The ETF market is becoming increasingly innovative as promoters look for new ways to capture investorsâ interest â Nicholas Pratt examines how far this innovation can go
It has been ten years since the first exchange-traded funds (ETFs) were established in Europe. In that time they have proved to be hugely successful. The success has been largely due to changes in both the market’s conditions and its structure that allow ETFs to be accessed and traded by investors directly on exchanges, on an intraday basis and with multiple counterparties. In Europe, the success of the Ucits guidelines has been the single most important development for ETFs. Passporting rules have enabled funds to be distributed and registered throughout Europe and with Ucits IV set to be implemented next year, the growth of the ETF market looks set to continue.
Additionally, there are greater levels of liquidity in both the secondary and primary markets, enabling fund promoters to establish new ETFs in a number of new and innovative markets and instruments. According to Daniele Tohmé-Adet, head of ETF and indexed funds development at Sigma, BNP Paribas Asset Management, the innovation in the ETF market has been in line with market trends and asset managers’ needs – particularly the demand for more globally diversified portfolios. “The traditional 60/40 equity/bond allocation has shrunk because of the percentage of diversified asset classes such as real estate, currencies, commodities and alternative investments that reside within even the most traditional of pension funds.”
Consequently, many of the newest ETFs are looking to exploit this demand for more exotic and volatile asset classes or markets. On the equities side, new ETFs are focusing on emerging markets such as Latin America, Asia and Eastern Europe. “We are seeing more wealth managers and IFAs invest in ETFs, not just pension funds, and they are attracted by the ability to access emerging markets from their local exchange and without any of the logistical constraints normally associated with these markets,” says Claus Hein, head of Lyxor ETFs for UK, Nordics and Latin America.
On the fixed income side there is a lot of interest in government bond ETFs and corporate bond ETFs. The attraction for investors is the fact that these funds are available on an exchange and not OTC (over the counter), as is usually the case with fixed income. There is also growing demand for ETFs that offer inverted bond exposure based on the market’s anticipation of a bond bubble. For example, Amundi has recently launched a range of six short fixed income ETFs which seek to replicate a family of short Eurozone government bond indices of all maturities, and a series of ETFs which track a family of short US Treasury bonds indices. “These ETFs offer investors an inverse exposure to their bond portfolios. They also cater for investors that want to hedge their existing portfolio or benefit from interest rate increases,” says Matthieu Guignard, head of product development at Amundi ETF.
Elsewhere innovation is continuing in ever-more exotic areas, such as leveraged ETFs, actively managed ETFs and hedge fund ETFs. Deutsche Bank has recently launched both a hedge fund ETF and a private equity ETF. “We listen to client feedback and try to launch new products on the back of that but we also look at market trends,” says Manooj Mistry, head of ETF structuring at db x-trackers. “For example, the hedge fund ETF was launched in the wake of the new Ucits rules.” Mistry accepts that not every new product will automatically be successful. “We want to provide a wide range of products, some will be blockbusters, but others will be less big although still useful to investors. Of course, some of this demand will change depending on market conditions. For example, we launched a private equity ETF that had only raised €10m by the end of last year but is now worth more than €90m. And the hedge fund ETF we launched 18 months ago is now worth more than €1bn.”Increased complexity
But as the innovation increases, there are some concerns that the ETF brand will move too far away from the values that made them so successful in the first place – the simplicity, transparency and low cost. Consequently, some providers are choosing to stay away from the more esoteric end of the market, particularly those that deviate from the index-tracking nature of mainstream ETFs. “At Amundi ETF we only offer index products as we want to remain vigilant regarding transparency,” says Guignard. “With some of the more exotic products on the market, such as hedge-fund based ETFs, there is a need for greater clarity in the market.”
Guignard’s concerns are shared by Lyxor’s Hein. “The great thing about ETFs is that they can be used by many different investors in many different ways and for a wide range of investment strategies,” says Hein. “Institutional investors are looking for strategic and tactical asset allocation, core beta exposure, sector rotation, cash and transition management and an alternative to derivatives and traditional index funds. But we are also seeing more wealth managers and IFAs embracing ETFs as they recognise that these products can be used as flexible, cost-efficient and transparent asset allocation tools.”
Given that ETFs can be used by such a wide range of investors, any newly launched product has to have a wide appeal and relevance for these various investor types. And if they are following Ucits guidelines, the ETF promoters also have to satisfy a number of requirements relating to the investment management process and transparency. But, says Hein, as, the market becomes more popular and more competitive, some of these requirements may get lost and the definition of an ETF may get stretched.
“Maintaining transparency is imperative and investors must evaluate carefully the various index tracking vehicles they are considering implementing and check that these vehicles really are ETFs. Are they listed on an exchange and traded by multiple brokers and market makers? Is the underlying structure an open-ended Ucits fund or note? Two different instruments may have the same investment objective but very different risk profiles and structures. I expect the market to continue growing but it will be important for clients to consider each ETF and issuer carefully and make sure that they meet their own investment requirements.”
Fund providers will also have to consider the true value of innovation and ensure they are not just innovating for innovation’s sake, says Farley Thomas, global head of wealth solutions and ETFs at HSBC. The success of the ETF market to date has been based on their simplicity, accessibility and transparency. They are also good vehicles for delivering performance based on an index. But as this popularity increases, the desire to deviate from this template may prove too tempting for many product developers, says Thomas. “They may begin to think that anything in an ETF format will be successful. This is not necessarily so.”
“In order for an innovation to be a success it has to be closely in line with new market developments and opportunities, in accordance with regulations and fitting investors’ demands,” says BNP Paribas’ Tohmé-Adet. For example, ETFs that enable synthetic replication and the importing of trading room-type strategies into a Ucits III-compliant and listed product are very much in line with all of the aforementioned criteria. In contrast, actively managed ETFs have not been so successful because the European market is more institutional than the US market and there is less demand for actively managed ETFs.
A failed ETF may not just affect the specific promoters and investors involved, says Thomas. His concern is that the more esoteric ETFs that prove not to be successful may damage the good reputation of the ETF brand. “Liquidity is a strong part of the appeal of ETFs. With most ETFs it is easy to put your money in and get your money out. With more complex and innovative ETFs this may not be the case and this could set the whole market back”.
Providers will have to consider the cost of setting up these ETFs and the sustainability of the demand, says Thomas. “I think mainstream providers with esoteric products have to be willing to have a lower success rate. There is also the link to the whole issue of segmentation and the ability to target the right kind of investor. Fund providers will have to tread carefully because an inverse ETF, for example, is a tricky concept to explain, there are very specific daily returns involved and you do not want investors that do not understand the complexity getting involved.”Transparency issues
Most ETFs in Europe are covered under Ucits rules and this has pretty much driven the swaps-based ETF market. But increased innovation and complexity could herald negative scenarios, says Thomas. The more complex an ETF becomes, the more difficult it is to provide transparency and the harder it is for investors and potentially even market makers to understand them.
There may also be some regulatory pressure that leads to a split between the traditional ETFs that encourage transparency and the newer breed of actively managed ETFs that require a degree of opacity.
Thomas says that although regulators have a positive approach to cheap, simple investment products, they may decide to define ETFs in a more restrictive way than Ucits in general.
“I think that the core, mainstream ETFs have a very solid and rosy future. The more esoteric end of the market has an important role for specific investors that are looking for innovation. At the moment there is no differentiation between what a Ucits ETF can do and what a non-ETF Ucits fund can do, but should this happen, I think it would put a question mark over some of the more esoteric products.”©2010 funds europe