ETFs have been hugely popular and this has led to much innovation and creation. Experts discuss industry developments past and future. (part 2)
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: As an investment tool, are ETFs likely to be considered as a low-cost investment alternative to indexed funds? I’m aware that this depends on who the investor is.
Fernandes: ETFs have certain things that non-ETF index funds don’t, which are flexibility and accessibility. Those two things can be key in very tough market conditions. For example, during the high volatility seen after 2007, the flexibility to come in and out of an ETF in realtime was something highly valuable. That was key for investors to understand that if volatility is high, if an investor’s investment horizon is short, maybe it is better to go to an ETF, due to its flexibility.
Aybran: The answer to your question depends on who is investing, in what and for how long. If you’re a huge investor with very long-term investment, I don’t see the point of investing in ETF. If you’re not that big of an investor or not in for the long haul, then maybe you’d be better off with an ETF. ETFs and index funds are two different investment ‘Market makers play a very important role by contributing to price discovery’ tools for two kinds of investors, or two different investment horizons.
Tohme Adet: It depends if you are talking about the distribution. For a distributor and for retail investors, an ETF is a very good deal compared to a regular mutual fund. Were retail investors to invest in a mutual fund they would fall into the share class that is designed for distributors, which is much higher than the institutional share class. For the institutional investor, I’m not sure that for the core portfolio, ETFs would be the best deal because the index fund will have an institutional share class that would be of a smaller margin. But it depends which asset class we are talking about. Some asset classes are not delivered through index funds and in those cases you have to compare the ETF to the future. Then you need to see how many times you will roll your future. And in this case, if you stay long in the future allocation, then the ETF is better because you are not constantly rolling that future.
Sometimes the institutional investor doesn’t have the choice between ETFs or index funds. If we’re talking about a portfolio that cannot invest in any derivative products, then the investor would go for the ETF, even if it’s more expensive than the future because it’s a Ucits III vehicle.
Due to the volatility we’ve been seeing, for the core portfolio, investors were very keen on having ETFs because they allow them to instantly see what the risk is in their portfolio. You mentioned Asia earlier. In Asia, they do not like investing on an unknown Nav, which they’re only going to see the next day at midday. With ETFs they can get out when they want because they can see the level of the Nav.
Lorenzini: Regarding the price of ETFs, the TER is not the only thing to consider. You should take into account the global cost of ownership, which includes the TER, the bidask spread and the tracking error. You have to consider all these things together because as Danièle was saying, in some passive funds you have institutional share classes, which can be very cheap.
Tohme Adet: Another thing to consider when we compare an index fund to an ETF, is that there is a little bit more transparency with an ETF at the level of transaction cost. When you are dealing with an index fund, the transaction costs are dealt with at the level of the execution desk of the asset manager. We have an execution desk that will always hold an auction, in line with MiFID, but at the level of the ETF, you can monitor that transaction cost because it’s very transparent at the level of the market maker. When the market maker gives you a spread he is effectively telling you, ‘If I need to buy all the stocks that are in your ETF on the index the ETF is based on, this will be my cost, and the spread will be this. Do you accept or not?’ Maybe the investor will say, ‘I’ve put in a bid for this but I don’t want
to go for this offer’, and so the investor would go for the Nav of the day plus a fee that is very transparent. With an index fund, the ransaction cost will affect the performance of that index fund and you are not able to monitor it.
Fernandes: Because ETFs generally have several authorised participants, who compete for price, investors are given good execution conditions.
Aybran: Listening to Danièle, it seems as though the casualty of the ‘ETF versus index fund’ war will be the futures contracts. For many asset classes, futures are no longer competitive.
Fernandes: I think you’re right. But you know, on the main index, the future is still the leading product, although you’re starting to see that when it comes to sectors, there is more AuM than the open interest in the futures.
Tohme Adet: That’s very interesting because three or four years ago, if you wanted to launch an ETF and there was no future on that index, the market maker would tell you, ‘I don’t know how I’m going to hedge against it’. But today there has been a lot of development into correlation and such products. I remember once we had even the future on the Cac40 was suspended while the ETFs on the same index were still trading, at least ours were. This is because the market makers took the correlation with the Dax, which was still trading, and herefore, they took the risk of quoting the ETF on the Cac40 versus its relationship to the Dax because they knew that the suspension would not be for more than an hour or two. At the end of the day, they have to deliver shares of Cac40, which they knew they would have had because the futures would open back again. Today you have many emerging markets that are quoted in Europe thanks to those correlation metrics that all those engineers in the market-making centres are developing. Therefore, with these constructs, you are going beyond the futures liquidity.
Fernandes: Something very important to note is that we are turning ETFs into a 24-hour market. Emerging market ETFs are traded almost 24 hours; they trade in Europe starting at nine o’clock, then they start in the US at three and in Asia at eleven, one hour after the US market closes. It’s a 24-hour market.
Tohme Adet: The spreads will be affected, of course. But if you trade an Asian ETF when its morning in Europe, it will be the afternoon of Asia and it’s still more liquid than your day. ETFs give investors a very good opportunity to get a price on Asian stocks during the day. So if you think that it’s worthwhile getting out now rather than tomorrow morning, which is during the next day in Asia, then it could be cheaper for you. So from this perspective, ETFs are more valuable.
Fernandes: The idea that spreads re larger when the underlying market is closed is true for European ETFs but it’s becoming less true for US ETFs based on non-US underlyings as those underlyings get more popular with investors. So the ETF market is transforming the underlying market into a 24-hour one with a very tight spread.
Tohme Adet: We have the ETF S&P GSCI that is trading in the morning when the future is closed. The future opens at three o’clock European time, which is around eight o’clock in Chicago. Therefore it gives you the possibility of taking advantage of that liquidity much before the future opens. Therefore, you’re going beyond the liquidity of the future itself, thanks to the liquidity of the components.
Fernandes: There are other things to note on how the liquidity is built. For example, you can add more liquidity on the Cac ETF than on the future because you can build the liquidity of the Cac ETF with your stocks because they are correlated. The market maker price then brings together the two underlyings because they are correlated. And these are all benefits of ETFs, due to the tremendous liquidity that they have. In fact, the most traded security in the world is an ETF right now.
Tohme Adet: So the ETF has become the reference. It’s the same with the AuM [assets under management]. If you look at the ETF on gold, it’s got more AuM than the Central Bank of Switzerland’s gold reserves, which is supposed to be the reference for gold.
Funds Europe: What do you consider the greatest area of growth within the ETF market?
Paquier: In terms of exposure, we are witnessing some level of change in plain vanilla ETFs and regular exposures. So although for European investors, European exposures are still interesting, emerging markets are even more so, both in equity and fixed income asset classes. We have seen this developing tremendously over the past year, especially on the fixed income side. Investors now have the possibility to gain both long and short exposures to fixed income markets. We noticed that investors are becoming very selective when choosing their ETF; they know what to look for in terms of exposure for their asset allocation, they know they need justification of the tracking error and the spread. And we aim to provide them with quality products. Investors are also now aware of listings. I think the listing venue of ETFs has a significant psychological effect on investors. They don’t necessarily always trade on exchange, but they know that if the product is listed in their country they can trade it easily in terms of execution and delivery and settlement.
Fernandes: And they know hat it’s registered with the regulator
Tohme Adet: Ucits IV is going to make things a bit simpler and will hopefully open more doors for different countries in Europe to access ETFs. We have the language barrier, which is also an obvious burden for marketing tools, etc.
But whatever the development in asset classes, and we still have some asset classes that could be developed, this growth is very much related to how efficient market makers can be in market making these asset classes. I agree that we still have some areas of pure underlyings to develop, and whatever we would develop in Europe is always going to go very pure, but I think we are going one step beyond. For instance, we used to have the emerging markets as a global allocation, but today it’s getting more and more specific. So we will see some development there. We’ll also see further development in the fixed income space and even in the alternatives area. We need to see if we can find some routes for management of alternatives management that are not only dependent on the indices, which are not considered to be transparent enough and have the hurdles of the lock up periods etc. We might see some developments that are the result of legal constraints, like Solvency II. It’s a new world for the development of new tools that will fit into Solvency II. I think we are going to see less of these discretionary strategies that are developed in two indices because they are less transparent.
Fernandes: There was a small thematic launch in recent years but not with great success. The thematic ETF exposures could gain some traction in the future to allow investors to capitalise on certain investment opportunities.
Lorenzini: Fixed income is where we see the major potential of growth for ETFs because there is some more work to do in terms of the offer and the slicing of the asset class. Commodities are a potential area of growth as well. The demand for commodities is huge and investors consider commodities as a good way to diversify portfolios.
Regarding equity ETFs, we think this phenomenon of slicing will continue. We will have much more smaller and smaller country ETFs. We will see further slicing in terms of ‘Fixed income is where we see the major potential of growth for ETFs’ sectors and sub-sectors, which brings with it some dangers. In the US you’ve got some, not exotic, but useless ETFs; for example there was an ETF on a biotech index made just of six stocks. The provider not only created an ETF on this index but it also created an ETF replicating an index of biotech companies with early research for oncology. Those products lasted less than one year because there was no market within that. So we will still see some creativity in the stock ETFs, but the more serious things will be happening in fixed income and commodities.
Fernandes: I would not be too worried about what you said about the biotech index. It is part of the innovation process; products are launched and some do not work, they are delisted and closed. Then new products will come. It’s part of the innovation process and it’s something that is normal.
Aybran: I can expect we are going to have more and more slicing and dicing of the subsectors and the things like having an index with just two stocks. We have been seeing this happen for years and most of these are left to die slowly after a few years.
The areas of growth for ETFs are going to be largely the same areas of growth for mutual funds, so fixed income and emerging markets. But what could be useful for investors, and I’m not sure how big this is at the moment, are the ways of doing things that cannot be done easily through mutual funds. For instance shorting or leveraging; I have the feeling it’s not that popular at the moment for many good and bad reasons, but the further growth around this could be helpful for some types of investors.
Fernandes: You have already some leveraged and short products, but they provide daily performance. Another thing that is much more developed in the US is the borrowing and lending ETF market. This allows investors to get a short position for the time of their investment. The issue is that a lot of ETFs are referenced as mutual funds in the custodian’s accounts and because they’re referenced as mutual funds, they cannot be lent. That is one of the biggest problems, it’s because if they’re referenced as equity they could be lent. That is one of the key elements that would have to change.
Aybran: These kind of small, seemingly insignificant, things will be key going forward. You have plenty of things like this within information and IT systems, that don’t make that much sense but that do exist and that are really hard to bypass. So there is the need for growth to get over such silly things.
Fernandes: But the client demand for the short products already exists, with some daily short products being among the most traded ETFs.
Tohme Adet: Yes they do trade a lot and people have understood how useful they can be on a trading basis. I think it’s because of that daily readjustment. You need to readjust your data on a daily basis and that could be totally feasible for investors or asset managers, but not for distribution. And nobody’s going to adjust his data on a weekly basis.
Funds Europe: What is the greatest area of growth in terms of demand?
Fernandes: Even in Europe where the market is becoming more mature, there are some countries where the use of ETFs is still very low, like Poland and Spain.
Tohme Adet: Earlier we talked about the level of investment of institutional investors in ETFs, so the potential is really huge. I think there will very soon be some wrappers in the distribution networks of most of European countries that will include ETF investments. We have o find a solution of to motivate and incentivise the distributors. In three or four years’ time, the distribution landscape for ETFs will not be the same.
Funds Europe: How close is the European ETF market to saturation? Although there is potential is for growth in certain areas, is it close to saturation when it comes to vanilla products?
Fernandes: Just to put this into a context of figures; the AuM of European ETFs represent only 3% of the €210bn in assets under management.
Tohme Adet: Let’s consider possible saturation at the level of issuers. In Europe we have three main issuers that have something like 70% of the market. The other 30% is therefore divided between many providers and despite this, you still have newcomers to the European ETF market. Linked with what Pedro said, this means there is room within the market. Also, with a little bit of help from Frédéric and Morningstar we can make things more transparent and then people will be in a better position to choose which ETF is managed the best, which is the most efficient or transparent. If we combine these aspects of the market we can comfortably say it’s not yet at saturation. I heard there are 32 Euro Stoxx 50 ETFs in the market. The customer will wonder why there are so many and conclude that it’s because each one is different. They trade differently, but they also are different in their management and performance.
Lorenzini: Yes, there is definitely room for growth because the cake is getting bigger and more providers want to get a slice of that cake. Some segments are overcrowded, you mentioned the Euro Stoxx 50, but there are still many segments to explore. The European ETF market today is one-fifth of the US market. So there is a large avenue in front of the investors as well for the providers.
Fernandes: It’s also important to promote and educate. The more issuers we have in the market, the more experts there will be who will provide promotion and education. It’s a joint effort; you have more people working together to increase the use of these products.
Funds Europe: Does that overcrowding in some portions of the market cause any issues at all?
Paquier: I think it’s a very good thing actually. As this draws prices down, it drives competition to the maximum level possible and, in the end benefits the end-users.
Tohme Adet: Yes, it stimulates competition and so you will get better results. You can’t have a monopoly.
Fernandes: Competition also drives creation and you need to create to grow the market.
Aybran: If you had the same question a couple of years ago, maybe we would have answered, ‘Yes, the market is saturated’. In the meantime, you’ve had many new entrants to the ETF market and quite successful ones in some cases. You’ve also had many new products, 99% of which are dead and a couple of which were hits. So you never know, but there definitely are still big pockets of potential growth.
Funds Europe: Have product demands or requests changed and if so how have they changed?
Lorenzini: Recently I attended a trade show for individual investors and we organised training on how to improve your portfolio and how to use ETFs. I was really surprised at the number of questions I got from individual investors. It seems that now, in France they really understand that they can benefit from ETFs.
Fernandes: It’s completely true. I speak at a lot of conferences around France and three years ago the main question was, ‘What is anETF? Explain’. And now they ask things like, ‘I don’t understand how the performance of an ETF compares to the index’. So the level of questions being asked has become much more sophisticated.
Tohme Adet: And you have to understand that they have come a very long way. For instance in France, before getting to talk about the ETF, you need the index education which is already a very big step ahead. Problems arise when they ask us why we haven’t launched an ETF on an index we didn’t even know existed, most often something that has about three stocks on it. They would want an ETF on that, because they want to trade it in a more flexible way.
But we have very good and very specific demands from the asset managers themselves. We must not forget that asset managers are the big users of ETFs in Europe. Wherever they see a need for development means that this area is going to be something that is going to become important within the portfolios from a diversification perspective. When we want to develop something, we talk to different asset managers and we try to see whether they have an appetite in this type of vehicle. This way of doing things always leads us to good things. If you are counting on retail investors, they will ask you for the moon to be wrapped into ETF.
Paquier: You are right Danièle, that happens to us as well. When looking at a new product idea, or collecting feedback from institutional investors or asset managers, we systematically make sure that the planned ETF will comply with the Ucits III benefits in order to maintain the primary characteristics of ETFs, which are simplicity and transparency. As soon as you start to tackle esoteric exposures that are on the borderline of Ucits III compliance you’re in danger of complicating the product. We strongly believe that there is still room for innovation and product development without necessarily falling into too exotic structures.
Tohme Adet: But the asset managers will always request something very pure, as opposed to the retail clients. Another consideration on top of Ucits compliance is quoting by market makers. If you cannot have the ETF quoted by the market maker then you need to avoid having that product as an ETF because you would be lying to the customer as it’s not really liquid.
Aybran: The demand will always change over time, depending on different themes that are in the air at particular moments. You’ll have some providers that are more advanced compared to others. So, for example, the investment banks with ETF factories send their research on a macro view going forward and then say, ‘By the way we’ve got an ETF tracking that theme’. They helped create new ideas of investments and they issue the solution at the same time. But talking about how demands or requests have changed over the last year, I don’t think that two years ago we had any RFPs [request for proposals] on ETFs, and now we do. So the next step is for institutions to say, ‘Yes, okay, I do use ETFs’. They haven’t started doing that yet, there are no numbers available on this but at least they’re asking us for explanations about the ETFs we are manageing.
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