March 2011

ALTERNATIVE ETFS: "A great financial innovation of the past two decades"

ETFBut the growth of alternative strategies that are being sold as ETFs is a challenge for the industry and for investors, says Debbie Fuhr of BlackRock

The exchange-traded fund (ETF) landscape will continue to evolve in 2011 and beyond as we see more products from traditional active asset managers and alternative asset class exposures becoming available to mainstream retail and institutional investors through standardised and regulated fund structures such as Ucits in Europe.

Hedge funds have historically been difficult for many investors to access with the high minimum subscription levels and maximum investor limits, but hedge funds are now noticing the growth and appeal of ETFs, which are easy to access but have powerful distribution networks. So we expect to see more hedge funds looking to create ETFs, with their own funds as the underlying exposure, in an effort to broaden their distribution capabilities.

This will, on one hand, give more investors access to the asset class and the ability to do so in small sizes, with daily liquidity. But it will also make it challenging for them to understand what they are investing in compared to the historical daily transparency of the underlying portfolio in low-cost index-based exposures for which ETFs have become known.

It will be important in the coming years to ensure that as the new generations come to market, investors are educated on their structures and mechanics when they deviate from the traditional definition of ETFs as exchange-listed, open-ended, and liquid products with secondary and primary in-kind creations and redemptions, and with real-time indicative net asset values (Navs), and with transparency where underlying portfolios are concerned.

Institutional embrace
One of the reasons larger institutions are embracing ETFs is because that many have indicated in various surveys that one of their focuses for product development is multi-asset class investing, and given this focus, many firms are embracing the fact that the ability to deliver alpha across all segments of all asset classes (equities, fixed income, commodities) is not achieved by most firms.

Based on net new asset data, we can see that ETFs are being used to implement exposure to various asset classes, with equities being the most popular in Europe in 2009 showing US$33.4bn (€24.1bn) net inflows. In 2009 we saw that investors were moving up the risk spectrum to emerging market equities, corporate bonds and commodities.

It has become hard for participants in the financial markets to ignore a product category that broke through the US$1trn assets under management milestone for the first time at the end of December 2009. Today, there is a growing fan club who cite ETFs as one of the greatest financial innovations of the past two decades.

How investors are using ETFs
The motivations for using ETFs have expanded, including the ever-relevant cost advantage and broad market access, as well as themes that have emerged over the past year. Examples of strategies being implemented include managing asset allocation, taking tactical positions and increasing diversification. Investors are also using ETFs to take negative positions in asset classes, either to remove existing unwanted exposure or to express a negative view.

This expansion has been fuelled by the increase in the range of asset classes accessible through ETFs. Moreover, the introduction of ETFs covering emerging markets, commodities and property has allowed investors to access some of the best performing asset classes of the past few years. On top of greater asset breadth, the range of instruments has also grown.

This increase in usage, breadth and product flexibility has driven a steady growth in their use over the past decade.

The growth in beta investments in recent years has been driven by a number of factors. While market conditions have had a noteworthy influence, some other key factors are driving a more permanent shift towards beta, including:

• Access: beta products are providing access to an expanding range of market and asset classes, and through a much wider range of instruments.

• Diversification: increasingly, investors are widening the scope of their investments and looking for exposure to new asset classes and markets.

• The changing role of beta: as investors are altering the way they view their investment objectives, alpha and beta decisions are being combined in different ways.

The range of beta tools available to investors has also grown with traditional index funds, index futures, over-the-counter derivatives and ETFs. Exchange-traded funds share many characteristics with traditional index funds. Importantly, they also offer intra-day liquidity and enhanced flexibility, allowing investors to take both long and short positions.

ETFs have been embraced because we are in a “back to basic” environment where they provide transparency and other favourable features. We risk moving away from this product and description that has been increasingly embraced by retail and institutional investors and find ourselves at an important crossroads.

This new and growing awareness is causing more people in various types of firms and regulators to look at ETFs. Many are hoping to find a way to make money from the growing industry, such as fund ratings firms, consultants, websites, fund platforms, and fund research firms to name a few. These new participants and potential tax and regulatory changes were the new forces impacting the traditional ETF ecosystem in 2010.

Investors need to be aware of the various biases that are inherent in many of these new services. Many are focused on US-listed ETFs; others require the exchange-trade fund manager/provider to pay to have theirs represented/rated. Some will require them to be over a specific size and/or be at least a certain age. These biases miss factoring in basic requirements for investors such as structure, domicile, registration and tax reporting to name a few important criteria.

The impact of regulatory and tax changes – such as the EU’s Markets in Financial Instruments Directive (MiFID II), the Ucits IV directive, the Retail Distribution Review and the Alternative Investment Fund Managers Directive, and so on, is an area of considerable uncertainty at this time.

Many regulators around the world are looking at rules regarding short selling, the use of derivatives, the use of commodity futures, and transparency of fees to name a few. Many of these documents are in the consultation phase and/or the specific guidelines for implementation have not yet been defined.

We are at an important crossroads in the ETF industry. We are seeing funds which do not provide transparency on their underlying portfolios and do not offer in-kind creation/redemption. Also, they do not have real-time indicative Navs. But they call themselves ETFs, as are products which are not even funds.

Now that the industry accounts for over US$1trn in assets, product developers are working hard to find ways to put structured products, hedge funds and active funds into exchange-traded funds. Agreeing definitions for ETFs, ETNs, ETCs, ETVs, ETPs and so on, is one of the growing needs in the industry.

Debbie Fuhr is managing director & global head of ETF research and implementation strategy at BlackRock.

©2011 funds europe