Tactical plays boost ETF inflows

There are now 2379 exchange traded funds (ETFs) globally, with assets of $1,181.3bn (€833bn), a figure that has risen 14 per cent January to October and is expected to top 20 per cent by the year-end as active managers enter the space and alternative asset classes are more widely marketed to retail investors.

Market volatility and uncertainty have been big drivers for ETF growth. According to a recent Greenwich study, ETFs Gain Foothold in Institutional Market, almost half of the respondents use ETFs for tactical tasks relating to managing their portfolios, while 20 per cent use ETFs only for long-hold positions and another 20 per cent use ETFs for both.

High turnover

Providers which offer long and short sector products say the fund flows rotating through the different sectors are large and rapid, indicating many investors are looking to optimise their portfolios by switching frequently.

Demand for ETFs will also be boosted by the Financial Services Authority’s proposals to remove commission bias in financial advice and improve clarity around adviser services. The Retail Distribution Review (RDR) will make advisers describe the service they provide as either independent or, if it is limited to certain investments, as “restricted”. Many advisers are still oblivious that ETFs must be considered as part of the product range, as they fall within the FSA’s definition of packaged products.

“RDR clearly sets the stage for greater use of ETFs than ever in the wealth management space,” says Vin Bhattacharjee, head of EMEA intermediary business at State Street Global Advisors.

“Asset allocation counts for 80 per cent of return, and ETFs are extremely swift ways of expressing an asset allocation view. Wealth managers will be judged on their ability to generate returns so they need to build on their tactical and strategic asset allocation models.”

IFAs and smaller wealth managers are stepping up their efforts to put in place scalable models to sustain their businesses.

“Only a short while ago many adviser platforms did not have the ability to trade shares but infrastructure has improved greatly,” says Dan Draper, head of ETFs at Credit Suisse. “Portfolio managers and investment advisers can use ETFs as a low cost and durable product. We too are gearing our model to help advisers build portfolios.”

There is no single model, however, with almost as many different permutations of portfolio construction as there are adviser firms. Even fund providers such as 7IM, which always focused on active investment, are scaling their infrastructure to build passive portfolios.

Model portfolios

One development is the emergence of model portfolios. “In the past wealth managers typically constructed portfolios using actively managed funds,” says Manooj Mistry, UK head of db x-trackers. “As well as these actively managed fund portfolios, many are now beginning to offer passive versions. These discretionary portfolios are often offered on to financial advisers, who don’t have the knowledge and skill-sets to develop their own portfolios and need to outsource the building of their portfolios.

“These arrangements always existed but looking ahead to RDR, wealth managers are ramping up their businesses because they know IFAs won’t have the ability to manage these portfolios. In five years, most wealth managers will have a set of active and passive portfolios to push out to advisers and clients,” he says.

“In a world where clients want more accountability and competitive pressure is increasing, passive portfolios will also be more common. It is similar to the US a few years ago when stockbrokers set up discretionary portfolios with ETFs,” adds Mr Mistry.

Even big name private banks are constructing passive portfolios, using ETFs to cater for the core affluent market with around E1/2m to invest. For example, ETFs can provide bond exposure in much smaller chunks than the $1m typically required to buy a bond.

Emerging markets

While the massive shifts out of structured products and active funds have now slowed, ETFs are starting to see net new money, and this year there have been particularly large inflows into emerging markets, fixed interest and gold. For example since January db x-trackers’ MSCI EM equity fund has grown from $3.5bn to $5.5bn.

Developed market funds are simultaneously benefiting from investors anticipating an economic recovery. Some $250m flowed into Credit Suisse’s S&P 500 and Nasdaq funds in a single week, immediately ahead of a key announcement on the Fed’s quantative easing in October.

Some investors are still looking for the underlying exposure wrapped with features such as leverage, and ETFs can be structured as the basis for more sophisticated products. For example Credit Suisse investment bank recently launched four structured products based on its 12 new emerging market ETFs.

Long/short and leveraged funds are becoming heavily used by certain asset managers, but not all providers are gunning for these markets.

“We think the market is not yet right for them – they involve too much potential brand and reputational risk as has been evidenced in a number of lawsuits,” says Dee Brown, head of UK wealth sales at iShares.

“Investors do not understand these products. There would need to be better education before we launched funds of this type.”

As investors become more familiar with ETFs, they are demanding greater granularity. Lyxor, for instance, launched sector-specific funds on the Asian and global markets in September. “Wealth managers are using ETFs and ETNs (exchange traded notes) to construct well diversified portfolios and while traditionally it was all about broad asset classes, now it is more in depth in each asset class,” says Alexandre Houpert, head of exchange traded products for the UK and Northern Europe at Société Générale/Lyxor.

“Detailed solutions are required in each asset class to offer sufficient granularity,” he says. Banking and oil are the more active products.

Similar granularity is demanded in the bond and commodities markets. Lyxor for example is also studying the opportunity to launch a range of gilt and corporate bond funds in the UK.

In commodities, Market Vectors has even launched a rare earth metal product (REMX) offering exposure to companies engaged in the production of rare earth metals used in advanced technologies such as flat screen televisions and cell phones.

Volatile currencies

Volatile currency markets have prompted a raft of currency-hedged fund launches this year, and these have been particularly popular in the gold space.

“Historically speaking, when the price of gold rises, the dollar weakens,” says Mr Houpert. “Since November 2007 gold has risen by roughly 200 per cent but if a UK investor had bought a gold ETN at that time he would now be posting a gain of just 106 per cent, owing to the currency drag.”

There is also huge appetite to own a portfolio based on a basket of local Asian currencies as a way to play the secular economic story based on the balance sheet strength of emerging markets, and a scarcity of other product in this space.

A significant number of hedge funds are also expected to create ETFs using their own funds as the underlying.

Investors will be able to hold them in small amounts and enjoy intraday liquidity. However funds that depart from the principles of transparency, and scrutinisable real-time NAV, could ultimately tarnish the image of the market.

While the US and European markets currently account for more than 90 per cent of ETF assets, potential flows for Asian stock exchanges are expected to explode as Asian investors who used to invest off-shore begin to revert to their domestic exchanges. x-trackers estimates that around $30bn could be switched in this way.

“Many Asian investors used to buy ETFs on US or European stock exchanges because they were attracted by the larger volumes generated in those markets,” says Marco Montanari, head of db x-trackers ETFs in Asia.

“However, concerns about liquidity in Asian markets have now been largely addressed. Besides, buying off-shore listed ETFs involves trading at a risk price that is based on estimations when the markets of the underlying assets are closed,” he explains.

“There may also be some tax advantages in trading ETFs listed in Asia as Hong Kong, Singapore and Taiwanese investors may face tax of up to 30 per cent on the dividends received from US ETFs,” says Mr Montanari.

Convenience and speed make ETFs vehicle of choice

Many wealth managers use ETFs in discretionary mandates to implement asset allocation decisions more quickly. An example of this may be buying commodity ETFs when they are looking to increase their alternative weightings, or adding a sector ETF to an equity asset allocation to gain exposure to an area they are positive on. Another example was increasing exposure to US oil service companies just after President Obama lifted the moratorium on offshore drilling.

BNP Paribas Wealth Management stresses the importance of being able to offer its clients a wide range of choice. “In regards to advisory accounts, ETFs have played a vital role in offering our advisory client base exposure to almost any asset class through a competitively priced, highly liquid, transparent product,” says Miles Berryman, investment adviser at BNP Paribas Wealth Management.

“This may be a leveraged zinc ETF or a short gilt ETF. Typically investors will not hold these leverage and short positions for a long period but it gives them choice which is vital for us to offer as a large financial institution in our industry.” The manager also highlights the ability to offer single market ETFs in emerging markets, as well as a broad emerging market fund such as iShares EM ETF.

Recently there has been a shift towards access classes that are difficult to get exposure to for private client investors, such as commodity ETFs, leveraged ETFs, short ETFs, currency ETFs and most recently commodity ETFs that are currency hedged.

“The best received ETFs of late have been in the ETF securities universe of commodity ETFs (including leverage and shorts),” adds Mr Berryman. “We think currency hedged products will be the next big area as some investors are desperate to get rid of currency exposure. For example sterling denominated clients want exposure to gold, silver, platinum and palladium without necessarily having exposure to the US dollar. Over the past year, any UK based investor going into US dollar denominated assets would have benefited from the price rise in gold, silver, etc, but this would have been offset by exposure to the dollar.”

Heartwood Wealth Management in London currently uses ETFs for around 20 per cent of their discretionary multi-asset portfolios. One surprising application is international property.

“Our use of ETFs is dominated by equity and fixed interest because of costs, convenience, speed and price behaviour and this is where ETFs have proliferated,” says Alan Sippetts, investment director and head of research.

“But we also use an ETF for real estate outside of the UK, where it can be difficult to get access to property that is rationally and sensibly managed. Not all territories benefit from a long-standing and well developed institutional property market such as the UK’s – so ETFs invested in real estate investment trusts are useful for accessing country exposure where the physical property market is not terribly liquid and may be dominated by local corporates.”

One debate that can divide advisers is whether to use a swap-based or a physically-based ETF, where a choice of structures is available. “Although there is counterparty risk, there are advantages in swap-based products compared with ones that replicate,” says Mr Sippetts.

“There are no cashflow management issues associated with dividends and dividend reinvestment. In major liquid stock markets where competition is fierce, total return swap-based funds charge around 8-15 basis points compared with the equivalent replication model where charges might be 20-30 basis points.”

In practice, however, physically-backed funds tend to be favoured. “If at all possible, we gain exposure to ETFs through physical backed products,” adds BNP’s Mr Berryman. “We are trying to stay away from as much counter-party risk as possible and we also try to keep things simple by staying away from dealing with issues such as contango.”