Following my conversation at year end with Andrew Black, a multi-asset trader in Franklin Templeton’s Edinburgh office, I recently turned to my Frankfurt colleagues for a discussion on the myths and misconceptions about exchange-traded fund (ETF) liquidity and trading. Our team has covered many such topics in the past, but it’s worth gaining perspective from those who actively use ETFs to help investors achieve their goals. Here, I’m delighted to share a discussion I recently had with Marzena Hofrichter, portfolio manager with our Franklin Templeton Investment Solutions team in Germany.
JX: Marzena, thanks again for taking the time to speak with me today. I know you’re very busy, so I really appreciate this.
MH: No problem.
JX: Why don’t you tell us a little about your role, background and your work within Franklin Templeton Investment Solutions. What does your group do?
MH: I joined Franklin Templeton more than 12 years ago. Prior to that, I worked for another asset manager and for Morningstar. In my current role, I manage multi-asset funds for clients based in the EMEA region. We typically combine our views on capital markets with client-specific needs and guidelines to create competitively priced bespoke solutions.
And because I know you are going to ask, yes, we use ETFs in our portfolios.
JX: Perfect! So, you mentioned competitively priced bespoke portfolios. Hence, is the utilisation of ETFs because of their cost benefits?
MH: That’s right. We use ETFs mainly for two reasons. One, to get tactical exposure to an asset class. Two, to get broad exposure to an asset class that is relatively efficient. In other words, where it’s hard to consistently generate alpha, or above-market returns. That said, we also complement our active-manager holdings with ETFs, if the guidelines allow for it, as we believe they are an integral part of a well-diversified and dynamic portfolio.1 More and more, investors want cost-efficient, multi-asset solutions and hence, we often find ETFs are ideal building blocks to deliver this. It’s also worth mentioning that using ETFs helps us manage environmental, social and governance (ESG) mandates, especially in efficient markets.
JX: That’s great, so quite a broad application. I’m curious, you mentioned—and we often talk about—using ETFs for tactical exposures. I’m keen to hear why ETFs are ideal for you in this scenario?
MH: An ETF has many advantages that make it an attractive investment for multi-asset strategies and a really great addition in different scenarios. Besides cost-efficiency, they are generally very easy to trade. Passive ETFs have a defined exposure that tracks an index and allows for custom-fit exposure when we need it. Multi-factor (smart beta) and active ETFs provide more active exposure to the benchmark while maintaining cost and liquidity advantages. So, for us, utilising these benefits is at the core of tactical positioning. Leveraging these can often make the difference, especially in volatile markets.
JX: Can you expand on what you mean in terms of volatile market scenario?
MH: As an active, multi-asset portfolio manager, having the freedom to make investment decisions based on our clients’ specific needs and our views on the capital markets, and hence, navigating the daily changes that occur is what we see as the key to success. The ETF is a great vehicle that can increase our chances for success. Additionally, they allow us to gain exposure to different asset classes, such as fixed income or commodities.
JX: Can you expand a little more on fixed income exposure via an ETF?
MH: Within fixed income, ETFs can be quite effective in helping us manage volatile periods. This was something we fully appreciated during the fallout at the onset of the COVID-19 pandemic. Both passive and active fixed income ETFs have the ability to offer real-time, mark-to-market pricing and information about what’s occurring in the underlying bond market. But again, it’s most relevant for us as either a liquidity sleeve or price discovery information barometer in volatile markets.
JX: Thanks, Marzena. That’s something I’ve been talking about a lot recently. For me, the fact that the ETF has taken a fragmented market structure and successfully put this onto centralised exchanges for real-time price discovery and execution is powerful, and within the fixed income space, it’s another tangible benefit for utilising the ETF vehicle.
MH: Yes, but what about those who have suggested the ETF vehicle within fixed income exacerbates volatility and reduces liquidity in the bond market, especially when considering passive fixed income?
JX: Ah those who can’t do—write about how to!
So, the first thing to acknowledge is that volatility and subsequently liquidity is and always will be a function of investor flows. The investor makes the decision to buy or sell a security (stock or bond). While the macro environment or the stock- or bond-specific attributes will obviously be a reason for the decision to buy or sell, the security itself can never lead the creation of volatility, and liquidity is a finite function of this volatility.2 The suggestion that 20% of the market is causing 100% of the issues is another example of the tail wagging the dog.
Lastly, we’re always trying to educate and dispel the myths around ETF selection. Two areas I’d be keen to hear your views on are ETF spreads and assets under management (AUM). Do they factor into your ETF selection process?
MH: To be honest, we focus on selecting the correct exposure and look predominantly at the total expense ratio (TER) and AUM size over the on-screen spreads. TER and AUM size are certainly important. I fully appreciate your justification for size not being an issue; however, we still have to acknowledge mandates restricting percentage ownership and that would be the case across all underlying constituents. But I agree. Those same restrictions could and perhaps should be reassessed when looking at ETFs, which are obviously only investing in deep, liquid underlying markets. You could certainly argue that the percentage restrictions should, at a minimum, be increased for ETFs.
On spreads, our dealers will know the best and most efficient method for executing, fully appreciating that over-the-counter trading drives the market structure in Europe. And that optimal execution can be achieved regardless of what on-screen spreads are via the utilization of ETF market makers and features such as request-for-quote systems. If needed, they can always reach out to a team like yours for assistance.
JX: Marzena, thanks again for taking the time to highlight your various use cases for ETFs. I’m sure these ultimately help you achieve the best possible outcomes for your clients.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Generally, those offering potential for higher returns are accompanied by a higher degree of risk. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets.
For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.
ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
Commissions, management fees, brokerage fees and expenses may be associated with investments in ETFs. Please read the prospectus and ETF facts before investing. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated.
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1, Diversification does not guarantee profit or protect against risk of loss.
2. Source: Morningstar, as of 31 December 2023.