It is often forgotten that exchange traded funds were developed to offer a cheap and transparent way for investors to dip in and out of a particular asset class quickly.
Only recently have these investment vehicles become popular as buy and hold instruments, particularly among US retail investors, because they are transparent and, in many cases, have become as cost effective as standard index trackers.
Institutional investors, however, have continued to use ETFs in a manner very close to their initial purpose: to invest in an otherwise difficult to access asset class or to make a short-term tactical bet.
The use of ETFs by institutional investors is also growing because of the rising popularity of multi-asset strategies such as diversified growth funds among pension funds, which often use ETFs to achieve their asset allocation targets.
Trends in the institutional investor space often bleed through to retail investors so it would be logical to assume that this use of ETFs to implement an asset allocation strategy could be picked up by retail investors. That is already starting to happen.
Frank Spiteri, head of retail distribution at ETF Securities, says: “Over the past few years, retail investors have become more aware of the products available to them and the traditional portfolio mix has started to shift.”
Just as institutional investors use ETFs for asset classes that are hard to access, so, too, do retail investors. Deborah Fuhr, managing partner at ETFGI, says: “For example, in the past, most retail investors could not access commodities because they cannot participate in the futures market, but exchange traded products have allowed them to do this.”
Mr Spiteri agrees: “Retail investors have moved from a traditional portfolio where 60 per cent is allocated to equities and 40 per cent to fixed income, to switching a significant proportion of the fixed income funds to commodities”.
Much of this drive towards a more experimental approach to asset allocation originated with independent financial advisers. “IFAs are much more cost conscious and are now looking at passive investments as a way of building portfolios,” says Mr Spiteri.
In the UK at least, this cost awareness is a direct result of the retail distribution review. But the RDR has also had another interesting consequence – the emergence of the self-directed investor.
“There are a number of private investors who do not have enough assets to justify them hiring an IFA,” says Mr Spiteri. “ETFs are ideal products for these investors because they are cheap and easy to use. Once they become comfortable with the asset class, they start to branch out from simple equity trackers and be more experimental with their asset allocation.”
For many retail investors, however, a move towards a more sophisticated asset allocation is likely to happen at one step removed. Firms are starting to offer retail investors access to a diversified, risk-targeted portfolio that uses ETFs as the underlying investment.
Anthony Christodoulou, independent ETF consultant, says: “There is an emergence of online ETF portfolio management tools which enable retail investors to build their own risk-targeted model portfolios at the click of a button.”
Incorporated in those strategies is another trick from the institutional investors’ tool box: the use of automated rebalancing of those portfolios.
“The automatic rebalancing tool is the real beauty of these types of portfolio. It ensures that investors buy low and sell high, as well as ensuring your portfolio doesn’t drift from your risk appetite,” says Mr Christodoulou.
Asset allocation is not the only way that investors are becoming more sophisticated in their use of ETFs. Adam Laird, head of passive investments at Hargreaves Lansdown, says: “Strategies that five years ago only institutional investors would have used are now being used by those retail investors who have become comfortable with ETFs.”
Such strategies include the use of interest-rate hedged products, as well as short and leveraged products.
“There are now 14 per cent more sophisticated ETFs available on our Vantage platform than there were a year ago,” says Mr Laird. “By sophisticated ETFs, we mean short or leveraged products, specialist asset classes such as commodities or other strategies that would not qualify as Ucits retail products.”
While retail investors are just getting to grips with the benefits of using ETFs to access a broad range of asset classes and the benefits of going short, in the future they will go one step further and use these products for tactical asset allocation.
Michael Gruener, head of wealth and retail sales for iShares Emea, says: “As the retail market becomes more sophisticated, advisers and self-directed investors will want to implement trading strategies, and ETFs are the perfect tool for these types of investment.”