Commentary by Marzena Hofrichter, Portfolio Manager Franklin Templeton Investment Solutions and Jason Xavier, Head of EMEA ETF Capital Markets at Franklin Templeton.
As a component in actively managed portfolios, ETFs can currently provide an efficient solution for diversified and dynamic portfolios, especially when market conditions make consistent alpha generation difficult or return targets outperform the market. Thus, ETFs can be used for tactical exposure on the one hand, but also for broad exposure to an asset class.
ETFs are often ideal building blocks for low-cost multi-asset solutions. In addition, ETFs can be used to better manage ESG mandates, especially in efficient markets. In addition to their cost efficiency, ETFs are very easy to trade. Passive ETFs provide a clearly defined exposure that tracks an index and can be customized as needed. Multi-factor (smart-beta) and active ETFs provide more active exposure to the benchmark index while still offering the cost and liquidity advantages. Taking advantage of these benefits often makes a difference during volatile markets. They also give the opportunity to gain exposure to different asset classes, such as bonds or commodities.
Use in the bond segment
In bonds, ETFs can help quite efficiently through volatile periods, as was the case in the Covid-19 pandemic, for example. Both passive and active bond ETFs can provide mark-to-market valuations and real-time information on what is happening in the underlying bond market. This is a good example of how ETFs can be used as a liquidity component or price discovery barometer within fixed income.
There is a view that ETFs in the fixed income segment amplify volatility and reduce liquidity in the bond market, especially in passive strategies. It is important to understand that volatility, and consequently liquidity, always depends on investors’ investment inflows. The investor makes the decision to buy or sell a security (a stock or a bond). The macro environment or the stock or bond specific attributes are of course also a reason for the decision to buy or sell. But the security itself can never cause volatility, and liquidity is a finite function of that volatility. ETFs, and bond ETFs in particular, make up only about 18% of the fund universe. However, 20% of the market cannot account for 100% of the problem.
ETF selection
When choosing the right exposure, it is advisable to focus on the total expense ratio (TER) and the level of AUM, rather than on-screen spreads. However, there are mandates where the percentage of exposure is limited. These limitations could and perhaps should be reevaluated when it comes to ETFs that invest only in deep and liquid underlying markets. One argument might be that the percentage caps on ETFs should at least be raised.
On spreads, experienced traders know the best and most efficient methods for execution and that over-the-counter trading drives market structure in Europe. With the support of ETF market makers and features such as request-for-quote systems, optimal execution can be achieved regardless of on-screen spreads.
