June 2014

EDHEC: ETF industry wins satisfied customers

HammockIn the first of a two-part article, Felix Goltz, of Edhec-Risk Institute analyses the usage of ETFs in Europe and their satisfaction rates. He also looks at the outlook for the success of smart beta. The exchange-traded fund (ETF) industry has undergone rapid growth since inception. The first ETFs appeared in the US in 1989 and they started trading in Europe in 2000. Assets under management of ETFs and other exchange-traded index products in Europe amounted to $395 billion (€289 billion) as at the end of 2013, according to ETFGI.  There are a number of studies on the ETF industry in Europe. A key advantage of employing a survey methodology is that we obtain direct information from market participants concerning not only which instruments they currently use, but also how these instruments fit into their overall investment process, and how they are evaluated.  Moreover, in addition to current usage, we are able to harness information concerning future plans of investment professionals, which therefore provides an outlook of some possible future industry developments. To summarise the main findings of the study, we will first explain key survey results on the rates of usage and satisfaction with ETFs. We then look at how ETFs are integrated in the investment process and for which purposes they are being used. To address a recent development in the industry, our survey assessed the views investors have about ETFs tracking smart beta indices, which we also summarise below. Finally, we analyse investor expectations of their future use of ETFs and their requests for further product development, which provides some hints with regard to the outlook for the ETF industry. While ETF usage is no longer growing at previously seen rates, product development within certain asset classes has driven increases in ETF usage. There were significant increases in rates of ETF usage in 2013 within the asset classes of real estate (5.8% increase), hedge funds (14.8%) and infrastructure (14.8%). The increased usage of infrastructure ETFs seems likely due to an increase in the range of ETF products available to infrastructure investors. This may be due to the recent emergence of more “specialised” infrastructure ETF products. For instance, investors are now able to gain infrastructure exposure to individual geographic regions through ETFs, whereas previously ETFs could only provide “global” infrastructure exposure. Hence it would seem that continuing innovation within the industry is perpetuating increased usage of ETFs within certain asset classes. Satisfaction has remained at high levels across most asset classes. There have been increases in satisfaction for corporate bond, commodity, real estate and sector ETFs.  This may also be linked to the fact that there has been an increase in product variety for these asset classes resulting in a product that is more likely to satisfy investor requirements. Of all asset classes, satisfaction with equity ETFs has been the highest and the most consistent over the last seven years. Aside from the greater variety of products, another reason for the consistently high satisfaction rates within equities may be the fact that they have the longest history, hence investors are most familiar with their advantages and their drawbacks. This could also be related to the highly liquid nature of the underlying equity asset class when ompared to other types of ETFs. Satisfaction rates for ETFs based on the most liquid ETF asset classes are far more consistent compared to those based on illiquid asset classes.  For instance, hedge fund and real estate ETFs have exhibited variation in satisfaction rates between 30% and 60%, and 50% and 95% respectively over the last seven years.  In contrast we can see that equity and government bond ETF satisfaction rates have been consistently in the region of 90% and 80% respectively. This may be due to the fact that two of the key attractions of ETFs are their liquidity and relatively low levels of mispricing, both of which are determined by the liquidity of the underlying assets.  It is worth noting that there has been a constant increase in the satisfaction rate with corporate bond ETFs, rising from about 60% in 2009 to about 90% in 2013. SATISFACTION RATE
This increase in the satisfaction rate is observed as product variety for corporate bond ETFs has been increasing strongly over the past years and corporate bond ETFs are increasingly used by investors to diversify portfolios that are heavily exposed to sovereign debt. It is likely that investors – given the increasing variety of corporate bond ETFs – are better able to select an appropriate ETF which may explain the rise in satisfaction. ETFs are an important instrument in the investment process. Investment in ETFs may be long-term or short-term in nature. Also, when using ETFs, investors may aim to gain broad market exposure or, alternatively, gain access to specific segments of the market through ETFs on sectors or styles. Beyond such broad categorisations of use, we also assess how often ETFs are used for specific purposes such as neutralising factor exposures or arbitraging related assets.  Our survey shows that the frequent use of ETFs by about 70% of respondents to gain broad market exposure is a constant trend over time from 2009. If around 60%, on average, use ETFs to obtain buy-and-hold investments over the period starting in 2009, more variations are observed from one year to another than in the use for broad market exposure. Over time, the use of ETFs to obtain short-term (dynamic) investments, specific sub-segment exposure or for tactical bets is frequent for around 50% of respondents, with a slight decrease for these three uses in 2013, compared to 2012. CONSTANT DECREASE
Other uses of ETFs are more rare: the use of ETFs for management of cash flows is frequent for a percentage of respondents ranging from 15% to 20% over time; the use of ETFs for neutralisation of factor exposures related to other investments and dynamic portfolio insurance strategies is frequent for a percentage of respondents ranging between 10% and 15% over time; the frequent use of ETFs to access tax advantages is capped at 10% of respondents; and the use of ETFs for capturing arbitrage opportunities has shown a constant decrease since 2009. These results show that investment in ETFs is mainly associated with a long-term exposure to broad market indices, a trend that is observed in successive surveys. Still, over time, frequent use of around 50% over time, of ETFs for short-term exposure and for specific market sub-segments exposure indicates that other investment purposes are also important for respondents. This is not surprising given that the liquidity, low cost and product variety benefits of ETFs make them such viable tools for these purposes.  In view of the considerable development in new forms of indices, in this 2013 survey we asked investors about their use and perception of ETFs tracking smart beta indices.  It appears from the results that more than a quarter (28%) of respondents already use products tracking smart beta indices and that more than an additional one-third of respondents (36%) are considering investing in such products in the near future.  These results demonstrate that investors have significant interest in these products. This broad use of ETFs based on smart beta indices is explained by the favourable perception that respondents have of smart beta indices as tools for improving their investment process. FULL TRANSPARENCY
At least three quarters of respondents think that smart beta indices provide significant potential to outperform cap-weighted indices in the long term and that they avoid cap-weighted indices being concentrated in very few stocks or sectors.  The same proportion of respondents think that the diversification across several weighting methodologies allows risk to be reduced and adds value, while 86% of respondents agree that smart beta indices allow factor risk premia, such as value and small-cap, to be captured. Interestingly, an even greater share of respondents (92%) agrees that smart beta indices require full transparency on methodology and risk analytics diversification across several methodologies. The research from which this article was drawn from was supported by Amundi ETF & Indexing as part of the ETF and Passive Investment research chair at the Edhec-Risk Institute. Felix Goltz is head of applied research at the Edhec-Risk Institute ©2014 funds europe

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