ROUNDTABLE: Intelligent tracking comes of age (part 2)

The popularity of ETFs is booming and providers are having to supply unique and clever products to cope with demand. Some industry experts give their opinion on what investors should look out for. Roundtable_ETFs

Bernard Aybran (deputy CEO, Invesco), Pedro Fernandes (head of ETPs, NYSE Euronext), Frederic Lorenzini (head of research for Morningstar, France)
Tony O’Brien (head of ETF sales Emea, BNY Mellon Asset Servicing), Denis Panel (CIO of Theam, BNP Paribas IP)
Funds Europe: So will it be ten years before we see active ETFs take off in Europe? Fernandes: You have to consider that the pace of change is also growing, but you cannot forget that it did take ten years before ETFs started doing well. Panel: There is definitely a contradiction between ETFs and active management. I don’t believe that there is strong potential for active ETFs, especially in Europe. This is because, when you want active management it means that you want to have longer exposure, so it would be more of a buy-and-hold strategy. That is where the contradiction begins because one of the main reasons of investing through an ETF is to get immediate exposure, with a real-time quotation. You don’t need this for active management. We have to bear in mind that an ETF is transparent and liquid and, therefore, you need to have very tight spreads. How can we have tight spread with an active ETF? I’m not sure that we will find good market makers in Europe to lead to very tight spreads on an active ETF. I’m not sure that active ETFs will be successful in general, not only in Europe. Fernandes: According to recent reports, investors seem increasingly interested in products that offer both exposure to active strategies and ETFs, like intraday liquidity. Aybran: And doing it in an anonymous way would have been beneficial as well. This anonymity I would say is the only upside. I can’t see any reason to have an active ETF except for the desire to be hidden. I’m not sure it’s a good reason but it’s a reason. Otherwise, I don’t see the point, really. Honestly, the liquidity [in traditional index funds] is usually daily and traditional mutual funds were just perfect for us. As investors, we don’t really trade intraday, that’s not part of my job, so daily trading is perfect. Second, I would hate for the liquidity of the wrapper to clash with the investment strategy of the fund manager. If you have some kind of active management, you have to have longer than a one-day time horizon for managing your fund, so intraday liquidity kind of clashes with the fund manager interest and the performance interest at the end of the day. I could understand why investment banks would like to get into the playing field of active management through ETFs, whereas a traditional asset manager, I don’t know why he would do that. Fernandes: But why do you think that intraday liquidity will affect the performance of the active managers? Aybran: It will affect it to some extent because if you want to run an active fund, you have to have a time horizon, one that is hopefully longer than one single day. Fernandes: But the creations and redemptions should continue to occur in the same way as if the funds were not listed. Aybran: Therefore, isn’t the problem switched to the market maker then? How will the market maker quote a price on a portfolio that changes intraday? Fernandes: Maybe we can go back to the mechanics of an ETF. This ETF is an open-end fund with a transparent portfolio that can be hedged on a continuous basis. As long as the portfolio of the fund is transparent and can be hedged intraday, the conditions should be met for intraday liquidity. Aybran: But the portfolio can change intraday. Lorenzini: It can and from time to time it will, but it won’t change every day. It is managed on a regular basis so once the manager has a conviction, he will have that for weeks or months and is not going to make big changes daily. Fernandes: The portfolio turnover, which depends on the active manager strategy, has an impact on the liquidity. Lower portfolio turnover drives better spreads and market depth, thus improved executing conditions for investment. O’Brien: In our experience, the portfolio is not transparent and that’s one of the main issues. Investment managers go to some lengths to make sure that their trading strategy is not shown to the market, even to the extent that they may issue a portfolio composition file to the market which doesn’t equal the portfolio. The other issue is around liquidity. For example, you have some ETFs based on hedge fund strategies. These hedge funds are set up to generate higher returns and often deliberately lack liquidity. So when you have an ETF based on that strategy you have to address the liquidity issue. If you’ve got money coming into the fund that ultimately originates in the secondary market and you’ve got a market maker wanting to come into the fund, you need to have some form of liquidity buffer in order to protect your strategy. Otherwise you won’t get returns and then there’s no point in having the product in the first place. You would also need a buffer in case a market maker comes to the fund to redeem. The buffer would act as a protection because you can’t easily liquidate your assets in order to meet those redemption requirements without sacrificing a significant portion of your performance. There are issues [with active ETFs], although I wouldn’t say that they’re unsolvable, there are many ways around them. Panel: It’s quite important to differentiate between the active ETF and the ETF based on an efficient [or enhanced] index. With an efficient index, we keep the general philosophy of an index, but it’s a different way of exposure. We maintain the general philosophy to have exposure to one asset class, but we introduce different inputs. Lorenzini: Another argument in favour of active ETFs is that in the fixed income arena, active managers are not always very active and in many cases they tend to be index followers. What I appreciate with active ETFs is that they address the problem of fixed income indices. They could be a way for fund managers to assume that they have to invest away from the index, especially when it comes to fixed income indices. So this is one more reason why we should support this kind of initiative, it won’t happen immediately, but over time it will change the habits of investors and managers. Funds Europe: Can investors use ETFs to manage volatility? If so, what products would they need to do this? Lorenzini: Using products based on the Vix [the volatility index] is not such an easy thing to do, because as with futures in the commodities world, you have to manage the roll costs. This means that if you have a long-term investment horizon and have no volatility over that period, it costs you money because of the carry costs. It’s like the ‘contango effect’ on the commodity futures market. So the concept is good and the idea of benefiting from volatility is pleasant but putting it into effect is not so easy. One example is the Lyxor fund launched recently [Lyxor ETF S&P 500 Vix Futures Enhanced Roll]. Again, the product seems pleasant but time will tell if it works because there is an element of active management in it. Funds Europe: Because the exposure moves between long and short-dated futures according to the volatility? Lorenzini: Exactly, it’s a mixture between short and long-term contracts on the Vix. According to their expectation of volatitlity, they will move the cursor to be more long or more short. So it’s an ETF because it’s transparent but at the same time it is active. So it seems to be a good mixture. But now the question is, as the product is new, whether it will work or not. Panel: We launched mutual funds on volatility with active management around the position on the curve. We don’t think that the ETF format is well adapted for this specific market. The volatility within the volatility market is very high. To manage volatility through ETFs I think investors are increasing their diversification. This is now being carried out much more on the portfolio construction level. I’m convinced that diversification is the best way to build a market proof portfolio and be sure it performs even if there is strong volatility in the market. Fernandes: Volatility is a risk, but it’s also an opportunity. You have several exchange- traded products that offer an easy, transparent and liquid exposure to volatility and therefore additional investment opportunities for investors. Aybran: Volatility ETFs can be attractive but they’re so tricky. It’s easy to be on the wrong side of the bet and to pick the wrong maturity. It’s very technical so although these products can be useful, they have to be used very carefully. Funds Europe: What has been the market’s response to socially responsible investments (SRI) ETFs? Are we likely to see any other similar “niche” developments? Lorenzini: It’s a fact that we are seeing more exotic products and those products could lead to investors having bad experience with ETFs and conclude that these vehicles are not a good way to invest. We don’t think this will happen because investors will learn how to use those products. For example, in France we had an ETF on Egypt [a BNP Paribas ETF which was closed in December 2010]. Although we have great respect for Egypt, an ETF on the country is not the best way to invest your money. Even forgetting the political events, I don’t think it’s a good idea to put much money into the Cairo index. We have also seen strange things, like indices coming out of nowhere… So investors could potentially be misled. They feel a product is robust because it’s an ETF and find comfort in the fact that its tracking an index. But in reality, the index is just a ghost; the index doesn’t exist. We have seen this happen in the US with some sub-index trackers. One example of this is the HealthShare Cancer ETF. This was tracking an index investing in small biotechnology companies specialising in oncology. In reality, there is no market for this type of product and the product disappeared after less than one year. O’Brien: I wonder whether there is a strong enough definition around some of these exotic indices, like socially responsible indices. Do investors truly understand what a socially responsible index is? Also, how are these indices built? Is there a methodology or is it arbitrary? We’ve seen SRI ETFs come and go; they don’t seem to gain the traction that they need to be enduring. Interestingly, iShares just launched an SRI ETF so, clearly, there’s some sort of perceived demand out there. We are also seeing interest in Sharia-compliant ETFs. These may provide a more substantial foundation for a type of socially responsible ETF. Lorenzini: There are around 20 of what Morningstar classified as “socially conscious ETFs” in Europe. Most are environmentally focused (alternative energy, water, carbon efficient). One has a religious theme: the db x-trackers Stoxx EuroChristian ETF. Fernandes: Product launch and closure is part of the product innovation process, which leads to further use of ETFs by investors.
Panel: That’s the reason the industry realises that we need to liquidate these kinds of ETFs, those that are not gaining traction. If you take the example of Egypt, we closed the ETF there because we didn’t have the assets. Even before the political events broke out, it was not a successful product. Funds Europe: Does the trend for pension funds hiring in-house experts bode well for the potential take-up of ETFs in Europe among this client base? Also, does it matter that the take-up of ETFs among pension funds is still in its infancy in Europe? O’Brien: Yes, it does matter that pension fund use of ETFs is still in its infancy, although· I do think it’s growing. A cursory glance at some of the activity we’re seeing shows that more pension funds are showing an interest in ETFs. I can say this with some conviction from our interaction with the consultant community. Being a service provider for ETFs, we mainly deal with the market makers in Europe, that is, the wholesalers of ETFs. Although this usually puts us a step away from the end users, we’re finding that the end users are starting to come directly to us for education and to understand how the ETFs work. Pension funds are a class of investors that have a fiduciary responsibility to meet their liabilities and their obligations and, therefore, will typically make great efforts to understand the investment objectives of any product they invest in. I’m receiving more calls from pension funds and pension fund consultants, not as direct business for us but just to provide that educational support to help them understand the products. That fact alone tells me that there’s more interest out there than has been expressed financially. So this is possibly a leading indicator of what’s coming down the road. Panel: Client education will definitely be one of the key drivers of the success of ETFs. The more the clients know the products, the more comfortable they will be using them. And, of course, ETFs are not as simple as one may think. You need to know how the ETF is built, for example, whether its synthetic or physically backed. You also need to know the hidden revenues of an ETF. So, for example, you have to take into account the securities lending. Funds Europe: What future developments do you see in the ETF market? O’Brien: We think the RDR [retail distribution review] is going to have a huge impact in the UK. After all, in the US, ETFs really took off when they started to get some measure of penetration into the retail market. I’ve often asked consultants and ETF providers how we can achieve that level of success across the retail space in Europe? What’s stopping us from getting there? The answer is that it is in some ways infrastructural as there’s no real way to reach out to a distributor or an IFA community with a cohesive and compelling product in an ETF that pays them and that allows them to reach out to a retail investor base. There is also no way to hook all those distributors together. It’s going to be incumbent on service providers like ourselves to help provide that infrastructure. Europe needs some infrastructural changes on the regulatory side of things. In the UK, the RDR is going to help tremendously and may drive ETFs down to a retail market. We’re already seeing product providers in the UK and Europe teaming up with more retail focused organisations, distributors and publications to help put the message out. Lorenzini: One trend we expect to see is more transparency. The advent of swap-based ETFs pushed for increased transparency. People were scared because physical replication was easy to understand while swap-based structures are more complex. The trend for more transparency is very positive. Some promoters play the game, you go to their website and have access to a lot of information, such as the composition of collateral baskets and swap counterparty exposure. Others are not yet so transparent, but soon they will all have to be at the same level or standard. Another trend we expect to see is more ETFs tracking small slices of indices. For example, ETFs on the European transportation sector or maybe the emerging market transportation sector. We also anticipate more ETF products to be launched in the fixed income area because there is much more to do there. Fixed income remains one of the few asset classes ETFs have not yet sliced and diced into the tiniest sub-sectors, but this will not remain the case for long. We expect credit-focused ETF launches in 2011, covering the euro, sterling, and dollar bond markets. We also expect more emerging market funds to come out as providers chase the hottest investment story around, so expect launches of local currency EM bond funds, more single-country equity products, and perhaps even sector-specific or single-country small cap ETFs. Panel: Regarding regulation, I think more people will make a distinction between ETFs and ETCs [exchange-traded commodities]. ETFs under the Ucits format have to respect that framework, and that offers investors a certain amount of protection. This is not the case for ETCs, therefore I think regulators and the industry in general will make a more clear distinction between ETFs and ETCs. Aybran: The legal framework has to change over the next few years so there is more clarification between ETFs and non-ETFs on the producer side. The blurred line between these products makes everyone uncomfortable – from investors to regulators – and it has to be clarified. ©2011 funds europe

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