Once considered a threat to active managers, more and more ETF launches today are in active wrappers, our panel hears. We also find that promoters have difficulties with identifying their end ETF investors.
Participants:
- Caroline Baron, Head of ETF distribution, Emea, Franklin Templeton
- Gilles Dubos, Senior expert, ETFs, Caceis
- Manooj Mistry, Chief operating officer, HANetf
- Tony O’Brien, Chief commercial officer, US Bank
- Robert Rushe, Global product head for ETF servicing, HSBC
The closing stages of 2023 saw the prediction that global ETFs would exceed $11.5 trillion of assets under management by the end of the year after the industry experienced its second highest inflows on record, according to ETFGI data.
Liquidity, transparency, tremendous promotional activity and an increasingly granular exposures have powered the growth of ETF assets for a decade. But ETFs benefit also from the wide perception that active managers predominantly underperform benchmarks, at least once fees are extracted. Many investors, it seems, have resorted to accepting an index return for part of their portfolio – but only as long as they get it cheaply through an index-tracking ETF. ETFs, therefore, have proved to be one of the biggest challenges to active fund management houses.
But a twist in the story has emerged: active ETFs. Led by some US providers that have launched ETF businesses in Europe consisting only of active ETF products, the bank Brown Brothers Harriman last year predicted that the funds industry will see assets in the ETF sector reach $30 trillion in the next ten years, helped partly by greater inflows to active ETFs and also by traditional asset managers entering the market.
“An active ETF can have many flavours and is essentially a wrapper that’s put round a portfolio manager, who picks stocks or bonds on a completely discretionary basis,” says Caroline Baron, Emea head of ETF distribution at Franklin Templeton. “It’s active management in an ETF wrapper.”
Baron was speaking at a Funds Europe ETF roundtable and Franklin Templeton is one of the US-based asset managers promoting a suite of active ETFs in Europe, having launched its ETF business here in 2017.
Tony O’Brien, the Dublin-based chief commercial officer at US Bank, has considerable experience with the firm’s US clients. Pointing out that many financial trends in the US later manifest in Europe (the ETF itself being a case in point) he says: “Every Monday morning I get a list of ETFs that we are going to launch with our clients in the US and Europe over the next six to eight months, and nowadays they are almost always active products. All of the clients I’m talking to want to launch actively managed products in Europe.”
“An active ETF can have many flavours and is essentially a wrapper that’s put round a portfolio manager, who picks stocks or bonds on a completely discretionary basis”
He adds: “Most active ETFs have the transparency of passive ETFs, and so the idea among our cohort of clients seems to be that, unlike with traditional active mutual funds, there is no ‘secret sauce’ to protect. Instead, it’s more about providing granularity of exposures using an actively managed and curated basket of stocks that represents a particular sector or subsector.”
Gilles Dubos, senior expert in the ETF division of asset servicer Caceis, said that although active ETFs are nascent in Europe, even in the US they still have their best days ahead.
“The US has marketed active ETFs for longer than in Europe – but active ETFs are still only about 6% of the overall number of ETFs available there. Despite this, they were capturing some 30% of the inflows towards the end of 2023, while mutual funds were suffering outflows.”
Dubos pointed out that providers in Europe now marketing active ETFs included JP Morgan Asset Management, Axa Investment Managers and Robeco.
“The US has marketed active ETFs for longer than in Europe – but active ETFs are still only about 6% of the overall number of ETFs available there. Despite this, they were capturing some 30% of the inflows”
Franklin Templeton’s Baron said that for fund managers with active strategies, it would be the “cherry on the cake” to boast that an existing active strategy would now also be offered as an active ETF, with the inherent transparency, liquidity, low fees and accessibility of these products.
“Fixed income crowd”
With active ETFs forming a landmark in the evolution of exchange-traded products, Baron points out that bonds were important to their development.
“A big part of the appeal of active ETFs has been from the fixed income community. Whereas passive ETFs started life with equities, active ETFs originated in fixed income because investors were not satisfied with market cap-weighted bond indices that expose them to the more indebted nations and companies when they invest passively.”
She emphasised that active managers who already have successful track records would more likely be those to find success in the active ETF market.
Manooj Mistry, chief operating officer at HANetf, a platform that provides ETFs for asset managers to ‘white-label’ with their own brands, echoed this. “The ETF is just a wrapper and is a conduit to deliver an investment strategy. In the US, the tax advantage has driven a lot of mutual fund conversions to ETFs and although we don’t have that advantage in Europe, we are seeing a lot of interest in launching active ETFs and ETF share classes within mutual funds. This indicates that, although we might not see conversions of mutual funds like in the US, we could see active managers launch active ETFs in order to survive.
“But if they don’t have a good track record already, they will need the patience to build it.”
The active ETF will “not be an instant, overnight success for fund managers”, he said. But active managers may see these products either as a defensive or growth strategy for their businesses. Ultimately, the ETF wrapper could give active investors a new lease of life.”
“we are seeing a lot of interest in launching active ETFs and ETF share classes within mutual funds. This indicates that, although we might not see conversions of mutual funds like in the US, we could see active managers launch active ETFs in order to survive.”
Robert Rushe, global product head for ETF servicing at HSBC, said active managers had previously “buried their heads in the sand” around the perceived ETF threat, using the transparency requirements of an ETF as the rationale for not having to take any action.
However, he said a “different momentum” had begun, which could see more active managers create ETF share classes within existing mutual funds, if not launch pure ETF products.
“Many active managers now see the ETF wrapper as the potential digital distribution channel it represents rather than a threat. And so, offering listed, ETF share classes for an existing active mutual fund is a logical next step. This enables an active manager to maintain their product scale and performance history, while getting access to the ETF ecosystem.”
Who’s in my ETF?
Ironically, for a product glorified for providing transparency to investors, ETFs can be remarkably opaque for promoters who want to identify who those investors are.
Our panel discussed the rise of ETFs among retail investors, where in Germany, for example, ETFs have been adopted widely by individuals within their investment accounts.
“Many active managers now see the ETF wrapper as the potential digital distribution channel it represents rather than a threat.”
But it is difficult for ETF promoters to know who among their clients is a retail customer or who is an institutional investor. Knowing the difference is important. An institutional investor could be a key client to the ETF promoter, perhaps holding wider mutual funds or even segregated mandates with the firm.
Also, the scarcity of this information makes it hard to confirm a widely held belief about institutional ETF ownership, which is that UK pensions funds rarely own ETFs, unlike some of their counterparts in Europe.
HSBC’s Rushe said: “There’s a question we have to ask ourselves: Who is buying European ETFs? Because for all of the ETF transparency, due to the fact they are issued and held in the same way as equities, ETFs do not provide any transparency to the underlying investor when compared to mutual funds. It’s very difficult to know.”
Whereas mutual funds enable the fund manager to “see all the way down to the end investor”, Rushe explained that there can be many layers of contractual arrangements and no direct link between the ETF promoter and the actual end ETF investor. ETF issuers can spend significant sums and time surveying market participants, such as market makers and fund platforms, on gathering this information.
“Although the transfer agent can see that ETF shares are issued into the international central securities depositary (ICSD), that’s where visibility into the ownership chain ends for the fund. Without actually going out and talking to market makers, multilateral trading facilities, brokers and even directly with pension funds, it’s difficult to know whether they are using your ETFs in their portfolios.”
US Bank’s O’Brien agreed, adding: “For US issuers in Europe, this presents an enormous challenge just to figure out how well their distributors and sales people are doing. How do you reward your sales people if you can’t see whether your prospective clients have bought the fund or not?”
HANetf’s Mistry said usage of ETFs by pension funds varied from country to country. Where ETFs were less popular, pension funds would argue they did not need ETF liquidity for index exposure because pension schemes tend to be long-term investors and could benefit from tax treatments of mutual fund vehicles, such as CCFs.
“But where pension funds do use ETFs is when it comes to accessing markets or certain strategies that are not easily available – such as gold and emerging markets,” said Mistry.
With specific reference to the UK, he added: “Markets like the UK are very much dominated by consultants and trustees who basically have an aversion to change, whereas in continental Europe, a lot of pension funds have their own distinct decision making and will consider a variety of products.
“How do you reward your sales people if you can’t see whether your prospective clients have bought the fund or not?”
“However, I would say that take-up of ETFs by pension funds in Europe has not been great. Although we have seen pockets of activity, it has been about accessing asset classes or markets that they can’t get easily.”
However, Rushe argued that pension funds that selected conventional mutual funds for index exposure do miss out on benefits related to ETF liquidity, even if they did not need the liquidity itself.
“One of the areas that ETFs offer a real benefit to any investor is in terms of their liquidity – but I don’t just mean the ability to trade them intraday. I am also referring to the impact that liquidity can have on the execution price and how this can deliver additional value to investors.”
The benefit, he pointed out, is in bid-offer spreads, which as well as giving price information to an investor also signal a fund’s liquidity. Tighter spreads indicate greater liquidity.
“For example, looking at data across various European exchanges, you can observe emerging market ETFs, on venues with significant liquidity, that can trade with a bid/offer spread of only 1 or 2 basis points. This is very cost-effective when compared with similar mutual funds.
“Spreads can be very low if you know where to trade, and a consolidated tape would be able to show us just how liquid ETFs really are. It would demonstrate how ETFs can deliver value though liquidity, enabling an investor to get in or out of a fund not only quickly, but at potentially a fraction of the cost of a traditional mutual fund.”
But back to the issue that ETF promoters can face around lack of client visibility. Franklin Templeton’s Baron acknowledged this problem. Although she said the firm did have a “fairly good picture” of ETF clients, she added there were times when visibility was not clear.
On the broader point of ETF popularity among pension funds, she said “100% of clients around us” use them. Use cases range from transition management, where ETFs are favoured over “mean-hungry” derivatives; to liability-driven investment strategies, where fully funded pension schemes use ETFs and enjoy the absence of margin calls (in contrast, again, with derivatives). And to liquidity management, where ETFs are used to create a layer of liquidity around less-liquid assets.
Sustainable investing
But beyond tactical use cases like these, the panel discussed whether ESG investing is forming a greater strategic portion of portfolios that focus on sustainability.
Recent Funds Europe research in partnership with Caceis found that a high proportion of the 250 asset owners and other investment professionals surveyed said ETFs can be useful tools for helping to implement their sustainability strategies.
Caceis’s Dubos said that regulation had driven the pension fund market into adopting greater levels of ESG investment and that the Task Force on Climate-related Financial Disclosures – or “TCFD” – was the latest driver. He argued that against the current regulatory backdrop, ETFs were seen as a cost-effective way for investors to achieve sustainability outcomes.
Mistry said a driver for ETF usage within sustainable investing was, again, the granularity of exposures – or thematic investing, which extends to ‘green’ themes.
“Over the past 20 years, ETFs have led the way in terms of granularity, coming in more refined flavours, such as single-country indices or sectors. Similarly, there are traditional benchmarks, and then sustainability versions of the same benchmark.”
ETFs have grown significantly off the back of thematic investment trends, with products positioned to gain from the energy transition and certain social themes. But there is also “thematics within thematics”, said Mistry. “As well as ETFs positioned on the broad clean energy universe, there are ETFs specifically for solar or hydrogen energy. Again, it’s about granularity. The ETF market has been very good at tapping into demand for granular exposures, where a single stock links via an index to a specific theme.”
HANetf offers a uranium miners ETF. Being Article 6 under the EU’s sustainable investment classification system, the ETF is “not ESG, but investors see that uranium is part of the energy transition and recognise this plays a part in ESG portfolios”.
HSBC’s Rushe pointed out that an ETF’s strength within sustainable investing is transparency, owing to a strict set of rules or criteria for a stock’s index inclusion, in contrast to an active fund “where you have to keep up with, and monitor, what fund managers are doing”.
But he also emphasised transparency for stock lending, where ETFs lend stocks – typically to short sellers like hedge funds – for extra revenue and to offset the running costs of a fund.
“From an ESG perspective, should an investor only consider the fund’s holdings or also the collateral being pledged if the holdings are on loan? More clarity, I think, is needed in this space.”
Individual investors
The complexities of securities lending may be beyond the average retail investor’s knowledge. Regardless of take-up from Europe’s pension funds, the ETF – like the classic mutual funds – was an innovation from the US designed partly to open up stock and bond investments to the public.
ETFs are forecast to be held within 32 million savings plans in Europe by 2028, versus 7.6 million now.
Franklin Templeton’s Baron said the market is still predominantly dominated by institutions and wholesale discretionary plans. Retail clients are still a very small portion but are growing quite substantially, she said, with most growth coming from Germany due to reforms there that have aligned the ETF more with retail investors. Robo advisers and platforms have played an important role, too. Elsewhere in Europe, some platforms cannot accommodate for ETFs because of the fact they trade intraday.
Mistry added that some markets like the UK have in past faced compliance problems with their ETF platforms, which made low-cost ETFs expensive to support.
Dubos, of Caceis, said the ETF market benefitted from Covid lockdowns, when people saved money and began to explore investment platforms. Education, he said, was starting to pay off.
For O’Brien, at US Bank, he again looks to the US for how the market may support retail investors – including via platforms.
“It’s a case of designing strategies that are more attractive to a self-directed investing public, like in the US, and we will probably see the design of ETFs change subtly. For example, fractional shares could make ETFs in Europe more amenable to platforms because, although fundamentally an ETF is a Ucits fund, and although Ucits funds have certain rules, they also have certain flexibilities, including that a basket of shares can be broken into smaller baskets at the design stage and sometimes when the product is already up and running.
“There are things that ETFs can do that make it quite easy for ETFs to become more amenable to platforms.”
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