As the market for exchange-traded funds (ETFs) expands, new products and trends surface regularly. Our investment team outlines their approach to navigating an increasingly crowded marketplace.
In the past four years, global ETF assets have nearly doubled, jumping from $5 trillion in 2018 to an impressive $10 trillion by the end of 2022.
What Drives This Remarkable Growth?
One significant factor behind this evolution is cost. ETFs provide investors with access to a diverse array of securities at a lower expense, while also offering transparency, liquidity, and flexibility. These qualities make them an excellent foundation for investment portfolios, enabling investors to build a core set of diversified, broad market exposures while minimizing fees.
Today, asset allocation is recognized as more influential in driving investment returns than individual stock selection. This shift has increased the popularity of passive funds, especially ETFs, as they allow investors to gain exposure to entire markets, sectors, or asset classes simultaneously.
Furthermore, ETFs can be traded throughout the day, enhancing their usability, which has contributed to their rising prominence relative to mutual funds, which are only tradable once daily.
Performance trends have also favored ETFs. Over the last decade, about 75% of passive funds have outperformed their active counterparts. Even during last year’s volatile markets—typically seen as a realm where active managers excel—passive strategies proved to be effective.
At Nutmeg, we’ve utilized ETFs since our inception more than 10 years ago. As the market has matured, we’ve continually refined our ETF selection process while adhering to the guiding principles of our investment strategy.
What is an ETF and Why Do We Use Them?
Exchange-traded funds (ETFs) allow investors to acquire exposure to a group of investments without the need to buy each one individually. They can track share indices like the FTSE 100, asset classes such as government bonds, specific market segments like short-term bonds, regions, or sectors.
Two main advantages of ETFs are transparency and flexibility. Investors have clarity regarding their portfolio holdings and can trade whenever markets are open. Additionally, ETFs offer significant benefits, including variety and diversification.
Another compelling reason for selecting ETFs is cost. As of December 2021, the average fee for an actively managed stock fund was 0.60%, while the fee for a passive fund averaged just 0.12%. We strive to keep costs low, and the use of ETFs enables efficient investment on your behalf.
How is the ETF Market Evolving?
The launch of SPDR in 1993 marked the introduction of the first major ETF, designed to replicate the performance of the S&P 500.
Since then, the ETF landscape has evolved dramatically. Over the past decade, the number of available ETFs has surged by 80%, accompanied by a diversification of styles and types. The market now features increasingly active and innovative ETFs, opening new investment opportunities.
In recent years, ESG ETFs have gained considerable traction. These funds allow investors to focus on strategies that emphasize environmental, social, and governance factors. We’ve also noted a growing demand for active ETFs, such as the research-enhanced funds featured in our Smart Alpha portfolios, powered by J.P. Morgan Asset Management. Other innovations in the market include inverse ETFs, smart factor ETFs, and commodity ETFs.
Thematic ETFs, which concentrate on specific trends or long-term themes, have also seen rising popularity. This trend enables investors to target particular interests while benefiting from the transparency and flexibility of traditional index ETFs.
How Do We Choose ETFs for Your Portfolio?
With the increasing complexity of the ETF market, selecting the right funds has become more crucial than ever.
When determining which funds to include in our portfolios, we consider several key factors. After fund selection, we leverage our extensive expertise to blend them for a diverse array of investment exposure while aligning with your risk profile. Our considerations include:
- Market Index Components: Many ETFs aim to replicate the performance of specific indices, like the FTSE 100. We assess the underlying components of these indices, evaluating whether they align with our investment team’s views and making suitable investments.
- Replication Method and Tracking Error: Different funds utilize different methods to hold the components of an index. We examine the tracking difference of each ETF to ensure that the manager closely matches the index’s performance and select funds with minimal divergence.
- Costs: We aim to hold the fund with the lowest overall costs in each asset class, focusing on the total expense ratio (TER), management fees, and trading costs. Our goal is to select the fund that offers the best overall value for our clients.
- Size and Trading Volume: The size and trading volume of an ETF are crucial factors. We avoid investing large amounts in ETFs with limited trading volume and evaluate the liquidity of the underlying index components to manage trading and creation/redemption costs effectively.
- Type of ETF: We focus exclusively on physical ETFs, which aim to mirror the performance of an index by investing directly in its components. To delve deeper into the various ETF types, click here.
After selecting our ETFs, we deploy proprietary macroeconomic and market research to optimize the asset allocation of our portfolios, making adjustments and rebalancing as opportunities arise.
How We Use ETFs Across Our Investment Styles
We employ a mix of ETFs across our diverse range of investment styles and portfolios.
In our Fully Managed and Fixed Allocation portfolios, we access a broad universe of more than 1,800 equity and bond funds. Our Socially Responsible portfolios prioritize ETFs that exclude companies involved in controversial activities while emphasizing those with strong ESG practices. In our Smart Alpha portfolios, we combine passive ETFs with innovative active ETFs selected by J.P. Morgan Asset Management, aimed at delivering above-index performance.
For more detailed insights into the specific ETFs we utilize, click here.
Risk Warning
As with all investments, your capital is at risk. The value of your Nutmeg portfolio may fluctuate, and you may receive less than you originally invested. Past performance is not a reliable indicator of future results.
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