ARE YOU MAKING THE MOST OF PASSIVE INVESTING?

Wealth Management & Private Banking

15 July 2018James Goad

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Not all indices are created equally and the session addresses this by giving participants market leading insight to investigate the underlying index which an ETF tracks and how to make the most of passive investments.

Headlines:

  • The varying performances of different ETF funds come down to number a points, including construction methodology, concentration and investability, maintenance rules of the index, index turnover and liquidity, and whether the index is screened for ‘factors’ (smart beta)
  • The expert provided examples of indices which deliver surprisingly divergent performance and discussed important considerations when selecting ETFs of various asset classes, including equities, fixed income and commodities

Key issues and challenges:

  • The expert kicked off the session by stating that five years ago, a roundtable session on passive investing would have entailed a debate around passive versus active, and whether or not ETFs had a place in institutional or HNW investment portfolios.
  • With lower costs, more liquidity, and inherent diversification, ETFs have been widely accepted and are increasingly used by investors of all sizes. While there’s still room for growth in this space, the conversation has very much shifted from “Should I invest in ETFs” to “Which ETFs should I invest in”.
  • The expert began with the importance of analysing the underlying components of a given ETF. To make the most of passive investing, the expert talked through the UBS house view of ETF investing strategies across equity, fixed income, and commodities markets.
  • Within equity markets, the shift away from active investments and towards ETFs has given rise to a wide range of ‘smart beta’ solutions. This approach sits in-between passive and active investing, delivering the benefits of both strategies. UBS has conducted extensive research in this area and now focuses on six key smart beta solutions: value, quality, momentum, volatility, size and yield.
  • Value: Stocks which trade at relatively low market prices relative to their fundamentals and tend to outperform expensive stocks.
  • Quality: Typically identified by fundamental quality characteristics e.g. high return-on-equity, low debt-to-equity
  • Momentum: Momentum stocks aim to capitalise on continuance of upward trends in market prices.
  • Volatility: The goal is to deliver a lower volatile profile portfolio and provide a tilt towards lower risk stocks, which typically deliver positive excess returns.
  • Size: Different market capitalisation segments perform differently over the business cycle, and smaller companies typically have more systematic risks, but they outperform in good times.
  • Yield: Yield factor aims to capture excess returns of stock stemming from higher-than-average yield, which can be measured as a combination of dividends, buybacks and debt reductions.
  • This multi-factor methodology replaces traditional index tracking in that underlying companies within a given index won’t necessarily receive a representative share of the ETF investment. The expert points out that selecting just a single weighting factor for an ETF investment is akin to timing the market and may produce high volatility, much in the same way that active investments could. However when these factors are combined, returns tend to be smoothed out over time with more limited risk exposure.
  • Similarly, investors should exercise caution when it comes to the frequency of rebalancing their ETF investments. Rebalancing too frequently, perhaps monthly, may incur significant fees and mitigate any potential upside to the investment. Conversely, if the portfolio is not rebalanced often enough, then there may be considerable risk of drift.
  • When Smart Beta factors are analysed against historical performance, it becomes clear that some factors tend to produce more upside than others, prompting a delegate to question why UBS suggests equally weighting Smart Beta as opposed to overweighting factors with historically superior results. The expert responded that deviating too far from a rules-based approach would step into the active investing territory.
  • Turning to fixed income ETFs, a new problem in the form of currency risk crops up, which causes fluctuations in returns depending on the market investors are from. While hedging is a possible solution, the expert showcases another which is by capping holdings at 3% per country. For ETFs covering emerging markets, this also limits exposure to sovereign debt.
  • Finally with commodities ETFs, which are “less marmite than three years ago”, the expert presented an innovative technique to diversify risk. By rolling small proportions of underlying futures, problems associated with punctual rolls of traditional indices are avoided although this strategy does not guarantee outperformance of traditional commodity indices.
  • Another technique used is to diversify contracts across maturities and to take positions across the liquid part of the futures curve, while not concentrating exposure on the front part. By introducing these innovations, the problems of negative roll yield are reduced (but not completely removed) and the underlying spot commodity prices are more closely tracked.

Conclusions and solutions:

  • To get the most out of passive investing, investors now need to adopt smart beta approaches.
  • The Alternative Beta methodology developed by UBS is an equity smart beta approach which allocates equal weights to six individual equity factors, which could smooth out returns over time and limit risk.

Expert: Andrew Walsh, Executive Director, Head UBS ETF Sales UK, UBS Asset Management

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