ETF providers have done well to provide investors with building blocks for equity portfolios. There is now a need for more fixed income development, our ETF panel hears. Currency hedging woud also be useful. The panel also considers how regulatory changes, like the UK’s RDR, is helping the ETF market. Chaired by Nick Fitzpatrick.
Christopher Aldous (Managing director, Charles Stanley Pan Asset Management), Simeon Downes (Investment analyst, SCM Private)
Pedro Fernandes (ETF consultant), Chanchal Samadder (Head of UK & Ireland institutional ETF sales, Lyxor Asset Management)
Funds Europe: Have ETFs responded to the main investor trends of recent years, such as the equity income theme, and the need for fixed income? As well as these, which are some of the biggest drivers for ETF products?
Christopher Aldous, Charles Stanley: From the perspective of the ETF user, there has been a continued rapid growth in the number of ETFs available, but sometimes you question whether they’re created to meet an investor need or created to meet a need for higher margins – for example, smart beta ETFs. There has been a continued lack of supply of fixed income product, even through this period of sensitivity in the fixed income market with rates about to rise.
There’s been really very little progress in property ETFs.
We have been looking for convertible bond-type exposures and there’s nothing like that around. This and a sensible high yield exposure are very hard to get.
Providers have responded reasonably well, but they could do a lot more.
Pedro Fernandes, consultant: At the same time, we need to understand that ETF construction needs to take into account elements such as the liquidity of the underlying assets, so it would be difficult to create a pure real estate ETF.
The way around it is to have an ETF that invests in listed firms that are invested in real estate, which is not exactly the same investment as investing directly in real estate assets. There is a limit to the ETF exercise.
Chanchal Samadder, Lyxor: Fixed income is something we have been looking at closely. The industry has responded quite well to the demand for equity product, such as equity income. Products are weighted and screened in different ways so investors have a lot of choice.
Fixed income does come back to the question of liquidity. What we really have to be conscious of is that the ETF is not a magic wrapper that enhances liquidity. When we are designing products we look at the pool of potential assets and how liquid and tradable they are.
European loans is an asset class we’ve been asked about quite a lot, but there is not a huge secondary market, they are very thinly traded. So the issue is if there is a situation like in 2008 when money in credit markets quickly dried up, what will happen to the ETF? As an industry, we want to stay on the safe side of that.
Simeon Downes, SCM Private: That’s the point: to stay on the safe side. The point of an ETF is that it is a transparent vehicle and it is a liquid index-based product that anyone can buy. But certain risks with, say, a convertible product that has two credit ratings, need to be made clear to the end investor. Sometimes that is very, very difficult to do. ETFs have addressed bond, certainly corporate bond, demand very well in terms of duration, from ultra-short to long duration.
The high yield space is tricky. The market itself isn’t the biggest market anyway, but there is exposure to US high yield, there is exposure to European high yield, and so I think providers are doing pretty well.
Fernandes: There is a fundamental problem with fixed income products: the opaque market infrastructure supporting the trading of these instruments. ETFs are doing much to bring transparency to the fixed income underlying market, but again, there is a limit to what ETFs can bring in terms of transparency to a market, particularly one that is fairly opaque. I would slightly disagree on the point of ETF liquidity because I do believe that ETFs can create an additional layer of liquidity.
Not from the inception, but once ETFs grow they will have their own assets, people will hold units of an ETF and create an extra layer of liquidity on top of the underlying instruments.
Samadder: Yes, I agree, Pedro. In the US – where there is one exchange, one currency and one market with many types of market participants trading quite actively – ETFs certainly can bring liquidity. The spread on-exchange can be inside that of the underlying instruments. In Europe, there are probably a handful that have achieved that and have traded spreads inside the underlying asset.
FE: As Lyxor, a provider, do you hear that European ETF users a largely satisfied with the product offering in fixed income, or not?
Samadder: I do agree with Christopher in terms of fixed income, where we’ve been asked quite a lot about different exposures. Whereas there are many building blocks in equity – such as large-cap, small-cap, value, growth, etc – in fixed income we do agree that there are some building blocks, or core sub-asset classes, which are still missing.
Aldous: There’s another theme here, too: currency hedged products. There probably will be more of them now, but it is after the event as sterling seems to have peaked for the time being. I generally find ETFs respond behind the curve, though I can see why that should be the case and it’s unreasonable to expect providers to predict big trends.
But there is a big argument that a retail investor shouldn’t be taking currency risk, meaning there is a shortage of hedged products. Arguably, the industry has been a little bit slow to respond to this and the product out there already is slightly expensive because hedging is not that complex.
Downes: For a global product with multi currencies as the underlying, the hedge is just an extra layer of cost, as far as I can work out. If you take the example of a FTSE 100 company, it could have global exposure, dealing in dollars, renminbi, pounds and euro. Companies like that hedge at source and I agree that there are some areas where a hedged version is a benefit. However, The hedged-versus-unhedged problem is sometimes over-complicated. People think they want hedging because it adds an extra level of security, but I don’t think it does 100% of the time.
Aldous: I sympathise on that point, where there is a broad spread of global international companies. But what about, for example, Europe?
When we hedged our euro exposures earlier this year, it worked very well. Yet we had to sell most of our European ETFs and buy the UBS EMU product because it is the only hedged one that we could find. What we really wanted was the Dax and one or two others, but the hedged product was not available.
I’ve got no gripe with the industry. All the things you say I completely agree with as a user, but there’s more to do and possibly rather than just creating more similar products, hedged products would be more useful.
Samadder: The only big story in currency hedging has been Japan and Abenomics. Without currency hedging, the effect of the depreciation of the yen would have been massive. But that’s the only type of product already available where we’ve really seen a strong and consistent demand.
FE: What are the main strengths and weaknesses of ETFs that the panel recognises?
Samadder: The majority of ETF investors in Europe are asset managers and wealth managers. The retail space and the asset-owner space is smaller, especially in the UK.
The main positive feedback is about liquidity, but not because everyone wants to trade intra-day.
What they want is price transparency and the ability to manage risk on an intraday basis.
And the other positive feedback is to do with choice and flexibility versus other instruments.
I speak to a lot of the larger asset managers and for them, in the world of futures, there are very few liquid contracts out there. Similarly in the index fund world, unless you’ve got a mandate for hundreds of millions, there’s not a great deal of choice.
Downes: The main strength is choice - but ETF variety and costs are important, too. Though I wouldn’t necessarily call it a price war, there has certainly been some significant reductions in cost as ETF providers have recognised the need to compete between themselves and against tracker funds.
Aldous: Charles Stanley has more than 40,000 clients and quite a few of those are execution-only or advised. So one of the great strengths for the non-institutional investor base is access. There are extraordinary things you could never have dreamt of accessing ten to 15 years ago as an individual investor with £100. But that’s also a weakness because the problem is, there are also complex products out there now, like 3 times short ETPs and geared products. Some investors really don’t understand the implications. Generally speaking, we don’t let them buy these products because the outcomes can be so unexpected.
I’m not sure that the sophistication or the understanding of the investor base has grown in line with the range of products on offer.
FE: In your product set at Charles Stanley, you have a suite of ETFs and also a suite of traditional index products.
Why, in this current age of the ETF, do you need traditional index funds?
Aldous: Because most ETF platforms don’t do half as good a job as they say they do. ETFs can be very expensive to trade on platforms.
In particular, although the platforms say that they will consolidate trades amongst portfolios to get a fractional cost, if somebody puts in a single subscription or a new subscription, you can be hit
with 15 or 20 times £15 on a £20,000 investment. So you can be hit with £200/300 of costs for a single subscription.
There’s only about one platform that is truly cost-effective for ETFs, otherwise we don’t take the risk because you get more complaints than it’s worth handling. It’s a shame because ETFs are better, more flexible and offer a wider choice of global asset classes.
Fernandes: From a construction perspective, the ETF tends to be more expensive than in a traditional passive fund due to the extra costs to make them eligible to on-exchange trading.
But, on the other side, the benefit is the easy access to a highly transparent product, that is traded intraday.
Aldous: Until recently index funds were usually cheaper than ETFs in TER [total expense ratio]terms, though this is not the case now, and so it is no longer a question of the ETF’s cost, but the cost of trading ETFs.
Fernandes: You are right, but that depends on the scalability of the ETF i.e. the size of their assets under management. As an ETF collects more and more assets, it may eventually be more aggressively priced in terms of TER. But, ETF creation and launch involve, by definition, more costs, because they are listed on-exchange and traded intraday, while index funds are not.
Downes: Yes, to add to Christopher’s point, I agree platforms themselves need to really address how they execute. There are certain platforms where the execution is all in-house and they have a capital markets team that understands it and, as a result, you get the right price for your execution. But in a lot of cases those platforms will outsource to the traditional broker who, dare I say it, likes to take their commission and you end up paying £15 per deal which, quite frankly, you don’t want to.
FE: Has there been any particular trigger for the significant fall in ETF costs in recent times?
Fernandes: The issuers are starting to give back some of the scalability benefits that they have been collecting. Today, several products with multi-billion dollars exist in Europe enabling issuers to offer more attractive total expense ratios.
Samadder: When it comes to the question of cost, one thing that sticks out is an over-focus on the total expense ratio.
There are so many other things to consider. Obviously liquidity, the spread, but also revenues and costs from rebalancing and stock lending.
You can have an ETF with a higher TER which, over a year’s holding period, will give you a better return than an ETF with a much lower TER.
As an issuer, that’s been our main focus and it seems to resonate with investors that, ultimately, the end outcome after all costs and revenues is most important.
Downes: I would agree with that. Cost discounting, too, has not necessarily come directly from the ETF vendor, but from the index provider. Many ETF providers will switch index providers and the cost of product becomes more appealing when the index provider is discounting for their services.
Unfortunately, there are variations between indexes and investors really need to understand them.
Fernandes: Prices charged by index providers tend to be somewhere between 10% and 20% of the overall TER of products, so even if they cut fees by half, the impact on overall TERs is rather limited.
Performance is really the key, not fees. The question at the end of the day for investors should be ‘what was the performance of the product that I am invested in?’
Downes: It depends on the products. I understand where a price has been discounted if a product is straightforward, such as a Euro Stoxx 50 ETF and there is no real reason why the charge should be higher than for a similar product. But it goes back to the complexity of the index. There’s a danger that people buy the cheapest product, which is not necessarily going to provide the best return.
Aldous: Though it is great that a lot of product is coming through, while FTSE 100 and the S&P 500 products probably get enough volume to be run for five or ten basis points, supply of some of the slightly more esoteric ones where competition is also emerging will eventually reduce if fees on new products are too low. That concerns me.
Samadder: From a provider perspective, obviously competition on fees means margin compression. Fee cuts are great for investors and should attract other new investors. Take UK pension funds, for example, who have been very reluctant to use ETFs because they could always get a better deal on index funds that have single-digit costs.
In terms of squeezing out other issuers, in Europe there is a surplus of issuers already – over 50, I believe – and there are now over 33 Eurostoxx products alone. Does it help the market having so many products on the same index? In the US there are only two or three products on each core index. No one in the US would dream of launching a new S&P 500 fund now.
Hopefully price competition will lead to consolidation because at the moment the oversupply of products on certain indices causes confusion for investors and detracts from liquidity.
Fernandes: In the US, ETFs have a single market infrastructure and unified distribution network. It’s not the case in Europe and that adds a cost to the ETFs here. There are some investors preferring to invest in US ETFs rather than European ETFs due to lower complexity, thus lower trading costs there.
Downes: Yes, that goes back to the spread composition as well. The average spread of a portfolio of ETFs in the US is probably 7 basis points (bps) and the average spread in the UK is probably 35 bps. That’s a massive difference and nothing to do with whether an ETF costs 10 bps or 50 bps.
FE: Does the UK ETF retail market lag that of Europe, as is commonly perceived? And will the RDR change that? Similarly, are regulatory changes at the European level likely to provide the European industry with a growth driver?
Fernandes: Interestingly enough, I’m based in continental Europe. Everyone there thinks that the UK is ahead of the other markets! It’s as if every market thinks it lags the others.
My perception is that the UK, due to the RDR, is well advanced in ETF penetration across the retail audience compared with other continental markets.
But it is worth noting that the Netherlands, which implemented a similar reform to the RDR in the beginning of 2014, is an interesting growth area in ETF penetration.
Downes: It may depend more on the type of investment and the range. If you look at the resources available for a retail investor who buys funds or individual equities on line, the choice is huge. ETF choice diminishes spectacularly and that needs to change.
Samadder: Pre-RDR, everyone thought there would be a massive shift. It clearly hasn’t happened and everyone is pretty frustrated.
In the UK, if you just consider retail to be both IFAs and individuals, there is still a very strong cult around active management. Although commissions have been banned, many advisers still prefer to push a story around a fund manager. Compared to Europe, in the UK there are so many star names in asset management. There has not been much of a shift in the retail space.
The Italian market is miles ahead. A lot of people actually trade many ETFs, even leverage products, quite frequently.
Fernandes: Yes, but once again, it’s also important to understand who the retail investors are.
The average man in the street in Italy probably doesn’t know that ETFs exist. The mass retail market in Italy is probably not yet investing in ETFs like they do in US. It is probably the highly specialised retail investors, behind online brokers and similar others, who are the ones most actively using ETFs.
Samadder: Until you get mass education at a retail level in Europe, that is not going to happen here.
Fernandes: There are positive signs. I was reading in the newspaper about UK pension funds considering shifting some of their assets from active to passive management, and therefore saving many millions of pounds. There are other signs too.
FE: ETF infrastructure is given as a reason why the European ETF market is just 10% the size of the US market.
The fragmented post-trade world and the lack of transparency for OTC volumes are salient weaknesses. What significant infrastructural gains are being made?
Fernandes: Target-2-Securities (T2S) covers the eurozone and the goal is to create a single settlement pool for equities and ETFs. Most frictions we observe today in realigning securities across different European markets will cease to exist, or be limited. The project will start next year and spells a big change in European settlement infrastructure. There is also the international ETF project from Euroclear Bank. It’s a different way of trying to achieve the same result.
An ETF with multiple listings could settle in one single place. Everything will be on Euroclear Bank – an international CSD (central securities depositary), sitting on the top of local CSDs. That has a benefit for the UK, too, which is not captured by T2S.
And MiFID II is another development. Approved by the European Commission in June, the discussion now is about the levels of transparency that have to be imparted to ETFs; should they be the same as for equities, or should they be different?
With transparency, people tend to focus more on the post-trade side, but pre-trade is just as important, if not more.
If no one is compelled to execute orders in a transparent environment and therefore to compete for pricing, spreads will probably not be narrowed. Regulations that ESMA will define should also apply to the pre-trade level to make sure that brokers and intermediaries put out client orders in a transparent environment to trigger more competition on execution. In the end, order book competition will drive spreads down.
Samadder: There is no getting around the optical aspect of liquidity. You can see volumes going through, but at the pre-trade level no investor can go onto a Bloomberg or a Reuters screen and really have any handle on what the liquidity is, and that’s because the product is listed on several exchanges, in several currencies, so is automatically fragmented.
For market makers it’s quite complex having to manage that from a systems and technology perspective with a moving price. They are always going to err on the side of caution and move their spreads out just to protect themselves so they don’t get hit or arbitraged by someone else in the market. Short of the UK and Switzerland joining the euro, optically it’s always going to be a challenge.
All that infrastructure should flow into ultimately a tight spread, that’s what we’re really focusing on, getting the spread on every exchange as tight as possible. Our capital markets team monitor all the ETFs across all markets and if they see a spread that’s very wide, they immediately contract the market makers.
Aldous: We are proactive in the Local Government Pension Scheme move towards passive investment. If you take into account the total cost of transactions for big pension schemes and dig down to look at the spreads on, for example, old-fashioned life insurance trackers, they can be very unattractive. It would be great to have more transparency pre-trade because we’d get a much better feel for what’s happening and they would compare favourably.
FE: Over the past five years and including any of the above issues, which have been some of the key developments in the European ETF market and how has the market developed as a result?
Downes: Growth, because it just makes traditional ETFs more attractive. Providers know that if a smart beta product costs 60 bps, then a plain vanilla index-based ETF should probably be less than 60 bps and that obviously helps the user.
Growth has led to further complexities and the end investor has been blinded by choice, but that’s probably a good thing.
After all, they are blinded by choice in the active fund world, they’re blinded by choice in the equity world.
Samadder: Smart beta and fixed income have been key developments. Pre-2008, fixed income ETFs, even in the US, had very few assets, not for lack of issuers, but for lack of interest. But market events have seen them take off enormously.
Fernandes: Smart beta is impacting the whole fund industry. A number of traditional asset managers are and will be rethinking their strategy and future, as volumes and margins are and will be under pressure.
Aldous: There has been a decisive move made towards physical replication. As a user, one has to make a decision and most of us decided that because of the complexity of synthetic replication and the difficulty of understanding it and explaining it, we wouldn’t go with it. So in fact we’ve definitely seen, a big trend away from synthetic towards physical.
Samadder: But that’s very UK-specific. In continental Europe, clients are much more agnostic. Even in the UK, larger asset managers don’t have an issue with synthetic. They trade swaps with banks all day.
Aldous: And that’s what’s very interesting. You could sit in front of the trustees of a £150 million pension scheme and they will not want synthetic “rubbish”, yet they’ve already been doing stock lending or total return swaps in LDI type strategies!
FE: What would the panel like to see next in the European ETF market in order to bring it closer to maturity?
Downes: More resources available to the investor and the provision of more information so that ETFs are represented on a much more level playing field with active funds and investment trusts.
Aldous: To get a better take-up and to bring it closer to maturity, We are, sooner or later, going to have to differentiate between complex ETPs and non-complex ETPs. The regulator needs to get behind this.
Samadder: We would also like to see better education in the markets – a neutral education, rather than just from providers, that will increase retail use. We would also like to see real uptake from institutions, as happens in the US.
Fernandes: The key to market development will be whether regulatory and market infrastructure reforms will deliver the expected benefits in terms of getting the products out to clients. The expectations on T2S and MiFID II reforms are quite high.
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