At Moneyfarm, we use Exchange Traded Funds (ETFs) to build our investment portfolios. Although they’re simple investments, picking the right mix to help you reach your financial goals is more difficult. This is where our experienced fund managers headed up by Chief Investment Officer Richard Flax use their skill and knowledge to ensure the ETFs we pick are best suited to you.
What is an ETF?
An ETF is a fund that tracks a market index (like the FTSE 100 or S&P 500), specific commodity, bond, or even a basket of assets. In an ETF that tracks an index, the fund will essentially own shares and trade them to reflect moves in the index they’re tracking.
ETFs can be traded just like individual stocks, but because they’re based on an underlying index or investment, they offer more diversification than individual shares. As ETFs don’t involve active management, they are lower cost than traditional investment funds.
At Moneyfarm, we choose to invest in ETFs for a number of reasons
Active management with passive investments
ETFs are passive instruments, which means they track markets rather than seeking to outperform them. It’s important to note that this doesn’t mean an investment portfolio based on ETFs involves no active decision-making.
Far from it. The enormous choice of ETFs – which some say now outnumbers individual equities – gives investment managers many opportunities to refine and tune portfolios.
Most of Moneyfarm’s equity ETFs are weighted by exposure to market capitalisation, but we make an active choice in deciding which benchmark to use. Should it be an ETF that weighs all stocks in the index equally, or one that sorts companies by profitability?
In our view, investors currently have a wider choice at a lower cost than traditional active fund management. Although Moneyfarm uses passive instruments, we don’t take a passive approach to investing.
So our selection process is incredibly important to ensure we’re building the right portfolios to help our investors reach their financial goals. Investing with Moneyfarm isn’t a case of picking a single index to follow.
Moneyfarm’s investment process
Our investment process is based around strategic and tactical asset allocation – our rebalancing process. Strategic asset allocation looks over a long-term investment horizon, whilst our tactical strategy makes adjustments over the short-to-medium term.
Moneyfarm’s strategic portfolios are built with a 10-year view. We develop forecasts about returns that reflect long-term expectations about the global economy and financial markets.
We also need to think carefully about the way different financial markets interact with each other, as these dynamics are important considerations for building well-diversified portfolios.
Whilst our strategic view looks out to 10 years, we know the journey there won’t necessarily be smooth. To optimise the risk/return profile of our portfolios, we put a tactical overlay on our strategic asset allocation, which is Moneyfarm’s rebalancing process.
The Investment Committee meets every month to discuss market and economic trends, review risk management and volatility, and make tactical allocations where necessary.
How we select ETFs
Moneyfarm’s experienced fund managers monitor the markets every day, evaluating thousands of ETF products listed on the London Stock Exchange in line with market trends.
We score ETFs by asset class, according to the following criteria:
- Underlying index
- Fund liquidity and size
- Replication strategy
- Cost of ownership
- Security lending
- Issuer quality
We believe diversification is important to manage the sector-specific risks in our portfolios, so we build our portfolios with globally diversified ETFs. This ETFs include exposure to
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- Cash equivalents – Low risk, low return but can be a good source of income
- Long-term government bonds – So-called ‘safe havens’ with higher yield than cash equivalents
- Inflation-linked bonds – Offer protection against inflation
- Investment-grade credit – Corporate bonds with BBB or higher rating; typically seen as secure assets
- High-yield credit – Corporate bonds with lower ratings than investment grade credit, which means higher risk, but higher yields
- Emerging market government bonds – Higher risk than developed markets, but also offering higher yields
- Developed markets equities – Traditionally these offer lower volatility, greater transparency and more shareholder-friendly governance
- Emerging markets equities – More volatile than developed markets, but offer the potential for higher returns
- Commodities – A good diversifier and hedge against inflation
- Real estate – Can provide a steady income and tends to keep pace with inflation, but has low liquidity, high transaction costs, and requires management.
The two main asset classes in our portfolios are equities and bonds. It’s important we value these carefully and accurately to build our forecasts and understand the role they’ll play in your portfolios.
How to value equity
Equity return is comprised of two main components; dividend yield and price appreciation, both of which are affected by earnings growth and economic conditions.
To forecast the expected share price performance, we use the Cyclically Adjusted Price to Earnings (CAPE) ratio to value equities. CAPE is a valuation tool used to assess future equity returns and is defined as the price of an asset divided by its earnings.
To compute CAPE, we calculate 10 years of historic corporate earnings and consumer price indices (inflation) for the main geographical areas (United States, United Kingdom, Japan, Eurozone and Emerging Markets). It’s important that we adjust these historic earnings to ignore the impact of inflation before computing the CAPE series.
The underlying assumption of our method is that in the long run, an equity market’s CAPE will converge to its long-term median. By comparing the current CAPE level to the long-term average, we can estimate its path (mean reversion) back to the median.
How to value bonds
To estimate the returns on a debt security, we start by looking at its price. This is best conveyed in its yield to maturity (YTM).
The YTM is the total expected return, assuming the bond is held to the end of its life, and includes any coupon pay-outs (income) and the final repayment. In other words, it’s a bond’s internal rate of return.
Starting with the current YTM of a security (a 10-year German government bond, for example) we then add real GDP growth forecasts and the long-term inflation outlook. We then add the Term Premium (the excess yield required for holding a long-term bond), assuming it will go back to the 10-year median level.
To model the current low interest rate environment, we introduce a financial repression factor to get an estimate of the YTM in 10 years’ time. We assume the Actual YTM will linearly reach the Expected YTM in 10 years to calculate the long-term expected return.
This is just an overview of the essential due diligence we go through to build your investment portfolios. This is a full time job for us, and it may feel like a second job if you’re doing it yourself – but you can’t compromise on this analysis.
The good news is that whether you work in finance during the week and don’t want to do it when you get home, you’re too busy juggling the school run with your career, or maybe you’re just not that interested in the financial markets, you don’t have to do this hard work yourself.
Role of technology and human expertise at Moneyfarm
Wealth management is changing. Today, technology has put more personalised advice and higher-quality products within the reach of more people.
At Moneyfarm, we’ve blended technology and investment expertise to offer efficient financial advice that helps you achieve your financial goals.
When you join us, all you need to do is complete a simple questionnaire. Once we understand your financial situation, our technology matches you to an investor profile that’s based on what you’re saving for, when you’ll want your money and your financial background.
Next, you’re paired with a portfolio that our team of investment experts have carefully built and will continue to manage right up until you decide to take your money – whether that’s for your child’s wedding, career change, or your dream retirement.
It’s important to know that whilst we make maximum use of the latest technology to keep costs down for you, a great deal of thought and expertise goes into the decisions we take.
If you’ve got any questions on our Investment Strategy, you can get in touch with one of our qualified Investment Consultants, or subscribe to watch our Monthly Market Updates with CIO Richard Flax on our Youtube Channel.