One of the ways Nutmeg adds value as a discretionary investment manager is the time and effort we put into choosing the exchange-traded funds (ETFs) in your portfolios. Analysing ETFs can be complex. There’s an abundance of choice with a multitude of factors to be aware of, and often the devil is in the detail. At Nutmeg, detail is paramount. Here’s how our approach to ETF selection makes your money work harder.
We scrutinise ETFs to understand their quirks
For a given asset class – for example, US equities or emerging market bonds – there are numerous different indexes and funds available, each with their own quirks and nuances; in fact, there are more indexes than there are ETFs. To understand a fund’s exposure and risk relative to its peers, we carry out detailed studies of fund exposures, some of which are summarised at a high level in the table below.
We also investigate the ETF portfolio management techniques employed to achieve physical or optimised replication – whether the ETF physically holds the underlying securities or a representative selection. Although most ETFs are considered passive rather than active investments, there are differences in how they can be managed. We get into the weeds so you don’t have to, which means meeting the portfolio management teams, vetting their processes and understanding the risks.
Our approach means we understand index management methods such as rebalances, hedging and corporate actions – and their inherent risks and costs. We scrutinise performance to understand any deviation from the performance of the index, positive or negative, over varying time periods and market environments, looking at factors such as domicile-related tax optimisation, securities lending revenue and currency movements.
Different portfolio management techniques often explain variations between products tracking the same or similar indexes. Where necessary, we liaise with the ETF provider to gain more clarity.
Ultimately, our approach ensures that we have a total understanding of product options, making the most informed decision possible towards best-in-class ETF selection.
We scan liquidity across all listings and share classes
Liquidity is king. The importance of being able to enter and exit a trade at fair and efficient prices cannot be understated. Most funds we look at will be screened out in the first instance if they present significant liquidity risks.
To properly consider a fund’s liquidity, it’s important to assess the fund across all listings and share classes, because they form part of the same pool of assets and are interchangeable to a market maker, meaning that high liquidity in one listing can translate into another.
As an example, the pound sterling listing in the iShares US Corporate Bonds ETF, known by the stock ticker LQDS, had an average monthly turnover of £5.6 million in the 12 months up to April 2020. However, the US dollar listing of the fund, known as LQDE, had an average monthly turnover of £376 million – almost 70 times as much1.
This is the same fund, just a different listing. Our strategy of trading “over the counter” (OTC) helps us access all of this liquidity.
We scan liquidity in a number of ways. Alongside exchange volumes, we study OTC volumes through Bloomberg and various proprietary tools to get a complete sense of the liquidity landscape.
As well as the quantitative research, we’re in constant communication with ETF market makers and capital markets teams to get a sense of what it costs to buy and sell across asset classes. This is part of our intelligent approach to ETF trading. Once invested, we continue to monitor liquidity to ensure our holdings within any given ETF do not exceed defined thresholds and that our client assets are not subject to concentration risk.
Liquidity is a key component of the total cost of ownership of a fund, and through rigorous assessment we ensure that clients save more in trading spread by being invested in the right product, which can compound over the long term to substantial gains.
We insist our funds are well governed
Focusing on cost is well and good, but it counts for little if a fund provider cannot be trusted to exercise good governance. To pass Nutmeg’s ETF selection test, providers need to demonstrate systems and processes to mitigate against operational and human risks. Good governance calls for clear articulation of structure, roles and responsibilities in the pursuit of good decision-making and risk management processes. In our due diligence, we look to understand the structure of the fund, the fund company, the board and management teams, along with minutiae such as auditors and administrators. Strong governance is essential to provide clear accountability for results and responsible management of our clients’ assets.
Our scale gives us influence over funds and fees
Our scale allows us to deploy influence in a manner that other firms cannot. We are among the largest UK wealth clients of several providers and are estimated to be in the top 50 buyers by size in Europe2. Managing over £2 billion in assets, we are a major buyer of ETFs and can ask ETF providers to launch products for us or lower their fees at our request. As an example, in 2018, one of the world’s largest ETF providers launched a US equity strategy specifically for Nutmeg at a lower cost, thus saving our clients about £350,000 a year in management fees. Through enacting the launch of new products and by switching to lower cost alternatives, we calculate that we saved clients £525,000 in 2019. These savings were immediately passed on to clients in their investment returns.
We’re recognised in the industry as experts
Automation and digitisation are good things, but we believe they go hand in hand with human oversight. We may be a digital wealth manager, but behind the screens exists an investment team with specialisms across disciplines, including investment strategy, macroeconomics, risk and quantitative analysis, and of course ETFs. We’re increasingly regarded as an expert in the European ETF market and are often asked to share our views in the financial press, industry conferences, surveys and events.
Oversight is an ongoing process in ETF selection
We dedicate significant resources to research and ETF selection to ensure our funds remain suitable for our investment portfolios and for achieving the investment goals of our clients. For us, continued monitoring and oversight is an integral part of the ETF selection process. We strive to remain at the forefront of the industry, proactively analysing risks, recognising opportunities and driving product development to ensure that our fund choices remain first class.
Sources
- Bloomberg data, 2020.
- Nutmeg estimate based on ETF trading volumes data and the proportion that our assets under management represent within the overall European ETF sector.
Risk warning
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.
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Rumi Mahmood
Rumi Mahmood is an investment analyst here at Nutmeg. He has two years’ industry experience and joined in early 2017 from the Bank of New York Mellon, where he was an analyst in Global Securities Operations. Rumi holds a masters degree in Engineering from the University of Manchester.Other posts by Rumi Mahmood