The fourth quarter of 2018 was a torrid time for investors, as significant volatility saw falls across all asset classes.
Yet exchange traded funds (ETFs) continued to see inflows. Indeed, 2018 was the second-best year on record in terms of asset gathering, behind 2017. “Globally we have had 59 months of positive net inflows,” says Deborah Fuhr, managing partner of research firm ETFGI. “I can’t think of any other product that would be able to say that. In Europe, we have had 51 months. The ETF industry is now bigger than hedge funds.”
Falling markets brought total AuM in ETFs down from their record highs, but the rebound in early 2019 along with net inflows of $17.35bn in January, saw assets invested in the global ETF/ETP industry finished the month up 7.13 per cent, to reach $5.16tn.
This growth looks set to continue, believes Ms Fuhr. “The challenge with ETFs is to get someone to try them. Once they try, they tend to use them more, in larger sizes and in different ways.”
ETFs are well positioned not to capitalise on the two major disruptions facing the asset management industry, argues Mark Fitzgerald, head of ETF product management, Europe, at Vanguard, namely the rise of low cost investing and the changing nature of distribution in Europe. ETFs have become increasingly popular among investors because they offer a number of benefits, including low costs, broad diversification, transparency and liquidity, which ultimately leads to better outcomes for investors, he claims.
“At the same time, European investors are still mostly serviced through distribution models that limit the use of low cost investment solutions because they don’t pay to play. This is beginning to change as regulators and investors demand more transparency, which is likely to encourage even further adoption of low cost products.”
The last decade or so has given passive investment products a major tailwind, with QE-fuelled rising markets providing plenty of beta. Some now argue that the predicted dispersion between assets that we are likely to see going forward will provide a more fertile ground for active managers, many of whom have struggled to find alpha in recent years. But Mr Fitzgerald believes ETFs will continue to thrive in a tougher economic times.
“With returns forecast to be lower, costs become ever more important. For example, in an environment where fixed income may only be expecting 2-3 per cent returns, an investor paying fees of 1 per cent for a fixed income fund will be sacrificing a third of their potential returns.”
He also argues that ETFs make excellent building blocks for the kind of low cost, diversified portfolios used by long-term investors through market cycles, while the tradability and liquidity of ETF is extremely attractive for investors who wish to express a market view.
Boom time for bonds?
Fixed income continues to represent one of the fastest-growing segments of the ETF market. Flows into bond ETFs came to $131bn globally in 2018, reaching a total AuM of $878bn. Based on an annualised asset growth rate average of 20 per cent over the past five years, iShares projects that bond ETFs could surpass $1tn by 2020.
“Whilst Bond ETFs still comprise only a fraction of the total fixed income market, the fundamental drivers of this growth are likely to persist,” says Brett Pybus, head of Emea fixed income strategy at iShares.
“These include diminishing liquidity in traditional bond markets, the demand for lower cost investment products and the adoption of indexing in fixed income, particularly as investors focus on the role fixed income is playing in their overall portfolio.”
Short duration and high quality bonds attracted the most interest in 2018, he reports, as investors sought to offset equity risk, generate income and reduce interest rate exposure.
In Europe, while 56 per cent of assets in mutual funds are in fixed income, just 15 per cent of ETF assets are, says Bryon Lake, head of international ETFs at JP Morgan Asset Management, so the potential for further growth is considerable. He believes that the potential for active ETF solutions in this space is considerable. “People just don’t like the passive vehicles. They don’t like the way the indices are set up, where they overweight the biggest debtors. Active solutions will become a big deal.”
The traditional, passive funds tracking major indices, which tend to be run by the major players, continue to hold the most assets and attract the lion’s share of inflows. But one of the most talked about sectors of the ETF landscape, and an area which has seen considerable product innovation in recent years, are the so-called smart beta strategies, which use alternative index construction rules to traditional market-cap based indices.
“Smart beta never took off the way that people thought,” admits ETFGI’s Ms Fuhr. “There are really three strategies which have the majority of funds – dividends, where people aren’t buying because it is smart beta, rather because they want income – value and growth.”
Smart beta flows were muted in 2018, admits Claire Perryman, head of UK at SPDR ETFs, but as the greatest upside happens early in the turn of the economic cycle, she believes investors may choose 2019 as the time to look at these strategies.
“One example might be quality income investing as an alternative to broad based country indices,” suggests Ms Perryman. “Equally we expect ongoing political risk will weigh on European stocks and likely lead investors to adopt more defensive positioning in strategies that seek to mitigate market choppiness, like low volatility.”
There is certainly growing interest in smart beta products from sophisticated investors, says Mr Fitzgerald at Vanguard, but it is also important to remember that clients are not necessarily looking for pure performance from a factor product.
“While clients do sometimes use these kind of products to substitute for traditional active funds in a portfolio, they are also often employed to implement static tilts or for portfolio completion.”
Assets in active and smart beta products are certainly growing, but there remains a difficultly in accurately assigning and agreeing appropriate descriptions, he says.
As a result, smart beta figures may be overstated, warns Mr Fitzgerald, as they include many dividend and yield strategies which are market cap weighted, but just filtered for the appropriate stocks, and have been around since long before the term smart beta came into being.
Valuable tools
The evolution of the ETF vehicle has provided wealth mangers with a valuable addition to their investment toolkits.
“I don’t understand why there is this big discussion in the industry about why this has to be a binary choice between active and passive,” says Fahad Kamal, chief market strategist at Kleinwort Hambros. “When it makes sense to use an ETF, we’ll use one. When it makes sense to use an active fund, we’ll use that.”
Market-cap weighted ETFs are “very cheap” and provide perfect data exposure to a market, he says, and the Kleinwort approach is to use ETFs in markets where it is difficult to achieve alpha, for example in US or UK equities.
“On the other hand, in more esoteric asset classes where information is less reliable and readily available, we prefer to use active managers because we feel they are generally adding value to the obscurity within those markets,” explains Mr Kamal, giving the example of emerging market fixed income.
Although price is a key consideration when picking ETFs – he says the big names such as BlackRock, Vanguard, Fidelity and Lyxor provide “cheap, effective and cheerful” products – other factors, such as liquidity, are also important.
Smart beta, though, is not currently on the menu for Kleinwort, as the firm prefers active managers when trying to find alpha, as they provide strategies which are more “dynamic”.
“Smart beta strategies are relatively new and very much in vogue, but we tend not to use them,” he says. “It is very difficult to know what regimes various factors will do well in. Over the last five years, value has been poor, whereas growth has done well. But that wouldn’t have been apparent five years ago.”
The ever-increasing range of ETFs of offer is a great benefit to wealth managers, says David Storm, head of multi-asset portfolio strategy at RBC Wealth Management, explaining how the Canadian firm uses a variety of products across indices, sectors or specific factors, to help build portfolios across its client base.
“As different exposures become available in ETF format, they provide a greater range of tools to help us express views as part of a complete portfolio. Our use of ETFs continues to evolve and we are seeing more of a partnership model in how we work with providers.”
Smart beta is certainly part of RBC’s thinking. “The most simple live example is using a factor ETF to tilt portfolios more towards value at this stage of the market cycle,” he says.
The growing number of smart beta ETFs offer dynamic solutions to investors and are interesting alternatives to pure passive products, says Marc Lansonneur, head of managed solutions and investment governance at DBS Wealth Management, but are also more complex, and therefore require special expertise to evaluate them effectively.
“We are closely monitoring this evolution and building up our expertise. Whilst demand from our private clients remains moderate at this stage, we believe these ETFs are slated to take a bigger share of the passive market in time to come.”
Investors slow to commit to ESG
Environmental, social and governance (ESG) criteria have become a key consideration in the investment world, and the ETF industry has responded by launching a number of funds in the space. Yet inflows have been lacklustre.
“Anecdotally, our wealth management clients tell us that ESG approaches are increasingly important in retaining assets as money flows down to the millennial generation, for whom pure accumulation is not a sufficient pull to stay with a provider,” says Claire Perryman, head of UK at SPDR ETFs.
“We have seen a proliferation of ESG ETF product launches over recent years but so far, flows have not kept pace, although most practitioners agree that adoption is expected to filter through.”
ESG has seen a lot of product development, but there is still some apprehension from investors to actually commit to ethical investing, reports Adam Laird, head of ETF Strategy for Northern Europe at Lyxor.
Nevertheless, ESG ETFs in Europe gathered more assets than in any previous year, he says. “So, there is some indication that ETFs will become the preferred vehicle for ESG investing. There is pressure from both the product development side as well as from regulators, which means there will be demand for low cost ethical investments.”
VIEW FROM MORNINGSTAR: As smart beta matures, complexity rises
Strategic beta ETFs domiciled in Ireland or Luxembourg attracted almost €4bn ($4.5bn) in net flows in 2018, pushing total assets to more than €51bn. Strategic beta, otherwise known as smart beta, funds aim to improve the risk and return profile of market-cap weighted indices by tilting towards one or more factors, such as value, momentum and size.
The menu of strategic beta ETFs has been expanding rapidly over recent years. In 2018, 19 such products came to market, bringing the total domiciled in Ireland or Luxembourg to 244.
Most new launches were multi-factor ETFs, which attempt to capture two or more distinct factors. Academic research suggests individual factors tend to outperform the market over the long-term, but they can go through long spells of underperformance. By combining factors, multi-factor funds aim to smooth out the ride.
If implemented intelligently and cheaply, we have a positive view of multi-factor strategies. For example, we have awarded the low-cost UBS MSCI USA Select Factor Mix ETF, which targets US stocks that have higher-than-average exposure to six time-weathered factors, a Morningstar Analyst Rating of Bronze.
Despite the large number of multi-factor funds hitting the market, income-oriented single-factor strategies continue to dominate the list of the most popular strategic beta ETFs. These strategies pick high dividend-paying companies from indices such as the S&P 500 or the FTSE 100.
The best dividend funds not only screen for high dividend-paying companies but also assess the health of their balance sheets, using additional quality-related metrics.
We expect the trend towards increasingly complex products to continue. While this provides greater choice, strategies are now frequently built using opaque algorithms making them tricky to analyse.
Then there is the added issue that most strategic-beta funds do not have long live track records. As such, it will take many market cycles to assess whether they behave as expected.
As a rule, when assessing strategic beta products, simplicity is likely to trump complexity. The more opaque and overwrought the process, the more likely it is a product of back-testing alchemy and the more likely it may be tweaked should its live performance not live up to its back-tested track record —a record that never looks bad.
Kenneth Lamont, analyst, passive strategies, manager research, Morningstar
