ETFs have been hugely popular and this has led to much innovation and creation. Experts discuss industry developments past and future
Bernard Aybran ( CEO, Invesco Europe), Pedro Fernandes (Head of ETFs, NYSE), Frederic Lorenzini (Head of Research, Morningstar)
Olivier Paquier (Poduct Specialist, Amundi ETF), Daniele Thome Adet (Head of ETFs, BNP Paribas AM)
Funds Europe: ETFs have seen considerable growth in recent years. How has the competitive landscape changed in the last three years and what have ETFs offered investors that they did not offer them before?
Danièle Tohme Adet, BNP Paribas Asset Management: In the last three years, we had many different scenarios to contend with: the crisis, the credit before the equity crisis, the govvie bonds development. ETFs have been very helpful in offering new asset classes and detailing the offer in each asset class very explicitly. For example, we now have the whole range of fixed income, from specific government bonds to different aspects of the yield curve, and the credit with the high yield and corporate credit.
ETFs also helped with market timing. After 2008, market timing became key for investors who used only index bonds or regular mutual funds. Risk budgeting also became an issue and being able to have a snapshot of your portfolio became very important. Furthermore, the idea of making very specific risk adjustments was very well promoted through ETFs. These products offered flexibility in the crisis through a diversified offer. The transparency of ETFs is also vital and so it’s very important that they stay very pure.
Pedro Fernandes, NYSE: I completely agree with Danièle. You saw the same thing happen in the US in 2003, after the internet crisis and in Europe after 2007. During such periods you tend to see a tremendous growth in the use of ETFs because the investors are much more sensitive to issues around transparency, accessibility and flexibility.
Frédéric Lorenzini, Morningstar France: We have seen a lot of innovation in terms of asset classes, but also in terms of marketing; For instance, Deutsche Bank introduced an ETF with a TER [total expense ratio] of 0%. In our opinion this is really a marketing innovation; it raises the question of where those people are going to make their money. So we are always cautious when we see such a free lunch and it’s not a good thing for the investor. We prefer providers being upfront and telling you straight away, ‘you are going to pay for that and for that’, rather than saying, ‘you are going to pay for nothing’ and then you’re made to pay for something later. I think we will continue to see more sales gimmicks like that.
Olivier Paquier, Amundi ETF: One of the key aspects we have witnessed over the past three years is an intensification of the use of ETFs in a maturing market. There’s a lag between the European market and the US. The US market development is five years ahead of ours, but the European market has recently matured. Nowadays, it is hard to meet an investor who has never heard of ETFs. Investors not only know about ETFs but they also know what to look for in the ETFs themselves; in terms of tracking error, replication mechanisms, risks etc.
Lorenzini: We’ve have entered the second, or even the third, generation of investors now. It’s no longer necessary to evangelise about the ETF benefits. It’s now time to start explaining the dangers of ETFs.
Fernandes: I agree that there was an incredible increase in ETF knowledge, but there is still a lot to do. For example, we still have people confusing ETNs [exchangetraded notes] and ETFs. Also, we should not forget the retail side of the market. In the US it’s estimated that 60% of ETF users are retail, while in Europe just 10% of the users are retail clients.
Bernard Aybran, Invesco Europe: Over the past three years, both the demand and the offer sides have changed a lot. Although we don’t necessarily know what institutions are doing when it comes to ETF investments, they have begun benchmarking investments against ETFs. So maybe ETFs have become a proper way of investing or at least, a way to compare fund managers. We see institutions working to a particular index having to make the choice between ETFs and passive funds. In many cases they opt for the passive fund, but they use the ETF to bring the fees down. So things have changed on the demand side because I don’t think that a French pension fund would have ever thought about investing in an ETF. Now they are considered, not much, but at least the pension fund thinks about ETFs or uses them as a benchmark. On the supply side, you’ve had many new ETFs, new asset classes and new indices. There has been a sea change on both sides of the market, but there is still some lag between what people know, or think they know, and what is going on in terms of assimilation.
Funds Europe: Institutional investors in some European countries, particularly where there are high levels of internal investment expertise, have been using ETFs, but institutional investors in other countries have not taken to these products. What, in your opinion, is the key to bringing the adoption of these products to the rest of Europe?
Fernandes: The institutional investor side is a big community, so we need to talk about the different segments within that. Asset managers should see the ETF as a tool for exposures where they have less expertise. Lorenzini: Institutional investors working with consultants are not pushed to use an ETF. This is because these consultants don’t get much money from ETF providers so they prefer to push active managers.
Aybran: We’re talking about institutions here, but on the retail side, the distributors to the retail market, like the networks or the banking groups, are not incentivised to sell ETFs. So the fees and the way fees are split is key to the way that ETFs are used and distributed.
Tohme Adet: For institutional investors it’s not just about a fee. ETFs are more expensive than index funds or a segregated mandate. So we’ve seen institutional investors use ETFs for tactical allocations, where accurate market timing is very important. These would be very short-term positions.
Within their core portfolio, institutions used to use mandates, but the 2008 crisis was key in teaching them that using ETFs may be appropriate even for the core portfolio.
Something that has changed is that before 2008, institutions used to invest in ETFs with their eyes closed. Today, you see due diligences on ETFs and on passive management.
Increased transparency is also very important. If you look at Europe today you’ll see that institutional investors have a maximum of 8% of their investments parked in ETFs. So the potential there is considerable. The research shows that they
are very interested in emerging markets and new fixed income areas; sectors in which they don’t really have an expertise. Therefore because of the risk involved, they would want to be diversified through the index, through either an index fund or an ETF.
Institutional investors are also developing many GTAA [global tactical asset allocation] funds and LDI [liability-driven investment] in which ETFs are used. So ETFs are not onsidered to be funds, they’re more like tools that institutional investors can use to create. Distribution is another issue. I think the fiscal end of distribution still needs a lot of work.
Lorenzini: Another thing that helped improve the usage of ETFs among institutions was the differentiation between beta and alpha products. It marked a clear line between 31 ‘We’ve seen institutional investors use ETFs for tactical allocations, where accurate market timing is very important’ one side and the other; if an investor wants beta they get it through an ETF, while if they want alpha they can select a product that will provide them with that.
Today, institutional investors are a bit conservative, and they try and follow the herd. Tomorrow when everybody uses ETFs, they will do so too, but today it’s a bit hard for them to take that initiative.
Funds Europe: But someone needs to make that first step.
Lorenzini: Yes. Another thing is that maybe some of them are afraid that their board could question what is the added value of ETFs. I think there is a lot of added value in asset allocation and with ETFs a large part of the value comes from the asset allocation. It could be that some institutional investors worry that their board will think they’re taking the easy way out if they use ETFs too much and therefore they would rather continue doing sophisticated things.
Aybran: The questions from the board can be key to the mindset of an institution. This is because it doesn’t invest for its own sake or for clients it never sees, it invests on behalf of a board of people who don’t always know how finance works. Therefore the person making the investment decisions has to explain them in simple terms. In many cases you can see an investor or institution taking very strong measures and firing fund managers. This sends a message to the press that they took action when a fund manager underperformed. But if that same investor picked something that didn’t do well, it’s his own fault and there is no-one else to blame.
Fernandes: Speaking about mindset, due to this transparency there are many questions about swaps versus full replication and borrowing and lending. These are used by a number of different products and not just ETFs.
Paquier: I would say there are two key drivers for increasing institutional usage of ETFs. First of all, the understanding of the roduct is a key driver and it’s part of the issuer’s role to educate their client base. We have to show them how to use these products within their asset allocation. The other key driver is to increase the awareness of clients because some clients automatically think of mutual funds, and not ETFs, for their dynamic or static asset allocation. In addition, they do not exploit the full capacity that ETFs offer; within the product itself or in its use. For instance, ETF lending, short selling ETFs, trading options on ETFs; all these sophisticated areas are completely under-used in Europe. It’s just a question of habit and client type. Also, the European market is very fragmented culturally speaking, so the level of instinct in using ETFs is very different depending where you are. As issuers, it is an asset to adapt to our clientele locally.
Funds Europe: Pension funds mainly use ETFs as a way of remaining invested while transitioning between asset managers or portfolios. Is this cash alternative going to remain the main function of ETFs among these pension funds or is their method of using these products going to change?
Tohme Adet: Today custodians are starting o really take advantage of this tool for transition management, considering the very high level of transfers from actively managed portfolios to passive and active allocation. It’s not really a question of active versus passive. The tools are passive but the way the management is addressed is active.
While ETFs are used in this type of transition management, some of the investments are being parked in ETFs for use in the global allocation. The architecture of asset management has changed and the idea of a fund managed according to a benchmark is a bit old fashioned. We are moving towards having absolute return alpha products at one end and allocation through ETFs or index products at the other. The usage of ETFs is definitely going move beyond them being used as transition management tools.
Fernandes: Once again, if you look at the US, which we said is five years ahead of Europe, you see institutional investors using them for a lot of strategies and not only instead of a cash transition. What also will drive the broader usage is diversification. There is a very wide range of asset classes being covered by ETFs in Europe.
Tohme Adet: Yes there are large families of asset classes, nine at least. What is very interesting is that within each asset class there are many areas that are very specific. But the diversity of ETFs is becoming a burden for the ETF itself. An issuer, he has to have such a broad range that he has to finance the development of tiny ETFs that are very specific in their focus.
Paquier: Again, as the European ETF market is becoming larger and increasingly mature, we all agree that the use of ETFs will become broader and they will not just be used as cash alternatives. ETFs are definitely becoming an essential tool for asset allocation and we do see that with our clients. They not only use these products for tactical bets but also when implementing buy and hold strategies.
Funds Europe: What do you think will be the catalyst for this broader range of ETF usage?
Tohme Adet: Pension funds are still a bit cautious about the replication within ETFs and how that is carried out. They still question how the index is replicated. There is still a need for consultants to be much more involved on the inside of the ETF world. Fernandes: I think ETFs will be used more for new money rather than for existing money already invested. This is because there is a cost for leaving existing investments.
Aybran: To build on the comparison between the US and Europe, one of the main differences is that in the US, ETFs are about asset management while in Europe it’s more the investment banks that have the large pots of ETF assets. If we were to split the assets held in ETFs in terms of market shares in Europe, the investment banks are massively bigger than the asset managers. So to relate that to the contact between institutions and the providers; simply put, in Europe the institutions are in contact with asset managers and not that much in contact with investment banks.
Tohme Adet: It’s very interesting because if you look at the users in the US, the situation is exactly the contrary of Europe. In the US the users are more retail and in Europe the users are more often the asset managers themselves. This might be the reason why ETF providers in Europe tend to be investment banks. Maybe its because they are not selling other asset manager products to those distributors so ETFs are not competing with their offer. In the US the retail investor is the main user and because of the fiscal approach and how products are distributed, the main ETF issuers are asset managers.
Lorenzini: One of the differences between Europe and the US is that in the US there is more open architecture and in Europe, at least in France, open architecture is not yet widespread. So you don’t find ETFs on banking networks.
Tohme Adet: That’s because they compete with funds that command higher margins.
Lorenzini: Definitely. I agree with that.
Tohme Adet: But now the [bank] customer is starting to request these type of products. You have more advanced countries, like Germany, where the e-trading is very developed and there you wouldn’t be able to hide the ETF range, its impossible. But in markets like France, Italy and Spain, although our products are on certain platforms, the distributors are not motivated to sell them because they don’t get enough margin from ETFs. But there are many ways around this. Distributors could sell funds of ETFs, or funds of allocations. Solutions like these are an answer for the distributor and even the end user of the ETF. This is because the end client is often a bit lost because there are so many offers available and he needs the advice, as well as wrapped products that use ETFs.
Fernandes: The fact that investors are now asking for access to these products is good news. Also the law is changing and financial advisory remuneration is going to change in 2012 in the UK with the RDR. It is possible that this trend will spread throughout Europe. This change was key to the growth of the ETF market in the US.
Funds Europe: What have been the greatest challenges for ETF providers and have products been understood by the market?
Lorenzini: I think there’s a lot of work left to do. We are an information provider and we get the feeling that people do not yet clearly understand and identify the difficulties and the issues with ETFs. They get the overall concept and that’s good, but now we have to educate them. We have to help them understand what is the difference between products so, for instance, replication, full replication or swap replication. Another issue is liquidity. Because a certain amount of business is done OTC [over-the-counter] you could have large spread between the price you offer and the price you get. This is something about which we have to educate investors. We should make sure people understand exactly how these products work. If they do not understand these issues then they can have a bad experience, get disappointed and say, ‘those ETFs looked good but they are too difficult to implement so I prefer not to invest in them’. So I think we still have some work to do, to explain not the benefits, which I think are clear now, but the dangers and the issues.
Paquier: At Amundi ETF, we have developed our product range over the last three years, during a period of turmoil in which 30-40 RoundtableTS:Layout 1 17/12/10 12:28 Page 33 we have had to face two main challenges. The first one is, as you say Frederic, to explain to clients the more sophisticated possibilities of using ETFs. We also need to explain how ETFs are dealt. Because another of the major differences between Europe and the US is that in the US, everything is dealt, or at least reported, on exchange whereas it’s not necessarily the case everywhere in Europe. In fact, in most European markets, institutional clients deal OTC. Also, they can deal in various ways with many intermediaries and so you need to be extremely clear with customers. The second main challenge, over the course of the last few years, has been for ETF issuers to provide quality products, across a very broad spectrum, in a very cost-efficient way. Being an ETF provider requires a lot of energy with people on the ground who know what drives clients’ needs locally.
Aybran: Whether you’re flashing the trades on the exchange or not makes a difference psychologically. It matters because when you go on your Bloomberg screen and you look at an ETF, you see all the trades in the US but you can see nothing in Europe, even if there is plenty of liquidity. So having a view about the rough liquidity level of an ETF isn’t that straightforward in Europe, whereas it seems more easy in the US.
Fernandes: The thing is that the liquidity of an ETF is the liquidity of an underlying. Very often investors look at an ETF that hasn’t trade and they think it’s not liquid. But this isn’t right, the liquidity of an ETF is potentially the same as the liquidity of the underlying.
Aybran: But this is the fundamental issue. Psychologically, it doesn’t follow that something that hasn’t traded is still liquid.
Fernandes: I completely understand, but that is part of the question as well. If you have an ETF on the Cac40, the liquidity of that ETF potentially is the liquidity of the Cac40 itself. But the good news is that there is a high probability that ETFs will be included in MiFID II. MiFID I does not require transparency on ETFs, meaning that people who trade are not obliged to report to the exchange. With MiFID II, that will be mandatory; when you deal a trade in ETF you have to report it through an exchange.
Tohme Adet: I think this is very important. Many investors have been a bit worried about the difference between the US and Europe in terms of what they can see on their Bloomberg screens. Investors need to understand that in Europe, you don’t have one exchange, but five or six that take the ain lead on ETFs. Also, they don’t have the same rules and they try to compete in between themselves.
Clearing is also very important because the same market maker will have to quote on two exchanges but still does not have the same clearing process. Therefore it makes it more difficult and more costly for that market maker to have compensation between one exchange and the other.
One of the important challenges we face now that we have seen the due diligence on ETFs is to show customers that the ETF is reflecting exactly the liquidity of the underlying. I think with the new rules, like Basel III, funding costs are going to be more expensive. Also, we are going to have constraints with MiFID that, although they are going to be good for the investor, are going to challenge the market makers to cope with it. It’s going to be more and more difficult for a market maker to ensure the liquidity the way they used to before on the OTC market.
Another thing is that when you look at Bloomberg, the quoting is only for small limited amounts. An institutional investor is interested to deal OTC because he will not just fill all the open book on smaller amounts that are shown by the market makers. So what is held in the uropean market, in terms of liquidity visibility, is calibrated for the distribution but the main users are institutional, while in the States, you have liquidity for large amounts but the main users are retail.
Paquier: There is also a lot of education to be done around execution and liquidity. There is a lack of understanding on how to execute an ETF and investors prefer to go directly OTC for block trading. Also, ETF users do not often know that they can trade at the net asset value just like a fund.
Tohme Adet: It’s simply because they are used to putting subscription orders through the custodian with a Nav. They’re are not used to working an order. Many of the institutional investors would love to do ETFs but some don’t have an execution desk, for example, so they cannot place an order with an exchange. Therefore, we had to help them monitor the whole process.
Fernandes: Market makers play a very important role by contributing to price discovery and it’s important that they are compensated for this.
Funds Europe: What about the issue of fees. Somewhere like Asia, investors are said to have more of a trading mentality and therefore are more sensitive to fees. What has your experience been?
Lorenzini: It’s very interesting because we are very aware of fees and the fee structure in the qualitative analysis of funds. We take into account the return, the team, the parent company, the process and also the fee. We all know that past performance doesn’t guarantee good performance in the future, but the past fee gives you a good idea of the difficulties a fund manager has to carry. Therefore, we spent a lot of time trying to understand where the fees are coming from, how the funds generate those fees, how the fund manager is compensated, how the bonus of the fund manager is calculated.
When we analyse an ETF we ask whether·it’s expensive, whether the tracking error is low etc etc. But there is a second part to our considerations. We look at the choice of index – for example, if you have a··· choice between the MSCI Europe and Euro Stoxx 50, which one will you choose?
Paquier: Clients remain very sensitive to pricing and especially the TER. It is worth· reminding people that the TER is directly deducted from the Nav, so the lower the TER, the better the expected tracking error. Clients tend to look closely at the TER that they’re paying on· their ETF, but they need to carefully examine the whole cost structure around it. They understand that they’re going to pay a management fee and some administrative fees, depending on the fund hey buy, but they don’t necessarily anticipate other fees such as the cost of· realtime liquidity. At the end of the day, there is no such thing as a free lunch.
This is the reason why, ETF providers need to build a strong partnership with market makers to provide liquidity on and off exchange; realtime access comes at a cost. In addition, they need to···consider creation or redemption fees when trading at Nav, avoiding real time liquidity costs. Furthermore, they’re dealing with their financial intermediary who may or may not charge some additional fees. So in the end, we are committed to educating investors about the·fee structure, to make things extremely clear in order to help them in their decision process.
Tohme Adet: What’s also important to note in Europe is that we have different domiciliation. So the fee structure for a Luxembourg-based fund is not the same as an Irish one and· is not the same as a French one. What you call management fees for a French fund is the TER, but it’s not the case for the Luxembourg fund. Then sometimes, in the prospectus, you’ll have the maximum fees but you don’t have the exact fees. Plus you have some hidden· fees in the ETFs depending on how you manage them.
We at BNP Paribas Asset Management always do a test before we launch a fund to see whether it’s going to be fully replicated or synthetically replicated depending on what’s going to be the best performing on that·index and what is possible, fiscally speaking. We work on open architecture and· so do most of the asset managers. But the investment banks don’t because the swap is the swap and even if you have 0% fees, it could still be something pretty interesting for the issuer. Therefore, the customer has to be aware of the different layers of fees.
End of part 1
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