Smarter products allow private banks to deploy ETFs strategically

The extraordinary innovation in the ETF space, particularly in the ‘active’ or ‘smart beta’ area, is driving a silent, but relentless evolution in the way private banks and wealth managers use these vehicles in the management of clients’ portfolios. 

These low-cost, liquid and transparent products, which are traded intraday on stock exchanges, are no longer just seen as useful tools for implementing short-term, tactical calls, but are starting to play a more strategic role, as the product universe widens and becomes ‘smarter’.  

The shift is particularly evident in the equity space, thanks to advances in factor-based investing which uses index construction rules alternative to the typical cap-weighted index strategy, taking into account factors such as size, value and volatility. 

“We have seen a tremendous growth of ETFs in clients’ portfolios, specifically in the smart beta area,” says Katie Nixon, chief investment officer for Northern Trust Wealth Management. 

“Clients are looking for efficient ways to get excess return over the market, recognising it is not a free lunch, it is a risk based return.” 

It is very hard to trade risk factors like value or size, momentum or quality over the short-term as they are very unpredictable, so investors need to hold them through a market cycle to achieve a return higher than beta, says Ms Nixon. 

Also, as some of these factors are uncorrelated to each other, combining them together provides an additional diversification benefit. “For our private clients, ETFs represent strategic positions, and we do not use them to tactically trade portfolios,” she says.

In the smart beta space, the US private bank greatly benefits from the group’s asset management arm, Northern Trust Asset Management, which designs and sponsors a suite of ETFs called FlexShares. The firm is the sixth largest factor-based manager worldwide with $46.3bn of AuM in factor-based strategies. 

Equity markets are expected to generate returns below their historical average over the next five years, and this may lead to some possible cannibalisation out of passive into smart beta, as investors look for higher than market returns to meet their goals, explains Ms Nixon.  

On the other hand, even if correlations fall and the market becomes more conducive for active managers, who have faced significant performance challenges over the past few years, investors will still flow into smart beta as “just a higher confidence bet over time”.  

This greater confidence lies in 50 years of academic data and empirical research supporting that, over time, “value outperforms growth and small outperforms large, while momentum or quality also are compensative risk factors”, she explains.

As a result, picking an active manager hoping that alpha will persist over time is not advisable, “unless you have pretty sophisticated tools that can help you identify alpha early and then get out of the manager as alpha deteriorates, which inevitably does,” she says. 

Increasing appeal

In continental Europe, the upcoming MiFid II regulation, introducing greater pricing transparency and banning retrocessions, is set to drive further ETF growth in wealth management, believes Olivier Paccalin, head of Wealth Management Solutions, at Société Générale Private Banking.

At the French private bank, ETFs have a acquired a more prominent role, representing today more than 15 per cent of assets in clients’ managed portfolios, compared to 5 to 10 per cent a few years ago. They are mainly used to access liquid equity markets, such as US or Japanese equities, or take core portfolio positions in plain vanilla government bonds, while 1x leveraged ETFs are frequently used for short-term tactical calls. 

But looking forward, their appeal is likely to increase, as new, innovative products are launched on the market. 

“For us, ETFs are a wrapper enabling investors to access not so liquid asset classes in a liquid way,” says Mr Paccalin. “We are looking at ETFs that could access the dividend futures market, or the hedge fund universe, for example.” 

In conjunction with the group’s investment bank and ETF provider Lyxor, the private bank develops proprietary indices and strategies, as a result of “high convictions on how to manage portfolios”.

Around 18 months ago, the French institution built a Risk Premia index, and is planning to launch an ETF tracking it. 

“In short, it is as if you were managing a multi-asset hedge fund,” says Mr Paccalin, adding there is significant momentum for these types of strategies generating a yield between 4 to 6 per cent, but with lower volatility than bonds. 

Such ETFs are very “technical” and are generally used by portfolio managers only, as a tool in discretionary portfolios. This is where innovation generally originates.   

On the advisory side, he notes, clients do not show any particular interest in these new instruments, but rather view ETFs as cheap tools to access beta in financial markets.

As more and more complex ETFs are being launched, it becomes paramount to allocate dedicated teams that monitor and understand the quantitative models behind this new generation of ETFs, warns Mr Paccalin.  

The French bank “carefully selects” ETFs from the top five largest players, with the lion’s share coming from BlackRock’s iShares and Lyxor. “We do not use small ETF providers,” he states.

Efficient replacement

As the ETF market “evolves and gets smarter”, ETFs might be playing the role traditionally taken by structured products in portfolios before the financial crisis, suggests Jon Wingent, head of portfolio specialists at the  Wealth Investment Office, Lloyds Private Banking.

Issues around liquidity and leverage in structured products in the aftermath of the crisis have driven private bankers to prefer highly liquid tools such as ETFs, “which are arguably a lot more efficient than structured products and can provide exposure to a theme or a tactical bet,” explains Mr Wingent.

In the bank’s discretionary portfolios, Mr Wingent sees a “large use” of ETFs, including traditional plain vanilla ETFs, but a higher growth of the more dynamic type products.

Short ETFs, for example, are believed to be particularly useful. “If you have got a view on shorting a particular market, and you can do that through an ETF, that can be quite an efficient way of doing it, compared to taking out futures and options on certain positions,” he says. “Short ETFs could possibly be a threat to some of those traditional hedge fund strategies.”

This new generation of ETFs have found fertile ground in Nutmeg, the UK online wealth manager, which exclusively uses ETFs to construct clients’ portfolios, believing in asset allocation as the primary driver of market returns.  

While wider market capitalisation indices represent core building blocks, new options such as regional, sector or factor-based strategies allow tailoring the market exposure, says James McManus, investment manager and ETF specialist at the firm.

To give an example of non-market cap-weighted index ETF used by Nutmeg, he picks the iShares Edge MSCI Minimum Volatility EM ETF, aimed at creating an overall low volatility portfolio focused on emerging markets. 

Hedged ETFs have been a really growing area, he notes, particularly in the UK over the last 12 months, as sterling-based investors are looking to hedge some of their foreign currency exposure post the Brexit referendum.

Also, the ability to segment the bond market by duration buckets “is a phenomenally useful tool for portfolio construction”. Such short duration ETFs are used in clients’ portfolios to access Treasury Inflation Protected Securities (TIPs) in the US, UK corporate bonds or Gilts, for example.

There is however further room for innovation in the fixed income space, in particular in credit, with the integration of fundamental credit research. 

Asset managers looking to enter the ETF market may use their in-house intellectual property and try and translate it into a rules-based format, he suggests. For example, a hypothetical low default high yield index could be appealing to investors, although there may be liquidity constraints to overcome, says Mr McManus. 

However, innovation is not risk-free. “Innovation is great, but a lot of products are launched based on back-tested data, which is often a kinder reflection of the performance that could have been achieved. When looking backwards, you are going to design a strategy that would have performed best in the past, but that is not necessarily true in the future,” he says.

Active versus smart

At Merrill Lynch Wealth Management there have been “some early adopters” of these new types of smart ETF solutions, notes Niladri Mukherjee, director of portfolio strategy, Private Banking and Investment Group and International, CIO Office at the US bank. 

Some, such as WisdomTree’s dividend weighted ETFs, “have been around for a while and have been very successful” and gained traction among financial advisers. Low volatility ETFs have also been quite popular, he adds. 

But there is still some way to go before these new vehicles can really take significant market share away from active managers or even passive solutions. 

“While their lower fees are undoubtedly an advantage over active managers, only time will tell if the rules-based or quantitative approach used by these ETFs will play out in a meaningful fashion, in terms of risk-adjusted returns, versus active managers,” says Mr Mukherjee.  

On the other hand, some of these active, factor-based ETFs, charge a higher fee than the traditional passive-based solutions, so investors have to be convinced they are paying up for higher performance.

One constraint about these niche ETFs is that they are “much tougher” to explain to clients, and as a result financial advisers may be reluctant to use them. 

However, as investors see the trade-off of fees versus performance, and innovation continues, ETFs will gain more ground in private banking, he expects.

Merrill favours a hybrid approach in portfolio construction, including both active and passive management, with the market environment determining which way to skew. 

When return dispersions are higher, and stock correlations are falling, as is the case now, as the unwinding of quantitative easing gathers pace, it makes sense to increase the active manager share, he says, mentioning their improved performance over the past six to nine months. 

Active management is also to be preferred for asset classes where the value of research or return dispersions are usually high, such as fixed income, international small caps or emerging markets, he explains.

“The best approach to portfolio construction is including both active and passive solutions, as well as tools like smart beta, and using all of them in a ‘smart’ fashion,” adds Mr Mukherjee.

Technological disruption

Private investors, who have lagged institutions in embracing the passive revolution, are now the first to realise they need active management to capture the market upside and avoid losers, which passive vehicles like ETFs force them into, says Burkhard Varnholt, deputy global CIO of investment solutions and products in International Wealth Management at Credit Suisse.

The new record highs reached by stock indices such as the S&P500 and the Dow Jones over the past few months belie an almost unprecedented divergence between winners and losers. Rather than any tapering story, such divergence is the result of the “next global wave in industrialisation”, which is driven by technologies, states Mr Varhnolt. 

“Technological disruption is affecting all walks of life and business, creating a much faster cycle of ‘creative destruction’, which has marked capitalism for the last 100 years.”

The winning businesses will be those able integrate technological development into their business model, rather than fighting it. 

“I still love passive building blocks, and we use ETFs in our portfolios, because they are liquid and allow us to implement views quickly and efficiently,” says Mr Varnholt, estimating they represent around 20 per cent of client assets in portfolios. “But I think we will see a renaissance of active management, at least for the next two years.” 

Among private clients, passive ETFs will grow, but will not cannibalise active management, he predicts, describing smart beta as the “reintroduction of active management through the back door in the ETF space”.