Fund of funds managers reveal their ETF investing secrets

Maximising short-term opportunities

James de Bunsen, multi-asset manager at Henderson, says: "When we invest in an active manager we think can outperform an index, we like to give them a reasonable amount of money and time to do that. But if we became more or less positive about a region and think it's shortlived we might use an ETF."

He has recently used iShares MSCI Emerging Markets UCITS ETF (IEEM) across several funds to make the most of the recent crash and exploit sour market sentiment.

"At the moment, many emerging markets have major structural issues and investors won't change their minds on that quickly," he says. "But emerging market underperformance had grown so stark relative to developed markets that we thought if we just put the money in ETFs we could take it out quickly in a few days or weeks."

He says that unlike an active manager who would buy quality companies that had outperformed, he wanted to gain exposure to the least loved companies in the region. "If you buy the bog standard ETF you are getting the largest companies in the region or sector and it is actually those companies we thought were due a bounce back because they'd performed particularly badly."

Lucy Walker, fund of funds manager at Sarasin, used the same tactic recently in Europe. "A while ago we did a piece of work on European equities and found that all fund managers were underweight financials. We felt that was a good contrarian indicator that financials were due a recovery, but didn't necessarily think the fundamental case for the sector was there."

Because European indices tend to have a substantial weighting to financials she chose iShares MSCI Europe ex UK (IEUX). "An ETF giving us market exposure to financials was the ideal tool."

"A similar example is when we bought China about 18 months ago through the iShares China Large Cap UCITS ETF (FXC)," she says. "In both the European and Chinese examples the ETFs would have had a decent proportion in financials and in both those regions financials had been particularly hard hit.

"The Chinese ETF was very short-term, we only held it for around 12 months and the European position for around 18 months. That is certainly shorter than we would hold the average position in the fund."

Best for bonds

ETFs certainly aren't all about short-term trading, though. Mr de Bunsen, Ms Walker and Peter Sleep, portfolio manager at Seven Investment Management, who manages portfolios of passive funds, are not convinced active managers can add value in fixed income. They say there is a dearth of cheap passive products that do as well as bond ETFs.

"Bond managers tend to produce less alpha," says Mr de Bunsen. "We don't think government bonds are good value and therefore it doesn't really seem right to give an active manager a big chunk of money. Because the underlying assets are liquid, bond ETFs are cheap, effective and track the index. What we're really buying them for is hedging - when we think they're not ridiculously overvalued."

Ms Walker says: "My reason for owning the gilt ETFs is that it is very difficult to generate alpha in government bonds, so we hold these ETFs for the long term." She holds iShares Core UK Gilts ETF (IGLT) and SPDR Barclays UK Gilt ETF (GLTY) across two of her fund portfolios.

Mr Sleep also holds them, having favoured emerging market debt bonds in the past, and is also invested in a more specialist bond product in order to get around the issue with bond indices - that the most indebted countries or companies have the highest weighting in the index.

"We hold a lot of high-yield bond ETFs," he says. "We've also got PIMCO Short-Term High Yield Corporate Bond Index Source UCITS ETF (STHY), which we like because Pimco's analysts have a traffic light system on those bonds, so anything with a red stoplight traffic light, they don't buy. A little bit of judgment is applied to filter out rubbish."

He also holds SPDR Thomson Reuters Global Convertible Bond UCITS ETF (GCVB) across his funds. "We helped seed it, and it is one of the few bond ETFs that is global rather than specifically US or European," he says.

Yes to (some) smart ETFs

Managers like smart and selective ETFs, but not all of them. As well as tracking all the obvious indices, it is also now possible to home in on specific market sectors or invest in low-volatility, high-value stocks, or those with high yields or dividends via so-called smart-beta ETFs. The range is expanding by the day, but managers aren't wholly convinced.

"We use high-dividend-paying ETFs," says Mr de Bunsen. "Our core multi-asset funds have an income target and pay a monthly income, so yield is important."

He uses two different dividend strategies by investing in SPDR S&P Euro Dividend Aristocrats ETF (EUDV) and iShares EURO Dividend UCITS ETF (IDVY), which homes in on the 30 European stocks with the highest current yields.

"It's nice if you can get different flavours. The ETFs that have fairly basic screens on who pays out the most are useful if you're trying to make sure you've got enough to pay out and there are also SPDR's dividend aristocrat ETFs, which select companies with a 10-year track record of paying dividends."

He is also convinced by low-volatility products. "They really have done the job and actually fared better than some active mangers that we'd selected to be low volatility," he says. "It has been tough for active managers who try to be low volatility. If you have this low-volatility approach to things but are also rigorous on how much you're prepared to pay, the universe has got much smaller because everyone has been after the same stocks, so the price has gone up."

Mr Sleep says he likes "smart beta everywhere" and is very keen on the concept of equal weight indices.

Smart beta dividend ETF performance (% total return), yield and ongoing charge

Source: FE Analytics, at 27.10.15

Costs, commodities and when to say no

For all managers, the choice is often between ETF, passive fund or future tracker fund. The trading costs of ETFs (when the buy and sell price differs widely) and dealing costs mean that in some cases it is not cheaper to buy an ETF than a future. Managers are also able to negotiate with other fund managers to secure better rates, and say that in some cases smart-beta ETFs or more complicated ones do not work out cheaper than active funds.

Mr de Bunsen also says he steers clear of niche products such as ETFs based on loans. "There's a loan ETF listed in the US, and loans are not publicly traded and have a three-week settlement window. The ETF is something you can trade in and out of by the hour based on underlying assets which settle within three weeks, so that seems risky. Otherwise the bad ETFs are just the ones that are too small and have big trading costs (a large difference between the buy and sell price, known as bid-offer spread)."

He adds: "Commodities are tricky, too. If you buy any bulk commodities, such as copper or iron ore, you're buying a future, and futures' return can vary significantly."

Funds' favourite ETFs

Source: SevenIM, Sarasin, Henderson