…that’s the ratio of traded passive to active equities. The statistic is significant given the ‘bull market’ in ETFs and the supposed risk around this, our panel hears. Plus, smart beta and the rise of active ETFs.
Manuela Sperandeo (head of iShares Emea specialist sales, BlackRock)
Mohamed M’Rabti (deputy head of FundsPlace and head of ETFs, Euroclear)
Matthew Tagliani (head of product and sales strategy, Invesco PowerShares)
James McManus (Investment manager, Nutmeg)
Funds Europe – Who are the primary users of ETF and smart beta products in Europe: institutional, retail or wealth management?
Manuela Sperandeo, BlackRock – The landscape has certainly been evolving. What was predominantly the realm of discretionary wealth and asset managers is expanding to involve advisory wealth. There are a lot of phenomena around the regulatory wave, as well as changes in advisory distribution models, which are driving this adoption.
At the other end of the spectrum, we are also seeing institutional investors getting more involved. Insurance companies were early adopters – minimum-volatility strategies especially were appealing to them in terms of low beta equity exposure for their portfolios. Now, increasingly, we are seeing pension funds opening up to ETFs, and also to alternative indexation such as smart beta.
James McManus, Nutmeg – Over the last two or three years, even within the institutional space, different types of users have been coming into the market. Active managers and hedge fund managers that typically were not that interested in ETFs are starting to use those products within their wider portfolios, either for liquidity or for hedging, or for tax purposes.
In the wealth space, ETF use is still quite tactical. That will change under MiFID II – the cost difference between passive vehicles and active vehicles will be much more apparent. Costs have been a big focus over the last couple of years, and investors will be driven further towards passive as the true cost of active becomes apparent.
Smart beta is still the preserve of institutional clients. I don’t see many retail clients using those products, or at any rate implementing them in their portfolios the way that they should. They require a deeper level of detail and insight, and I’m not sure retail clients are there yet.
Mohamed M’Rabti, Euroclear – We view the market from a market infrastructure perspective. There are more types of investors now using ETFs - central banks, for instance. Many years ago central banks were only exploring ETFs; now they are investing with them.
Also, more and more wealth managers in the Netherlands, which is a very retail-oriented market, are investing in ETFs and leveraging different platforms for access.
MiFID II will bring more transparency, and my discussions with some market makers in Germany suggest German investors will start comparing instruments, so there some good opportunities across Europe.
We have also noticed that more UK retail platforms are making ETFs available to their clients.
Matthew Tagliani, Invesco PowerShares – You have a spectrum of investors, with large pension funds at one end, and small retail investors at the other.
Historically, ETF activity has concentrated in the middle, among asset managers, private banks and multi-managers. With the growing acceptance of the ETF structure and its benefits, we’re seeing interest broaden and engaging much more with traditionally conservative clients, such as pension funds or family offices.
If we now look at smart beta, there’s a similar progression, and to be honest, we in the industry may not have approached things in a way that maximises client engagement. There are some very clever smart beta strategies and when speaking with clients there’s a tendency to want to show this. But more traditional managers may find the language and terminology unfamiliar. It’s important to know how to pace the conversation to ensure a client always feels 100% comfortable and in control.
McManus – What’s critical with any smart beta or factor strategy is understanding what factors you have in your portfolio in the first place. So, if you have a market capitalisation-weighted portfolio, you need to understand whether you are already slightly overweight in value, slightly overweight in momentum, underweight dividend yield, or whatever it may be.
There is a proliferation of complexity. It takes a lot longer to get comfortable with the products, and a deeper level of insight and analysis is required. That is a key factor in slowing uptake.
Funds Europe – Should investors and regulators be worried that ETFs are taking up an ever-greater portion of daily trading? Are there any structural or systemic risks associated with this? What other concerns do you hear from clients about ETFs and smart beta products?
M’Rabti – ETFs are a fungible instrument at the trading level, so for example you can buy them on the London Stock Exchange and sell the same ones on Euronext or on Xetra. Theoretically it should be simple, but in practice it took many days to complete. Consequently, market makers used to have high spreads to cover the risk, but that was not sustainable. There was a lot of inefficiency, which would have been an obstacle to ETF market growth. So, after many discussions with the industry to make this more efficient, we came to one common solution: centralise all trading and settlement in one place.
Therefore, over the last four or five years, we have built pipes between the stock exchanges and central counterparties (CCPs), worked with market makers and worked at the clearing level with the prime brokers.
We have been able to create a new type of post-trade process for ETFs, allowing the market to trade them at any stock exchange and settle in one place. We have many issuers on board, and that should allow the ETF industry to grow with fewer post-trade failures.
Settlement efficiency has improved. In the past, liquidity was split across Europe, but now everything is in one place. Similarly, securities lending was, in the past, fragmented. Now everything is centralised, which has also helped.
Sperandeo – While index investing has been a transformational driver of change in the industry, its impacts need to be put in perspective. We carried out several pieces of research to measure the real size of index investing across mutual funds and ETFs, as well as to identify what drives flows and the actual drivers of price movement.
We estimate that, across global equity markets, a combination of listed ETFs and index mutual funds make up less than 20% of the equity portion. That figure is actually lower if you look just at Europe, Middle East and Africa.
We also know that 76% of assets are held by asset owners rather than by asset managers. Index strategies are just one of the equity investment styles that an asset owner might select, rather than the driver of the amount of assets invested in equities.
Moreover, despite its popularity, index investing still plays a relatively small role in the price discovery process. When looking at the percentage of daily trading attributable to index products, we estimate that for every $1 traded by index managers, roughly $22 is traded by active stock selectors.
Tagliani – There is a natural tendency to be wary of anything that is new, rapidly growing and very successful, so it’s unsurprising that the ETF industry comes under scrutiny. But if we look closely at ETFs, they have a lot of characteristics that regulators should like, both at the institutional and individual investor level.
As an alternative to single stocks, ETFs are Ucits vehicles and therefore even the most narrowly focused products still provide significant diversification, which is a natural buffer against the volatility or idiosyncratic risks of any particular company.
As compared to traditional funds, ETFs offer intra-day entry or exit from the market, so rather than focus all that trading at the close of business, you now have a full day of trading and a secondary market of other investors who can purchase the ETF.
There are many other examples of characteristics of ETFs that are attractive not just for investors but also from a market-structure and oversight perspective. I think much of the concern stems from a lack of understanding. My experience has been that these fears dissipate once the product is properly understood.
McManus – Rising trading volume doesn’t necessarily worry me; if you were looking at single equities, it would be seen as a sign of the stock’s liquidity. It reflects the fact that there is higher demand from investors to be in a diversified basket of assets rather than just a concentrated set of stocks or bonds.
For some asset markets, trading the ETF can be significantly cheaper than trading the underlying securities – high yield bonds, for example. An ETF investor also has transparency on all of those costs: the creation cost; the redemption cost in terms of administration, custody and all the operational aspects; the costs to hedge it; what risk premiums market makers require to step into that transaction.
The vast majority of ETFs are based on broad index exposures, many of which have derivative instruments tied to them. So, for example, in a crisis, a market maker may be much more comfortable hedging a broad, diversified basket of assets that has a cheap efficient hedge tied to it, versus a basket of ten stocks that are highly concentrated, where there is not a quick and easy hedge.
Tagliani – The point about derivatives markets is a good one. Trading volumes in futures are, in some cases, multiples of the trading in either ETFs or the underlying asset itself. They’re also very highly leveraged. Futures just have the advantage of having been around since the 1970s and both investors and regulators have achieved a degree of comfort with them.
ETFs are just a newer thing. People who have been in the industry or have been more intimately involved with how the markets work are very comfortable with them; others are still coming up that curve.
Funds Europe – It is inevitable that markets will fall, quite possibly when rate normalisation sets in. Could we then see the outperformance of active management and a reversal of flows between active and passive?
Sperandeo – As part of our research, we also looked at how performance correlates to flows in active. If the past informs the future, then higher dispersion could facilitate better relative performance of active management, and so could help flows in that direction.
We feel the dialogue should move beyond active vs passive. Among the biggest users of ETFs are asset managers, who have enhanced their asset allocation skills with this new investment tool.
Tagliani – One risk in a correction is that active managers tend to hold more concentrated portfolios than broad indices. There’s also a tendency for managers to gravitate towards the same set of popular trades. A market correction occurs when investors start selling, and if many active managers hold a small number of similar positions, we can expect this to more significantly impact the performance of that group, as compared with a more diversified passive portfolio.
McManus – We want to be able to control the cash in our portfolios and the defensive assets in our portfolios. With active managers, one of the problems we have is the lack of transparency. On an up-to-date, immediate basis, you aren’t able to see how much cash they have in their portfolios and what defensive positions they’ve taken. We’d much rather be in control of our own destiny as asset allocators than hope the managers in our portfolios have taken more defensive positions compared to the last month end.
I honestly don’t see a reversal of flows. Possibly short-term, but over the medium term I don’t see it, even in the event of underperformance from passive vehicles in a sell-off. The growth in passive has been about more long-term trends, the long-term cost impacts, and long-term performance impact. I just don’t see those reversing off a short-term event.
Tagliani – One of the nice characteristics of index products is they don’t have opinions, they don’t follow crowds, they don’t change their views. When you’re trying to construct something, you want to know that the tools you’re working with have the characteristics that they’ve always had – and always will have – because that’s how they’re defined.
One of the challenges of working with active managers is the degree of due diligence and interactions you need to have with them to understand how they are responding under different market environments, because that fundamentally shifts your whole portfolio.
Funds Europe – What is an ‘active’ ETF, and how does the panel view the development of these products? Are they distinct from smart beta?
Sperandeo – An active ETF is an exchange-traded fund that does not track a stated benchmark, bearing the characteristics of an actively managed mutual fund but listed and traded on an exchange. Active ETFs could be smart beta in that the active element relates to a stated investment objective of outperformance of a standard market-weighted benchmark. For example, if the objective is actually to target an investment factor, that would qualify the investment strategy as smart beta.
Active ETFs are an interesting topic. If you look at the US, it is definitely an area that is growing. It is more untested here in Europe in terms of size of assets. ETFs tend to be still very much a benchmark-driven franchise. But as the ETF also increasingly becomes a wrapper of choice for more creative and outcome-oriented investment strategies, I could see the universe of available products potentially growing. We’re seeing new entrants, such as traditional asset managers who view active ETFs as a first point of entry into the wider ETF arena.
Tagliani – We draw a clear line between active and smart beta. Smart beta strategies should always be formulaic in nature. You’re moving away from market-cap to introduce different stock selection and weighting criteria, but in the end, it should be something an investor could recreate for themselves. In active management, there is always something that cannot be foreseen by an outside investor – whether that is subjective human judgement by the manager or a black-box quant strategy. That is the line for us.
McManus – Active ETFs are definitely different to smart beta. One is a rules-based, rules-driven methodology, while active implies to me some level of human overlay or oversight.
Active ETFs raise fundamental questions for investors in the ETF market, not least ourselves, about what we’re willing to sacrifice. The major issue here is transparency, which we would not be willing to sacrifice. One of the things we love about ETFs is how transparent they are and the fact that risk can be modelled in a way that is almost real time.
Funds Europe – Are there any infrastructure issues arising from active ETFs?
M’Rabti – No, we accept all types of ETFs, whether it be smart beta, active or plain vanilla. We are agnostic when it comes to helping the issuer to distribute the product, provided that the ETFs are eligible in our system.
McManus – The infrastructure piece is the big question for product development. How do active managers protect their proprietary view? How do they avoid opening themselves up to arbitrage by the market participants, while also providing ETF consumers with the transparency and the key product attributes that they want? It’s a difficult one to solve, and probably prohibits very concentrated positioning in active ETFs.
Tagliani – One of the big challenges around transparency in an active strategy is that if you want to have a community of market makers who are going to support your product on exchange, they need to know what’s in it.
This is a tricky problem which comes down to a balance between the amount of information you provide – whether it’s full portfolio holdings or just general risk characteristics – and to how many people you provide it.
Funds Europe – Are smart beta ETF products best seen as a replacement for active or passive funds, or are these now a product in their own right? Is smart beta going to make traditional passive ETFs obsolete in time?
Sperandeo – I would challenge the ability of smart beta to displace the traditional beta ETF product, because the core beta offering has a value of its own and an identity of its own as a financial instrument. Indeed, some of these exposures are so cheap that they are starting to replace futures. So there is still going to be a place for core beta ETFs as financial instruments, which is a role smart beta would not be able to fulfil to the same extent.
McManus – Nutmeg is focused on asset allocation and so for us, smart beta products are another tool. They’re complementary to what we already have on the market capitalisation side. We don’t use active managers in our portfolios, but I am aware that other wealth managers would use smart beta alongside active managers, whether to complement or to take a more directional bet.
They are certainly products in their own right, sitting between market-cap and active. There are always going to be some active managers who outperform and deliver phenomenal results. But where active managers have just been tilting towards a factor – whether it’s size or value – to create that long-term outperformance, in some cases asset owners are going to move away from those managers towards smart beta.
Tagliani – I think it’s a bit like asking, “Is fish is a lighter option for steak lovers or a gateway meat for open-minded vegetarians?” The reality is that it’s all three – it sits in the middle, but it’s also a valuable thing in its own right.
You can have spaces where markets are less inefficient, where information flow is slower to be reflected in the price of assets. In that situation, an active manager can do quite a lot. Similarly, traditional market-cap weighting has its place as a broad representation of the economy. Smart beta can be viewed on this spectrum but can offer exposures that neither traditional passive nor active can provide.
McManus – There is still a big piece of investor education that needs to happen for there to be a much wider acceptance of smart beta ETFs, and for them to be adopted on the same level as the existing active and passive universe. In any of the products that we’ve ever looked at there is no such thing as a pure factor – for example, along with a value factor, you are getting either negative or positive biases towards other factors. Investors now having the tools to understand those exposures is driving increased adoption, but they are nonetheless a lot more technical. A very different skillset is required to assess them.
Funds Europe – Is there any sense that Brexit might affect ETF product development?
Tagliani – Brexit will change the behaviour of markets and there are some interesting ideas out there as to how you might respond. For example, indices that focus on companies that primarily export – and are therefore less sensitive to the UK economy – versus those that are more domestically driven.
In terms of higher-level product structures, however, we haven’t really seen anything of note. There is insufficient clarity at this point to determine if new approaches are needed. We’re focused on staying on top of market and regulatory developments so we can be nimble and respond quickly to any required changes.
McManus – As a UK-based investment business that looks after UK sterling-based clients, at some point we might potentially want to be 100% sterling-hedged given the move in the pound. We can’t currently buy US small-cap in a hedged structure, for example, along with many other styles, factors or thematic exposures. Straightaway from June last year, we were telling product providers that at some point we might go to a significant hedge ratio, if not a full 100% hedge, and discussing how we might build that into our portfolio. It’s very easy to hedge large-cap or the core exposures, but when you’re talking about a more complex portfolio, how do we ensure that that product is available for us if we need it? I would imagine many other UK investors are thinking along similar lines.
Tagliani – That’s a very good point. Large institutions will generally manage their currency risk themselves but among private bank and retail clients, this is something they prefer to see built into the product. Currency hedging has been a big trend in Switzerland, for example, as it’s a private bank-heavy market and many people look for Swiss franc and euro-hedged exposures. In the UK, you have sterling-hedged product becoming a fairly core part of the way the market is evolving.
Funds Europe – Which ETFs, by country, region, sector or theme, are currently the ‘hottest’ and why is this? Where do you see growth over the next year or two?
M’Rabti – We see demand from ETF issuers, asset managers and distributors for one vehicle that they can distribute globally, not only across Europe but also in Asia and Latin America. Another area for growth is on the retail side. We have had conversations with asset managers wanting us to help them distribute more ETFs across Europe via our FundSettle platform. We have also seen some traction from some German and Dutch retail platforms.
Sperandeo – The point around global distribution is a very important one and ties back into currency hedging. We have seen phenomenal demand for our currency-hedged share classes, from retail distributors through to some of the largest defined contribution pension schemes. That is only going to increase. The whole ‘set and forget’ approach is no longer fit for purpose and currency is not an awarded risk, so investors want to have solutions to mitigate that.
In terms of new investment exposures, we have seen a lot of interest in our thematic range – those new indices that try and capture some megatrends. Robotics and automation, for example, have been quite popular. ESG [environmental, social and governance] is an area that was really niche but is now growing in popularity. Product proliferation is only set to grow.
Tagliani – Given the continued level of global bond yields, income is not going away as a theme any time soon. There is just too large a need for it. That need drives flows as well as product innovation.
The equity market’s been very strong for a long time. The US led the way, although more recently we’ve seen flows into Europe. The question on people’s minds is how long will this continue? For the time being I think people are willing to ride the wave but we definitely see them asking the questions and preparing their Plan B scenarios of more defensive equities positions, as well as gold and cash.
McManus – In terms of interest, if perhaps not flows, ESG and socially responsible investing (SRI) are going to be the hottest. There is clear client demand on an institutional basis, as well as underlying or developing retail demand, particularly in the wealth space. Research suggests this will be a long-term trend that’s going to stick around, and that the new core portfolio in five to 10 years’ time will be ESG and SRI, rather than the current market-cap weighted portfolios.
Particularly in the wealth space, there is a changing demographic trend with clients. Their engagement levels are higher, and their demands when investing are not necessarily just returns-driven. It may also be driven by other factors, such as wanting to ensure they are allocating capital to those companies that are demonstrating positive corporate behaviour, or having a positive social impact.
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