Has the ETF universe really got any ‘smarter’?

The growing popularity of Exchange Traded Funds (ETFs) and other Exchange Traded Products (ETPs) is showing little sign of abating. Inflows of $34bn (€24.6bn) in April pushed assets in the global ETF/ETP universe to a record high of $2.49tn, with investors showing a strong preference for equities, according to ETFGI.

Alongside demand for traditional products tracking stocks in countries, regions or sectors, there has been a definite uptick in demand for more specialised vehicles such as those offering currency hedging, reports Deborah Yang, managing director and head of the MSCI Index Business in Emea and India.

“In many ways, the rigour that has been applied to active fund manager and/or stock-selection is now coming to ETF selection as the sheer number of available options multiplies,” she explains. “It is this diversity of available liquid ETFs, not currently available in index-tracking mutual funds, that is one of the significant drivers of the growing interest in ETFs.”         

The 33 currency-hedged ETFs launched by UBS in late November last year have enjoyed inflows of almost £2bn (€2.5bn), claims Andrew Walsh, head of ETF sales UK at UBS Global Asset Management, Europe’s fourth largest ETF provider with £10.7bn in managed assets. Stockmarkets across Europe may be on the up, but investors are concerned about possibility of rising interest rates, and what that might mean for currencies.

“Currency hedging allows you to play Europe without getting caught up in the potential negating effects of a weakening euro,” explains Mr Walsh, highlighting how ETFs can negate what would once have been a hard to fix problem.

“ETFs are all about simplicity, and people can now buy something which previously would have been a complex thing to do, but with an ETF it is all embedded into the product. Investors can then neutralise the effects of foreign exchange rollercoaster rides.”

Demand for these vehicles tends to come from the smaller asset managers and the wealth management industry, as the bigger investors are more likely to have their own hedging strategies, adds Mr Walsh.

UBS plans to add to its suite of currency hedging products, while ETFs looking to capture high dividend yields are also a possibility, playing to investor demand for income.

Indeed, while ETFs have often been seen as benchmark-replicating passive vehicles, the rise of more complex products is fast-becoming a feature of the industry. Central to this is the concept of ‘smart beta’ strategies, which promise to exploit the inefficiencies displayed by index-based ETFs and improve returns for investors.

The concept of smart beta is nothing new, says Ms Yang at MSCI – based on factor investing which has been used as an investment approach for many years – but by bringing it into the ETF universe, investors can implement an index-based transparent and cost-efficient approach to seeking the extra returns and/or lower risk historically associated with active factor-based strategies.

“We’ve seen significant and increasing demand for our factor indexes, with the number of ETFs linked to them growing by almost 30 per cent over the last 12 months,” she says.

During the first quarter of 2014 there were almost as many newly listed ETFs based on factor indexes globally as ETFs based on market cap indexes (39 versus 45). In contrast during the whole of 2013 it was 53 versus 244.

The fact that the majority of the ETF industry is market cap weighted is little more than an accident believes Eric Anderson, European portfolio manager at First Trust.

“When the ETF industry began back in 1993, it started by following indexes that existed at that time, and even today most of those indexes are market cap weighted,” he explains. “Cap weighting is a great way to measure the market, but it is not a great way to invest because you are over-exposed to the largest securities and under-exposed to some of the best investment prospects in a given universe.”

Seven years ago the Illinois-based firm launched its Alphadex range of ETFs in the US, which weighs stocks in an index according to six criteria: price momentum, sales growth, price to sales ratio, price to book ratio, price to cash flow ratio and return on assets. Last year the firm launched three Ucits funds in Europe, tracking the US, UK and emerging markets, and plans to launch more.

Although some criticise the term smart beta, saying it envelops a wide range of unrelated strategies and is little more than a marketing gimmick from product providers looking to charge higher fees, Mr Anderson believes that the concept is good for the industry.

“I think it helps to develop the ETF space a little bit more,” he says. “While smart beta is something of a new terminology, the idea is nothing new. But the term smart beta does tend to be a catch-all for anything that is non-market cap weighted. Investors need to consider what the index is, or what the strategy actually is. They need to look under the bonnet to see what is actually going on.”

 It is vital that investors find out what they are getting with these strategies, agrees Ursula Marchioni, head of ETP research and equity strategy, Emea at iShares, BlackRock’s ETF arm. “It is important for investors to bear in mind that these new types of beta are not necessarily smarter or better than traditionally market-cap weighted strategies, they are simply different,” she warns.

“Investors looking at these funds need to apply due diligence as thoroughly as they would with actively managed funds.”

Ms Marchioni highlights fixed income as proving particularly popular with European investors, contributing more than half of all inflows into European ETPs (exchange traded products) year to date as of the end of April.

“Fixed income ETPs are still in their infancy compared to equity funds, and we expect the types of bond exposures investors can access through an ETP to grow in the years to come,” she says. “We recently launched a series of short and ultra-short duration ETFs, in order to help mitigate the risk posed by potential rising interest rates, whilst providing better returns than cash.”

Investors are naturally attracted to products that offer them a possibility of beating the market, believes Christopher Aldous, managing director at Charles Stanley Pan Asset Capital Management, although he has his reservations over smart beta. “I am naturally cautious about not getting dragged into a closet active strategy, and many of these things are probably just a means for a provider to differentiate themselves and charge a bigger fee.”

The London-based firm, which was formed in 2007, believes in the premise that asset allocation is the crucial factor in investment management, and reducing cost is vital in terms of long-term returns. This led the firm towards an almost exclusive use of ETFs, although this is now changing as there is more choice available.

“There are now more and more conventional tracker funds available,” says Mr Aldous. “After all, these do the same thing as an ETF without the ‘ET’ bit. And actually these have lower stated costs and you can pinpoint asset classes quite accurately. It is still less granulated than the ETF world, but it is getting much, much better.”

The attraction of actively managed funds is becoming less and less apparent, he claims, as the ETF universe continues to grow, although there will always be a case for specialists having to use active management. “We have used a couple of active funds when a passive product didn’t exist, but once a trend emerges you tend to find that a passive product soon follows.”

But are there any asset classes or investment strategies that ETFs are not suited to? Mr Aldous believes the characteristics of property ETFs are very different to the real estate market itself, while much of the alternatives universe is similarly out of sync. For example private equity ETFs would give you access to the venture capital firms themselves rather than underlying investments, while hedge fund trackers tend to be invested in more liquid type plays, as opposed to distressed debt or deep value.

Managing volatility is another area where active management has the edge, believes Ryan Taliaferro, senior vice president at Boston-based Acadian Asset Management and lead portfolio manager for their managed volatility strategies. Although admitting index-linked strategies offer appeal in terms of simplicity, he believes an active strategy is capable of both lowering risk and improving returns from equities.

“Many low volatility ETFs are based on traditional cap-weighted indices and may contain constraints around sectors, regions, size, and other risk parameters, as well as on number of stocks and turnover,” he explains. “This means that while the fund may have lower risk than a cap-weighted index, it is working from a narrow range of opportunity.”

In contrast, an actively managed low-volatility portfolio can be optimised without reference to any benchmark, and can draw on the full universe of available stocks, claims Mr Taliaferro, while allowing more frequent trading which means portfolio risk can be rebalanced continuously. 

The private banker’s view

While institutional investors have long been open to utilising ETFs, private investors have been much slower on the uptake. However this is gradually changing, believes Sebastien Gyger, head of portfolio management multi-asset for the private banking business at Lombard Odier, as clients become more aware of how they can be put to use in their portfolios.

“I was talking to a client this week whose mandate was for 50 per cent equities and within that 50 per cent was to be allocated to ETFs,” he reports. “One of the reasons for this was diversification – not wanting to put too much risk in specific stocks – and the other being cost.”

Although this figure of 25 per cent is high for a client’s ETF exposure, with 5 to 10 per cent being more common, it is not long ago that Lombard Odier was running entirely actively managed portfolios.

Mr Gyger explains how the Swiss bank tends to use ETFs in short to medium-term investments, when moving in and out of mutual funds can be expensive. They are also useful when it comes to accessing sectors that they do not have expertise in, such as Japan or emerging markets.

But in some sectors actively managed funds remain the better option. “We have used ETFs for gold, but that is as far as we have gone into commodities,” says Mr Gyger.