As exchange-traded funds continue to amass assets in a difficult market, Funds Europe speaks to key ETF industry figures about their concerns and strategies.
Tom Caddick (head of global multi-asset solutions, Santander Asset Management)
Jose Garcia-Zarate (associate director, ETF research, Morningstar)
Philip Philippides (head of ETF and index fund sales, Amundi)
Adam Laird (head of ETF strategy, Northern Europe, Lyxor ETF)
James Mcmanus (ETF research, Nutmeg)
Funds Europe: The European ETF markets tends to be institutional compared to a more evenly split US market, where there’s a lot more retail invested in ETFs. What factors are driving this change to more European ETF retail investors and will it continue?
Philip Philippides, Amundi: ETFs are simple, transparent and low-cost products to use. This is why, although dominated by professional investors, we see on the European ETF market a growing interest and adoption of ETFs by retail investors. At Amundi, we believe the retail/distribution segment will be an additional driver for ETF and indexing product demand over the next years; in response, we recently announced the upcoming expansion of our physical ETF range, in order to support distribution networks in the development of ETF-based solutions to address retail investors’ needs. We are also witnessing the development of do-it-yourself asset allocation tools which tend to use more ETFs. We believe that this type of solution will be an accelerator for the adoption of ETF usage among retail investors.
Adam Laird, Lyxor: In my previous life I worked with retail investors a lot and I have seen double-digit growth over the last few years in individuals’ take-up of ETFs. It is still a product that has a lot of uses for institutions. There are a lot of products that have been created for professional investors, for fund managers to use, but there are a lot that will filter down to the individuals and make sense for them. The breadth of access is one of the big drivers in the UK and in Europe. In the UK, we’ve got a great range of index tracker funds that are available but they are really focused on only a few core markets.
Tom Caddick, Santander: There’s probably been some push and pull factors. On the push, we’ve had an active market in the retail space which has been relatively slow to adopt and to acclimatise to a new price regime and the new threat. In a low growth, low inflation, low interest rate environment, price is going to become more and more of an issue and the active market has been relatively slow, partly because it’s built on a legacy of reasonable margin and a pricing model that is set out in a particular way, and it’s been fairly slow to react to the threat of passive generally, regardless of whether it’s ETFs or the the wider passive mutual fund space. People are looking more and more at pricing as a major factor and the active world hasn’t necessarily responded. All of these things are pushing people into looking elsewhere.
The pull factors, ETFs as a sector of the industry have been fairly good at getting that message across to the European market, which in turn is slightly behind the US in terms of development and maturity. At the same time, potential investors are increasingly looking at investment as more of a commoditised entity, where you have greater ability to be able to compare price, compare performance and multiple other factors, and people are going to be increasingly focusing on this area, so all of this has helped the ETF cause.
James McManus, Nutmeg: When you look at the move that we’ve seen from active assets into passive assets this year, ETFs are clearly going to be a beneficiary of that. That’s part of a wider structural market change and it comes back to lacklustre returns in active, information flow, information being more readily available to retail investors, the details of what the underlying performance is, what the fees are.
Jose Garcia-Zarate, Morningstar: The regulatory changes are transforming the way that financial advice is given. In the coming years, everybody is looking forward to the implementation of MiFID II, and potentially the abolition of retrocessions. And also the changes in the distribution network, of additional distribution network funds, where commercial banks, particularly in continental Europe, had such a massive support, whether that’s actually being challenged by new technologies, new ways of investors actually trying to look for information and accessing funds. So you don’t rely on your bank manager any more to sell you the product: the DIY-type thing is becoming more and more important, and ETFs are well-suited products for that modern technology generation.
McManus: What we see is higher engagement across the board, so higher engagement from a younger generation, higher engagement from older generations as well, but also higher engagement from areas in the market that typically maybe wouldn’t have been clients of the traditional platform business. So women are a classic example of a big demographic that is taking much more interest or engaging much more with retirement, with pensions, with investments. That’s a great thing.
Funds Europe: There’s been a move into a fixed income ETF this year, supposedly due to quite a lot of equity volatility. What type of fixed income products do you think investors are looking for in this low yielding environment and why?
Garcia-Zarate: This is quite interesting because some equity markets have done quite well for the best part of the year. And yet, in terms of money flows into equity ETFs, we have only seen a net positive result in Q3. At the beginning of the year there were a lot of macro concerns. I can recall some fears about China and so on, but actually when you look at the performance of equity markets, not all of the equity markets, but some, they haven’t really done that badly.
Philippides: We see investors looking to allocate in products where they can capture yield as interest rates are low or even negative, providing no income. At Amundi, our latest innovations to address this demand on the fixed income side have been driven by such client feedback. We recently launched a BBB Euro Corporate ETF and expanded our floating rate notes range. Floating rate notes can be particularly attractive for investors, as they are able to offer higher yields with low interest rate sensitivity. This is especially true in the US credit space where the yield is around 2.16%. In the current low rate context and in an uncertain rate environment, floating rate notes are attractive for investors who seek yield and to reduce their exposure to interest rate movements.
Laird: We’ve seen a lot of flows into government bonds this year. Equity markets have risen to record highs and it seems investors want a little bit of security in their portfolio. This is a good, positive behaviour for the investment public – money is flowing to less risky areas when the future is uncertain for equity markets.
Garcia-Zarate: The US equity market could be overvalued, but to me that doesn’t fully answer the question as to why people are willing to go into negative rates.
Caddick: I agree. I don’t buy the argument that people are looking for security through increasing overall ownership of fixed income, because actually how much security are you getting from investment grade sovereign? Traditionally, you would buy all maturities-type sovereign vehicles as a degree of insurance within the portfolio, but for it to form any kind of insurance you need a starting yield, and if you’ve got a starting yield of zero or negative, you actually aren’t buying any security. All you’re really doing is finding somewhere to put your money. For me, this is more about active versus passive; so people looking for different ways of accessing the asset class, and I know we have been utilising ETFs in fixed income for the first time, really, in the last year or so.
Funds Europe: It has been warned there’s a danger that if the price of debt falls and people start selling off their ETFs, it could cause increased market volatility or market stress. I’m just wondering if you think that danger applies to fixed income ETFs?
Garcia-Zarate: There are still a lot of misconceptions about the different layers of liquidity in ETFs, and that a lot of the concerns in particular are being expressed about fixed income ETFs. I do understand where they’re coming from because you have got something which in its natural state trades over the counter, and suddenly you’ve got an exchange trade equity-like instrument that offers you fixed income exposure.
There is still a lot of education to be done on making sure that people understand that liquidity in the primary market and in the secondary market, where the ETF shares actually trade, are two very different things. This is a difficult thing to do, actually, because most ETF providers will happily emphasise that ETFs bring in extra liquidity via the secondary market trading, but perhaps fail to properly explain that ultimately the ETF cannot be more liquid than the underlying market it represents. Many investors are still confused by this apparent contradiction.
Caddick: It is a nothing story because it’s stating the obvious, that this is a marketplace for a relatively illiquid asset class and that creating an ETF does not change this, nor damage. You’ve only got the added advantage or potential for the future, because one of our problems at the moment is there’s probably not enough volume in a lot of these instruments to really make them viable for us to invest in, given our size of investment. But in the future if you’ve got large pooled assets, then as a player within that you’ve got an increased layer of liquidity because you are a small player within a larger pool, albeit that there’s no change to the underlying.
Philippides: Firstly, if the price of debt falls, this would likely be on market fundamentals or other key economic factors affecting bond pricing, not on how a specific product like an ETF is bought or sold.
We have to remember that ETFs are a fund wrapper and the ETF liquidity and pricing are based on the underlying market. ETFs do not add liquidity to the underlying. They may, however, be easier to trade than holding all the underlying constituents, as they are traded on exchange. Some examples would be if the underlying market is closed such as an EM Debt ETF trading in European hours.
Certainly for fixed income, it could also be easier to find a buyer of an ETF on exchange versus trying to find buyers of individual bonds in the OTC market. The price that the ETF traded on exchange, however, is based on the executable price of buying or selling of the underlying constituents.
McManus: That’s where there’s a misunderstanding, so the idea that unlike a mutual fund, the units of the ETF can stay warehoused in the market, whether it be on a bank’s balance sheet, a market-maker’s balance sheet, and essentially what that comes down to is how cheap the product is to hedge and how efficient it is for those liquidity providers to hold it.
Philippides: What I’d also add, from a provider’s point of view, is that during the product development stage, we look at the underlying liquidity of the indices we intend to use and also work with index providers to select or create appropriate indices for our products. One of our primary concerns is to bring out products that can have the right liquidity and pricing to do what investors expect them to do. At Amundi, we also use our capital markets teams that deal with the ETF market-makers and authorised participants, and use our pricing power to be able to support our ETFs in terms of trading, spreads and so on.
McManus: One important piece in product development has been bringing in flexible creations in bond strategies, so not having to go out and buy every single bond in the index. That’s a really important development because it really aids liquidity on the day you trade. The bonds to be sold or bought can be determined by the portfolio manager, be determined by what they want to remain in the portfolio in order to hit their tracking objectives, and it just makes that whole process a little bit more flexible, should they need to sell or purchase.
Funds Europe: There’s been some notable asset houses entering the ETF space – Franklin Templeton, Fidelity, Goldman Sachs Asset Managment just to name a few. Should this worry the established passive players in Europe?
Philippides: While it may not be too difficult to bring an ETF product to the market, the real challenge is to be able to remain on the market in the long run and to become a reference player for investors. To achieve this, size is crucial, as demonstrated by the strong concentration of AuM within a small group of big players.
We are seeing in the European market some consolidation as well, with a number of issuers looking for buyers. Overall, I definitely think that it is a good thing to see new entrants as it ultimately shows that ETFs are popular vehicles and that the ETF industry is a growth area managers want to expand into. It also helps spreading the message, leading to more education for end investors, more innovation in terms of product development and greater investor adoption, which helps the ETF industry’s growth.
Funds Europe: What specifically, though, about smart beta?
Philippides: Smart beta is an area where we are seeing a lot of product issuance and innovation. Certainly this is an area where new entrants may have a better chance to challenge the more established players. Having said that, all the other factors still remain and criteria such as size, price, liquidity are still key to investors. Existing issuers are not standing idle either and are also launching innovative products and expanding their smart beta offerings.
We offer investors the full scope of smart beta solutions and obviously the support of the whole group in terms of size, research, trading capacity, which one of our key strengths.
Laird: This is one of the reasons I love the ETF industry, because it’s really dynamic and we’ve seen a lot of innovation and a lot of new products launched. Some of them will probably be quite successful; there’s room out there for new strategies, but I don’t think that all of them will be. Investors have access to over 1,000 products in the UK, and there’s a lot of those which are core mainstream and are likely to succeed, and there are a lot of them which are niche products which have a limited market and probably won’t. And I know that when we’ve been talking to fund selectors that people are getting a lot more sophisticated in the way they analyse investments and that they’re looking for more. Take size of assets, that’s something that people come to us because we’re a big player and they want the security that we’re going to be in it for the long run. That people want to see that they’re investing in the right product – they have got the options that if the index isn’t right, or if the performance isn’t stacking up, that they can go elsewhere. We’ve seen a few of the smaller players that have entered recently who just haven’t had that ability to trade cheaply and tightly and regularly.
McManus: Where there is an interesting space for new people to come in is where you have some intellectual property that can be reformatted into a rules-based format, and is then attractive to investors in that format as well, so one area might be fixed income smart beta, so if you have a research team of 150 analysts, why not utilise that research, repurpose it into an index product, and provide an ETF?
Funds Europe: According to the research by Edhec, cost considerations are among the top drivers behind increasing ETF allocation; how much impact does product pricing have on the sales of ETFs? How vital is cost?
Philippides: The three main investor criteria are cost, size/liquidity and tracking/track record, with cost being the highest.
As a live example, I can take our emerging markets ETF. It had an extremely good tracking error of under 5 basis points and a competitive cost of 40bps versus the next best that was at 50bps. It had attracted around half a billion over a number of years. We recently reduced the cost to 20 basis points, making it the cheapest of all other similar exposures. This year, the fund has grown to become the second-largest EM ETF in Europe with over €2.5bn AuM. The tracking error remains the same, as does everything else. This is a good example of how crucial the cost is to investors and how providers and issuers are trying to give the most cost-effective solutions.
Laird: Whenever you’re choosing an ETF, look at everything. That will be the cost, performance, what index your product is actually tracking, how dependable it is – all of these are important aspects. Sometimes we can focus on costs too much and make out that that’s the only part that matters to an investor, but actually it’s the whole package that really drives the decision.
McManus: That’s why I would actually have a different order of priorities to you in that cost is lower down than the performance you’re delivered. I don’t mind what the headline cost is, I care what I’m actually delivered after the holding period. But we would look at things on a total cost of ownership basis, so not only the performance you’re delivered but also the costs of actually trading the products or rebalancing a product, but that this is where it’s increasingly difficult for retail investors without a deeper understanding of the ETF strategies, because you may have one strategy that costs ten basis points, one that costs nine basis points, but the strategy that costs ten basis points benefits from securities lending and the strategy that costs nine basis points doesn’t.
Philippides: I agree, you do have to look at the overall performance and many investors have exactly that approach. However, the TER is a large component that influences actual performance and, as it is a headline figure, tends to be more visible.
Caddick: We’d all agree that the process of analysing the passive world, ETFs et al is far more complex than the headlines might suggest with replication methodology, implication for taxation, etcetera, to be considered. It is actually very complicated and is a very worthwhile exercise to do right, but cost as a headline can’t be ignored. Whether it’s the first thing you ask, second or third, it’s going to be a barrier in one form or another, and understanding this is critical. The cost or certainly at an OCF level is the piece that feeds through if you’re in the retail world, through into your own synthetic OCF, which in turn creates the headline for the end customer. Tracking error doesn’t have a headline impact, even though it’s important. OCF does. Now, I know that OCF has an impact on tracking error, but as a headline number those are the critical, even at an institutional level, depending on who your underlying client is. Again, headline numbers matter.
Garcia-Zarate: From an investor point of view, it’s the only known quantity. You don’t know what you’re going to get, but you know what you have to pay. So, an easy way to maximise these unknown returns is to minimise the known costs from the get-go, which clearly supports the case for low-cost funds. This is something that applies both to passive and active funds. Morningstar has run plenty of analysis on this topic, and the conclusion is recurrent: the cheaper funds – whether active or passive – are the ones producing the better returns for investors over the long term.
Funds Europe: Emerging markets have seen a renaissance this year. Are ETF players participating in this and seeing strong growth as well as for the broader market?
Caddick: It is an increasing area of usage as an asset class. It’s one we invest in anyway, but it’s a very useful way of accessing a market quick and easily and, as pricing has come down, this has been an added benefit. The historic argument against has been that the more inefficient a marketplace or an asset class, the greater the opportunity for an active player for you to be able to create alpha. But for quick access and broad beta coverage, the passive market has benefits.
Laird: In the emerging markets, a lot of countries’ markets are becoming increasingly dominated by local policy decisions and there are unique factors that are impacting a lot of different areas. The Brics was a great headline for us, a great way to group some of the bigger countries, but actually people do not want to be invested in Brazil, Russia, India, China in each proportion in each different portfolio. I printed out the returns of some of the biggest indices. This year we’ve seen, in sterling terms, Shanghai Composite is up 2%, the Ibovespa up 125%. So if you’re an investor and you want broad emerging markets, great, that’s a really simple starting place for a lot of portfolios, but if you need to manage your risk, or if you want to look for returns, or if you want to make a play on the oil recovery or the emerging growth, the demographic plays, all of these big things that are impacting the emerging growth, actually it makes sense to go more granular, start looking at the different markets and their different features, and if you want to do that, ETFs are the most straightforward way to get exposure to just one country or one region, or one thing, rather than going down the traditional active route where they bundle a lot of different ideas in one, because that’s what the manager is looking for.
Garcia-Zarate: When it comes to emerging market bonds, active asset managers don’t come up very well when compared to a global broad-based ETF, whether it’s local currency or hard currency. As per granularity of exposures, the flexibility of
ETFs to adapt and offer very delimited exposures clearly plays in their favour, and I’m pretty sure we’ll be seeing more single emerging country ETFs from you guys going forward.
McManus: I would agree, but when you look at the flows, you’re not seeing those granular exposures coming through.
What you’re seeing is money being allocated to broad EM equity and broad EM bonds, and if I were to say how we see it as an investor in some of those markets, it’s that actually, this is an area where trading spreads are very, very meaningful, so in those broad EM strategies, bonds and equity, actually pretty liquid, pretty cheap to trade, quite a lot of volume.
If you start wanting to allocate tactically to Taiwan, to the Philippines, to Thailand, you’re talking spreads of three times the product cost on occasion. What really benefits the broader strategies is that they are established and have been around longer, therefore those ETF units already exist in secondary market, there’s no creation cost.
The creation cost in emerging markets in equity and bonds can be quite high, which means if you’re coming into a fund that’s small and you’ve got to create units in it, all of a sudden you’re adding basis point to your cost.
Philippides: I would echo that. Emerging market equity ETFs have attracted over €6 billion of inflows from European investors year to date and the Amundi ETFs have been in the fortunate position to have benefited from over 30% of this inflow. This has mainly been in the global and regional emerging exposures such as MSCI EM, Asia-Pacific and Latin America.
We have not seen much in the way of single emerging country flows, however. These exposures are available and are being used by investors because they facilitate access to markets that would be harder to invest directly.
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