Passive investments thrive in harsh climate

It is hard to find a silver lining in the current climate, but for the exchange traded fund (ETF) industry at least, the economic backdrop has helped boost inflows because ETF charges are low and do not obliterate low investment returns, and their extreme liquidity is helpful during current market volatility.

At the same time, the ETF market has developed funds in a very wide range of geographies and sectors just when investors have come to truly believe in the mantra of diversification and at a juncture when they are most cynical about active management.

Then there is the Retail Distribution Review (RDR) in the UK which will prohibit commission, so cheap, non-commission products will suddenly start to look more attractive. The new RDR regime is also encouraging big advisers to put together off-the-shelf model portfolios, which generally have an ETF component to keep them competitive on costs.

The flexibility of ETFs means they can have one purpose one day and a completely different purpose the next; they are used widely both as tactical instruments for active trading and for buy and hold investments. Currently, the style of use varies by region, according to Alexandre Houpert, head of exchange traded products for the UK and Northern Europe at French funds house Lyxor. “The UK is still asset allocation driven and portfolios are more often constructed entirely out of ETFs, but in France and Germany they are more frequently used as a trading tool,” he says.

At multi-manager FundQuest, which focuses on active managers, ETFs account for just 10-20 per cent of portfolios, and are primarily used tactically for short-term holdings of one to three months, owing to their liquidity. As a supreme example of liquidity, the SPDR on the S&P500 trades more than any security in the world – four times more than the next most traded security, Apple.

TRADITIONAL USES

Traditionally ETFs have been used within multi-manager operations in the UK for structural exposure to more efficient markets such as the US. An ETF may typically be used for core S&P 500 exposure, with two to three active managers positioned around it.

Other markets are now habitually considered difficult to succeed in, however. “ETFs are useful for exposure to the Euro Stoxx as there are also many managers in those markets that we are not confident will add significant value after fees, and for smaller esoteric asset classes where an active manager may not be available such as parts of the property markets in the US and Europe,” says Hans Hamre, research director at FundQuest Europe.

A similar argument can be applied to individual developing country funds where managers may not have a long track record and there is above average manager turnover. “We want a high degree of certainty about the managers’ style – that whatever it looks like now, it will still look like that in six months, and we prefer track record of more than a few years as recent years have experienced only a small part of the economic cycle,” adds Mr Hamre.

There is also the consideration of scale and the need to be able to accommodate large investments – some small active funds of $50-$100m (E37-E73m) may not cope well with large inflows and outflows.

A look at the table opposite shows how much the market has developed, and how the universe of funds and providers has expanded. In 2009, six of the largest funds in Europe were managed by iShares, with the top spots going to the S&P 500 and FTSE 100 respectively, while four funds in the top 10 were overseen by db x-trackers.

In this year’s table, the listing includes a wide variety of providers such as ZKB, ETFS, Credit Suisse and Lyxor. The largest fund is the iShares DAX, which at E10.7bn is more than twice the size of the 2009 leader. The switch out of broad eurozone indices and into the DAX is a clear flight to quality and a reflection that Germany is the largest ETF market.

Four of the largest funds track the price of gold bullion. Investment in precious metal ETPs (exchange traded products) has ballooned to $141bn industry-wide, compared with $123bn at the start of the year, and just $14bn in 2006, and according to Barclays Capital, this bull has run far enough.

REPLICATION

Debate on the structure of ETF replication came to a head in the summer as lobbyists whipped up concern about the risks of swaps and securities lending, educating the marketplace in the process.

A new set of guidelines is now expected from the European Securities Markets Expert Group in the middle of next year. Practitioners say that standards in the ETF industry are already high and as securities lending and derivatives are not unique to ETFs, any new restrictions should embrace the whole marketplace, as will be the case in France, rather than targeting only ETFs which account for less than 3 per cent of the fund universe.

Some wealth managers and clients have begun to demand only products using physical replication, according to reports from physical ETF providers such as State Street Global. The debate has led some wealth managers to implement additional sign-offs for synthetic ETFs, in place of previous informal procedures such as acceptance by brand.

Ironically, ETNs (exchange traded notes) have enjoyed a lift from the debate because although they involve counterparty risk, they offer a certain transparency. An ETN is like a bond – it is a security issued by a bank with a known position in the credit pool. One can take a view on their risk by looking at the CDS (credit default swap) of banks, while for ETFs a host of factors come into play such as how frequently, and to what extent, they are collateralised.

GREATER TRANSPARENCY

Meanwhile, the difficult economic backdrop and the prospect of the Retail Distribution Review are forcing wealth managers to be more transparent about their own costs, and many are turning to ETFs to keep charges down.

The same happened in the US when it shifted from the old commission structure to a fee-based structure. “The RDR is likely to boost adoption of ETFs,” says Tim Huver, UK ETF product manager at Vanguard, “particularly as it will be coupled with the regulations for Mifid 2 which aim to provide greater transparency in how products are sold, traded and their structure and liquidity and, unlike Mifid 1, now includes ETFs.”

The impact of RDR may not be immediate, however. “RDR will eventually change the commission mindset, but it won’t happen on 2 January 2013,” warns Manooj Mistry, head of db x-trackers UK at Deutsche Bank.

“It will take a while and in the meantime advisers will find ways around the rules for incentivising sales.”

ETFs have nonetheless already become an integral part of wealth manager processes. Two or three years ago a long-only research team would have looked at active funds separately, but now both active and passive funds are typically analysed by the same team and treated in the same way. Today a wealth manager might typically put five active managers on a list and include one or two ETFs.

“Wealth managers are now more agnostic about whether the management is active or passive,” says Nathan Bance, director in Investor Solutions at Barclays Capital.

“Partly this is driven by the climate on fee structures. If investors are spending fees on alternatives, then they may substitute an ETF for active funds elsewhere. This is a problem for the long-only + or – 4 per cent closet tracker funds in the middle that are being squeezed because fee budgets are being saved for alternatives.”

“The other big trend is wealth advisers putting model portfolios on to platforms such as Axa Elevate and Novia which means funds must be easy to trade and flexible, as this money will generally be switched more quickly than sticky private client money,” adds Mr Bance. “The platforms regularly see inflows and outflows.”

Model portfolios strip out the need for IFAs (independent financial advisers) to monitor manager risk in multi-manager funds for themselves, and the models can be risk-rated with strict asset allocation constraints. But while the charging structure may compare well to typical active fees of 2-3 per cent, it remains to be seen whether performance matches the multi-manager market.

“Most multi-asset portfolio managers are akin to dinosaurs which use an antiquated investment system containing two layers of excessive charges together with many other hidden charges, all of which will typically sum to 3-3.5 per cent pa,” argues Alan Miller, founder of specialist ETF-based wealth manager, SCM Private.

“In the current environment where many assets may not return over 5 per cent pa in the future, one can easily see 50-70 per cent of returns being eaten up by charges,” he adds.

“Active funds tend to be more volatile as they are normally much more concentrated, so investors are effectively getting the worst of all worlds – higher volatility and higher charges,” says Mr Miller. “Even worse, some of these funds, often within the larger fund management groups, are simply closet index-tracking as the managers are petrified about underperforming their competitors.”

Mr Miller’s research reveals that the real cost of the active management within the largest IMA sector, the UK All Companies funds, is over 6 per cent pa (derived by calculating the amount of any fund which is different to the benchmark and then calculating its cost). Sometimes the total expense ratios of ETFs are actually even less than the reported costs because the reported costs exclude securities lending.

Providers are focusing on regulation and so product development is relatively quiet. Funds that offer extreme diversification have recently proved popular such as ACWI-IMI which tracks 8000 securities. Lyxor’s three new ETFs on Euronext also offer wide exposure tracking the Russell 2000, the Russell 1000 Value and the Russell 1000 Growth.

DIVIDEND EXPOSURE

Dividend funds have obvious appeal in this market. State Street recently launched two high yield funds – one is invested in US stocks that have increased their dividends over a 25-year period, which attracted $100m in 10 days. The other launch offers emerging market dividend exposure, stipulating the index constituents should have three years of earnings growth and four years of increasing reserves and earnings per share forecasts, a formula that historically has yielded 7.4 per cent annually.

Wealth managers have also been looking for effective volatility hedges in their portfolios. The iPath ETN rose by 164 per cent in the three months to the beginning of October, providing a hedge just when investors needed it.

While sector funds received a cool reception when they were first launched five years ago, they have become much more popular as wealth managers are now looking to diversify within asset classes, not just across them. Style-related ETFs are also used to implement tactical asset allocation views, both aggressive and cautious.

Packaged all-in strategies that can include sophisticated strategies in a simple wrapper also appeal in a low-return world.

“The availability of standard products climbed recently and we think a corresponding consolidation will take place,” says Didier Böckli, head asset management passive investments, at Zürcher  Kantonalbank.

“We are also of the opinion that flexible and predictable entire solutions as well as locally oriented special products represent an interesting perspective for the future,” he adds.

Size is everything

In the world of ETFs, big is decidedly beautiful. “In selecting ETFs, the criteria is good liquidity so the size of the ETF is important and we also want to see a substantial provider,” says Hans Hamre, research director at FundQuest Europe.

He has no preference regarding physical or synthetic replication but takes a good look at the tracking record.

Alan Miller, founder of SCM Private, also prefers ETFs that track large indexes for their liquidity, recounting how two clients recently liquidated their portfolios and the job was completed in under 30 minutes with the cash sitting in their accounts three days later.

“This is a huge improvement on many traditional funds or portfolios, which appear to have forgotten whose money it is they are managing,” says Mr Miller.

The increasing range of ETFs makes them hard to monitor, however, and some areas require specific investment expertise. “When the range of choices increases, for example with specialised commodity products, wealth managers may be tempted to do new things, but they may lack experience,” says FundQuest’s Mr Hamre.

“I’d caution that some smaller wealth managers may be taking an aggressive approach while the risks may not always be considered.”

VIEW FROM MORNINGSTAR

‘Safe-haven’ seemed to be a good investment

The sovereign debt crisis in Europe and a cool down of the global economy have encouraged investors to re-allocate their money into perceived less risky assets – the so-called “safe-havens” – in a bid for capital protection. The most sought after safe haven has been gold. In the full year to September, precious metal ETPs have attracted €3.6bn in net new assets. It comes therefore as no surprise that some physical Gold ETCs are not only amongst the world’s largest ETPs, but also amongst the best performers, as the accompanying table indicates.

German government bonds have also been a safe-haven of choice as money fled other troubled Eurozone government bond markets. Meanwhile, European stock indices, like Germany’s DAX 30 or France’s CAC 40, have found themselves amongst the worse performers as investors turned their backs on them. By contrast, despite their own domestic problems, US stock indices have outperformed their European counterparts. As things turn bad globally, US-investors tend to withdraw money from abroad and re-invest it in their own domestic market.

Also, interesting to note is the performance difference of the SFr denominated Gold ETC and the dollar-denominated equivalent. Over the last year, CHF Gold ETC has returned some 15 percentage points more than the dollar-denominated fund, due to the safe haven flows into Switzerland over this period and the subsequent appreciation of the Swiss franc. However, would-be investors should be aware that since September the Swiss National Bank actively targets an exchange rate capped at 1.20 to the euro.

Gordon Rose CIIA, ETF analyst, Morningstar, Inc