OakTree Wealth Management CIO Ian Brady outlines his approach to using passive products and explains why he shies away from swap-based exchange traded funds (ETFs).
What type of beta products do you use and why?
Ironically, we use allegedly passive products in order to generate alpha at a lower cost.
Like all our investments, the product will have a specific role to perform within our overall portfolio. If we can fulfil the role at a lower cost, then we will obviously use that option – but we won’t buy for cost reasons alone.
We do attempt to control the ‘all in’ total expense ratio (TER) to our clients, including ongoing advice fee, discretionary fee, fund charges and platform charges, to 2%, so appropriate use of passives helps us achieve this.
We are intellectually indifferent between ETFs and index funds (including SPDRs) and will allocate to whichever product best fits our investment criteria.
How do you choose the type of beta products to implement your views?
We choose the type of beta product to suit the specific role it has to play. In March 2009, we met with the management of five oil and gas companies, who said they needed between $70 and $80 [per barrel] oil before they would drill again. Oil was trading under $40 at the time, so we decided that a bet on rising oil prices was one worth taking.
However, we wanted to avoid issues with rolling over underlying positions every few months on a futures-based contract, so we decided to buy the Energy Select Spider in the US. This gave us exposure to a variety of US energy shares and provided us with a dividend too. It wasn’t pure oil exposure, but the share price had collapsed from over $80 to below $40 in six months as the oil price corrected.
We therefore felt confident it would provide meaningful upside if oil approached $70 again. This did happen and we made good money, but I have to admit the dollar fell over the holding period and took away some of the profit we made on the underlying share.
In another instance, we held the iShares DJ Asia Pacific Select Dividend 30 fund for more than two years. This gave us exposure to the 30 highest dividend paying shares in the developed markets of Asia Pacific. It also has the proviso that the dividend can’t exceed 85% of the average earnings per share. We wanted exposure to the growth of this region but also wanted to control the overall beta of our portfolio and focus on companies paying good dividends. This seemed to fit the bill and held up very well last year, compared with the average active Asia Pacific fund.
However, when we researched the underlying holdings, we found the majority of the top 10 had dividends that were expected to be flat to down over the next three years. High but declining dividends don’t usually lead to attractive total returns so we sold and moved the money back into active managers in the region.
Why can ETFs be seen as efficient vehicles for tapping large markets?
ETFs can be attractive for tapping large markets because, by definition, they are good at capturing large flows of liquidity.
This thinking led us to buy the iShares FTSE China 25 fund. The Chinese market had been out of favour for two years and valuations were close to lows at the index level. We were already playing the Chinese consumer story via active funds and came to the conclusion that if China and therefore Asia were to work, the Chinese banks would need to play a part.
Many active fund managers were underweight banks because of concerns about the property market and local government lending, so we wanted a decent exposure within our China weighting towards banks.
We didn’t want this banking exposure to be sold down as a ‘tactical play’ by an active manager, so we went the ETF route to augment our active holdings.
What about using active ETFs to help manage exposure to the underlying asset, or are you against this concept?
I have not given too much thought to active ETFs. Daily listing of holdings could lead to front running if a large successful fund is noticed to be significantly changing a position or strategy. I am keen on buying sector ETFs as well as general indices. However, at the moment, many of the interesting ones are US-domiciled and therefore subject to income rather than capital gains tax. Hopefully, in time we will have a raft of qualifying sector ETFs available to UK clients.
Do you have any concerns about using swap-based ETFs as opposed to physical?
Like many others, I initially considered swap-based ETFs too difficult a sell to clients and would rather have the underlying asset as collateral. I accept this still can leave investors open to the risks of stock lending. However, my research has helped assure me that the big players such as iShares have robust procedures with regards to such activities, and individual investors are unlikely to lose large amounts due to ETFs lending out stock.
AND WHEN SMART BETA DOESN’T WORK...
Are there any asset classes where you think beta products are inefficient, such as fixed income?
I am not keen on products where you have to roll over contracts every three months to follow a futures price. It makes both correlation and cost difficult to predict.