Exchange traded funds had gotten used to month after month of uninterrupted inflows, but when the coronavirus pandemic hit markets in March of this year even these products were not immune from changes in sentiment. The European ETF market saw net outflows of €21.9bn ($24.6bn) that month, according to Morningstar.
The rout did not last long though. Although many commentators had predicted ETFs would struggle to perform in difficult markets, investors thought otherwise, and inflows soon returned. Assets invested in the global ETF/ETP [exchange traded products] industry increased by 4.7 per cent in May, to reach $6.1tn, with net inflows of $48bn, according to ETFGI. This brings year-to-date net inflows to $225.41bn which is significantly higher than the $140.54bn gathered at the same point last year.
“The ETF market saw quite big outflows in March, at the height of the volatility, but the months leading up to and since then have been positive,” says Chris Mellor, head of equity and commodity ETF product management at Invesco. “Total net inflows have been pretty impressive considering the state of markets.”
Safe haven assets saw the lion’s share of inflows during the most turbulent period, he reports, with gold ETCs [exchange traded commodities] seeing positive inflows in each of the first five months of the year. ETCs have made investing in gold much easier, he explains, as investors no longer need to buy physical coins or bars, with the associated transport, insurance and storage costs on top, or to enter the futures market. Rather these ETCs are backed by gold bars stored in bank vaults and the products are designed to track the gold price minus a fee.
Government bond products, in particular US Treasuries, also took in assets when investors were de-risking their portfolios. Within equities, the technology sector proved particularly popular. More recently though, there is some evidence that investors are starting to increase risk, says Mr Mellor, either because they are gaining confidence in the possibility of an economic recovery, or because they are looking for what they consider good value, buying back into equities, high yield and other areas that had been beaten down.
Questions had been raised about the liquidity of ETFs long before anyone had heard of coronavirus, but the volatility caused by the pandemic has certainly provided a stern test for ETFs and, indeed, markets in general.
Fixed income ETFs came under the closest scrutiny, as some of the underlying bond markets in which they invest can be quite illiquid, says Mr Mellor. “During the most volatile weeks spreads widened, as would be natural, even to the point that some ETFs appeared to be trading at big discounts to their net asset value (NAV). However, it was very difficult to know with any certainty what the ‘true’ NAV was, because many individual bonds are not traded every day, many may not even be quoted, and trades are not always reported.”
In spite of this, fixed income ETFs continued to trade, even when liquidity in the underlying markets dried up, with ETFs continuing to be the “price discovery” mechanism for markets in difficult times.
Passed the test
ETFs have passed yet another test, believes Joe Parkin, head of banks and digital wealth UK at BlackRock, whose iShares brand dominates the European ETF market. “They have absolutely performed as people would expect them to. They have acted as price transparency vehicles in the fixed income market and allowed people to move around their portfolios in a very quick and nimble way.”
Private banks have been “heavy” users of both equity and fixed income ETFs for a while, he reports, though he does see some evolution in the way they are being used, for example to carry out tactical asset allocation changes, using them as “liquidity sleeves” on top of their active managers.
Mr Parkin also reports that where investors typically held government bond ETFs, a lot more are now using high yield or emerging market debt products. He also reports growing demand for thematic and environmental, social, and governance (ESG) products, as well as a surge in the use of DIY investment and robo-adviser platforms, whose portfolios are often built largely around ETFs.
Wealth managers have commented that the primary properties of ETFs, namely transparency, liquidity, access and diversification, have served them well in their portfolios, claims Claire Perryman, UK head of SPDR ETFs.
Furthermore, new uses have emerged. “We’ve seen many wealth managers who hadn’t previously used sector ETFs start to invest in themes such as healthcare and technology.”
In the fixed income market, she points to clients who wanted to take advantage of the “follow the Fed” trade finding that ETFs provided them with an efficient vehicle to build a diversified portfolio of bonds, including in small unit sizes.
With the hunt for a Covid-19 vaccine, the reopening of economies, geopolitical uncertainty, Brexit and the US elections all set to have an impact on markets in the coming months, Ms Perryman predicts the need for investors to be nimble in their asset allocation will remain, which should continue to add to the appeal of ETFs.
Another boost
Covid-19 has been accelerating many trends that were already in place, says Jeffrey Sacks, head of EMEA investment strategy at Citi Private Bank, with one being the increasing use of ETFs by private clients.
That is largely because of what ETFs can offer, he explains. “Clients particularly like the liquidity they provide which in fast, volatile markets is very important. The diversification benefits of ETFs have been well appreciated because we have been advising our clients to diversify, by asset class and by region, and ETFs are a great way to do that.”
In addition, the transparency of these wrappers is “excellent” and the speed of execution has been “really good”, adds Mr Sacks, predicting that their usage will continue to be very high.
Clients have been using ETFs both as portfolio building blocks and in a more aggressive, tactical manner, depending on their mindsets, he reports, while highlighting their use as an efficient way of gaining access to the themes Citi has highlighted in its investment outlook.
DBS Wealth is a strong advocate of active fund management, says Marc Lansonneur, its head of managed solutions, balance sheet products and investment governance, but the Singapore-based bank recognises ETFs can be useful tools for constructing both simple and complex passive portfolios, and at relatively lower costs.
“They allow cheaper access to certain asset classes, country indices, industry sectors and so on and, as listed securities, also provide transparency in terms of pricing and product information,” he says.
During periods of high market volatility, clients tend to hold on to their actively managed products as there is reassurance in having an expert actively manage the risks and portfolio decisions on their behalf, adds Mr Lansonneur. “However, ETFs can be useful for those who wish to take new short-term and tactical positions during volatile times, particularly in the equities space,” he explains.
DBS Wealth uses ETFs across all asset classes, although it does prefer an active approach to fixed income, says Mr Lansonneur. Demand for so-called smart beta products remains “lukewarm” among clients however, he adds.
Covid-19 sparked one of the fastest market falls on record, says Fahad Kamal, chief market strategist at Kleinwort Hambros, and if an investor during this time wanted to de-risk an actively funded portfolio they had to rely on end of day NAV prices which made things difficult. An ETF, on the other hand, is much easier and faster to trade, he says.
“At Kleinwort Hambros we passively invest where it makes sense, for example as part of our US allocation, but also actively where we think the manager can outperform.”
Keeping costs down is a major focus for all wealth managers, he says, and as long-term investors it makes sense to stick to the basics when it comes to investing client’s wealth. “Some active managers can justify the costs they charge but research would show most cannot,” adds Mr Kamal.
Liquidity did hold up well in the ETF market during the fall, which many doubted would be possible, he says, though there were some issues. “Regulators are looking at certain bond and oil ETFs that may have traded slightly away from NAV,” points out Mr Kamal.
Digital building blocks
Wealth managers have been using ETFs as building blocks in portfolios for some time, and no more so than those operating in the digital arena, many of which have offerings which are 100 per cent invested in these vehicles.
That is certainly the case at UK online wealth manager Nutmeg, which uses them for three core reasons - transparency, liquidity and cost efficiency.
“For us they serve as a great tool, acting as the building blocks for a global, multi-asset portfolio,” says Rumi Mahmood, head of ETF research at Nutmeg. “They have removed a lot of the barriers in the investment landscape that were previously there, allowing access to things that were not once available to retail investors, such as high yield corporate bonds, emerging markets and so on.”
As a wrapper, ETFs are exceptionally transparent, he says, as unlike their mutual fund counterparts, they publish their holdings on a daily basis so investors like us know exactly what they hold. Meanwhile ETFs have a secondary market, as shares in them can be bought and sold, just as the underlying securities can, with both listed on exchanges. This means there are two layers of liquidity, says Mr Mahmood, while lower costs means more savings for investors.
And ETFs have had a good crisis, he believes. “When the going got tough, ETFs got traded, and as a percentage of market volume, actually increased. We have never found ourselves in a position where we are asking for a price and not getting one. The spreads we have been getting have been more than fair given the level of market volatility.”
One area he thinks will continue to prove particularly appealing to investors going forward is socially responsible investing (SRI). Although Nutmeg launched in 2012, it was not able to launch an SRI offering until 2018, because the options in the ETF format were too limited. That has now changed though, with many more products in the sector, and importantly, he says, ones built around a strong methodology.
“We have received a lot of interaction from clients around these portfolios and they have already been one of the swiftest growth sectors for us,” adds Mr Mahmood.
VIEW FROM MORNINGSTAR: Central bank actions ensure investors keep faith with corporate bonds
Corporate debt has experienced a bit of a rollercoaster in 2020. At the height of the market turbulence in mid-March it was badly hit on expectations that the lockdown of the global economy would trigger a wave of corporate bankruptcies. But sentiment has changed dramatically since the intervention of central banks to stem the rout.
On both sides of the Atlantic, monetary policy authorities have rolled out unprecedented stimulus packages featuring purchases of corporate bonds. For the first time this includes the US Federal Reserve. And you know how the saying goes: “Don’t fight the Fed”.
Policy action has generated very strong momentum behind corporate bonds. This is the kind of unidirectional bet that limits room for manoeuvre for active managers and benefits passive funds.
The ETF flows data nicely tells the story. European investors pulled out €3.6bn ($4bn) of corporate bond ETFs in March. But this has been more than offset by inflows of €6.3bn in April and €2.4bn in May. Combined assets in these categories fell to €63.5bn in March from €71.7bn in February but have rebounded to €74.6bn in May.
In Europe, a large selection of the ETFs providing exposure to corporate bond markets have ongoing charges ranging from as low as 0.05 per cent to 0.2 per cent.
Investors can find ETFs for multiple geographies, such as the US, UK, eurozone, global and emerging markets. There are also ETFs that limit exposure to the shorter end of the maturity spectrum; generally, up to five years. And the past two years have seen the arrival of several corporate bond ETFs with ESG screens too.
iShares is the leading ETF provider in Europe, and its position is particularly dominant in fixed income. However, all other main providers offer corporate bond ETFs too and so it makes perfect sense to compare all available choices. In many cases the differences between the indices that these ETFs track is negligible and so the decision to purchase one over another may be ultimately determined by the fees they charge.
Jose Garcia-Zarate, associate director ETF research EMEA, Morningstar
