ETFs promising to become investors’ vehicle of choice

Exchange traded funds (ETFs) are now such a mainstream investment tool that it is easy to forget that they are still equal to only 1.5 per cent of assets under management in mutual funds in Europe, and 4.5 per cent of those in the US. But inflows into ETFs continued to grow even during the worst phase of the crisis, with particularly big inflows into fixed interest and commodities, where their liquidity was highly prized. Many wealth managers have conducted studies of their clients’ attitudes this year which largely concluded that while investors understood that the first half of the year would be a good time to re-enter the markets, they were nervous and looking for transparency, flexibility and simplicity – the very qualities that take an investor to an ETF. Emerging markets Investors flocked into cash last year but as appetite for risk returned, emerging markets were the first risk asset class to be added with strong inflows into Brazil, China and India. Here ETFs came into their own, as trading shares directly on local emerging market exchanges is often complicated by the need for foreign entity ID, while their futures markets are relatively illiquid. That trend has started to slow with flows switching back to developed markets in anticipation of a rebound. European sector funds have also attracted strong inflows in recent months as investors used them tactically to long/short sectors on the back of adviser commentary, with particular focus on utilities and telecoms. “We’ve seen more and more interest from the wealth management space over the last 12 months,” says Manooj Mistry, head of db x-trackers UK. “Managers are looking at ways of making themselves more competitive or different and ETFs provide the building blocks they need. A number are looking at ETFs as a way of reducing costs and offering clients access to new markets, for example by putting 20-30 per cent of portfolios into passive and using the rest to go for value added strategies,” he explains. “ETFs are a good way to cut costs, particularly standard funds covering developed markets such as the FTSE, Eurostoxx or Japanese market,” adds Mr Mistry. Lower fees ETFs will also be a major beneficiary of the Retail Distribution Review in the UK, which will eliminate product bias stemming from commission payments. In the emerging markets and alternative investment spaces, investors will probably remain prepared to pay for active management but ETFs could well become the vehicle of choice for most asset classes, as the average charge of less than 0.4 per cent will still be half of an active manager’s fee, even after the commission element is stripped out. “There is a realisation that finally the game is changing, the rules are being rewritten, and that the Financial Services Authority is in the vanguard of rewriting those rules,” says Farley Thomas, global head of wholesale at HSBC global asset management. “The abolition of commission in the UK will trigger a rethink of how wealth managers build portfolios, and many are anticipating this and changing the way they charge clients. It will change the way wealth managers look at active products because in one to two years active funds will be priced net of that portion of the annual management fee normally paid by the fund manager to the distributor or wealth manager. Will they continue to actively focus on managed products even where they don’t receive commission?” The consultation period for the review has just finished and the current rules are likely to be phased out by 2011. Mr Thomas points out that in India commission was abolished this year within two months of a similar consultation. Like Y2K and Mifid, there is a need to plan well in advance of implementation. “Today’s default setting is active management but in future the default setting will be indexation and advisers will need to justify it if they do anything different,” adds Mr Thomas. “It’s a potential seismic shift. Active managers will have to really demonstrate their skill, but as more of the world’s wealth is put in ETFs and similar products the dynamics of the market will shift and there will be greater opportunities for active managers.” As the industry matures, greater distinction will be made between providers and funds. A wealth manager in Europe is faced with an overwhelming choice of 30,000 collective funds, compared for example with 8-10,000 in the US. This means they must find reasons to avoid mutual funds because they need to filter out so many quickly. Currently there are probably no more than five to ten ETF choices for each index but as this market grows wealth managers will quickly become judgmental about firms they do and do not want to conduct business with, with a lot riding on the brand and strength of the provider. As funds proliferate, there will be a business case for service providers to rank and rate ETFs and several advisers are already reporting demand for this service. Price is not the only issue – if it were, the highest priced FTSE 100 fund would not be the largest. Strength and sustainability of providers is critical because investors have seen firms they thought they could trust go under. The overwhelming focus on counterparty risk this year has led to a preference for funds based on physical assets, particularly amongst smaller wealth management firms. It is worth remembering, however, that even where products are swap-based, these are Ucits and as such the un-collateralised derivatives exposure is limited to 5-10 per cent of assets. There can also be an issue of handling client expectations because low costs are expected, but the cost of some ETFs such as emerging markets is generally higher. Liquidity is not a given, either – some funds trade in only tens of thousands each day. An emerging market infrastructure fund for example might have such thin volumes that advising clients into such a fund would be hard. “ETFs are not as vanilla as many people believe,” says Gavin Rankin, head of investment consulting and business development at UBS Wealth Management. “There is a diversity of providers, and lots of ETFs where you might think you’re getting the market, but in reality tracking error can be quite large.” He cites as an example the FTSE All-Share which over a 10-year period has exhibited tracking error of 1.7 per cent on an annualised basis, owing to difficulty in capturing movements in the small caps. There is no simple answer to how best to replicate the index with arguments supporting both the synthetic and physical methodologies. Each case will depend on how well the provider can execute the strategy. In some cases, such as the All-Share, the preferred model can be a hybrid structure. ETFs are often used by firms that lack the ability to conduct their own research in certain asset classes because they lack the resources to research that marketplace. Funds of ETFs and all-ETF models have been springing up as the range of funds available becomes wide enough to build a complete portfolio. “We get a lot of calls about this and to talk about how other firms are managing it,” says Dee Brown, senior business development officer at iShares. “For instance, there are 12-16 fixed income products for investors looking at this asset class. Take inflation – if you have an opinion you can express it. Bond ETF ex-financials have been popular because clients have exposure to the financial sector elsewhere.” The db x-tracker hedge fund ETF has struck a chord with the private wealth community because it is a solution to the issue of hedge fund liquidity, gating and pricing transparency. The fund tracks 40 different real managers, including names such as Paulson & Co and Blue Crest, and five core hedge fund strategies, for a fee of 90 basis points. Investors are also looking to currency ETFs for other sources of non-correlated performance.

ETFs’ cost-effectiveness attracting wealth managers The European ETF market, which is worth over $200bn, is growing at an astonishing rate of 30-40 per cent per year, and a significant driver in that has been increased adoption by wealth managers. ETFs are used for both the core and satellites in core/satellite strategies. A common strategy is to hold a chunk in MSCI World as a low-cost core and to deploy risk money to under and over-weight different regions around it. “ETFs can now be used to replicate almost all asset classes,” points out Christian Nolting, lead strategist and head of portfolio management at Deutsche Bank Private Wealth Management, Asia Pacific. “A good active manager should give some value by outperforming in all markets but in reality, no one manager could outperform every year,” he says. “There is no systematic method to do that. “The issue of cost has come to the fore, and ETFs are the most cost-effective solution for building an asset allocation, so we always go for an ETF where applicable,” adds Mr Nolting. “We also think that they are very important for private investors considering dynamic asset allocation at this time. “As the market matures, there is greater understanding about the construction of ETFs. Investors have become experienced and are now differentiating between ETFs and examining which have higher volatility or tracking error,” he explains. Further convergence of the indexed and active industries is expected, and major players are preparing for this. For example, BlackRock bought Barclays Global Investors, and Fidelity, Pimco, Charles Schwab and Russell have all launched ETFs, and momentum is still growing. The model also lends itself well to further innovations. But there are still die-hards who believe that certain active managers can repeatedly beat the market. David Alexander, founder of Mayfair-based Alexander Associates, points out that a global portfolio can be built using just five ETFs covering the UK, US, Europe, Japan and Asia. However, he says there is a chasm between reality and perceptions. “The perception is that these funds can be traded in real time, and that they are cheaper, but that may not be the case, for example, if broker commission is paid,” he says. While he has seen a marked increase in his clients using ETFs in their Self-Invested Pension Plans, Mr Alexander is convinced clients still look primarily to active funds, and ETFs still make up only a small part of the firm’s portfolios.