Factor investing series

Factor liquidity sleeve (using ETFs)

| 7 July 2017

Satrix factor series: “Practical applications of factor investing”

Part 3/10: Factor liquidity sleeve (using ETFs)

Client level of adoption/allocation:

Factor investing has the ability to empower consultants, multi-managers and advisors to build client portfolios simply and efficiently.

From 1) the transparent manner in which factor portfolios are systematically constructed, to 2) the capability of building tailored investment outcomes with greater diversification and predictability, to 3) the low fees, to 4) the reliability in consistently delivering a specific investment philosophy. Factor investing is beginning to revolutionise the investment industry.

While the potential impact of factor investing is transforming in nature, the level of adoption by clients varies by degree of simplicity, from ‘not allocating’ to ‘sophisticated allocation’. In this series we aim to highlight all applications of factor investing across this continuum.

This article is the third in our series of articles aimed at discussing practical ways to employ the power of factor investing. In our previous article, we discussed the concept of portfolio completion, where an investor could address unintended factor exposures through plugging a gap in their portfolio with complementary factor exposures.

In this article, we discuss employing factor investing to enhance the trading flexibility of a portfolio through the use of ETFs (exchange traded funds) [See Figure 1].Specifically, we focus on the practical application of building a liquidity sleeve around your portfolio to aid liquidity management in the following scenarios:1) the portfolio is expediting a style change 2) the portfolio has large and frequent cash flows in and out of the fund, or 3) during a period of market stress, where price discovery and improvement is paramount.

Essentially, constructing a ‘liquidity sleeve’ involves building a portfolio of ETFs around your existing active managers to provide similar market exposure, but with additional liquidity to absorb unexpected changes in the portfolio when needed.

Figure 1: Applying a factor liquidity sleeve on a hypothetical multi-manager equity porfolio

Expediting a portfolio style shift

Using factor ETFs to quickly realign style exposures of a portfolio can be a useful tool to employ. If a decision is made to change the overall factor exposure of the portfolio, shifting allocations between underlying managers is an option. However, should there be a requirement to introduce a new manager, using an ETF to swiftly attain that exposure would mitigate the often lengthy process of manager selection and due diligence. Additionally, in the scenario that an underlying active manager experiences style drift (change in factor exposure due to deviation from their self-stated investment objective), the portfolio will experience a misalignment. Temporarily using an ETF to realign factor exposures would make sense in this case

An ETF is a fund that bundles a portfolio of shares into a single, simple package and trades on an exchange like a share.

Because an ETF is simply made up of a collection of shares, its market price will typically fluctuate along with the collective price of its underlying securities. So, when buyers push up the prices of shares, the prices of ETFs should rise, and vice versa.

Cash flow experience

If a portfolio experiences large and frequent cash flows in and out of the fund, continual transaction costs associated with rebalancing the portfolio through directly trading the individual securities can occur. If any of the underlying funds hold shares with smaller market capitalisations, acute liquidity problems could exist, including low volume and high bid/offer spreads. This in turn could lead to either delayed trading, market impact or opportunity costs incurred in the fund. Trading in ETFs when dealing with these cash flows is often cheaper than directly trading the underlying securities, as the ETF bid/offer spread can be tighter than on the underlying securities.

Market stress

While ETF prices do fluctuate in line with tough conditions in the market, they have become an important tool that allow investors to observe market movements in real-time, and to transact even when markets are stressed. During these periods, uncertainty could lead many investors to want to sell shares at the same time, and prices may move sharply in a single day. As prices in the equity market fall quickly, so too will the price of an ETF, reflecting the changing value of the securities it holds. However, because a share and an ETF trade in distinct markets, an investor’s ability to quickly sell these two securities can be very different. In well-developed ETF markets, price improvement and the ability to trade during periods of market stress can be hugely beneficial during a period where liquidity of underlying shares are poor.

For more information on this topic, please feel free to contact us directly.

In our next part in the series, we will discuss the application of combing factor allocations strategically to achieve a diversified investment outcome.

Watch this video for practical ways to employ the power of factor investing by head of portfolio solutions at Satrix, Jason Swartz.

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While the South African ETF market has not developed to wholly embrace this application yet, we feel discussing the above scenarios are still valuable.