By James Dunn

Exchange-traded funds (ETFs) have become, arguably, the fastest-growing investment product in the world. There is now US$3.3 trillion ($4.4 trillion) held globally in ETFs and exchange-traded products (ETPs), up 11.5% on a year ago (July, 2015). Around the world, investors pumped US$55.2 billion ($73.6 billion) into ETFs in July, the highest monthly flow since December 2014.

Why investors like ETFs

The prime attributes that have driven this growth are the simplicity of the ETFs in offering investors exposure, through one listed stock, to a wide range of asset classes and investments.

These range from share and bond market indices, to commodities and currencies, to various investment styles, strategies and themes. This makes ETFs very efficient in diversifying a portfolio in a cost-effective way, given the typically lower management and transaction costs of ETFs compared to actively-managed funds.

All kinds of investors can use ETFs for a variety of roles, but achieving precise exposure to certain asset classes and investment niches is a feature most retail investors would certainly find handy.

Tailor your exposure

Investors can now diversify a portfolio much more effectively than before using other asset classes, and benefit from the fact that asset prices are not perfectly correlated. In other words, not all asset prices move in concert, and price movements in one asset in a portfolio can counteract price movements in another asset. A properly diversified portfolio can achieve higher levels of return, while reducing overall portfolio risk.

Even within asset classes, different sectors can give varying exposures, decreasing correlations. ETFs allow retail investors to tailor their exposure.

Within an investor’s core Australian equities allocation, for example, investors can segment their investment by factors such as market capitalisation, level of yield represented by the stocks’ dividend payout ratios, or ‘style’ considerations (whether the stocks represent “value” or “growth” opportunities). Again, this segmentation taps into differing correlation records.

Simple exposure to hard-to-reach investments

ETFs can be particularly helpful in achieving exposure to asset classes which retail investors would otherwise find hard to access. For example, fixed-income has historically been a difficult asset class for Australian retail investors to enter, as most kinds of bonds were sold in prohibitive minimum investment parcel sizes. Effectively, this locked retail investors out of the market, unless they wanted to use unlisted bond funds. But fixed-income ETFs offering exposure to investment-grade securities in the Australian commonwealth government and state government bonds space, and the global corporate bond market, have opened up these asset classes for investments of any amount.

For example, the iShares Core Global Corporate Bond (A$ Hedged) ETF (ASX code: IHCB) offers investors exposure to a portfolio of thousands of global corporate bonds, through simply buying one stock on the Australian Securities Exchange (ASX).

Small caps don’t always march to the market’s tune!

The capitalisation issue is relevant to the Australian share market, which has become one of the most concentrated in the world. The top 20 stocks account for about 62% of the total value of the benchmark S&P/ASX 200 Index. The top seven stocks represent almost half of the index. Therefore, these stocks account for most of the movement of the index.

When large-cap stocks are lagging, the index lags with them – but small-caps may be performing well, independent of this movement. For example, in the year to June 30 2016, the benchmark S&P/ASX 200 earned a return of just 0.2%, but the S&P/ASX Small Ordinaries index surged by 14.4% over the same period1 (The S&P/ASX Small Ordinaries index represents members of the S&P/ASX 300 Indexthat are not in the S&P/ASX 100 Index). 

Australian small-cap companies are easily accessible directly to local investors, but there is an information risk in the fact that the small-cap stocks are not as widely covered by investment analysts, making it a potentially troublesome sector for individual investors.

However, investors who are aware of the concentration effect of the Australian share market, and who understand the lack of correlation of the small caps’ performance with that of the market’s benchmark index, can customise their domestic stock allocation – and further diversify their portfolios – by holding a broad ETF that gives them the performance of the sector. For example, the iShares S&P/ASX Small Ordinaries ETF (ASX code: ISO) is designed to capture the performance of those 200 Australian small-cap companies not part of the S&P/ASX 100 Index.

Emerging markets give a portfolio a distinct twist

Similarly, investors can tailor their global equities exposure in a number of ways to pick up on differences across regions, sectors and markets. Within global equities, for instance, emerging markets (those countries classed as not yet at the level of developed nations) are considered a discrete asset class, with a risk/return profile different to that of standard international equities investment.

Emerging markets equities show little correlation to the developed share markets, and thus can work to reduce the overall volatility of the portfolio. Allocations within emerging market funds vary, but China usually represents the largest exposure.

China, South Korea, Taiwan and India account for almost two-thirds of the MSCI Emerging Markets Index, and therefore, an investment in emerging markets is increasingly a bet on Asia. 

Emerging markets have usually shown a strong correlation with commodity prices, being seen as producers. Returns from emerging markets shares have been largely weak since the GFC, hurt by soft commodity prices and the slowdown in China. Emerging market assets are typically considered vulnerable to periods of strength in the US dollar. For example, following US interest rate rises, because that depresses commodity prices and relatively low returns in US$ keeps money invested in emerging markets. Usually, rising US rates causes a flood capital to flow back to the US, and emerging markets are usually one of the first assets to suffer.

However, emerging markets as an asset class are changing. The emerging markets-commodities correlation – while strong between 2005 and 2013 – has lessened. The combined energy and materials sector weights in the MSCI Emerging Markets Index have come down from close to 40% at the height of the commodity boom to just 13.8%, not much greater than the 11.7% in the MSCI World Index.

The performances of the MSCI World Index and the MSCI Emerging Markets indices can diverge widely. In 2013, for example, in US$ terms, the Emerging Markets lost 2.3%, while the World Index gained 27.4%. But it would have been helpful to hold the Emerging Markets in 2009, when it gained 79%, compared to the World Index’s rise of 30.8%.

The MSCI Emerging Markets Index is heavily weighted at the top end to IT stocks. Its five largest holdings are internet company Tencent Holdings, Korean giant Samsung Electronics, Taiwan Semiconductor, Chinese online marketplace Alibaba and Chinese telecommunications company China Mobile. This makes it a different exposure to a standard global investment, picking up on different themes. The problem can be that many emerging markets are restricted to foreign investors, and expensive to enter even if not restricted. But investors wanting to tap into this exposure can easily allocate some of their international share portfolio weighting to an ETF like the iShares MSCI* Emerging Markets ETF (ASX code: IEM), which seeks to track the performance of the MSCI Emerging Markets Index. This kind of portfolio tweak is easily implemented through ETFs, tailoring an allocation more specifically, and allowing both greater diversification and the ability to make strategic tilts.

This is a sponsored article by BlackRock Investment Management