talks to Arnaud Llinas, head of ETFs & Indexing at Lyxor Asset Management, about building balanced ETF portfolios.
The European ETF market has had a very impressive year, reaching more than $500 billion (€444 billion) in assets under management (AUM) and collecting $59 billion in the first seven months. It is the first time that growth in European ETFs – which is 15% this year – has been bigger than in the US. Not even the market turmoil of August saw any significant outflows in the European ETF market. While investors were getting rid of riskier assets, they held on to ETFs. Indeed, net new assets in August amounted to €9.7 billion, close to January’s all-time high of €10.9 billion.
All of these impressive statistics are in line with the trends over the last five years and they also increase confidence that the European ETF market will double in size in the next five years, says Arnaud Llinas, head of ETFs & Indexing at Lyxor Asset Management. He says Lyxor itself has seen similar growth in its ETF range.
“We are in the top three of ETF issuers in Europe in terms of assets [$54 billion] and the top two for net inflows so far this year [$8.2 billion].”
With a change in US Federal Reserve monetary policy expected before the year-end, investors are likely to continue moving their allocations from riskier assets, like emerging markets, to the relative safety of European equities and ETFs.
Regulation within Europe will also be conducive to the growth of the ETF market. Rules that ban inducements paid by funds to distributors, greater transparency on fees, and advice on complex funds for retail investors are all likely to make it more expensive to distribute mutual funds and push more investors to opt for ETFs as cost-efficient alternatives, he says.
In addition, investors have become comfortable with ETFs. They are no longer new investment vehicles and for many institutional investors and private banks, ETFs have become ideal building blocks for their portfolios.
As the ETF market has grown, it has also created some challenges for investors when it comes to selection, says Llinas. “Many may come with some misconceptions about how ETFs and other index-based funds operate. For example, two different funds that are replicating the same index may not produce the same performance or the same returns.”
This becomes an important point when it’s considered how ETFs have proliferated in recent years, Llinas says.
“There are now more than 4,000 ETFs globally and more than 1,500 in Europe alone. Many of these will be tracking the same indices – either the FTSE 100 or the Euro Stoxx 50 – yet there will be a wide variation in many aspects of these funds. For example, management fees can vary in size by up to three times; performance can vary by as much as 75 basis points.”
There are also qualitative as well as quantitative factors that have to be considered, such as the domiciliation of a fund and the various tax properties – all of which will be important, depending on who the investor is and where they are based.
In addition, the analysis tools traditionally used for active fund selection are not best suited for assessing passive instruments like ETFs. “This challenge of building a balanced portfolio from the several ETF providers and different asset classes available is something that we at Lyxor have considered for some time,” says Llinas. “To this end, we developed the Efficiency Indicator in order to calculate the total cost of ownership of an ETF.”
The indicator produces a robust evaluation of the ETF’s performance by measuring the three most commonly used criteria: performance relative to benchmark; liquidity spread; and tracking error volatility. The aim is to maximise performance, minimise tracking error and limit trading costs.
“The Efficiency Indicator has become a standard part of the toolkit for our managers to examine our own range of ETFs and that of our competitors. The result is then published on a quarterly basis and made available to our clients to help pick the best ETFs on the market. It gives complete transparency.
“We have seen external consultants take a similar approach and no doubt other ETF providers will be looking to develop their own tools. In time there will be a commonly agreed, industry standard for rating ETFs, equivalent to what Morningstar provides for the mutual funds market.”
Producing an industry-wide comparison of ETFs assumes that Lyxor is confident in putting its own ETF range up against those of its competitors.
“The strategy is two-fold, encompassing everything from high-quality blue chip stocks to more innovative exposures and investment strategies. For blue-chips we aim to cover all major developed markets, and for the more innovative stocks we look to harder-to-access sectors and emerging markets,” says Llinas.
“Smart beta is an area we are really focusing on. Our aim is to cover all main markets with a variety of different strategies, from conservative minimum variance, to more aggressive outperformance strategies using risk factors. We have worked hard to create the best range of ETFs possible with huge diversity across all asset classes, geographies, sectors and investment styles and quality tracking runs throughout the range.”
The other step that Lyxor has taken to address the challenge of building a balanced portfolio of ETFs is to produce a range of core ETFs that ensure access to the best products for institutional and retail investors alike. “The aim is to make it easier for clients by cutting through the overwhelming choice, and focusing on just a few key exposures while ensuring best performance,” says Llinas.
The Lyxor ETF “Essentials” comprise 15 of Lyxor’s best-performing ETFs tracking major international equity, bond and commodity indices. “We select the best-performing blue chips on the market – funds that have got a track record of more than five years, are of a good size and have good performance,” says Llinas. “We have not created new funds but extracted the best parts from our existing funds to produce a basic toolbox and some building blocks for investors.”
Balance also holds the key in the current debate among investors about passive versus active management. Instead, says Llinas, passive and active funds should be seen as complementary. “Portfolios should be diversified with a core of passive funds, typically ETFs, that provide low-cost and liquid access to beta. But it also makes sense to have an active part of the portfolio through alternative assets, provided that you are able to find truly active managers.”
* The rationale and construction of the indicator are detailed in an academic paper published by Thierry Roncalli, Head of Research & Development at Lyxor and Professor of Finance at the Evry University, and Marlene Hassine, Head of ETF research, Lyxor
** Ref study published by Marlene Hassine, Head of ETF research Lyxor (Active funds vs. benchmark performance comparison)
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