Next in the hot seat in ETF Stream's Expert Investors series, where we interview fund buyers about their ETF usage on a fortnightly basis, is Mark Northway, investment manager at Sparrows Capital.

Northway joined Sparrows Capital in 2015 from Fourwinds Capital Management where he spent a year as global head of sales and distribution.

He has also held roles at LBBW, Rabobank and Standard Chartered Bank, and is chairman of the UK Individual Shareholders Society (ShareSoc).

How much of your portfolio is made-up of ETFs/index funds?

All of our investment activity is via ETFs and index funds.

Sparrows Capital follows a strategic, rule-based investment philosophy which does not pick stocks, pick managers, time markets or engage in tactical allocation; what we do can therefore be expressed very efficiently and cost effectively via index instruments.

We tend to use index funds for cost efficiency in generic risk classes and ETFs (due to the much richer range of products and strategies available) to access targeted risks such as factors.

When did you start investing in ETFs?

The founding family’s portfolio has been invested in ETFs since July 2008. The switch from a traditional managed portfolio came about through a review of the historical value received.

That entry gives us a unique perspective of how these instruments perform in a full-blown market crash.

Our experience has been overwhelmingly positive, and we are pleased with the way ETFs have performed across the COVID-19 crisis from a performance and liquidity perspective.

Which asset classes do you tend to invest in through ETFs?

It varies by portfolio/underlying client, but we use ETFs to access everything from capitalisation weighted equity market risk, factors (size, value, low volatility, momentum), real estate (REITS), fixed income, inflation protection through to commodities (including gold).

Our socially responsible portfolios tend to use MSCI’s ESG/SRI indices. We are careful to present responsible investing as a filter process, and not as a factor.

We have a preference for regional products where available as these tend to be more granular than their global counterparts.

Which areas would you avoid?

We would not use highly structured or leveraged ETFs or alternative asset strategies, primarily because these tend to represent trading styles rather than long term investment strategies.

There are some developments, though, in credit derivatives space which may have a role to play in due course. We have no need for sectoral products as we do not allocate tactically.

Our strategies focus on core markets, and we tend to avoid drifting into inefficient areas such as frontier markets or micro caps. These are areas where specialist managers may retain an information edge.

What is your methodology for selecting ETFs?

Our portfolio construction starts with a strategic asset allocation, and from there we move to index selection and finally filter down to the individual ETFs/index funds.

Selection criteria include replication method, optimisation methodology, structure and domicile, provider, AUM and liquidity, cost, tracking error and tracking difference.

The latter is key, as it is surprising how many instruments display a performance drift over time which cannot be explained by the declared ongoing charges.

Do you have an ETF provider preference?

The screening and selection process undoubtedly favours the larger houses, except in the case of specialist risks where the smaller providers can often maintain an edge.

We are keen to see continued competitive tension in the sector and low barriers to entry, so we are wary of further consolidation.

We are perhaps naturally aligned with Vanguard, with whom we share a strong culture of efficient democratisation of rule-based investment processes.

What ETF products would you like to see more of? 

The range of products needed to serve UK investors is still limited, and we would like to see continued focus here.

There are very limited choices, for example, for managing duration in sterling-hedged global fixed income, particularly since the recent exit from the market by BMO.

Areas ETF providers could improve?

Provider support and education is generally very good. Some provide good pre-trade pricing services which can be very useful.

An area which could benefit from clearer explanation is settlement, which is often unintuitive to both investors and custodians and can result in fragmented holdings under a single ISIN.

I would like to see improved transparency around ETF charges, specifically a breakdown of items such as index cost and stock lending gains which are currently bundled in with the management fee. ETF providers should be leading the way in transparency.

Expert Investors

Expert investors is a series brought to you by ETF Stream where on a fortnightly basis we interview the key individuals from across the fund selection and research space about the ETF ecosystem.

Fund selection plays a crucial role in portfolio construction. Once the asset allocation decision has been made, these individuals need to decide how they want to be exposed, be it through a mutual fund, investment trust or ETF.

Over the years, ETFs have become an increasingly important part of any investor’s toolkit. This series will show how the key players across the fund selection space use ETFs in their portfolios while asking what more can be done by the ETF providers to help with this increasing adoption.

To read the previous edition of Expert Investors with Matt Brennan, head of passive portfolios at AJ Bell, click here.

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