The ETF Advantage in an Institutional Portfolio

Index Investing — The Beginning

Growth of ETFs
The use of ETFs in institutional portfolios has been growing at an amazingly rapid pace in recent years. In 1996 there were few ETFs available, (mainly the S&P 500 Index-SPY, and the NASDAQ 100-QQQ), with under $5 billion in assets under management. Now there are new ETF launched monthly, with over 400 separate ETFs with assets growing at 29% year to date.

Why the growth in ETFs
To understand the ETF phenomenon one must understand the origins of index investing. Index investing goes back to the early 1970s when mainly academics studied its theory and concepts.

The philosophy fundamental to index portfolios is managing risk through diversification while minimizing turnover, transaction costs, and tax implications. Instead of putting a hand full of the best performing stocks in a portfolio it was found that optimal performance related to superior return and risk management can be gained through portfolio diversification.

Institutions began using indexing for four main reasons:

• Ease in risk budgeting
• Lower management fees and expenses
• Ease in manager evaluation
• Competitive performance against active managers.

It was found that since most portfolio managers are compared to an index benchmark, it was difficult for them to gain consistent returns year after year through stock selection alone.

To gain diversification and lower risk requires active mangers to purchase many stocks in the allocations they have chosen. This adds to the portfolio expense. To make changes in allocation and rebalance again requires many stocks to be traded often over several days depending on the size of the portfolio. In many cases, depending on the stock selection, a manager can get burned by taking a major position in a stock that experiences a heavy loss.

Index investing gives an active manager a major advantage in managing expense and risk while keeping on track with the benchmarks.

Using indexes allow a single trade to be made to fully invest in an allocation with many underlying securities. This lowers the expense of diversifying the portfolio while keeping the risk close to the index. A change in allocation or rebalancing the portfolio can be done quickly with a few trades, thus keeping the portfolio in sync with the underlying benchmarks and keeping it on target with the portfolio goals.

In the early 1990’s S&P realized that the institutional market needed an index investment that had the characteristics of a stock, traded intraday. By working with the American Stock Exchange and State Street Global Advisors a pooled fund based on the securities in the S&P 500 Stock Index was created (SPY). This was followed by the creation of ETFs covering the nine sectors in the S&P 500 Index, the NASDQ-100 Index, and several of the major MSCI International indices.

In the last two years there has been a flurry of new ETF funds launched covering nearly every type of investment class available. Many of the ETFs can also be optioned or sold short without the uptick rule that applies to stock shorting.

With so many ETFs now available, the challenge to the active investment manager is to, not only select the allocation of assets investments within asset categories, it is also important to select the best ETF within each specific category as several ETFs exist for each sub category.