create a
real headache for fund managers. Managers are often forced to sell their most liquid holdings.

This can have an impact on performance and penalise other unit holders. Fund management groups are getting wise to this and many are threatening to start imposing dilution levies on investors who are not long-term holders.

So how do investors make quick and easy asset allocation decisions? Many are starting to realise that ETFs offer an attractive solution. Investors can take quick exposure to an asset class without worrying about cost or liquidity issues.
ETFs are also commonly used for short-term positions and tactical views. ‘Cash equitisation’ by institutional investors remains the biggest use for ETFs. If a fund has a big cash inflow, it takes time to decide how to invest that money. A manager will want to be in line with his benchmark in the meantime and this is driving demand for ETFs
as a means of gaining market exposure rapidly.

ETFs can also be used where investors and fund managers do not have specific competence or expertise. Traditional large investment managers will have capabilities in both equities and bonds. But for smaller, equity-focused groups and many private investors, when equities don’t look good, they may not have the expertise to move into the fixed income markets. Equity hedge funds are some of the largest users of fixed income ETFs for that reason. They are outsourcing a potential problem to ETFs and this is also true for the more esoteric asset classes, like inflation-linked bonds.
The outsourcing argument also holds for smaller allocations within many portfolios. Property and commodities are typical examples, which both tend to have a low correlation to some traditional asset classes and can improve an investor’s returns and lower the risk in a portfolio.

ETFs are also likely to be used when exposure to a region or sector is needed where an active investor finds it hard to outperform the market. The most obvious example of this is in the US large cap arena, which is very efficient and most investors find it far more rewarding to seek opportunities to outperformance elsewhere.

This is also often true for investors operating away from their home market. Institutional and retail investors in Europe may find it harder to outperform when investing in US stocks and vice versa. Both groups tend to naturally have more local expertise. This may be particularly important when investing in more obscure areas such as emerging markets.
In addition, ETFs are finding a natural home in investors’ portfolios when exposure to a specific theme is desired. A highly topical example, which looks set to endure, is the growing demand for products that deliver exposure to the environmentally related businesses. This demonstrates the increasing awareness of all things environ-mental, as well as recognition of the strong growth potential that this sector appears to offer. The drivers behind the growth opportunities in this space include increasing governmental backing in the form of rising official targets for renewable energies and subsidies into the sector.

Indeed, the UK’s Financial Times reported in January this year that $70 billion of new money was invested globally into clean energy in 2006, up 43 per cent from 2005. ETFs providing exposure to this global sector, represented by the S&P Global Clean Index comprises 30 of the largest publicly traded stocks in the global clean energy industry, provide an effective route to gaining exposure to this theme.

But ETFs don’t need to be just a ‘filler’ in a portfolio. They can also be used as the entire basis of a fund,
if an investor believes that asset allocation is the most significant generator of return.

Written by Andrea Morresi, Managing Director and Head of Sales for iShares Europe , Barclays Global Investors