THE inability of many active managers to beat their index over a year should shock investors. Their failure over a longer period of time should have them running for the hills. Through luck or judgement some outperform, but often not for long, and picking those that do is a lottery. Investors of the future may look with incredulity at the investors of our time in a similar way to how we perceive Renaissance mountebanks, fleecing the gullible with cures of snake oil. The future is closer than many think: exchange-traded funds (ETFs) within managed portfolios, funds of ETFs and ETFs of ETFs will be the death of many active managers hugging or underperforming their relevant index.

It’s easy enough to get an ETF, but it’s not simple to know which one to choose. For example, if you want to invest in China from the UK you would have to choose between around 15 ETFs. For the UK the choice is 34 and if you want to jump into the US market there are 67. Unless you drill down into each fund’s fact sheet to decide whether it is doing what you want you will have to make a leap of faith – many of these track and perform very differently. But one fund doesn’t make a portfolio, so to be diversified you will need to do this many times over and rebalance your positions intermittently. There are some investors with the skill, time and desire to do this, but immensely more would rather someone else did the work.

BORN IN THE USA
Managed ETF portfolios are already taking the US by storm. In the recent ETF Managed Portfolios Landscape Report, Andrew Gogerty, ETF managed portfolio strategist at Morningstar, gives a comprehensive overview of the industry in the US. Morningstar estimates that the total ETF managed portfolio space in the US is likely between $40bn (£25bn) and $100bn (£63bn) and that assets under management have grown 43 per cent over the last 12 months. Morningstar currently tracks nearly 370 strategies from 95 firms with collective assets under advisement of $27bn (£17bn) as of September 2011. This has all happened very quickly: nearly two-thirds of the strategies started after 2004 and 30 per cent of the strategies are less than three years old.

The FSA and some in the media have been suspicious of ETFs, particularly the synthetic varieties. This has been largely misinformed – counterparty risk is not peculiar to synthetic ETFs, or even ETFs. But for those with concerns, an ETF portfolio manager can “view all counterparties, collateral and custodians and thereby have a comprehensive measure of investor safeguards,” says Anthony Christodoulou, founder of Worldtrack, a specialist UK ETF investment business.

Christodoulou is excited about the future. He “expects that high net worth investors will increasingly access ETFs through personalised and segregated ETF strategies managed directly by experts.” But he also thinks options will open up for those without assets large enough to be managed by experts. Let’s hope this is indeed the case. Most people haven’t heard of the Retail Distribution Review (RDR), but those in the business of managing money talk of little else. It will change the way that each and every investor receives advice. On the positive side, trailing-fees – whereby financial advisers are paid to sell certain products – are on the way out. But the unintended consequences of RDR will hit those at the margins of being able to afford advice, at least initially: the net effect will be better advice, but less of it.

TAKING AIM
As such, the introduction of funds of ETFs or ETFs of ETFs, which will be easy to access and distribute, could step into the breach. Christodoulou says “the benefits of such products include improved cost efficiency, performance and liquidity.” Deborah Fuhr, who recently moved from heading up ETF research at BlackRock to set up ETF Global Insight – which provides independent research and consultancy to the global ETF industry and on the selection and comparison of ETFs and ETPs – thinks ETF portfolios will increasingly be bought as building blocks to tie in with specific investment goals. As such, if an investor needs to save to pay for school fees ten years hence, they will buy into a portfolio that is designed to mature given the expected returns, on the required date. This means the right level of risk is shouldered to meet a specific goal.

The investment landscape is always in flux, but the instability appears particularly acute right now. ETFs offer investors the low-cost alternative that they deserve, but creating balanced portfolios isn’t easy – managed ETF strategies and solutions will provide a stable base upon which to build your wealth.