Evolution of ETFs creating both obstacles and opportunities

Participants:

1. Lorne Baring
Managing Director, B Capital 

2. Pauline Engelberts
Global Head Investment Products and Wealth Solutions ABN Amro

3. Alex Marshall-Tate Head of Third Party Research, Citi Private Bank Emea  

4. Alan Miller
Founding Partner and CIO, SCM Private 

5. Philip Philippides
Head of UK ETF Sales, Amundi 

6. Delyth Richards
Head of Funds Research, Kleinwort Benson 

7. Ashok Shah
Investment Director, London & Capital Asset Management 

8. Andrew Summers
Head of Collectives and Fund Research, Investec Wealth and Investment

Moderator: Yuri Bender
Editor-in-chief, PWM 

Yuri Bender: Our aim is to get an indication of how ETFs are currently used in private client portfolios, what the future holds for these investment vehicles and how their proliferation will shape the wealth management landscape. 

I remember when some of the Swiss banks, UBS in particular, made a very strong point before the global financial crisis of channelling 50 per cent of assets of new discretionary clients into ETFs. Do you recall any ‘Eureka’ moment after which you used more of these funds in your portfolios?

Pauline Engelberts: I’m not sure if there was a ‘Eureka’ moment as such, but we did start realising there was added value in our total portfolio strategies for clients, giving them quick access to markets they usually couldn’t get to, and based on that, we worked with it. 

A lot of clients are looking to the lower cost and greater transparency of ETFs. And the time is also right for many clients; they are asking more questions than they used to in the past and ETFs provide more answers.

Our investment themes can be accessed both from mutual funds and also through ETFs. I think with ETFs, you’ve got a broader playing field because you can use different strategies. Clients don’t have to know all the technicalities but they understand the theme. They know what they’re following and the ETF gives you more flexibility to play with different strategies than a traditional fund does. 

Yuri Bender: Have ETFs fundamentally changed the way private banks work? 

Andrew Summers: Not really. We are pretty strong believers in active management and with a few notable exceptions, with the right team and process, you can find active managers to outperform. 

Although there are certain situations where ETFs are very useful, on the whole in most markets, in difficult volatile markets, there is no substitute for human experience and the role of the human being in making investment decisions. So the vast majority of our assets are in active managers and that probably won’t change much in the foreseeable future.

Alan Miller: There’s hope and there’s fact, isn’t there? And the facts are these. If you look at the last 110 years, the average real return on equities is just 5 per cent, so if the whole chain of costs for many private wealth managers adds up to 3 or 4 per cent, it doesn’t actually leave a lot. And according to Cass Business School, to actually judge whether a manager is lucky or skilful, you require 22 years of investment performance. 

It’s a bit like betting in a casino. The longer you’re in the casino, the more chance the casino has to win. So the casino wants you to stay in there as long as possible. 

And here is another fact. The actual chance of an active manager beating the index three years on a trot is 4 per cent. So everybody says, “Ah, that doesn’t matter because I am going to select this 4 per cent that can do it.” Everybody says that so you have to actually look at reality – few will ever achieve it.

In Holland, where they are much more advanced in terms of regulation and literally two or three years ahead of the UK, they’re putting into practice rules for people to see total cost. In the UK, there are a huge number of wealth managers whom the client thinks they’re paying 1 per cent, when they’re really paying 3.5 per cent by the time you’ve added in transaction costs, underlying fund costs, initial fees etc. We’re only 18 months from the truth being revealed by MifidII. If the money vacates one third or more of the industry identified as closet indexers, logically, all of it should go into index funds, whether it’s mutual index funds or ETFs.

Delyth Richards: We have about 40 per cent of our book in ETFs, which we introduced into portfolios some time ago purely on a cost basis when we came up with our multi-asset strategies. Cost was a very major drag and ETFs were a quick way of being able to provide that allocation. 

But we have different clients with different requirements. Some actually state a preference for purely active selection. We can also offer a more passive variation, but our main proposition is composed of a blend of both. 

Looking at the metrics we’ve run for the performance of active funds last year – a very, very difficult year – only 22 per cent of US active equity managers in Europe outperformed their strategic benchmark. 

Even among UK managers, who had a good year, only 47 per cent outperformed benchmarks, so on that basis, unless a manager can consistently outperform their benchmark, I find it hard to justify their position in the portfolio versus the cost of a passive tracker. 

However, there are other strategies where maybe we don’t like a passive approach, as we can see there has been a higher significance of active managers outperforming or as a sector. For example, with credit, do you really want to follow the issuance of the largest issuers as opposed to an active manager who is doing fundamental credit analysis? 

Ashok Shah: We consistently talk about TER [total expense ratio] and turnover, and the flexibility of selling and coming back in. What we know is that if it takes 22 years to decide if a fund manager is performing or not, how many years will it take before we can fully understand ETFs are actually what they promise to be? In other words, we already know there is a huge systemic risk because the biggest providers of funds into the fixed income area are now the ETFs, as an industry. 

If we have a big liquidation phase, the market is just going to disappear which is what the active manager everyday is faced with. You ring up and you want to trade a particular bond and the market is unwilling and the next price is 10 points down. You will have exactly the same situation happening to ETFs as has happened to the active funds. 

So I think we need a much longer time experience before we say “Yes, ETFs are delivering what they are designed to do.” They are basically going to become a much, much bigger systemic risk and by definition, a systemic risk sooner or later explodes. And when it explodes, then you have the full experience to compute and analyse or whatever you can do to figure out so it can really deliver what you want it to. Then relate it to what the active managers want to do. 

So I think the jury is out. Just be very careful about drawing conclusions on a very incomplete period. 

Alan Miller: If you actually look at the last credit crunch when corporate bonds became totally liquid, there were lots of corporate bond mutual funds that had to be suspended or had to charge investors redeeming huge penalties. 

But the largest fixed income ETFs became a liquid proxy for the market. Whilst a discount indicated the underlying bonds were less marketable, at least you as an investor could buy and sell that. And you were buying and selling at the right price. The fixed income ETFs became more liquid and the mutual funds became less liquid. 

Ashok Shah: The only thing to add to that as a counterpoint is of course, since the last crunch of 2008 and 2009, fixed income ETFs have gone exponential. So you can’t rely on that experience to say that next time there is a credit crunch, we will have exactly the same experience. We just don’t know. That is why we really need to give it enough time before we draw a conclusion that you are getting what you are promised. 

Philip Philippides: Before addressing the point about what ETFs offer to do, I wanted to touch on your first questions on adoption. ETFs in Europe were originally only used for cash equitisation for some more sophisticated investors. They soon began to be used for mid term asset allocation but as their costs reduced, while their range and liquidity increased, they became more useful to a wider range of investors and for many more uses, from tactical to strategic. 

Going back to the current question, ETFs have become an access product for many users and fixed income is one such area. It’s made it much easier to invest in bonds, when it was a privilege of the few historically. It allows investors to  access diversified products . I think what ETFs say they’re going to do, is that they will follow an  index, with very low tracking error and very low fees. This is what they are delivering. 

What ETFs don’t say, is that in the face of crisis, they  will make the underlying market more liquid . It is a access tool and in a crisis scenario, the ETFs are doing what they’re supposed to be doing but given they are listed instruments they can possibly give an alternative source of liquidity and price discovery on exchange. 

 Yuri Bender: State Street, has lowered the fees on 41 ETF funds from its range to 35 basis points from 50 basis points. Is this the start of the next round of the ETF price war? 

Philip Philippides: I wouldn’t call it a price war. From when Amundi ETF set out six years ago, we’ve always set our range to be 25 per cent cheaper than the market and we continue to pay much attention to costs when launching new products. In 2014, for example, Amundi listed the cheapest JPX-NIKKEI 400 ETF on the market at launch date and halved the cost of its emerging equity ETFs. So that is one of the key tenants of how we build our business, which is to be cost effective. The others are innovation, and quality of tracking. 

I think it is a good thing for everybody. It improves adoption and I think as an industry, if we become more cost effective, the uses of ETFs become wider. So for example, if the TERs were still at the rates they were five or six years ago, we wouldn’t be effectively competing versus other instruments like futures at this moment in time.

Lorne Baring: Cost is important but I don’t think it is the biggest concern. It’s all about performance at a much higher level. If you get the asset allocation right, you’ll have good performance. If you get it wrong, it’s very hard to have good performance. Then you come down to this fight between the passive and the active managers and I don’t think there’s a binary outcome. 

I don’t think you can say one is right or one is wrong. The more efficient the market, the harder it is for an active manager to outperform that index. So therefore, you might want to build a core portfolio with ETFs that give you a very close tracking to an index, very low cost and beta. But there are parts of the portfolio that can be followed by an ETF. So you might create a satellite range around that core holding, maybe tracking property, maybe investing in emerging markets. You need an active manager to select those assets and be very good at working out where the value is. 

So it’s not a fight between the two that ends up with just ETFs, even though the ETF market is growing by about 22 per cent a year compound annual growth rate. It’s a differentiation between the two parts: the core portfolio and the satellite portfolio. If you put the two together then you get the best performance, having got your asset allocation right. 

Alex Marshall-Tate: With regards to ETFs in particular, the market has grown in terms of the availability of products seeking to provide exposure to more niche and specialist areas of the investment markets, such as commodities, specialist parts of the equity and fixed income markets, income orientated and smart beta type strategies. 

With this in mind there is a real need for investors to ensure they assess these ETFs from a due diligence and research standpoint in a lot more detail. There is an increasing risk out there that less sophisticated investors believe all ETFs are created equally. But an ETF on the S&P500 is not necessarily the same as an ETF on the leveraged loans market or frontier markets. 

That’s where investors more broadly need to spend more time to do this; they need to dig down in terms of understanding the underlying exposures, clarify what the ETF is actually seeking to provide, what the underlying index is, and what the inherent risks are in this exposure. They must look at the structure of the ETF and how it achieves its returns, look at its AUMs, the expected tracking error versus the underlying index, and the ETF liquidity for some of these specialist areas we’re seeing ETFs go into.

If we can’t find the investment talent to provide clients with an active exposure then certainly they should consider looking at passive investment options to see if these can offer an alternative opportunity.

Andrew Summers: We’re not huge believers in the ETF space, but some of the smart beta stuff is quite interesting. If one believes the vast majority of an active manager’s return actually comes through smart beta or entrenched style biases which can be more cheaply replicated, then why should you pay an active manager 75 basis points for a fund where 90 per cent of returns come from factors that can be replicated for a fraction of that cost? 

Smart beta enables investors to say: “I don’t just want to buy the FTSE All Share because it’s got all sorts of sectoral biases. There’s going to be lots of stuff in there I don’t necessarily want to own.” 

Smart beta products actually allow you to filter some of this out, so the second generation of ETFs is potentially more interesting than the bog standard variety, which just give you market beta. 

Lorne Baring: I think it’s wrong to call it smart beta. The ‘smart’ should be moved up to asset allocation, where you prove whether you’ve made a difference at a much higher level. The ‘smart beta’ range should be called ‘factor-based investing’. You’ve decided that you want to have dividend income so in the S&P 500, you choose the highest dividend. That’s factor based. 

Smart beta makes it sound like the investor puts their money in and somebody is being smart on their behalf, so they can relax and go and do something else. That’s just not going to happen. The factors will be applied mechanically and operationally, and the values will go up and down with the market. There’s nobody looking after the money inside smart beta and that’s why it’s mislabelled. 

Philip Philippides: Some of these ‘smart beta’ concepts have actually been around for a very long time, like high dividend, style or size indices. ‘Smart Beta’ seems to encompass  tried, tested strategies that the  market is familiar with. But also encompasses newer strategies. 

Here, there are  not yet any homogenous methodologies  so it’s important for investors to understand and have a look at what it actually delivers. There is a lot of education and innovation in this space. 

Pauline Engelberts: The danger with some of the products either labelled as smart beta or more active ETFs is we’ve given it an ETF brand and that’s what the clients understand. They’re buying it themselves and think they’re doing the right thing. However, regulators will want to know what is driving these ETFs and maybe they will actually be deemed as too complex. So we’ve got to watch out that we’re not trying to break something actually working pretty well.

Andrew Summers: Isn’t there a contradiction because on one hand we’re talking about how important human involvement and interaction, and judgements are when it comes to asset class allocation but on the other hand we’re saying at the fund management level, humans can’t add any value. 

And certainly in the bond space, top-down decisions are crucially important for managing bond funds. Yet we’re all sitting here saying, “yeah, human involvement is really, really important for tactical allocation, adding value. But at the fund level, forget it, guys.” 

I just don’t think that’s true. I don’t think you can have that contradiction and with all due respect to the Cass Business School research, which came out with that 22 years, figure, that’s just Cass’s opinion. 

Alan Miller: The average active bond fund manager performs just as badly as the average equity manager. There isn’t actually a difference. 

If you look at performance of the average UK active equity fund in the credit crunch, it was within a fraction of the average passive fund. So it is a complete myth that somehow a human is going to eventually say “Oh, I’m just going to spot the market is going to fall 30 per cent tomorrow” and do something about it. Some will, some won’t but on average, you’re going to get the market return less the cost. You can’t get away from this fact. 

Some people will beat the market, but the question is can you select those people in advance? The fact that those people are there doesn’t prove somebody can actually select them in advance. 

Yuri Bender: Do you believe in this innovation mantra: the idea of boldly going where no man has gone before? Or do you feel there is a limit to innovation in ETFs and there are certain areas that people shouldn’t be mistaken in thinking they can track? 

Alex Marshall-Tate: Innovation is important. I think the industry certainly needs to explore better, more cost efficient or more effective means to provide market exposures for clients. This is where our research role comes in, providing independent product research, stress-testing investment strategies and investment processes. There are certainly constraints in terms of the types of assets you can feasibly put into a liquid, intra-day traded passive investment strategy. At some point a limit is reached. That’s where maybe a client has to take on decreased liquidity or have a longer-term investment horizon. 

I think the leveraged loans space is one of those areas where the jury is still out. It’s still a very small space within the ETF market. Leveraged loans have certain characteristics, including reduced liquidity and extended trade settlement cycles, that make exposure via a liquid ETF difficult to implement. That’s one area where we’re currently using an active manager and that makes sense for us. We have looked at passive strategies in this space, but we will be doing a lot of homework on these before we’re comfortable in offering them.

 Philip Philippides: There are cases where products that clients have asked for - can’t be put on the shelf, because of different factors that effectively would make that product a non-starter or non-competitive.

Andrew Summers: We say ETFs are low cost and obviously, in terms of management fees they are but actually, in terms of the cost of replicating effectively an index which we know especially in things like high yield, the costs can be astronomical.

You can get years where certain high yield ETFs are in the bottom decile. So it’s a question of let’s be careful. Not all ETFs are cheap. Some actually end up with total cost much more expensive than an active manager, but with no opportunity of outperforming. It’s guaranteed that 100 per cent of ETFs underperform.

Lorne Baring: I like the analogy of the healthcare sector. The ETF market has grown and its innovative technology has brought it on leaps and bounds. The problem is investors can end up with a load of products they don’t fully understand; a bit like going into a hospital and expecting to be able to choose which procedure or which piece of equipment to use. 

You still need a GP to be able to make the referral and you still need a specialist to be able to decide which of the products are really going to give you the outcome you expect. If you don’t do that, the likelihood is investors will choose unsuitable products.

So there is still a need for the investment management industry, whether it’s the private bank or the fund selectors or the direct investment managers, to work out which of the products are right. 

Delyth Richards: These are great building blocks and they allow retail investors to pick and choose and select, but how many of them really understand those complexities? Stock lending, synthetic exposures; how many of them are actually looking at the prospectuses, the insurance clauses? There are risks. It’s about risk management and the real danger is that ETFs are a fantastic development of our industry – look at the US market and its size but there are embedded risks that a large number of retail investors do not really understand they’re taking on. 

Philip Philippides:  The world today in the ETF space is very different to three years ago or ten years ago. It’s a continued evolution. You’ve seen ETFs over time become adopted by not just sophisticated investors and wealth managers, but now filtering down more into retail. There’s a wider range and a wider product offering. The fees are more competitive and there is more liquidity. In terms of how they’re applicable to the wealth manager, it just gives more cost effective investment options for core, satellite or tactical investments. 

As for the way ETFs provide their tracking, whether it is synthetic or physical, let’s not forget that pretty much all ETFs are regulated Ucits funds, meeting the same investor protection requirements. They are extremely scrutinised and the ETF industry is one of the most transparent parts of the fund industry. We’ve moved onto a level of transparency irrespective of replication method, where investors can fully see and analyse how the fund does what it does. 

Delyth Richards: Our industry is in the midst of a massive transformation. Traditional wealth managers are all being challenged by people doing their own investment and the younger generation are very tech savvy. 

They’re going to be running their own portfolios and saying, “I can outperform you using cheap synthetics.” So it will be for us to evidence why and how we’re producing better risk adjusted returns or how we’re reducing risk. I suspect a lot of the things we’ve discussed in terms of the risks in terms of systemic risk or a major bank failure, only when the next major event happens will we see some of the consequent effects on some of these more complex products. 

Another very interesting thing is the reaction after Lehman to synthetic versus physical replication. When Deutsche Bank launched their physically backed range last year, they saw $5bn (€4.4bn) immediately flip from synthetic to physical. 

So we’re in the middle of a journey. This journey is going to be changing all the time for many reasons and ETFs are absolutely in the middle of our set of building blocks or colours, or palettes that we have got to achieve the best client outcomes. 

Ashok Shah: I would like to see regulations come into existence where retail investors can buy a vast bulk of ETFs which are relatively plain vanilla. And anything that is more complicated should be really off limits unless you are a professional investor. And I continuously worry about the swap-based product. Not only does it have counterparty risk, but there are hidden costs in terms of profitability of the swap providers and the rolling over of the swaps, and so forth. And how do they get properly accounted for? 

I think only time will tell us as the evidence comes out because we are continuously focused on relative costs between active and passive management. Let’s hope competition brings the cost of active fund management down like it has done in the past. 

Pauline Engelberts: One of the strongest points is the transparency, which is creating the trust which our industry still badly needs with our clients. I think this will have an impact on the relationship we have with our clients. The only danger is that we are victims of our own intelligence, that we try to make ETFs more complicated again and kind of lose what we have already achieved.