The changing role of ETFs in private client portfolios

Elisa Trovato: How important have been investors’ increased cost awareness and desire for transparency – combined with the poor of performance of active managers over the past few years – in driving the growth of ETFs in client portfolios?

David Stubbs: They have been extremely important, especially on the cost side. There’s been what I would regard as a very healthy additional focus on whether active management is worth the money. And although there is an element of cyclicality here, with the conditions in the last few years making it probably more difficult than ever to outperform, especially in certain very liquid asset classes – the overall pressure on active managers to display performance, and to be very clear about how they intend to generate alpha going forward – is growing. Is it just going to be alpha by epiphany or is it alpha by process? We prefer alpha by process because you can replicate it, you can maintain it, and it’s very difficult to replicate elsewhere. It’s something that you can really build on and explain, and not be reliant on the great next thought from one individual.

As a private bank, a lot more of the active decisions that we used to let active managers make are now being taken in-house. It’s like the three S’s: sector, style and size. But often we are making those decisions in house and then using ETFs as implementation.

Because of our scale, we can go to key ETF partners and identify gaps in their range, which are usually very niche areas – like a slice, an industry level in a smaller developed market, where usually they wouldn’t release an ETF on its own because they fear it won’t gather enough assets - and say ‘we are going to put x billion in it if you make it forwards’.

They’re now making ETFs for us at exceptionally low cost, because we are the anchor investor into a whole new breed of very granular ETFs; we’re basically seeding them. That is really taking us to the next level in terms of our ability to target certain exposures in the ETF product area.

Elisa Trovato: Are these low-cost liquid vehicles used for tactical calls only, or do they play a more strategic role in client portfolios?

Ben Gutteridge: We’re very conscious of keeping clients within their risk categories and ETFs are very efficient in delivering and helping achieve that goal, while active management adds some risk around keeping clients in those parameters. We’re less focused on short-term macro trades, and more on longer-term efficiency delivery of meeting client objectives. About 20 to 25 per cent of our portfolios is going to be deliberately passive vehicles.

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But we’re not moving into quite as exotic areas as David was suggesting. We’re still using them in the core space.

You do get some ETF launches in some relative esoteric areas and those areas are hot for a while, and clients find themselves in them. Then that area goes out of favour, and that ETF collapses into another ETF. So, proliferation of ETFs isn’t something that necessarily makes us enthusiastic about these vehicles.

Sue-Wei Wong: We like to take a blended approach and I think clients like that flexibility. We could use an ETF for example in those markets that are liquid, more efficient, where it is more difficult to find alpha, and blend that with a high conviction manager. If a client wants a 100 per cent passive portfolio, we work very closely with our investment management research team and we can build it, and select the best ETFs.

The growth of ETFs and the underperformance of active managers has been in the media a lot, and clients have come to us. And it’s really a question of education here. ETFs do have a tracking error, you have to understand the underlying constituents, the market and the structure behind it. And sometimes, especially with the new ETFs that are coming out, the smart beta ones, they’re not that cheap, and so active managers are more comparable.

Marcel Wagner: ETFs have changed the way we all invest. In the past, pension funds and managed accounts used ETFs, then banks started to use them, more for tactical shifts. Then we started to integrate ETFs into our core holdings and nowadays we have evolved into smart beta and factor investing. You basically can slice and dice almost every segment or mimic active managers. We have passive only portfolios, where clients have the choice to use ETFs and index funds only. For a tactical move, you tend to use an ETF even more.

Antoine Lesné: The advantage of ETF is extreme transparency. There is no other vehicle which gives you transparency of holdings in real time. It’s a very convenient product to integrate into risk systems.  

Elisa Trovato: The European ETF space has long been dominated by equity products, but last year most inflows of European ETFs went to fixed income exposures. With central banks’ tapering of asset purchases gathering pace, what impact do you expect on bond yields and client portfolios? Are there any specific segments in fixed income, which you particularly favour?

Antoine Lesné: Our view is that tapering will have a small impact on yields, mainly due to the global economic environment which is relatively positive. Looking at the very long-term trajectory, we don’t see yields going up very high or very soon, also because tapering is extremely well telegraphed.

However, investors are looking carefully at duration, and moving very short duration to neutralise interest rates sensitivity. At the same time, they want to keep being risk on, through credit, a lower quality within credit, or high yield to some extent.

Also, investors have come back massively into emerging market debt, in hard currency for the first few months of the year and then local currency. We had a big rally from a currency standpoint due to a weaker dollar, and if you are long-term investor, especially in the private wealth segment, you need to generate a form of income.

As at the end of September, out of $25bn dollar of inflows into fixed income ETFs in Europe-domiciled vehicles, close to $9bn went into emerging market debt ETFs. The trend is quite impressive and carries on.

Elisa Trovato: What investment opportunities does policy normalisation bring?

Didier Duret: I think the effect of tapering will be mild, but there is no such thing as global tapering. Central banks will proceed at a different pace. That means currency variations. There will be tactical opportunities between regions, but beware of the currency risk. The beauty of ETFs is that it offers you the flexibility to enter and exit a market rapidly and you can choose to have a local market exposure or invest in a currency risk hedged version.

Elisa Trovato: How important is the ability to segment the bond market by duration exposures for portfolio construction in the current environment?

Ben Gutteridge: That’s where we think ETFs and the fixed income market offer us something. The market consensus is that there’s a synchronised global recovery and that on that basis, as well as a few other factors, yields should drift higher. But if you are overweight equities and your bond portfolio’s underweight duration, then you’re looking a little bit in one direction, and therefore active bond fund managers tend to be short duration. So, it’s ETFs in the fixed income space that can give you that full duration, because active managers don’t tend to give it to you. We primarily achieve that through ETFs.

Didier Duret: When we look at the massive consensus in favour of corporate bonds, it has introduced the equity risk in the fixed income area. It’s a massive equity risk that investors are taking through credit, while the purpose of bonds in a portfolio is to be an insurance. It’s the rush for safe assets that will make the difference. I also find ETFs very interesting as a way of gaining full exposure to the market duration, which you will need in case there is a recession or an extreme risk. You can have that through a whole market benchmark and the ETF tracking it.

Delyth Richards: If you only had exposure to passive indices, by default you get sector biases in there because of the big issuances coming from certain sectors. That’s exactly why you would want an active manager to be able to do that assessment, alongside your passive. We’re all living in this land where high yield default rates are still extremely low. That’s why you do not put all eggs in one basket.

Marcel Wagner: Passive investments on the fixed income side are small. I don’t think there’s a major market impact when it comes to price discovery, so in the end it’s all about active managers and maybe about central banks distorting the price.  

Antoine Lesné: Within the fund industry, passive investments in fixed income represent roughly shy of 11 per cent. It’s three times what it was in 2007, it’s been a strong growth, but still far away from the proportion of the equity market, which is around 30 per cent.

Sue-Wei Wong: The majority of our portfolios on the fixed income side are actively managed. And when we have exposure to high yield and emerging market debt, we do prefer active managers. We’re currently overweight emerging markets; we believe the growth is coming through. But we look towards active managers in that space for liquidity and transparency, and also fundamentals.

Elisa Trovato: Ted, how do you persuade clients to use ETFs in asset classes where the value of research or the dispersions of returns are generally high?

Ted Malcolm: What fixed income ETFs offer, particularly in the private client world, is the ability to match exposures closely with a client’s risk profile. Traditionally we have seen a lot of private client managers allocating to strategic bond managers who can invest anywhere in fixed income, credit, govies etc. hence you don’t know what kind of risk they are going to be taking in the next stage of their investment process, and so how can you control that overall risk? ETFs give you the building blocks to be able to manage your client portfolios in a very risk controlled way.

When it comes to the active versus passive debate, we completely get the fact that we’re forced buyers of bonds, that’s how passive works. But equally there’s a lot of research coming out showing active managers are underperforming the index. Ultimately, you’re looking for performance and asset allocation calls. If there’s a manager who can demonstrate over a long period of time that they can add alpha, then sure, definitely go for them. But with the advent of a lot of fixed income indices and hence choice in fixed income ETFs, active managers have got to show their worth.

Elisa Trovato: Where would you like to see innovation in the ETF space?

Marcel Wagner: As a portfolio manager, definitely on the fixed income side. I see a lot of opportunity to have more and better products. In Europe, you may have 10 or 20 flagship products, which you can trade very efficiently, very cheaply, with very narrow spreads. But as soon as you start to slice and dice the market, duration wise or rating wise, there are products available, but trading wise it could be more efficient.

But because ETFs are on exchange and the bond market is OTC [over the counter], you have two worlds coming together. You need a decent size, you need a lot of authorised participants, market makers’ competition.

That’s one tiny drawback of passive funds, if you have a very broad fixed income benchmark, let’s say 5000 lines, you must be able to invest daily in all bonds or do a massive sampling. If you are an active manager you can invest on day one in one subset, on day two in another subset.

Antoine Lesné: It’s not a market that’s easy to enter for competitors. There’s a lot of new entrants on the equity side, and far less new entrants on the fixed income side. Because it means infrastructure, dedicated investment management systems and people and access to the market. The ability to make a market on these exposures is going to be very important. And that’s where you are limited in terms of where and how much you can innovate, because you want to keep the spirit of ETFs. What we should be aiming for in everybody’s interest from an ETF industry standpoint, is that we could find more liquidity on a more diversified set of funds. That would allow investors like private wealth managers and others to tap into it in an even more comfortable manner.

Elisa Trovato: Do you think that going forward, ETFs will increasingly enable investors to access asset classes that are not so liquid?

David Stubbs: A great recent example which is particularly innovative is perhaps Bitcoin. There’s a Bitcoin ETF. I’m not saying you should buy it but it’s a great vehicle. You can put anything in an ETF. Gold ETF was a significant step forward for a lot of investors a few years back, and there’s a lot of flexibility in this vehicle.

Didier Duret: In the Netherlands, we have a huge progression of ESG investing, it’s growing 35 per cent a year, it’s massive, as in the Nordic countries. From the pure passive perspective, it’s an impossible task to see one single leading ESG index. Maybe MSCI might be the leader on that. But we need to probably go into smart ESG, we need to have instruments in various segments which allow the client to select the type of ESG product they want. In my opinion, ETFs can offer that. We have also to keep in mind that in the ESG business, being active is pretty tough. There is probably more room for passive or some form of smart passive.

Elisa Trovato: Should investors look at the of managers they have traditionally used, and then ask if there is a more systematic product, which can replace active managers, taking into account size, value, quality, volatility, momentum? Do you use smart ETFs or non-market cap weighted index ETF in client portfolios?

Ben Gutteridge: Smart beta’s a bit of a broad church. We have invested with the SPDR S&P US Dividend Aristocrats Ucits ETF for a number of years and our clients have had great outcomes as a result. It’s a dividend based factor model. Is that smart beta?

There is certainly proliferation of smart beta products based on value, momentum and other styles and other factors such as size. And when they launch, they launch with this fantastic simulated track record. But we’re not about to put the clients’ assets at risk on that basis, and so to date really the hard evidence isn’t one that inspires us to go too deep into this area. I think we do need to see more demonstrable evidence that this can add value. Perhaps there needs to be smart betas that can better spot the rotation of styles and factors that come in and out of favour, but that’s going to take time.

Ted Malcolm: There’s still a huge demand for income and a passive quality dividend strategy makes a lot of sense. It’s not just about blindly buying the highest yielding stocks. Our US dividend strategy looks at quality metrics, so companies have had to increase their dividends every single year for 20 years or more. This produces a high-quality basket of securities that have higher average yields, so you’re getting nice exposure to income through high quality stocks.

It’s still very early days for smart beta, here in Europe. We need to see a decent track record and we need to educate clients. A lot of these indices are pretty complex, so clients need to understand what they’re buying and what to expect in different market environments, because they will behave in different ways. That will come with time, but I see it growing.  

Elisa Trovato: What are your key criteria for selecting ETFs? And what’s the current state of the debate of physical versus swap-based replication?

Ben Gutteridge: We’re looking for low cost and low tracking error, perhaps they’re one and the same. And for nice tight spreads on the marketplace. Clearly that is going to have an impact on client experience.

We recognise that synthetic and innovative ways of replicating indices can improve client outcomes. We’re desperate to educate our clients about it, but we are very much a retail business, and even though we have discretion, we have a very intimate relationship with our clients. We talk to them, and we recognise that there is still a lot of concern about more complex ways of putting together these structures. On that basis, there is still a leaning towards physical replication.

Marcel Wagner: The market has decided, there’s a strong preference for physical products with the main swap-based players switching to, or launching physical products. But in certain circumstances, if that Delta One desk hands you over the benefit, or if you can access exotic sub-asset classes then I think there’s a strong case for synthetic replication. Everything else equal, I think it’s easier to communicate with clients and model the ETF within your internal risk system. With the synthetic ones, you always have to tweak something.

Delyth Richards: We err towards the physical because it’s easier to explain. If you’ve got a synthetic product that happens to be more expensive but is outperforming, and you have to then explain how to make that outperformance, you’ve got several legs down into that conversation that makes it really tricky. It is up to us to build the blocks together, but a knowledgeable client will ask ‘Why are you using such an expensive product?’

But think how far we’ve come, even if you wind back seven, eight years, we probably used one provider and now we have a wealth of different providers, having new, innovative solutions which are forming main parts of our portfolios. It’s not led by clients, it’s led by us, by our conviction, and we’ve had to educate them.

But I still remember seeing some representatives of ETFs who did not know the credit rating they were representing. We’ve educated ourselves and we’re a much more knowledgeable industry now.

Elisa Trovato: Do you adopt a provider approach or product approach when it comes to selecting ETFs?

Didier Duret: We cannot talk of open architecture anymore as such. The goals you want to achieve for clients lead to the selection of one or several providers.

One of the key elements for the future is education. There is a paradox here. It’s a simple product but we need to educate people a lot, because there are several misconceptions about ETFs. You really need to get into the heart of what an ETF is, its benefits, but also its risks. What are the risk of underperforming? What are the risks of being a hidden, active investor behind the passive and so on.

To address this complexity, we built a programme together with INSEAD to train more than 500 advisers on the active versus passive debate. This investment has created comfort and relevance to implement the right solutions.

Elisa Trovato: Do you see that for clients it’s important to select a provider offering a wide range of products, or what really matters to them is the firm’s specialisation and its ability to provide innovative solutions?

Ted Malcolm: If you’re taking the time to approve a provider, you probably want them to have a lot of products, because it means you don’t have to approve lots of different providers. But ultimately choice is good. What generally happens is a client will approve us as a provider, and then we’ll go into the individual products.

But it’s crucial to understand how ETF providers manage portfolios. Passive is not rocket science, but in particular areas, such as fixed income, you do need experience, the systems, a large trading desk, experienced portfolio managers, to be able to manage those exposures effectively.

Elisa Trovato: Is there any underrated criteria for selecting ETFs?

Delyth Richards: Here’s my one that always makes people laugh. Ease of access to the website. When you deal with private clients, they want information now, so you expect those websites to be well maintained. You need to be able to get the fact sheets immediately, to understand what the index construction is immediately. And you need to know if they’ve got reporting status. For me it’s a big thing, because it’s about service. It might sound soft, but it is an important factor.

Marcel Wagner: Looking at the overall cost of investing, taxes are very important. Very often we have a ranking of, say, five ETFs, and maybe the third is the best for a specific client, after withholding tax. That’s quite hard to assess in standard systems. It’s kind of odd for the client because they see they don’t have the best performing ETF on the factsheet, but after all costs it’s the best for the portfolio, and that’s important to assess as well. This is very often overlooked.

Elisa Trovato: In a liquidity crisis, how risky is it to hold certain types of EFTs?

Ted Malcolm: ETFs are only as liquid as the underlying and are another access tool to that market. Investors need to get comfortable with that underlying liquidity, understand the risks associated with those particular exposures and make appropriate decisions based on that.

Antoine Lesné: ETFs are still very small compared to the overall fund market. What happens if investors start to desert corporate bonds? Are they going to sell a trillion dollar of bonds overnight like that? I don’t believe that. But ETFs will show liquidity where the rest of the industry will not show it. You will see a discount during the day, it might be up to 3 per cent, if that’s the cost of getting your money out on that day. In some cases, you just can’t get it, so it’s your call ultimately to decide whether you want to take a 3 per cent hair-cut or not, but that’s the cost of liquidity.

Marcel Wagner: I think it’s perfectly fine with traditional asset classes, if there’s normally a market for it. But as soon as we start using ETFs on some exotic exposure, where you have a liquidity premium, then it can be dangerous, but I think we’re not there yet. As an example, if you have private equity wrapped into an ETF, the underlying market is not super liquid. This might be an issue.