With the rise of robo-advice and trend towards passive investing, our panel of experts sees a bright future for the ETF market, way beyond its US birthplace. But are we in a mania phase? Is there a liquidity risk? And will ETF products keep up with investors’ demands?
Philip Philippides (head of Amundi ETF, indexing and smart beta sales for UK and Ireland, Amundi)
Lynn Hutchinson (passive research analyst, Charles Stanley)
James Waterworth (vice-president, UK and Ireland institutional ETF sales, Lyxor)
Hortense Bioy (director of passive fund research, Europe, Morningstar)
Funds Europe: ETFs have found an important foothold among investment providers targeting the retail public with low-cost portfolios constructed by robo-advice. How significant is this opportunity for ETF providers, and will providers satisfy the investment needs of individuals?
Lynn Hutchinson, Charles Stanley: I see the expansion of the robo-advice service as a tremendous opportunity.
A recent report said there was around $20 billion in assets under management in the sector and within five years it’s expected to grow to over $255 billion, so there’s a real offering there for small investors who don’t necessarily want to use a financial adviser.
Philip Philippides, Amundi: ETFs have proven themselves to be very cost-effective building blocks for institutional and advisory investment strategies. They provide the right tools for retail investors as well. Although the European ETF industry is currently more geared towards institutional and advisory businesses, robo-advice is facilitating an evolution.
James Waterworth, Lyxor: It is an exciting time for robo-advice and generally for discretionary wealth management. This is due to the perfect storm of new technology and the RDR [Retail Distribution Review]. RDR has created a subset of clients that have, perhaps, fallen off the radars of the larger houses.
I expect the burden will fall on the robo-advisor to ensure that the products and offerings they choose for clients are fit for purpose.
Hortense Bioy, Morningstar: Robo-advice is a great opportunity for everyone in the industry, even for advisers. It means they could spend more time on complex situations and building personal relationships with clients by, say, offering reassurance about market volatility.
Hutchinson: Yes, in the same way advisers use platforms for model portfolios now. However, in terms of what sort of ETF products would fit this robo-advice retail market, I think it would be limited to long-only traditional, as the robo-adviser would perhaps not want to take responsibility for putting leveraged ETF vehicles in these portfolios.
Philippides: The challenges of robo-advice also include smart beta. The portfolio construction models/tools available right now are based on asset class, country and, maybe, sector-based allocations. Smart beta ETFs look at exposures to factors, alternative weighting schemes or both, and this is something that would be hard to factor in. As technology increases, however, we could see these coming into play later.
Funds Europe: ETF assets have reached about $3 trillion and are on a par with hedge fund levels of assets under management. Is this entirely a good thing, or is this a mania that might end in tears?
Bioy: ETFs still represent a small portion of the overall mutual fund industry. In Europe it’s about 4-5%; in the US, it’s about 10-15%.
The European ETF market is still very much dominated by institutional investors. Retail investors have not really embraced the product yet, especially in continental Europe. Many investors are still unaware of the advantages of ETFs – low costs, transparency, flexibility, breadth of choice, etc. So, in fact, this means there is still much more room for growth.
That said, not everyone needs an ETF in their portfolio and that is something we say a lot to investors. They can do exactly the same thing by buying a traditional index fund if they just want to buy and hold, although they might appreciate the intra-day trading feature of ETFs if markets go wrong and they really need to get out.
Philippides: With regards to UK institutional use, the UK pension fund market has idiosyncrasies. Firstly, it is consultant-led and consultants have not really focused on ETFs, and typically believe them to be a more expensive option versus index funds. In continental Europe and in the US however, many pension funds use ETFs as they find them cost-effective. The problem has also been one of fee transparency/disclosure.
In the past, I spoke to many pension fund managers that couldn’t tell me, specifically, how much they were paying for their index exposure in a traditional index fund; it was hard to do a like-for-like comparison and so index funds tended to appear cheaper than ETFs as they only quoted annual management fees as opposed to TER.
ETF prices, on the other hand, have also come down in price while, at the same time, disclosure in index funds has increased. Comparison is now easier and fees have become more aligned.
There is a misconception of cost within the pension industry in the UK about ETFs, though a lot of pension funds do have holdings in ETFs through their asset managers.
Waterworth: There is indeed a distinction between consultant-led pension funds and those who run their own money. Those who run their own money, generally, have primarily used strategic asset allocation and have pricing power to negotiate index fund fees, while those who tactically allocate, or cannot find a specific index tracker, certainly do use ETFs where index choice is more readily available.
It’s also worth noting that, as well as the explicit costs, there are other considerations such as tax. For example, UK pension funds can buy US-domiciled ETFs, given that they are tax-exempt clients, whereas that’s
not something that is readily available to UK retail clients.
Hutchinson: I agree that in the past, traditional index investors tended to look at the annual management charge rather than the ongoing cost, which doesn’t factor in the administration cost. Some ETFs are cheaper than index trackers, such as the physically replicating FTSE 100 and the S&P 500 ETFs. They are available at 7 basis points now, whereas until recently, you couldn’t get an index tracker that tracked those markets for that cost. There are some swap-based S&P 500 ETFs that have a TER of 5 basis points.
Philippides: On the issue of whether there is a mania, remember that an ETF is not a strategy like a hedge fund. ETFs are ready-to-use investment bricks, valued on an intra-day as well as an end-of-day basis and bought and sold on an exchange, as opposed to index funds that are valued only once a day and are mainly bought and sold through platforms and direct subscription with the issuers.
The US is the largest ETF market and there is significant adoption by both institutions and retail investors. Even under an assumption that the US penetration has peaked – which is not the likely case – that still leaves a huge growth potential for ETFs in Europe and Asia just to get to the US levels of user penetration. In reality, US ETF assets continue to grow, so by all counts we are still in a growth scenario.
Waterworth: I agree, but we are talking about the classical ETF, which is to say a transparent and liquid vehicle.
But the next evolution, which we’ve seen in the US already, is the active ETF and these ETFs will supply active strategies without displaying their holdings, which would go against the principal of transparency that classical ETFs have stood for.
For some active houses, active ETFs could be seen as a silver bullet in terms of a distribution strategy and raising more assets – but the active manager needs to take a step back and ask if the ETF actually adds any value, or if it is best to keep their portfolio in the mutual fund format.
Funds Europe: Liquidity risk in the corporate bond market has become a prevalent factor. How concerned about this should fixed income ETF investors be? And what measures do providers have to contend with a liquidity crunch?
Hutchinson: Fixed income ETFs can create further liquidity because they are traded on the secondary market. Most of this secondary market trading doesn’t require redemption or creation of securities and, therefore, the ETFs do not affect the actual bond market.
Philippides: I think it depends on the product. If it’s a small product, you’ll need creation and redemption; if it’s a bigger one, then you will find the on-exchange liquidity.
Bioy: People, and regulators in particular, are concerned about what would happen in a worst-case scenario if everybody wanted to get out at the same time. But if that were to happen, liquidity issues wouldn’t just affect ETFs, but everybody invested in corporate bonds.
Corporate bond ETFs still represent a very small portion of the overall corporate bond market, so when people talk about liquidity issues in fixed income ETFs, they have to be careful not to exaggerate.
The reason people talk about liquidity and fixed income ETFs is that, by virtue of trading on exchange, ETFs have brought a level of visibility to fixed income trading, which is traditionally OTC [over-the-counter].
Philippides: Generally speaking, the vehicle that you use to invest in fixed income is not going to add any liquidity or subtract any. So if the market becomes illiquid underneath, it would be the same whether you had bought that basket of bonds yourself, or if you had bought it in a packaged format like an ETF.
I take the point that there is a perceived additional liquidity in an ETF, because you can actually trade something on exchange without accessing the underlying market. You could say there is some added liquidity because it’s easier to trade. But we have to remember that the product was designed to give you what the underlying market is giving.
Waterworth: An ETF is liquid, it’s exchange-traded, supported by a network of market makers and authorised participants.
In other products, you may be gated and you may not have price transparency. I’m not saying that an ETF is a magic wrapper; your ETF will only provide you, in a worst-case scenario, with the liquidity of the underlying, and if the underlying is having a credit crunch, then that will impact the underlying product.
There’s also a transparency element. Fixed income is opaque and traded OTC. To get prices, some index providers survey brokers, others use traded prices. So when you have a time of distress, you might see a discount on the ETF versus the benchmark, meaning the benchmark may actually not provide a realistic price to get out at. A benefit of ETFs is that they can act as a price discovery vehicle.
Hutchinson: I cannot see why everybody would want to sell their bond ETFs at the same time, even if there was an interest rate rise. If you’ve got a balanced portfolio, you have to have some bonds in there, so if you’re holding them long term, there’s no need to sell them all straight away. We certainly would not.
Bioy: Also, if all of a sudden the market goes crazy and everyone wants to sell out, authorised participants could use cash redemption and sell the securities at a later stage. This would avoid everyone selling at the same time.
Funds Europe: Do ETFs linked to market-cap indices offer enough tools for investors to navigate the current phase of market uncertainty that has been created by, for example, China and the expectation of rate increases? Are smart beta ETFs absolutely necessary in this context?
Hutchinson: I feel there are generally enough market-cap indices available to investors, but I also think smart beta products are a good tool to have in your portfolio.
In terms of interest rate rises, dividend ETFs may not be so good and may take a hit, but the minimum-volatility ETFs could work well in your portfolio. Holding sector ETFs for diversification could be good. Banks, for example, could do quite well with interest rate rises.
Smart beta, or alternative beta, whichever way you want to call it, are a good allocation in a portfolio, I feel. But we need more offerings, which may come this year and next.
Bioy: There is a perception, perhaps, that smart beta is the smart way of investing nowadays, but they’re definitely not foolproof. They won’t save you from a market downturn or a big sell-off. Some smart beta ETFs might cushion the fall a little bit, but if you buy and sell these products at the wrong time, you could get hit just as hard.
I looked at the performance of a few US minimum-volatility ETFs in August. And it turns out that on a weekly, bi-weekly and monthly basis, some underperformed the S&P 500. Most strategic beta ETFs work best over the long term, especially those that have a value tilt.
I agree that the breadth of choice in market-cap is pretty good, though there are still gaps in the market, notably in fixed income.
Waterworth: The question I’m commonly asked when I’m talking about smart beta is: what is it at the expense of? What does it replace in my portfolio?
Perhaps it comes back down to asset allocation and if an asset manager has the ability to conduct asset allocation with smart beta strategies.
We are doing a lot of education of investors about smart beta at the moment. If you have a low-volatility product, or a minimum-variance product, you would expect it to underperform in a fast-rising market; that’s not saying it’s not fit for purpose, that’s doing exactly what it’s supposed to do, but the investor needs to be aware of that.
I think also there’s the added complication that, like with any ETF, that some strategies are more suited for strategic asset allocation, while others are more tactical. For a strategic allocation, I would position something like a quality income strategy. It’s quite defensive, you’re relying on the compounding of dividends over many years, and you’re investing in robust companies. In a fast-rising market, they would underperform; but over the years there is the compounding effect. Whereas something like a momentum factor generally outperforms in a fast-rising market.
Hutchinson: We don’t currently use sector ETFs. We have a number of discretionary portfolios and six model portfolios that are on platforms which range from defensive to aggressive, so depending on what our asset allocation is within each of these, we allocate to mainly countries, some smart beta products, property and sometimes alternatives.
Philippides: There are currently enough ETF market-cap tools to dissect markets, such as investing ex-China for example, to exclude an area or a sector, but as strategies become more sophisticated, there continues to be product evolution and smart beta can play an important role within portfolios.
For example, if an investor exposed in US credit anticipates US interest rates to go up, he might want FRN (floating-rate notes). Floating rate notes aim to insulate portfolios from interest rate moves.
As the coupon changes in line with interest rates, these products have a low degree of price sensitivity to interest rates and a yield which moves in line with interest rates.We launched a
euro and dollar FRN products, with great success towards European investors.
If you want to invest in smart beta strategies yourself, you’ve at your disposal many single factors to choose from such as min-vol, size, yield etc and you can tactically allocate. But in single factors, your time horizon is based on the market regime you’re trying to take advantage of. You will need to decide when to put a position on and when to sell it.
Now, however, we are seeing smart beta ETFs offering in a single product a multi-factor allocation. So in the robo-adviser context, it may be an option to allocate to smart beta products that package the factor allocation within the ETF.
Funds Europe: In which asset classes is ETF demand most out of balance with supply? Are the reasons for this imbalance more to do with a lack of product or the scale of funds being too small for large allocations?
Bioy: The growth in fixed-income ETF hasn’t been as high as in equity. There have been a lot of impediments because most fixed income indices traditionally used by investors were used to provide an idea of market performance. They were not meant to be investable. They are very hard to replicate because of illiquid bonds and pricing issues.
But providers are working on filling the gaps. There’s huge potential there in that area.
In smart beta, which we call strategic beta at Morningstar, there is also an opportunity to provide investors with better fixed income tools.
Hutchinson: I agree, yes. I think there’s a lack of product in those sorts of ETFs. I would also highlight the need for more currency-hedged bond ETFs.
Philippides: If a market, or certain pockets within it, is illiquid or difficult to trade, like fixed income, then ETFs have been good at trying to give easy and liquid solutions.
A lot of people are also trying to find ways to do smart beta fixed income with the rationale that market-cap weighting leans too much to the largest debtors. There is research going on around ratings and how it might be possible to filter out for downgrades. This would make fixed income investing more liquid and stable.
Ultimately, as issuers, we need to make sure that an index works in an ETF format and that it is sustainable.
Bioy: It is more difficult to capture factors in the fixed-income universe than in equity space and I would expect a great deal of research and index development in this field.
Waterworth: Fixed income actually lends itself more to the ETF wrapper than equities. Fixed income is not transparent and it is traditionally traded over the counter. Trading fixed income ETFs on screen would be an advantage. But fixed income in ETFs is more nuanced in terms of its portfolio management. You can’t always access all of the bonds in an index, which calls for ‘sampling’. From a provider perspective, you need to hire the right people with fixed income expertise. An equity ETF provider cannot easily just go ahead and launch fixed income products, but most ETF providers have now built out the infrastructure that’s needed.
Hutchinson: We would like to see more currency-hedged products, but I don’t think there is much call for this among providers because if people’s views change on currency, then products could see their AUM fall to a tiny amount.
But from our side, currency-hedged would be very applicable to something like, say, Indian bonds.
Philippides: As issuers, we see many and varied requests from investors over time and we constantly evaluate them in terms of being viable options for launching new, liquid and sustainable products.
Over the last years, as Lynn suggests, currency hedging demand and product availability is expanding. People are demanding it because of higher foreign exchange volatility.
Hutchinson: For our direct clients, we can hedge currencies ourselves. But there is nothing we can do on currency hedging on the platform model portfolios. Thankfully, more providers are bringing out currency-hedged products, though. In Japan and Europe, we are hedged on the currency, but for Asia, say, you just can’t get any currency-hedged products. I understand there is a cost involved. Currency hedging all of those currencies is extremely expensive, but it leaves us having to suffer the movements.
I have spoken to a new provider who was talking about bringing an India bond ETF – although not currency-hedged – to market and a physically backed equity Indian ETF. The physical replication equity ETF is of interest.
Bioy: In terms of further product development, I would expect more ETFs focused on ESG [environmental, social and governance] and SRI [socially responsible investment] criteria. These issues are finding their way back to the top of investors’ agendas.
Hutchinson: Yes, I agree – the full range.
Philippides: Amundi has been working with index provider MSCI and two major European pension funds to launch the MSCI Low-Carbon Leaders strategy indices in September 2014. The MSCI Low Carbon Leaders’ index methodology aims to achieve at least a 50% reduction in the level of carbon emissions (present emissions and reserves representing potential future emissions) compared to the parent indexes, while minimising the tracking error relative to them. Each strategy index will, however, retain a sectorial and geographical composition similar to its parent index. On the basis of these indices, we’ve created index funds and ETFs to allow all types of investors to access low-carbon intensity strategies, via listed and unlisted funds.
The rationale is that polluting companies might be penalised by regulators and investors one day, given the impact carbon intensity may have on their valuation. Rather than disinvesting and purely excluding polluting companies, we opt for a ‘best in class’ approach to bring a virtuous circle in financial markets.
Waterworth: I think there’s similarity between smart beta and ESG/SRI strategies at the due diligence phase. But what might be good for one pension fund won’t be good for another. Some will accept an exposure to tobacco, others won’t. Similarly for smart beta, some people want quality stocks, others do not. There is no silver bullet, either in smart beta or in ESG funds.
Hutchinson: I have looked at all the social responsibility products. There’s no call for them in our portfolios at the moment, but there may be going forward, depending on the type of client, like a charity portfolio. I think we’d have to put it under some sort of ‘alternative’ weighting, and then maybe reclassify our valuation.
Funds Europe: Alternative investing is becoming more and more mainstream. Is ETF product keeping up in areas such as property and hedge funds?
Hutchinson: I perceive demand for property. UK REIT property, which we have an allocation to, is one of the top performing ETFs in our portfolios this year.
A provider brought a recent UK REIT property smart beta product, though we have not used it yet. I think more providers could bring out UK property ETFs. They tend to focus more on global property, which basically means more than half of its weighting to US property, which we’re not in at the moment.
In terms of hedge funds, I don’t really see the call for it at all in an ETF wrapper within client portfolios.
Bioy: A few hedge fund ETFs have closed in the past few years. They’re not that popular, and there are probably several reasons for that, such as cost, opacity and complexity.
Waterworth: What alternative assets bring is de-correlation. By their nature, ETFs need to track liquid and investable indices, and to be transparent. So in the case of something like direct property, it’s very difficult to have an ETF on that. Theoretically, there’s no liquidity for an ETF format. So you either need to create a proxy, or you can offer REITS. But REITS have an equity characteristic, making it only property in name.
Hutchinson: We are not in direct property products but the UK REIT ETF that we hold is 40 basis points, which is lot cheaper than direct property funds and over the year has performed extremely well. The cost of going into direct property funds can be very expensive: in some cases there is an entry charge of around 5% of your initial investment on top of the total ongoing cost each year.
Waterworth: Popular strategies, potentially, could be mimicked, but it’d have to be replicated by an index. For investors who typically look at hedge fund-like returns, they would probably speak to hedge fund managers as well and would perhaps like that relationship where someone is ultimately responsible for the strategy.
Funds Europe: What can we expect to see over the next year in ETFs?
Philippides: ETF adoption will continue. The market is growing and I think we will continue to see innovation and more extremely cost-competitive products for investors.
Waterworth: Growth will be twofold. Passive instruments will continue to grow, so too will the number of new investors coming to the ETF market and finding specific product design for them. In terms of innovation, it will likely be about fixed income and smart beta. In smart beta, a growing area is multi-factor investing that is outcome-orientated and strategic.
Bioy: I think we will see more US providers – perhaps traditional active fund providers – coming to the European ETF market. Active ETFs are the future that never comes – but who knows, maybe next year we will see more of them!
Hutchinson: Again, I’d like to see more bond ETFs offering smart, alternative beta, but I’d like also to see the costs kept low. At the moment, costs are about 50 basis points. To me that’s quite expensive for a bond ETF, because they’re tracking an index and using sampling. But if providers keep costs low, we would use these.
There also needs to be cost reductions particularly in the alternative space. Some of the India products are expensive, perhaps with a 75-85 TER, but because of their synthetic replication, the swap-spread can be another 1% or more, so you’re looking at a difference in performance tracking of around 1.9% in a year. I think that’s quite a lot for an ETF.
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