Building an Exchange Traded Fund Portfolio
Welcome to 2024!
In this article, we would be reviewing recent trends in the Exchange Traded Fund (“ETF”) industry and discussing how to structure an ETF Portfolio.
The ETF Industry in 2023
No doubt, the Exchange Traded Fund (“ETF”) industry has had a good run in the c.30 years of its existence. With global ETF assets under management (AUM) reported to have crossed the $11trillion mark during the year, 2023 was not an exception. In the US especially, ETFs saw a large number of listings last year and going into 2024, the possibility of Crypto ETFs coming into play will be closely watched by ETF investors and could be a material development for the industry.
It is expected that global ETF AUM will continue to grow at double digit compounded annual growth rates (CAGR), reaching $14Trillion by the end of 2024 and $20 Trillion by 2030, as ETFs continue to play a significant role in investment portfolios. Also, with the advent of diverse ETF structures, e.g., Factor ETFs (a factor ETF is a type that focuses on investing in securities based on specific factors or characteristics, such as dividend yield, earnings growth, volatility, value, growth, etc.). Exchange Traded funds are commanding a broader appeal as investors can now use ETFs to pursue various asset allocation strategies in search for “greater than market returns”, thus strengthening the value proposition for ETFs in active portfolios.
In Nigeria, the suite of ETFs available to investors remains limited, with Equity ETFs dominating the space in respect of the number of listings. From a performance perspective, Nigerian Exchange Traded Funds (especially Equity ETFs) posted impressive returns in 2023, unsurprisingly, seeing that the NGX All-Share Index grew by 45.9% for the year. This is also reflected at the market sector level where investors in the NGX Banking Sector Index saw returns of over 100%, through this sector ETF.
Building an Equity ETF Portfolio
Following my last article, I received a question on how to use ETFs to execute an active strategy and seeing that we are in a new year, for starters, I thought to pen down and share a few thoughts on how to build an Equity portfolio, using ETFs, with the objective of outperforming the broad market.
Building an Equity portfolio with ETFs follows the same principles as building any portfolio (the assumption here is that you are already familiar and comfortable with equities as an asset class). The first step is to have an investment objective which, in this scenario, we have already defined as outperforming the general market, i.e., NGX All-Share Index. To achieve this, as with any other investment objective, the focus needs to be on the allocation strategy (i.e., the method of apportioning portfolio assets in line with desired objectives).
Whilst allocation considerations are critically important, there is no “one size fits all” allocation. Investor decisions are influenced by many factors and such portfolio allocations are unique to each investor. Suffice to say however, the allocation decision is arguably the most important decision for the investor, either when building a multi-asset portfolio or a single asset portfolio.
So then, how can we apportion assets in an Equity ETF portfolio? One way to approach this (please note that this should not be construed as investment advice) is to look at the various sector components of the stock market and based on the prognosis/outlook of each sector, assets as apportioned by sector picking (using ETFs to achieve sector exposure / desired sector weightings). A variation of this is using a core – satellite strategy. What does this mean? This involves having the main portion of a portfolio in diversified investments to provide stability to the portfolio, usually in low cost securities like index funds or ETFs and then having other peripheral investments or “satellites” by picking securities that are expected to outperform and deliver superior returns.
For example, using the core – satellite approach, one can start with a core (main) diversified exposure (say 40% - 50%) to the general market using an ETF that seeks to give exposure to the whole market (e.g., the NGX All-share index or NGX-30 index). Following this, a selection of sector specific ETFs can then be introduced to give exposure to sectors which are expected to deliver superior returns. Let’s look at a hypothetical scenario in which the view is that the Banking Sector will outperform other sectors in 2024, in constructing a Portfolio, one could consider allocating more funds to a Banking Sector ETF (e.g., another 40% in addition to the core ETF allocation), with supporting positions in other sectors with positive prognosis.
In our example above, a sample/dummy Equity ETF portfolio could look like this:
Broad Equity Market ETF – 40%, Banking Sector ETF – 40%, Industrials Sector ETF – 15%, Consumer Good sector ETF – 5% (please note that this is an illustrative portfolio and should not be implemented).
One can further drill down to the effective sector allocation of this dummy portfolio by looking at the weightings of sector components of the core segment of the Portfolio and adding same to the additional sector weightings achieved via the sector ETFs, to give a picture of the global sector weightings. With this information, allocations can be fine-tuned, at the core or satellite component level, to achieve an optimal Portfolio allocation.
Sounds complicated? You can start with a simple portfolio of 2 ETFs e.g., a broad equity market ETF and one sector focused ETF reflecting the sector you believe will outperform in 2024. Once you have a feel of it, you can begin to throw additional ETFs into the mix.
Happy Investing!
The author, Damilola Ajayi, is a Director at Vetiva Capital Management Limited and was involved in the listing of the first commodity ETF, the First Equity ETF, the first Fixed Income ETF and the first Shari’ah Compliant ETF listed on the floors of the NGX.
This article is not intended to provide the basis of any investment in any specific Exchange Traded fund (ETFs), nor should it be considered as a recommendation by the author to purchase any specific ETF. Each investor should conduct their own independent investigation and assessment of the investment opportunity in ETFs.
