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Why you should invest in exchange traded funds

May 05, 2015 09:30 IST

An ideal portfolio is one which not only takes care of the ultimate end goal of a secure retirement, but also takes care of the expenses in-between. Look no further than investing in exchange traded funds, or ETFs, says Vikaas M Sachdeva, CEO, Edelweiss Asset Management Ltd.

However, one does not have to become a financial genius to build a personal investment blueprint. Whether one is building a portfolio on her/his own or with the assistance of a financial adviser, there are two critical steps to complete:

1. Identify one's objectives, time horizon, risk tolerance, level of financial knowledge, and personal preferences.

2. Select a range of appropriate investments and decide how much to allocate to each asset class to maximise returns for a given level of risk.

Ideally, one looks forward to an optimal portfolio, a portfolio which provides maximum potential returns for a given level of risk. This is where the 'Right Asset Allocation' comes into the picture.

Studies show that asset allocation explains about 90 per cent of the period-to-period change of a portfolio. Extended research also reveals that about 40 per cent of the return variation between funds is due to asset allocation, with the balance due to other factors. But because the average of all investors is the market itself, with good asset managers and bad ones cancelling each other out, asset allocation ultimately accounts for 100 per cent of the absolute level of returns for a portfolio.

Asset allocation thus becomes one of the most important principles of portfolio construction and one of the primary drivers of portfolio performance. By being in the market, and doing a strategic asset allocation across a variety of investments, investors can reduce portfolio volatility and improve performance, as different asset classes may outperform at different times.

How do ETFs support asset allocation?

For asset allocation to work at its best, each asset class must be accurately reflected within a portfolio, and that's where exchange traded funds, or ETFs, play an important role. An ETF provides a true representation of an asset class, tracking the performance of a specific index, such as equity, bond or commodity index, mirroring its returns.

ETFs give investors easy and efficient access to:

• Different asset classes (equity, fixed income and commodities).

• Various markets (domestic, international, and emerging).

• Different market segments (sectors and themes across asset classes).

Hence ETFs play a crucial role for investors looking to implement their optimal asset allocation model as accurately as possible.

Some popular known strategies used to build portfolios through ETFs are:

• Low cost long index exposure -- ETFs are known for being one of the lowest cost exposure to the indices at large.

• Core and satellite investment strategies -- ETFs allow altering asset allocation in a single trade, maintaining broad-based index ETF as their core and moving to more strategy based ETFs as satellite exposure.

• Sector rotation and tactical allocation -- ETFs are used to add or be overweight in specific markets, sectors or industries to a core portfolio.

• Portfolio completion -- allows investors to fill gaps in a portfolio in specific asset classes or sectors.

Hence, one of the most popular uses of index based ETFs these days is plugging them into asset-allocation models and many investors have already started utilising low-cost diversified ETFs as their portfolio building blocks.

Photograph: GotCredit/Creative Commons

The views expressed above are the author's and not necessarily the organisation he represents.

Vikaas M Sachdeva