ETF Investment Strategies: Best Practices from Leading Experts on Constructing a Winning ETF Portfolio - Hardcover

ULLAL

Hardcover

ISBN 10: 0071815341 ISBN 13: 9780071815345

Publisher: McGraw Hill, 2013

Synopsis

ETF experts share their insights for growing wealth from this booming market

Whether you manage your own assets or help others reach their fi nancial goals, ETF Investment Strategies will help you securely grow wealth in the new economy.In this groundbreaking book, ETF authority Aniket Ullal lets you look over the shoulders of 10 top ETF investors to learn their processes and strategies. Through illustrative case studies, you learn the basics of ETFs: how they work, why they're growing in popularity, and how you can use them effectively in your portfolio. These innovative, early adopters prepare you with everything you need to improve your investments, including never-before-published insights. Whether you're new to ETFs or new to trading, this book will make you an informed investor who can:

Construct ETF-based investment portfolios to achieve your financial goals

Leverage the range of ETF products available to get improved outcomes

Avoid costly fees and taxes that cut into your returns

ETFs have revolutionized the investment industry, and with the reliable, objective guidance in ETF Investment Strategies, they can alter your expectations for what a portfolio can do.

Exchange-traded funds (ETFs) have been around for two decades, but, in the last five years, the market has grown rapidly. This growth has been driven by savvy investorswho want diversified, tradable access to asset classes such as emerging market bonds, commodities, and volatility that were previously difficult and expensive to access.

ETF Investment Strategies is a how-to gem that offers an insider's look at the investment practices of leading ETF portfolio managers.

ETF expert Aniket Ullal goes in-depth with 10 global ETF leaders--the pros who have traded many of these products since their launch--and presents the most comprehensive, accessible guide available for constructing and maintaining ETF portfolios. These early adopters sharetheir investment approaches and their practical insights on ETF-based portfolio construction, and they explain how you can use this knowledge to be a more successful investor. ETF Investment Strategies strips away the complexity of ETFs and enables you to:

• Develop your ETF investment strategy by applying expert best practices and understanding key concepts
• Navigate the top three megatrends in the industry, including the emergence of a "tradable beta" mindset, the proliferation of targeted ETFs, and the shift from commissions to fee-based advice
• Develop confidence in the techniques and knowledge you acquire because they are unbiased and do not promoteany investment product or firm

This hands-on guide balances the right amount of theory with actionable advice, and it gives you an advantage by providing a unique view into tricky ETF nuances, including product structure, taxation, and index methodology, that can have unexpected and signifi cant implicationsfor your portfolio returns. Keep this book at your side while you analyze and trade ETFs. Its conveniently organized final chapters consolidate best practices and product insights for quick reference.

ETFs are the fastest-growing investment innovation in the world, and now you can use them to manage your wealth just like the pros do, with ETF Investment Strategies.

PRAISE FOR ETF INVESTMENT STRATEGIES

"This is a useful and practical book on a topic of growing importance. Aniket Ullal has marshaled a group of authors, including himself, who are practicing experts in the field. This is a must-read and also a sourcebook of useful information related to the ETF market." -- H. Gifford Fong, Editor, Journal of Investment Management (JOIM)

"ETF Investment Strategies highlights funds and investment strategies fueling the ETF revolution. The book delivers a fa

About this title

About the Author

Aniket Ullal is the founder of First Bridge Data, which provides fi nancial advisors and hedge funds with institutional-quality data and analytic dashboards to evaluate, compare, and monitor their ETF investments. Previously he had product management responsibility forS&P's U.S. Indices, which have over $100B in ETF assets tracking them.

Excerpt. © Reprinted by permission. All rights reserved.

ETF INVESTMENT STRATEGIES

Best Practices from Leading Experts on Constructing a Winning ETF Portfolio

By ANIKET ULLAL

McGraw-Hill Education

Copyright © 2013 Aniket Ullal
All rights reserved.

ISBN: 978-0-07-181534-5

Contents

Acknowledgments
Introduction
1. The Emerging Mindset: Tradable Beta
2. The Emerging Tools: The Targetization of Investing
3. The Emerging Industry Model: Fee-Based Advice
4. Future Gazing: The ETF Landscape in 2025
5. Megatrends: Practical Implications for Investors
6. Key Features of an ETF
7. Differences Between an ETF and ETN
8. Case Study: Kal Salama, CIO, The Headlands Group
9. Fundamentally Weighted ETFs
10. Case Study: David Hultstrom, Founder and CIO, Financial Architects 
LLC
11. Growth and Value Investing with ETFs
12. Case Study: John O'Connor, President and CIO, 3D Asset Management
13. Case Study: King Lip, CIO, Baker Avenue
14. Sector- and Industry-Based ETF Investing
15. Case Study: Kim Arthur, CEO, Main Management
16. Active ETFs Versus Active Investing Using Index-Linked ETFs
17. Case Study: John Lunt, President and CIO, Lunt Capital Management, 
Inc.
18. Case Study: Rich Bernstein, CEO, Richard Bernstein Advisors
19. Low-Volatility and High-Beta ETFs
20. VIX Futures-Based ETPs
21. Case Study: Christian Wagner, CEO, Longview Capital
22. Alternative and Commodity ETPs
23. Case Study: Vern Sumnicht, CEO, iSectors
24. Leveraged and Inverse ETFs
25. Best Practices from Case Studies
26. Summary of ETF Product Insights
27. ETF Tax Strategies: Robert Gordon, CEO, Twenty-First Securities
Appendix A. Industry Classification Systems
Appendix B. Traditional ETF Classification Dimensions
Appendix C. Comparison of Style (Growth/Value) Index Methodologies
Appendix D. Table Comparing ETFS with Traditional Mutual Funds
References
Important Disclaimer
Index

CHAPTER 1

THE EMERGING MINDSET: TRADABLE BETA

"Is Buy-and-Hold Investing Dead?"

When monumental changes occur in our lives or professions, we often grasp forcatchphrases, words that can neatly summarize complex developments. In the realmof investing, the crash of 2008 was a monumental moment, and the catchphrase"Buy-and-hold is dead" suddenly became very popular. At face value, the meaningof this phrase is clear. During the crisis, there seemed to be no investing safeharbor, no asset class that was immune from the mortgage and banking crisis. Formany years, investors have operated on the theory that holding a diversifiedportfolio of assets over the long term is a valid way to ensure against adownturn. Some investors interpreted the 2008 crash to mean that this was nolonger true.

If one digs a little deeper, it's clear that saying "Buy-and-hold is dead" istoo simplistic and misses the point. Does a market downturn, even one of largemagnitude, imply that one should not be thinking long term as an investor? Theanswer would have to be unequivocally no. Does this mean that being diversifiedacross multiple asset classes doesn't work? Again the answer is no. In this bookwe profile several expert investors, and all of them, without exception,continue to believe in diversified asset allocation.

So has anything changed in the way sophisticated investors now constructportfolios? The answer to that question is yes. What has changed is theirinvesting mindset and the ways in which they are deploying new products likeETFs to create value. Their investment process has been steadily evolving due tothe availability of new ETFs, and the 2008 crisis merely served as a catalyst.

The Emerging Investing Mindset

To understand how sophisticated investors are now creating value, it is usefulto break down the investment process into four basic levels and then compare thetraditional and emerging mindsets (see Figure 1-1). We start with the broadest-leveldecisions and then go into the most granular. These four levels are:

• Investment approach. The underlying principles that guide portfolioconstruction

• Asset allocation. The way the portfolio is allocated across broad assetclasses (equities, bonds, commodities, etc.) or risk categories

• Fund or security selection. The specific investment vehicles in which theportfolio is invested

• Execution. Tactical and execution-related issues such as taxation, liquidity,and trading

We can now take a deeper dive to see how investing is evolving at variouslevels.

Level 1. Investment Approach

Traditional Mindset: Passive versus active

Emerging Mindset: Tradable Beta

Before ETFs became popular, the easiest way for individual investors andadvisors to get "beta" exposure was through an index mutual fund. These fundstracked indexes like the S&P 500, which provide broad exposure to the equitymarket. As a result, when investors were making even their most basic investmentallocation decisions, they had to make a very binary choice—to be passiveinvestors and index their overall equity exposure or to be active investors andinvest in active mutual funds that selected individual securities. The leadingadvocate for passive investing was Jack Bogle, the legendary founder ofVanguard. He argued that it was impossible for investors to systematically beatthe market. Instead they were better off holding index funds that had low costsand turnover. By contrast, active managers argued that there was no reason forinvestors to settle for "average" returns. The basis for their argument was thatactive managers are positioned to deliver the best returns since they can picksecurities as market conditions change, such as picking defensive securities inbear markets.

The rapid growth of ETFs is challenging this traditional categorization ofactive and passive investing. This is because ETFs now enable investors to getvery targeted, index-based beta exposure to specific segments of the market. (InChapter 2 we will look at this expanding universe of ETFs.) Investors can nowactively manage and reallocate their assets across these granular marketsegments.

I call this new approach a "Tradable Beta" mindset. In this new approach:

• Investors segment the investible universe at a much more granular level thanthey did in the past. These segments could be sectors of the capital market(emerging market bonds, master limited partnerships, etc.) or risk factors(growth and value, volatility, etc.).

• They analyze the risks, performance, and relative strength of each of thesesegments and then adjust their allocation across these segments in response tomarket conditions.

This Tradable Beta approach essentially combines elements of both active andpassive investing. It is passive in the sense that most ETFs track anunderlying, rules-based index and don't have portfolio managers actively makingdecisions about which securities to hold in the ETF. It is, however, active inthe sense that the investor is making tactical decisions about theattractiveness of market segments.

The Tradable Beta mindset represents a spectrum rather than one uniformapproach. Each investor and asset manager may have her own definition of thevarious market segments and opinion of how frequently one should rebalance orreallocate assets among segments. Also, it does not imply that investors withthis mindset will not invest at all in active ETFs or mutual funds. They maydecide to do so in specific situations. However, this decision is now made at amuch more granular level for individual market segments rather than as amacroallocation decision.

We can now continue to take a closer look at how this emerging investmentapproach is impacting asset allocation and the investment vehicles thatinvestors use.

Level 2. Asset Allocation

Old Mindset: Multiasset diversification is practiced by institutional investors

New Mindset: True multiasset diversification is available to all investors

The concept of diversification and asset allocation is not new. Academicframeworks such as the capital asset pricing model and the Fama-French three-factormodel are the underpinnings of modern finance. (We will discuss the Fama-Frenchmodel in a little more detail in Chapters 11 and 12.) Over the years,behavioral finance researchers have challenged the market efficiency assumptionsunderlying these frameworks. They argued persuasively that during crises such asin 2008, investors do not always act rationally. Despite this, there is stillwidespread agreement on the basic principles of diversification.

However, in practice a few things have changed in the way asset allocation isbeing done. The first is that the cost of access to different asset classes andstrategies has fallen significantly. It is now possible to build portfolios ofvirtually all asset classes using ETFs with expense ratios below 1 percent.Earlier, diversification into alternative asset classes was not easy for retailinvestors (we look at this in Chapter 22). Even a few years ago, it was notcommon practice for individual investors and financial advisors to usecommodities like copper or strategies like low volatility to diversify. Now,informed investors are taking advantage of these low-cost products to buildtruly diversified portfolios.

Second, sophisticated investors and financial advisors are spending much moretime on asset allocation decisions than ever before. A few years ago if one drewa pie chart of how investors allocated their time on investment decisions, asignificant chunk of it would have been on researching and selecting singlestocks or active fund managers. Asset allocation was important but wasn'tconsidered the area where investors and advisors added the most value. WithETFs, investors don't have to focus as much on individual security selection andcan instead focus on economic trends and how they impact asset allocation. Manyof the experts we profile in this book consider their ability to analyzeeconomic trends as the most valuable step in their investment process.

Level 3. Investment Vehicle Selection

Old Mindset: Finding "star" mutual fund managers or undervalued stocks

New Mindset: Finding the best ETF for a specific strategy

The biggest difference in the two mindsets is in the investment products used toconstruct portfolios. In the traditional approach, investors are focused onfinding either individual stocks or "star" mutual fund managers. Investors whosubscribed to passive investing may have used broad-based index funds. In thenew approach, investors use liquid, transparent, and rules-based ETFs that givethem targeted exposure to specific sectors, strategies, themes, and factors.They may also use baskets of stocks or mutual funds if no appropriate ETFs areavailable.

As a result, in the traditional mindset, investors and financial advisors areprimarily focused on manager selection at the expense of strategy selection.Though they do spend time on strategy selection, the bulk of analysis time isspent on winnowing through a list of active managers to identify high-performingequity or bond managers. Often these mutual fund managers are evaluated on theirpast performance, reputation, years in the industry, etc. Over the years anentire research industry has been created around providing rankings and ratingsfor mutual fund managers based on these various criteria.

In the new mindset, investors are less concerned with these issues. Since mostETFs track an index and publish their holdings daily, they don't need to spendtime on evaluating individual securities or the individual portfolio managers.Instead when choosing investment vehicles, they can focus on factors such ascost, liquidity of the underlying securities, tracking error, and fit with thedesired strategy.

This does not imply that ETFs are superior products in every situation. Thereare specific products that may be too complex or risky for those investors whoare not professionals, as we will discuss. It is also important to keep inperspective that there will always be investors following and trading inindividual securities. After all, ETFs are essentially packaging up thesesecurities and, by definition, need the underlying securities to be liquid.

Level 4. Execution

Old Mindset: Quarterly reporting; trade at end-of-day NAV

New Mindset: Daily transparency; intraday trading

At the execution level, ETFs have changed the expectations as well as the kindsof issues that investors are dealing with. Investors now have access to thedaily holdings of each ETF and therefore a much higher level of transparencythan they did with traditional mutual funds. They also have the ability to tradeduring the day, again something that is not possible with a traditional mutualfund. As this mindset of higher transparency and tradability continues to takehold, investors will not want to turn the clock back to having quarterlyreporting and less trading flexibility.

As we can see, the traditional and emerging mindsets are different, startingwith their investment philosophy down to execution issues. These mindsets resultin very different questions as investors construct portfolios. Table 1-1presents some examples of how the questions that investors ask are evolving.

Those investors who can adapt to this new mindset—who reframe the questions theyask in the investment process—will be best positioned to take advantage of thenew range of opportunities that ETFs have now made available.

CHAPTER 2

THE EMERGING TOOLS: THE TARGETIZATION OF INVESTING

At one of my earlier jobs, I worked alongside a senior sales manager. He was aveteran of several industries and a highly successful salesperson. The mostinteresting stop in his varied career had been at LEGO, the well-knownmanufacturer of building blocks.

"What was that like?" I asked him. "Everyone loves LEGO. The products are sowell made, and kids are crazy about them. It must have been the easiest sale inthe world. Did you ever have any customer requests that were hard to meet?"

"We did in fact," he said. "Our customers were retailers who always seemed towant one thing—transparent blocks. Our LEGO boxes included solid blocks ofseveral shapes and colors, but customers always wanted more transparent blocks.It wasn't an easy request to accommodate, since the transparent blocks were alsothe most expensive to manufacture." During his time selling building blocks,cost and transparency seemed at odds.

It's not hard to see parallels between the world of LEGO blocks and thefinancial services industry. Investors who use mutual funds and other pooledinvestment vehicles as building blocks for portfolio construction haveconsistently wanted certain attributes—low costs, ease of use, and transparency.However, this has been frustratingly out of reach. Investors often needed tomake a trade-off between cost and other factors like transparency and access. Onthe one hand, they could invest in low-cost, transparent index funds from a firmlike Vanguard. However, these index mutual funds were largely limited tospecific asset classes like U.S. equities. On the other, they could invest infunds that gave them access to more complex strategies like long-shortstrategies or emerging markets exposure, but these funds often charged fees ofabove 1 percent and sometimes up to 20 percent of profits.

The "Targetization" of Investing

The reason that ETFs have made such a significant impact is because they haveaddressed this problem and democratized investing. They have made previouslydifficult-to-access asset classes and investment strategies available toindividual investors and independent financial advisors.

To use another simple analogy, suppose many of the most sophisticated investmentstrategies were previously available for sale in only high-end boutique stores.The products in these stores were out of reach for the average investor forseveral reasons—they were expensive, they were not available in regular stores,or in some cases the investor required special accreditation to even get intothe store to purchase them. Then one day a retailer (let's pick Target just forthe purpose of our simple example) figured out a way to offer some of theseproducts, but at much lower prices and as registered securities that made themmuch more accessible. As these products started flying off the shelves, itopened the floodgates, and suddenly customers started demanding more productvarieties. As a result, the bar has suddenly been raised on what the boutiquestores can now sell, since a lot of their products are now available to"regular" investors.

It is important to clarify that calling this the "Targetization of investing" isnot meant in a pejorative sense. Lower costs and easier access areoverwhelmingly good things for investors. There are certain caveats, of course.Just because a strategy is in an ETF wrapper doesn't automatically make it good.As the ETF structure becomes even more popular, more investment managers willjump on the bandwagon, some of them with dubious ideas. Also, the increasedcomplexity of ETFs implies that investors have to be better educated when usingthem. On balance, this is still a very positive development for investors.

The reason I called this the "Targetization" of investing, and not the"Walmartization" of investing, is because cost is not the only variable thatdifferentiates ETFs. Cost clearly is a significant factor, and there are anumber of reasons why ETFs are able to operate at a lower cost, such as lowertrading costs since most of them track an index, tax efficiency due to the waythe fund units are created and redeemed, and lower shareholder servicing costs.There are, however, several other critical elements that have driven theirgrowth:

• Tradable. ETFs trade in the secondary market on an exchange. Tradability opensup a range of options for investors and asset managers. It allows them to get inand out of asset classes and strategies when they need to, place limit orders,take short positions, and trade options on ETFs.

• Targeted. As we discussed in the previous chapter, investors are moving from abinary active versus passive mindset to a Tradable Beta mindset. They want to beable to easily manage their exposure across multiple asset classes andstrategies. Since many ETFs are rules based, it allows them to get targeted andsystematic access to specific factors such as growth, value, or momentum.

(Continues...)

Excerpted from ETF INVESTMENT STRATEGIES by ANIKET ULLAL. Copyright © 2013 Aniket Ullal. Excerpted by permission of McGraw-Hill Education.
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Edition details

• Publisher: McGraw Hill
• Publication date: 2013
• ISBN 10: 0071815341
• ISBN 13: 9780071815345
• Binding: Hardcover
• Language: English
• Edition number: 1
• Number of pages: 256