Efficient way to build a core-satellite portfolio by using exchange-traded funds
par Vincent LLOVIO
Université Toulouse Capitole 1 - TSE - Master 1 in Economics 2016
ETFs are «new» vehicles, they appears in 1993 in the U.S. At the end of 2007, there were 1171 ETFs in the whole world, with underlying assets close to $800 billion 10 .
An Exchange-Traded Fund (ETF) is marketable security that tracks an index, a commodity, or a basket of asset like an index fund. Its goal is to replicate the performance of its underlying index. Therefore, an ETF which is tracking a particular index, will hold the same securities, and in the same proportion of this one. An ETF pays out dividends received from the underlying stocks on a quarterly basis.
Unlike index funds, an ETF trades like a common stock on a stock exchange. Thanks to its presence in both primary and secondary market, ETFs typically have higher daily liquidity than traditional mutual funds. The supply and the demand in the secondary market determine the price of ETF shares; this later can diverge from the value of the underlying securities net asset value (NAV). This fact provides an arbitrage opportunity for investors, one of the main feature of ETF. Note that the arbitrage activity keep very close the ETF price and the underlying securities NAV.
Furthermore, ETFs have low fees, this is due to the fact that an ETF is passively managed. Note that few actively managed ETFs exist. This reduction in cost can be balanced by the fact that investors must pay a brokerage commission to purchase and sell ETF shares. For those investors who trade frequently, this can significantly increase the cost of investing in ETFs.
Its daily liquidity allows a consequent flexibility, that's why it can be an attractive alternative to implement various investment strategies like hedging strategies, or to build an investment portfolio. For portfolio construction, one of the main advantage of this instrument is the broad diversification that it can provide. Add to total and broad market ETFs, a lot of type of ETFs exists, like sector ETF, market capitalization ETF (large, mid, small cap), fixed income ETF, currency ETF, commodity ETF, bond ETF, etc. The combination of several of them allows the investor not only to diversify across all the major asset classes but also to diversify into investments that have a low correlation to the major asset classes (commodities, emerging
market...). Furthermore, the diversity of ETFs allows to achieve specific segment of the market through low-cost indexes. Before, those segments could be reached through active management.
Another advantage of this instrument is its tax efficiency. It's come from the fact that most of ETFs have very low turnover, so investors amass only few capital gains by holding them. Moreover the tradability of ETF allows to sell it to another investor like a stock, this means no capital gains transaction for the ETFs. Moreover, ETFs offer better transparency into their holdings than mutual funds. ETFs disclose their full portfolios on public every single day of the year.
Overall, ETFs combine the advantages of both index funds and stocks. They are convenient, cost efficient, tax efficient and flexible; their diversity allows an investor to easily fill the «holes» in his portfolio to get a broad diversification. This vehicle provides investors the market exposure they require, at the level they want, at the time need it.