Exchange-traded funds: The shape of ETFs to come

Since the global financial crisis, the ETF industry has doubled in size to more than $7 trillion. So, where is the sector’s future growth most likely to come from?

Along with innovation opportunities, prospects for growth in the global exchange-traded fund (ETF) industry were top of the agenda at the Bloomberg Invest summit held in London last month.

A high-level panel on The Shape of the ETF Industry heard that, according to a recent estimate from the ratings agency Moody’s, index funds are set to overtake actively managed mutual funds by 2021 in terms of assets under management in the US.

Fannie Wurtz, head of ETF, indexing and smart beta at Amundi, said that a combination of consistently low bond yields and a high-pressure regulatory environment in Europe on the back of MiFID II’s implementation was putting pressure on the overall funds industry to find yield.

“If we exclude macroeconomic and regulatory factors, there is a growing demand from distributors and from end clients to find cheap, comprehensive, risk-efficient and cost-efficient products, and an ETF is a good solution towards that,” she told the conference.

“There are also new ways of distributing financial products – such as platforms, which are expanding very well in the UK – as well as a new generation of consumer financial habits.”

The summit also heard from Wei Li, BlackRock’s head of Emea investment strategy for ETF and index investments, who said that the penetration rate for ETFs versus the size of the underlying market is just 4% for global equities and less than 1% globally for fixed income

“So yes, ETFs have come a long way in the case of Europe, helped by regulation and by investors’ demand for cost-efficient products,” she said.

“The growth of indexing strategies, ETFs in particular, has been in double-digit territory for the last five years or so and we expect this to continue for many years to come as the penetration rate is still so low and the need for indexing ETFs as part of portfolios is significant.”

First principles
Asked what it would take for the penetration rate to rise, Rory Tobin, head of SPDR ETFs at State Street Global Advisors, said that “going back to first principles”, the success of ETFs until now had been largely because of their liquidity and transparency proposition.

“On top of that, you have got a very significant value-for-money proposition whereby ETFs, by and large in all jurisdictions, are a low-cost proposition versus some of the alternatives. ETFs have been pretty robust in terms of the value proposition offer, not just for intermediary or retail investors but also for institutional investors, and we see that continuing.

“What ETFs have done as they have grown is that they have raised the bar, so the active manager that was benchmark-hugging and not delivering alpha while charging a full fee is under threat and that is probably appropriate.”

ETFs are now, said Tobin, being used as “beta-building blocks” for a wide variety of portfolio management and asset allocation strategies. “On top of that, you have got active allocation positioning ETFs towards delivering outcome-orientated and wealth investors, for high-net-worth individuals, for institutions and for various other entities – and that growth is going to continue.”

Asked whether Amundi was seeing similar areas of growth, Wurtz replied that a decade ago, the ETF industry in Europe had been used tactically by some fund-of-funds managers to access specific markets.

“By comparison, if you look at the European industry now, ETFs are being used by sovereign investors, funds of funds, corporate pensions, retail investors and distributors,” she said. “The big question that we have nowadays is, whether with our institutional clients or distribution partners or networks, how we help them navigate through a challenging environment. What is the best investment vehicle to access the returns that need to be delivered?”

Li noted that an internal study recently conducted by BlackRock analysed the performance drivers of all fund managers monitored by Morningstar in an attempt to understand to what extent drivers came from single stock or single bond selection and “to what extent it is coming from market or factor exposure”.

“What is really clear is that the alpha strategy of the past may well be the indexing ETF strategy of the future and the best case in point is factor investing,” she added. “There is no such thing as passive investing in its entirety, in that all investment decisions are active decisions and oftentimes some of that involves actively deciding which index to use in your portfolio.”

According to Li, investors are increasingly adopting a “portfolio approach”, not so much selecting particular products but “actually thinking about how products are building blocks that are part of a portfolio”.

“With better data and computing power, we are able to help our clients see which parts of their portfolio can be indexed and which parts are truly alpha-generating.”

Li is convinced that if the US experience is anything to go by, this approach will ultimately lead to greater index adoption.

New uses
Next, the panel discussed new uses for ETFs. Tobin said that as the quantum of assets in individual funds has grown in recent years, investors have grown increasingly confident in the ETF as an investment vehicle.

“If you go back ten to 15 years ago, when it came to asset allocation, your choices for core beta building blocks were limited. You either had a basket trade or you tried to do an asset allocation strategy with future overlays and so forth,” he said.

“But now you have large liquid instruments in the ETF space which can be used by a whole variety of different investors, from large institutional investors right down to small portfolios from mass affluent investors.

“As a result, we are seeing some significant migrations and changes, whereby those building blocks are now being used for a whole variety of different investment management purposes, building portfolios to meet retirement saving objectives, college fees and so forth.”

Tobin’s view is that the online brokerage model is migrating towards a wealth advisory business model with overlays, in which ETFs are used as a significant component of building-block strategies.

Asked how much demand for intraday liquidity has contributed to the growth of the industry, Wurtz said ETFs offer a “tremendous wrapper” but “at the end of the day, it is just a wrapper that enables you to access some indices” and the question of ETFs’ liquidity “comes back to the liquidity of the underlying indices”.

“If the underlying liquidity of the underlying index is not liquid, whatever the wrapper you use, you will have a liquidity issue,” she said. “If you invest in an illiquid market when it is fairly balanced, maybe the ETF can create some extra liquidity, but when everyone wants to sell off, then you come down to underlying market liquidity.

“We need to avoid having a debate about whether an ETF is a liquid or illiquid product; about whether there is a bubble or not a bubble. Whenever you pick up an ETF, look at the underlying markets and at the indices, because that is a representation of the liquidity.”

A poll of conference delegates found that 35% believed that portfolio building blocks make up the area of ETFs that will see the most growth over the next decade. This was above 30% for smart beta, 20% for thematic and 15% for fixed income.

Fixed income
Tobin said it was interesting that Europe, at 27%, had a higher percentage of assets in fixed income ETFs than the US, where the figure is 20%. “Europe is actually ahead in terms of fixed income adoption, albeit in a smaller market,” he added.

Li said she was surprised that at 15%, fixed income was the lowest-scoring category of the audience poll. “When I look at the flows that we are seeing and the market share within fixed income, it is definitely the fastest-growing vanilla asset class exposure within the ETF space, but a lot of innovation still needs to happen to make bond managers and bond buyers comfortable with fixed income ETFs,” she said.

Bond investors are often used to holding fixed income instruments that pay a coupon. The principal is then paid off at the end of the duration of the bond. “Because of that, we are looking into innovations that structure an ETF in a similar way to a bond that gives you the coupon and the principal.

“A lot of innovation still needs to happen for everyone to be comfortable about the fixed income piece.”

Li added that recently, she had been shocked to learn that there are 70 times more indices than stocks in the world. “When you think of the number of stock-pickers visiting client organisations, why are there not just as many, if not more, index-pickers visiting client organisations?

“We want to help our clients select the outcome-appropriate index based on their investment objectives and mandate.”

Li said BlackRock receives many client queries that sound like the sort of queries an active portfolio manager would expect to field: questions, for example, about whether to invest in value stocks or the automotive sector.

Asked whether clients are confused by the sheer variety of ETFs and indices currently on offer, Wurtz said that there had been a proliferation of indices in recent years. “But at the end of the day, there is not one single answer to everyone’s needs, so it is a question of understanding your clients’ needs, what they want to achieve and making sure we wrap it into a good format.

“As an ETF provider, we have a responsibility and duty to make sure that whatever we issue will be liquid enough and that we make sure that the indices that we select are compliant with the benchmark regulation.”

Tobin agreed, saying that there was an increasing risk of “index proliferation and index spaghetti”.

He added: “I think we have an obligation to help educate investors to understand which index they should use for which purpose and at what point in time and what the outcome of that index is going to be.”

At the summit – From left: moderator Dani Burger, Amundi’s Fannie Wurtz, BlackRock’s Wei Li and State Street’s Rory Tobin

©2019 funds europe

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