The proliferation of exchange traded funds has helped investors and advisors create low-cost and tax-efficient ways to access various market segments.
With ETFs, investors are able to diversify risk-exposure, or maximize a portfolio’s Sharpe ratio, the return per unit of risk, according to BlackRock.
The Sharpe ratio is the average return earned in excess of the risk-free rate per unite of volatility or total risk. Higher Sharpe ratio readings typically correspond with better risk-adjusted returns.
One “can combine different investments together in such a way that the overall risk of the portfolio is substantially less than the sum of its parts,” BlackRock analysts said. “Such diversification is the cornerstone of good portfolio construction.”
Specifically, investors should consider major risks, including credit risk, interest rate risk and equity risk, for a risk-managed portfolio. For instance, in a stock-heavy portfolio, rate-sensitive bonds can diminish overall risk more than credit-sensitive fixed-income assets because rate-sensitive assets help offset equity market shocks.
“Although long-term Treasuries have higher volatility than high-yield bonds, a mostly equity portfolio can achieve more risk reduction by incorporating long-term Treasuries than by incorporating high-yield,” according to BlackRock.
Moreover, looking at interest-rate risk, bonds react differently to changes in various term interest rates. For instance, from 2012 to 2014, some of the greatest changes in the standard deviation, or volatility, were seen across bonds in the middle of the yield curve.
Investors will also have to consider credit risk, or the possibility that a bond issuer could default. Fixed-income traders typically measure the risk by taking a bond’s yield and the yield of an equivalent maturity U.S. Treasury note, or what is commonly known as the credit spread. Among fixed-income assets, high-yield speculative-grade debt securities show the greatest credit spread, which is not surprising since the debt assets would have to be attractive enough to compensate investors for the added credit risk.
While many investors may be used to their active fund investments, some of their active manager’s strategies may take little active risk and effectively mirror a benchmark. These closet benchmarkers are also charging hefty fees for their relatively passive strategies.
“Such managers can be readily replaced using ETFs that provide low cost exposure to a benchmark,” according ot the BlackRock analysts.
For instance, the average expense ratio on a U.S.-listed ETF is 0.59%, and the cheapest index-based stock ETF has a 0.04% expense ratio, according to XTF data.
Investors can still go with an active fund if the manager has proven to deliver active returns, or alpha, but the industry has not provided much confidence of late – according to S&P Capital IQ Fund Research, 80% of running large-cap mutual funds have underperformed the S&P 500 in 2014. [Why Active Funds Are Underperforming Index ETFs]
For more information on investing with ETFs, visit our ETF 101 category.
Max Chen contributed to this article.