How a robo-advisor selects ETFs in its portfolios

by , 13th October 2017

ETFs provide the incredible ability to diversify your investments, lower your costs and paradoxically outperform active managers most of the time. Yet when it comes to ETF/stock selection, investors can often focus too much on the specific asset class, region or thematic exposure rather than the bigger picture. They often want that newly listed robotics or AI ETF yet don’t pay attention to their portfolio as a whole.

We’ve just completed a periodic review of ETF implementation in our model portfolios, and wanted to share how we think about building our portfolios. When it comes to stock (ETF) selection, in essence we focus first on portfolio management by working at an index level (e.g. FTSE) then use a range of criteria to filter for the best ETFs.

Planning: How we balance alternatives and capacity

Constructing portfolios is often like stacking a dishwasher full of dirty dishes. The challenge is both about ranking the balance of cutlery, dishes and glasses that works for you and using as much of your dishwater capacity as possible. Finding the right sized dirty dish to fit the right space.

A more eloquent way to say this is that asset allocation is the most important factor for driving portfolios returns. This means that in some instances a specific dirty dish (less favoured asset class) does have merit to be included in a portfolio. To mix metaphors, it makes the sum greater than the whole of parts. Ensuring portfolios have some hedge in place for combinations of low and high growth as well as low and high inflation is incredibly important.

It is one reason we recently included inflation-linked bonds across all three currencies (GBP, USD and EUR) for our model portfolios. As an investor it is important to ask yourself if your chosen ETF materially improves the overall asset allocation, not only how it performs independently.

Execution: Selecting building blocks and deploying them

Once the broad asset classes are set the next focus should be on the geographic and asset class-specific exposure of each. We use the MSCI All Countries World Index for our regional equity breakdown, to ensure that we have diversified portfolios. Only then would we argue it is important to look at the specific individual ETFs to build the portfolio.

We’re using a range of criteria to select our ETFs. We focus on the largest providers, the lowest TERs, the lowest tracking errors, the highest liquidity to name only a few metrics. In fact, we have 11 criteria that we use to rank and select ETFs – from fund currency to share class currency, to domicility, listing and distribution.

We aim to select the right implementation for our clients all while adhering first and foremost to our core philosophy of asset allocation. We used this methodology to recently replace almost half of the ETFs in our model portfolios. As a result we reduced our portfolio TERs between 3 to 9 basis points in some of our models, while increasing diversification and decreasing risk in others. Although these few percentage points might not seem like much, over time these costs can severely impact investor returns. To illustrate, a simple GBP 10,000 portfolio invested for 10 years at 5% will miss out on GBP 1,343.55 due to higher costs.

Performance: Monitor 24/7

As a digital wealth manager or robo-advisor, it is critical to monitor the ETFs in our client portfolios continuously and we are constantly looking to see where we can improve the asset allocation, diversify risk and lower the costs for our clients. This is where we add value, by managing a portfolio of ETFs on their behalf. Not only focusing on the right asset classes for our models and the right ETFs for those asset classes, but implementing rebalancing policy and strategy. However, any ETF investor can follow the same strategy to not only arrive at their own ideal asset allocation, but build a model portfolio with the best ETFs that suits their need.

Our approach is focusing on asset allocation as the core driver when making our initial ETF selections, and then strictly filtering by a range of criteria to select the best ETFs. We think this will stand any investor in good stead when it comes to building a portfolio that meets their long-term investing goals.

Johann Bornman is the product and sales director at ETFmatic.