PARIS ROUNDTABLE: Room for improvement

The growth of exchange-traded funds has been steady for the past three years. But according to our panel, new products are being launched with a closer eye on risk and perfomance components. Chaired by Nick Fitzpatrick.

Bernard Aybran, head of multi-manager/CIO, Invesco
Pedro Fernandes, European head of ETFs, NYSE Euronext
Matthieu Mouly, client relationship manager, Lyxor Asset Management
Fannie Wurtz, head of ETF client relationships Europe, Amundi ETF

Funds Europe: In which areas have you witnessed the strongest demand and how are client needs affecting exchange-traded fund (ETF) product development?

Fannie Wurtz, Amundi ETF: ETFs in Europe now have around €250 billion under management, though this is still only a little less than 3% of total mutual fund assets. However, the growth seen so far this year of 17% is in line with what we have seen over the past two years. Product launches and development have continued, with clients requiring specific fixed income and emerging markets equities.

A driver in fixed income has been corporate bonds. European government bonds markets can be divided by ratings now and performance has been quite differentiated. Clients are looking for yield, as well as specific detailed asset allocation tools.

Matthieu Mouly, Lyxor: In fixed income a few years ago, the focus was on yield curve products because most fixed income players applied the yield curve approach. But following pressure resulting from the European situation we have all tried to identify and launch new products with performance and risk components.

This started with proposals for products focusing on the peripheral European markets and we are now moving to a country-by-country approach. The number of product launches this year on a country-specific basis has been quite significant.

Pedro Fernandes, NYSE Euronext: That is exactly the trend we are seeing, though not only on the fixed income side; it is also on the equities side.

There is a demand for products that integrate and insulate risks of certain exposures, such as products on national debt markets and equity volatility profiles. Investors want to identify exactly where the risks are and with this greater visibility, they are able to focus more on what they want in their portfolios.

Bernard Aybran, Invesco: There is a slicing and dicing of the investable universe happening, as we have just heard. But there are two other trends I see.

First, there is the issue of physical replication ETFs versus synthetic. Then there is the competition between traditional mutual funds and ETFs, where an investor has a choice to invest in either a traditional fund or an ETF that is supposed to replicate it. This is a big development and what is interesting is how spreads will look between the performance of each type of fund.

Mouly: It seems everything related to fixed income is in strong demand, and then also the slicing and dicing of products in different ways, such as by government bonds versus corporates, or by emerging markets. Emerging markets have seen impressive inflows this year.

Wurtz: More recently, European investors have felt more confident in the markets  so flows came back into vanilla equity indices ETFs.

Year-to-date flows can be divided into two different themes. The first one was the search for yield with corporate bonds. There were also some flows, though less important, into government bonds but differentiated by rating.

The second one was a search for security or for less volatility, which has focused on  money market products and daily currency hedging equity products.

Mouly: Since the beginning of June, the trend towards European equities has been better. There had been huge redemptions in the second quarter. It started with a small increase in June and July but then, in the months since, inflows on the equity side have targeted the US and, more recently, China and all emerging markets.

It remains slow for the European equities, but for the first time in the past few weeks we have started to see a double-digit trade on European equities side.

Funds Europe: How well is the smart beta component of the ETF offering developing and what is driving it on the demand side?

Mouly: Smart beta has to be divided into categories because there are many different approaches to it and different ways to use it.

If you look at minimum variance (MinVar), the maximum Sharpe (MaxSharpe) ratio approach or the risk-equalisation indices we are developing at Lyxor, these are not the same product. There can be huge tracking errors of more than 10% between them.

Risk equalisation is much closer to matching the index with a tracking error limited to 3-4%.

Depending on the smart betas we use there will be totally different types of players looking at it. The MinVar or MaxSharpe are mainly used by first-time institutions who are trying to reduce drawdown.

Investment-grade has seen interest in the MinVar area as investors look to trade a part of an index in certain market conditions.

Many investors have not understood the difference between MinVar and MaxSharpe ratio in terms of one being tactical and another being strategic.

Aybran: Smart beta is a trend that began as a regular mutual fund strategy five to ten years ago and is now migrating slowly to the ETF space.

Most research and development has been done into equities. Therefore, in fixed income, the vast majority of the assets under management in ETFs are invested in what could be called ‘stupid beta’, meaning that the more in debt a country is, the bigger it is in a fixed income index.

To that extent, smart beta in fixed income is new and emerging and I am not sure there are more than five products in the fixed income area in that space. This means there is a lot of a­­rea for improvement and for major inflows when investors wake up to the fact that there is an issue with fixed income benchmarks. It could be useful to have a smart, investable fixed income index.

Funds Europe: Markets have been particularly volatile this year. Can investors use ETFs to manage this volatility? If so what products would they need to do this?

Wurtz: The ETF is a good tool to manage volatility because it offers the flexibility to trade at any given time with a known price. If you want to enter at 10:12am and exit at 4:14pm, then an ETF is an easy way to benefit from market volatility.

Fernandes: If I had been an asset manager when there were significant volatility swings, I would have been reassured to have invested in a listed product such as an ETF, primarily due to the ability to open and close exposures in a timely manner.

Mouly: The market has been particularly volatile, but long position volatility has not been exactly successful this year.

But what we have discovered in long volatility is that there is a real need for it on the investor side and that many people buying a long volatility product had never in the past traded volatility. But it will take some time for portfolio managers and other players to understand the details and how volatility works and how to trade it.

Funds Europe: A number of providers are changing their range of products to include more physical ETFs rather than synthetic ETFs. Is this a new market trend and does it represent a victory for physical replication?

Aybran: The impression I get is that there is a great divide between the continent and the UK over this issue. In the UK, derivatives are considered almost evil while on the continent it is just business as usual. On the continent we are used to derivatives within ETFs, but in the UK providers have to publish cautions and disclosures. They are not comfortable.

A second point is there is an issue with the regulator. Even if we are still allowed, as we were before, to invest in synthetic ETFs, we are getting more and more questions from clients about ETF selection and quality; how to look into them based on liquidity and the security of the derivatives. So yes, there may be a trend from investors towards physical replication, even if we providers are quite comfortable with synthetic replication. But we have to meet the clients’ needs.

Mouly: At Lyxor we are switching a part of our fixed income ETF to physical replication – those that invest in AAA-rated bonds. For some indices, such as emerging markets, the best option is synthetic.

We are getting out of the synthetic versus physical debate. Our clients should try to understand in detail what it is we are bringing with a particular index we cover. Our job is to offer the best index and the best that an index has to offer. This means all the optimisation you can deliver.

But optimisation will be different depending on the asset class. We all know that in European equities the optimisation will be based around dividends, while for US equities investment optimisation is around the dollar, for emerging markets it’s about tracking error.

Our job is to define the right solution to deliver this optimisation. For example, swaps can have the lowest tracking error and that make the case for emerging markets.

When there is no optimisation it’s not worth doing a swap or securities lending, so you can do a pure, long, simple physical application and this is why it makes sense to switch a AAA-rated portfolio to physical.

But in Europe, if you are investing in European equities, the picture is not as simple because of all the local tax laws.  We do not know the future for developed-world optimisation. In France, thanks to synthetic application, we do a better tax job for the French product and we are delivering an optimisation of 20 basis points.

But we should always ask ourselves if optimisation delivered by a swap or by securities lending is worth the complexity and the risk.

Wurtz: Both techniques have witnessed positive growth year to date, which actually acknowledges there is room for both.

This was reinforced by the European Securities and Markets Authority (Esma) guidelines published in July 2012.

At Amundi we continue to believe that synthetic replication offers lower tracking error and lower costs for investors.

An ETF is an index-tracking product so people want us to get the best replication methodology at the lowest price and through a Ucits compliant format.

Fernandes: It is important to have a level playing field across products, because derivatives are not only used by ETFs but also by the fund industry, like stock lending. Thus, ETFs should not be treated separately  from the wider funds industry.

Investor trust is another point. There must be transparency on practices used to improve investor confidence, as market participants should be made aware of all risks involved to better manage their exposure.

It is also worth noting that the use of derivatives by funds is limited by European directive to 10% of the assets.

Wurtz: The recent Esma review of Ucits funds, which included ETFs, was actually quite positive in the sense that it has increased ETF transparency. The ETF is now one of the most transparent vehicles in Europe. We publish the basket of our ETFs every day on our websites. On our equity and fixed income ETFs we have a target of zero counterparty risk.

Mouly: All of us are publishing information daily on our websites. Today, the ETF is probably the most transparent product in the industry and this is due to the huge debate we had in the past few years.

Funds Europe: Specialist providers have come to the market, especially in Asia. What can we read into this and how might competition develop in Europe?

Mouly: There are more providers in places like Asia because the ETF has proved that when you sell an index, people can buy it on day one because it’s an index. It is not the same for active funds. People will take a few months, even a year, first.

Fernandes: At the same time, like elsewhere in the market, Asia is changing in terms of transparency. Chinese asset managers who launch ETFs will now have to abide by Ucits rules like every other market participant, if they wish to promote their ETF products in Europe. Thus they will have to be as transparent as European issuers.

The biggest year-to-date growth in ETFs by region is in Asia and there is interest from investors to get access to those products.

Funds Europe: What future developments do you see ahead for the ETF market?

Wurtz: It will continue to grow and to develop as it has been doing. We will continue to innovate to serve our investors’ demands and once again there will be room for new products and for development as long as it serves demand and for asset allocation. When it comes to innovation, our strong belief at Amundi is that ETFs should remain passive, simple, transparent, and liquid.

We do not explore any niche products or exposures that could lower the efficiency and core principles of an ETF.

Fernandes: I anticipate greater access for investors, which will be an incremental process, as more  distribution networks open up to ETFs in Europe. In the US it is very easy to distribute ETFs to all types of investors. In Europe the process is different, but there are new regulations coming in as well as investors and distributors changing their behaviours. Also, despite the increased transparency on how products are built, there is a significant lack of transparency on how products are traded.  Nevertheless,  I do see the ETF market growing for both institutional and retail investors in Europe.

Aybran: Probably we should expect changes going forward on both the supply and the demand side. On the supply side – including providers, fund managers and banks – we will see changes in regulation, and consolidation is still to come.

On the demand side, from the discussions with investors, institutions in particular, we have the impression that pension funds are becoming more familiar with ETFs whereas they previously were very much biased toward index funds.

I would say this is mainly in the main institutional markets on the continent: Germany, the Netherlands and France.

Mouly: As for consolidation, I agree there is probably some room for this in the industry because there has been a huge development in the number of players, yet if you look at the assets under management and profit margins, it shows there is still some room for it.

©2012 funds europe



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