Eurozone crisis taking its toll on ETF inflows

The sovereign debt crisis may be weighing down on investor inflows into exchange traded funds (ETF) listed in Europe, which have dropped by more than half in the first six months of the year, but the ETF markets still present considerable opportunities for wealth managers.

Europe’s volatile equity markets caused a drop in overall European inflows from ETFs linked to equity markets, where new investments sank to $1.8bn (E1.48bn) from $16.6bn in the same period last year.

However, this was offset by inflows into fixed income ETFs, which attracted $39.1bn of investments in the first half of the year, compared with $15.6bn during the same period in 2011. The global market for fixed income ETFs is likely to grow to more than $2tn in assets over the next decade, compared with $302bn today, according to iShares, the ETF business of BlackRock, the world’s largest asset manager.

Trading in ETFs is rising as wealth managers seek easier and more flexible access to the bond market, even as trading volumes in the underlying securities drop. The funds have grown to $1.5tn in assets from $724bn in 2008, according to ETF Global Insight, a London-based research company.

“Private banks and wealth managers have been active users of fixed income ETFs, mainly due to the fact that interest rates have remained low and look set to be low in the medium term,” says Nizam Hamid, head of ETF Strategy at Lyxor.

“This has left many managers seeking higher yields and has been apparent in the demand for corporate bond and high yield ETFs.”

He says the focus is not specifically on returns, but on the higher yields available in these asset classes. According to Lyxor ETFs, the flat yields in sterling-denominated corporate bonds are close to five per cent and 4.2 per cent for Euro corporate bonds, while euro high yield bonds currently offer yields of just under 7 per cent.

Growth of fixed-income ETFs will accelerate as fund managers expand offerings to new debt markets in different countries, according to BlackRock. The funds will also benefit from a probable shift in the average investor’s holdings to include a greater proportion of debt.

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In today’s volatile markets, ETFs can be useful if a manager wishes to move their asset allocation quickly and other passive strategies are not applicable, says James Klempster, portfolio manager at Momentum Investments. “Care must be taken to ensure that the ETF is appropriately priced at that juncture, especially ETFs investing in regions where the markets are closed at the time of your trade.”

“One of the great benefits of ETFs is their classification as low cost,” says Alan Miller, co-founder of SCM Private. “The big issue why ETFs are popular with investors is because of what you get via ETFs. You get much higher liquidity, much higher performance because of lower costs and more diversification.”

Mr Miller says SCM is unique in the sense that it is one of the very few family offices in the UK that run purely 100 per cent ETF portfolios, something common in the US, but relatively unusual in Europe.

Mr Miller is upbeat on ETFs, stating that by using them a portfolio manager can invest in any asset class more cheaply. “If you wanted to assemble a portfolio of local currency or emerging markets, it would be extremely complicated and incredibly expensive, whereas you can just buy bits of an off-the-shelf ETF,” he says. “You can buy or sell offensively, you know where the costs are and it starts with the spread and diversification from day one.”

He says ETFs are increasing being developed and innovated in their original home, the US, where there are more forward-looking managers. “If you look at the Pimco Total Return Fund, you will realise that they launched an ETF because it was very attractive to a lot of investments in the US,” Mr Miller says.

Higher standards of regulation for ETFs are deeply beneficial to investors and unbeneficial to fund managers in the UK, believes Mr Miller. “ETFs do not pay commissions and that has always been an issue with advisers and private banks in the UK,” he says. “The City tries to mystify the product as much as possible and ETFs do the opposite.”

ETFs are becoming popular as a fast, easy and low-cost play, says George King, head of portfolio strategy at RBC Wealth Management. “Given both a low yield and low return market environment, there is certainly an increased focus on fees and net returns by many investors,” he says.

“In addition, the performance of many managers in recent years has caused some people to question the added value active managers deliver for the fees they charge. In that context, ETFs are often perceived as an attractive alternative.”

Mr King says an ETF is only as effective as the underlying benchmark it is tracking. “Our general preference is not to use replication strategies and track the underlying benchmark as directly as possible,” he says.

He feels there has been so much proliferation of various ETF strategies that it is getting difficult to understand their use.

In such an environment, Deborah Fuhr, co-founder of ETF Global Insight, recommends wealth managers understand client needs. These include when they want their money, their appetite for risk and how that will help determine their allocations to products.

“I think ETFs can be a tool to do many things, but they really require you to understand the products, the benchmarks and how to use them,” she says. “You need to understand the product and make sure you understand how it’s going to work in the overall portfolio.”

A significant trend has been the rise of precious metal exchange traded products (ETPs), which saw strong demand during the quarter, with $702m of inflows as investors looked to precious metals as a hedge and a buffer against continued global financial, economic and political turmoil. “Investors look to precious metals as both an investment opportunity and a safe haven. The concept of a physical holding, coupled with the ability to access it in times of crisis, is part of their appeal,” says Stefan Garcia, head of commodity ETC sales at Source.

Gold ETPs saw the largest inflows in the precious metals sector, with $570m of net new funds purchased. “Gold continues to see particularly strong demand as concerns about European sovereign and financial risk, possible further US dollar currency debasement and a lower price attract investors,” says Nicholas Brooks, head of research and investment strategy at ETF Securities.

Possibly the most important recent trend has been client demand for smart equity ETFs, says Lyxor’s Mr Hamid. “By this I would say that clients are looking for risk managed means to maintain own equity exposure,” he explains.

“At Lyxor ETFs, we have addressed this need by launching two new ETFs last month with a focus on risk-balanced equity exposure with one using the Euro STOXX 50 as a base index but utilising Lyxor’s Equal Risk contribution methodology and another based on the MSCI World Risk-weighted index. In both cases, the need from clients is to maintain equity exposure but in a smarter way.”

Research by Lyxor indicates wealth managers have increasingly started moving into emerging market debt. The largest element of client usage has been in US dollar denominated debt, with a focus on currency returns as well as higher yields. Investors are also taking a greater interest in local currency denominated debt.

“Asian debt markets are a way to diversify your risk in portfolios,” says Alex Claringbull, a senior portfolio manager at iShares. The investment house is also considering products investing in investment-grade corporate bonds, high-yield corporate bonds and emerging market corporate bonds.

He says there are quite a few risk rewards within existing bonds and yields are attractive, despite numerous headwinds, such as a soft landing in China and slowing growth in Europe.

ETF providers are increasingly seeing an opportunity in emerging markets, which is reflected in the types of new products being launched.

Manoj Mistry, head of Deutsche Bank’s ETF platform, db X-trackers in the UK, says the provider is marketing new products as a variety of opportunities present themselves.

Recently, the China Securities Regulatory Commission decided to expand its quotas for foreign investment, which signalled the Chinese government’s willingness to open up China’s capital markets to international investors. “However, for many investors it remains a difficult market to access,” Mr Mistry says.

He says the provider’s new db x-trackers CSI300 index, which recently listed on the London Stock Exchange and tracks the performance of 300 A-shares listed on the Shanghai and Shenzhen stock exchanges is an attempt to help investors profit from the change.

Europe’s volatile equity markets caused a drop in the overall European inflows that came from ETFs linked to equity markets in the first six months of the year, where new investments shrunk to $1.8bn (E1.48bn) from $16.6bn in the same period last year

Precious metal exchange traded products saw $702m of inflows during the quarter