Often described as ‘shares with the diversification of a fund’, exchange-traded funds (ETFs) are the ideal building blocks for constructing a balanced portfolio. They can offer the same breadth of exposure as index funds such as unit trusts, but have the tradability of securities, providing investors with the ability to spread risk across different asset classes and geographical regions.

Portfolio construction

Thanks to the range of ETFs listed on the London Stock Exchange alone, it is possible to put together an entire portfolio simply using these products.

Manooj Mistry, head of db x-trackers in the UK, says an increasingly popular approach to portfolio construction and diversification is the ‘core-satellite’ strategy. This involves using ETFs to make up the low-cost ‘core’ of the portfolio, producing returns similar to market benchmarks. Individual shares and other assets then form the ‘satellite’ holdings, which hopefully add the outperformance potential.

So, for example, 60 per cent of a portfolio’s value could be put into ‘core’ holdings of ETFs covering major stock markets such as the UK, US, Europe and Japan, and perhaps also fixed-income ETFs linked to UK gilts or money markets. The remaining 40 per cent of the portfolio could then be invested in funds, stocks or even more exotic ETFs to give extra return and diversification potential.

As well as being ideal core holdings, ETFs can provide the ideal satellites to gain easy and low-cost exposure to less mainstream or alternative areas, such as specific industry groups, private equity or commodities, says Mr Mistry. Also, there are ‘short’ ETFs, which allow investors to speculate on particular markets going down.

Diversifying across asset classes

The benefit of using ETFs in the context of portfolio diversification is that they provide direct and precise exposure to a range of asset classes, says Nizam Hamid, head of sales strategy for iShares Europe. By using a handful of ETFs, it is possible to construct a broadly spread portfolio that is exposed to UK and global equity markets, as well as alternative asset classes such as bonds or commodities.

Gilts & corporate bonds

Although fixed-income securities are particularly important components within older investors’ holdings, they merit a place in all portfolios. Government bonds and high-quality corporate bonds tend to do well when the economy and inflationary pressures weaken. With interest rates in the UK at record lows, income-hungry investors are focusing heavily on fixed income.

To gain instant exposure to UK government securities of different maturities, there are products such as the iShares FTSE UK All Stocks Gilt ETF. For investors who want their investment to be protected against the ravages of inflation, there are products such as the iShares Index-Linked Gilts ETF. In the area of corporate credit, the iShares Sterling Corporate Bond ETF tracks the performance of a wide selection of company bonds.

The main role of fixed-income ETFs is that they can help manage your portfolio’s volatility, especially when used in combination with shares. Also, investors looking for security of income may wish to consider this area, says Mr Hamid. He adds that sterling investors would be better advised to avoid ETFs with exposure to euro- or dollar-denominated corporate bonds, given the high level of foreign-exchange risk, which could very well destroy any income earned.

Commodities

As well as delivering red-hot returns for much of the past decade, commodities are a great way to protect your portfolio from inflation. But, despite their importance as an ingredient in a balanced portfolio, there are currently limited numbers of ETFs covering commodities in the UK.

Mr Mistry explains that regulations governing the structure of ETFs dictate that it is not possible to offer an ETF tracking a single asset such as gold or oil. The regulations require that it must track a diversified portfolio.

Within db x-trackers, there is one diversified commodity index ETF linked to the DBLCI (Deutsche Bank Liquid Commodity Index), which is the most actively traded commodity index ETF in Europe, giving exposure to a broad range of commodities, including precious metals, agriculture and energy.

As Mr Hamid points out, however, the bulk of UK-listed commodity exposure is in the form of exchange-traded notes. These are debt instruments that have a degree of asset backing but, unlike physical ETFs, have the potential for exposure to counterparty risk, he adds.

Special types of ETNs include exchange-traded certificates and exchange-traded commodities (ETCs). While not funds, ETNs share several characteristics to ETFs, in that both are linked to the return of a benchmark index and trade on an exchange.

ETCs are linked to physical commodities or commodities indices, and are backed by either futures contracts or physical commodities. According to William Rhind, head of sales UK & Ireland for ETC provider ETF Securities, investors can choose to invest in major sectors such as energy, agriculture, precious metals, livestock and industrial metals via individual ETCs such as ETFS Physical Gold, ETFS Crude Oil or ETFS Corn.

It is also possible to buy leveraged and short ETCs, which allow investors to profit when the underlying index is falling, he adds.

ETF Securities also offers a complete platform of resource ETFs. These ETFs allow access to sectors where it is not possible to invest in the underlying commodity or resource examples include ETFS Janney Global Water, ETFS DAXglobal Alternative Energy and ETFS Global Nuclear Energy.

Investors can use ETCs to access asset classes like gold cheaper than they could achieve by trying to buy the commodity directly, adds Mr Rhind. In the case of ETFS Physical Gold, for example, the ETC tracks the spot price of gold less the management fee.

According to Mr Rhind, the advantages of ETCs are that they are cost-effective, liquid, transparent and easy to trade. ETCs have revolutionised the commodity markets as they now provide investors with the ability to invest in commodities that were previously unavailable.

Currencies

Whereas all shares, bonds and commodities can fall together, the same is not true of currencies. One currency’s losses are, by definition, another currency’s gains, with the effect that there is always something going up in the foreign-exchange arena. And, because exchange rates don’t always move in tandem with equities, they are good for laying off risk.

ETF Securities recently launched of 18 currency ETCs, providing long or short exposure to a number of leading currencies versus the US dollar. These new currency ETCs are fully collateralised in order to mitigate counterparty risk and are listed in the ETC segment of the London Stock Exchange. These currency ETCs also provide investors with exposure to local interest rates in addition to foreign-exchange movements between the relevant currency and US dollars.

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