EDHEC Study: ETFs Can Boost Returns, Lower Risk in Core-Satellite Investment Approach

(October 4, 2011) — Exchange-traded funds (ETFs) can help to improve returns and control risk within a dynamic allocation model, according to a new study by EDHEC-Risk Institute.

The research — titled “Capturing the Market, Value, or Momentum Premium with Downside Risk Control: Dynamic Allocation Strategies with Exchange-Traded Funds” — analyzed the performance of risk-controlled dynamic asset allocation strategies, concluding that implementation of dynamic risk budgeting can boost portfolio returns while keeping downside risk under control. The study said: “There is extensive evidence that investment strategies based on momentum and value are attractive for portfolio managers who seek outperformance. Momentum and value are among the most robust return drivers in the cross section of expected returns.”

The report continued: “Investors are usually willing to take on risk only if they are compensated for it with greater expected reward…Dynamic risk budgeting methodologies such as Dynamic Core-Satellite strategies are used to provide risk-controlled exposure to different asset classes. There is extensive evidence that investment strategies based on momentum and value are attractive for portfolio managers who seek outperformance.”

The research — conducted by Elie Charbit, Jean-René Giraud, Felix Goltz and Lin Tan — claimed that ETFs, which offer both liquidity and a broad exposure to the markets to implement portfolio strategies, on sectors rather than on stocks can be used to put these strategies into effect. The study concluded that ETFs additionally facilitate the shifts — required by dynamic strategies — from core to satellite.

The EDHEC report follows research last month by consultant McKinsey & Co. that found that global ETF assets under management are expected to grow to as much as $4.7 trillion by the end of 2015. The report — titled “The Second Act Begins for ETFs” — asserted that assets under management in ETF products, including exchange-traded commodities and exchange-traded notes, have ballooned 31% from 2000 to 2010. This compared with an AUM growth of about 5% to 6% for mutual funds during the same time period. Furthermore, McKinsey & Co.’s research noted that the next phase of ETF growth will be characterized by heightened competition, along with an increase in active ETFs and globalization of the marketplace. “ETFs are now a hotbed of competition,” the report said, “with an expanding and aggressive array of competitors.”

Previously, a report by BNY Mellon and aiCIO‘s sister company Strategic Insight — which analyzed the factors fueling the rapid expansion of the ETF market and how asset managers can profit from the expansion — predicted similarly optimistic findings. In a report published last month, the firms found that ETF assets will reach $2 trillion by 2015.

The report — titled “ETFs 2.0: The Next Wave of Growth and Opportunity in the U.S. ETF Market” — revealed that ETF assets grew by 28% to just more than $1 trillion in 2010, down from the 47% growth rate in 2009. Furthermore, roughly half of the U.S. ETF assets came from institutional clients.

A copy of EDHEC’s study — “Capturing the Market, Value, or Momentum Premium with Downside Risk Control: Dynamic Allocation Strategies with Exchange-Traded Funds” — can be found here.