A move by firms in the United States to better classify different types of exchange traded products (ETPs) is unlikely to be replicated in Australia as the market is already highly regulated and composed mostly of exchange traded funds (ETFs), say industry experts.
In May, BlackRock, Vanguard, State Street Global Advisors, Invesco, Charles Schwab and Fidelity made a proposal to US stock exchanges for four distinct categories of products.
These were ETFs, exchange traded notes (ETNs), exchange traded commodities (ETCs) and exchange traded instruments (ETIs). Currently all these vehicles are classified under the wider ‘exchange traded products’ banner.
Commenting on the proposals, the firms said the broad classification had led to ETFs becoming a catch-all term for a wide variety of different products and a stricter system would offer better transparency. There had also been dangers with a number of esoteric products being forced to close as they were unable to cope with the recent market volatility.
But in Australia, around 90% of the 249 exchange traded products available are ETFs with the largest providers including Vanguard Australia, BlackRock’s iShares and BetaShares. Most are passively managed and track an index such as ASX 200 but there is a growth in actively-managed ETFs coming to the market.
They can invest in Australian equities, international equities, commodities and there is growing demand for those which invest in fixed income, the fastest-growing ETF asset class as investors seek alternative sources of income in a low interest rate world.
According to latest monthly figures from BetaShares, total ETP assets reached $64 billion in May and the most popular categories were Australian equities at $665 million followed by international equities at $493 million and fixed income at $166 million.
ETP trading volumes during May 2020
The sector had withstood the volatility of the COVID-19 pandemic, seeing inflows of $1 billion in April and $1.6 billion in May, according to VanEck, as investors sought out ‘bargains’ in the market downturn.
Arian Neiron, managing director of VanEck, said: “ETFs are more liquid, lower cost and transparent. Investors don’t need thousands of dollars to make an investment and can buy and sell the exact amount they need on the ASX. ETFs are positioned to grab even greater market share through 2020 and well into 2021”.
According to the Australian Securities Exchange (ASX), there are three different types of ETPs available for investors. These were ETFs, exchange traded managed funds (ETMFs) and structured products.
ETFs and ETMFs are both types of managed investment schemes (MIS) and an investor would hold the units in the MIS that operated the fund, with each unit representing a proportionate interest in a portfolio of assets held by the fund.
ETFs are usually passive index-tracking investments while ETMFs could be active or passive and sometimes tailored to achieve certain outcomes such as inverse exposure, leveraged exposure or single asset exposure.
Structured products typically do not invest in the underlying asset at all but aim to replicate the performance of the asset synthetically by holding financial instruments such as a futures contract.
Products described as ‘synthetic’ are those where the firm has chosen to synthetically replicate the performance of assets they sought to track or outcome sought to be achieved, usually because it is difficult to hold the underlying physical asset.
Sam Morris, investment specialist at Fidante, said: “We already have a strict classification system here in Australia, you have to make sure the name accurately reflects the product and have to label it correctly and say whether it is active or passive. We have these naming conventions and I think it would confuse consumers if we did [what the US is proposing] here”.
The Government’s MoneySmart website already also warned investors that products such as ETCs, ETNs, exchange trade certificates, exchange traded securities were not the same as traditional ETFs.
“Some products track an index or asset and ‘look’ like an ETF. But they’re not an ETF and can be higher risk,” it said.
“There are also exchange traded managed funds and exchange traded hedge funds. With these, the investment manager tries to outperform an index and may use high risk trading strategies.”
Firms highlighted the strict level of regulation from the Australian Securities and Investments Commission (ASIC) when it came to launching an ETP meant it was unlikely Australia would see the same level of products as in the US.
There were over 5,000 ETFs in the US including many obscure angles such as tracking companies which benefit from the obesity epidemic, companies making video games and ETFs managed by artificial intelligence.
Schroders portfolio manager, Mik Kase said: “The landscape here will be less exotic than in the US. Australia is more closely regulated to make sure products are appropriate and the assets it hold are appropriate. When we bought an ETF to market, the regulator wanted to make sure it was right”.
Morris said: “We won’t get the same level of speculative ETFs as they have offshore as the regulator is very aware of them and scrutinising them. Any [speculative products] would be heavily scrutinised by the regulator in order to be approved, we have a bias for simple, transparent products”.
Alex Vynokur, chief executive of BetaShares, which had launched 60 ETFs since it was founded in 2009, added: “The barriers to entry when launching an ETF are high, the process is onerous, there is lots of testing to consider factors such as transparency, liquidity, the impact of different timezones, client demand and cost effectiveness. Firms need to have significant testing and processes and economies of scale to launch a product”.
COMPARISON TO THE US
While Australia is one of the fastest-growing ETF marketplaces with cumulative annual growth of 45% compared to 23% in the US, its total assets pale into comparison compared to the ETF market which is over US $4.2 trillion and expected to reach $50 trillion by 2030 according to Bank of America.
Industry figures are sceptical if the Australian market would reach the same heights as it is a smaller marketplace, has more regulation, and there are fewer free trading platforms.
Vynokur said: “ETFs are catching up to the US in levels of adoption, they have had ETFs in the US since 1993 whereas we have only had them since 2001. We have a lot of catching up to do but it is also a much smaller marketplace.
“The barriers to adoption have been addressed but we are still on a journey.”
People in Australia typically have to pay $5 to $8 per trade or go via a financial adviser whereas the US has various commission-free platforms for ETFs including TD Ameritrade and Robinhood. There was also less institutional buying of ETFs here with institutional players currently choosing to invest a small sum and watch performance before investing larger volumes of assets.
“In the US, the cost of brokerage is $0 but here there is still a cost or some charge via basis points. The market is getting cheaper but it still has a long way to go. But we are seeing more adoption by younger investors via platform such as CommSec which enables them to make regular investments and include ETFs as a building block in a portfolio,” Vynokur added.
Morris said: “In the US, there is huge retail participation in short-term products and people trade more frequently whereas in Australia, people pause more and think about their investments. We don’t have the same ecosystem.
“We don’t have the same quantum of highly-leveraged trading here, the products in Australia are all simple and transparent but they could get more sophisticated as the market grows. You’ll see more variety, more active ETFs but will also see products shut down if they fail to achieve scale which is indicative of a maturing market.”
However, all commentators agreed that investor education and awareness has improved over the years with investors now discussing different types of ETFs available and how they can use them within a portfolio. This is particularly the case for fixed income ETFs which are a fast-growing area away from the traditional Aussie investors’ domain of domestic equities.
Fixed income ETPs saw inflows of $166 million in May, according to BetaShares, with the majority going into Australian ones.
Kase said: “There has always been interest in stocks but investor education has improved in other areas. Historically, when I told people about bonds, they were not interested but now we are in a low interest rate world, people are looking for alternative sources of income and arming themselves with information about them”.
Morris said: “Five years ago, we were having to explain to people what an ETF was and we have passed that stage now and investors are investing more as their financial education improves and expands. Companies have put a lot of effort into investor education.
“The benefits of ETFs do not always apply to other ETPs even if the products are all exchange traded and sound fairly similar. It is always wise to read the product disclosure statement or consult a financial adviser before you invest.”
However, this inclination to “pause more” before investing was not the case during the market downturn as investors sought out a bargain as the market tanked. According to ASIC, between 24 February and 3 April, the average daily turnover in ETPs increased from $703 million typically to $1.8 billion. This was a relative increase of 159% compared to an 89% increase over the same period for broader securities.
The sharp spike in flows caused the regulator to issue a warning against speculative short-term trading including geared or leveraged ETPs.
In its report, ASIC said: “Gearing magnifies the risk of these ETPs, by increasing profits from favourable market movements but also increasing losses from unfavourable market movements. Additionally, geared ETPs are complex because they are actively managed to periodically reset the level of gearing, to ensure that it remains within a specified range after large market movements.
“Geared ETPs should not be traded by investors who do not have appetite for this risk or understand the complexity. We saw trading volumes for one geared ETP increase by 16x the normal volume to become the second most-traded ETP. Retail investors were on at least one side of 75% of turnover in this fund during the focus period.”
Robin Bowerman, head of corporate affairs at Vanguard, said: “[Investors should] be careful not to confuse Ps and Fs. Using riskier ETPs to capitalise on market volatility or magnify returns may seem tempting but the reality is it could lead to significant losses even if they are not fully understood.
“Geared ETPs magnify the potential gains from investing in ETPs if the market moves favourably but also the potential losses if it doesn’t. As such, and especially if the investor is using borrowed funds in the first place, it can be significantly riskier than investing in an ETF and is not suited to investors who do not fully understand its complexity and associated risks of gearing and potentially receiving margin calls if borrowings are involved to make the investment.”
Vynokur said there was a distinct difference between those investors who are using ETPs as a long-term investment and those who are making short-term trades on the exchange.
“The combination of valuations and social isolation during lockdown caused a pick-up in trading but we have to draw a distinction between trading and investing. There is no quick path to riches, if professional investors struggle to time the market then what chance do individual investors have? Unfortunately there is a portion of people who are gamblers and day trading is high risk,” he said.
“We encourage people to be investors, to stay the course and take a long-term time horizon.”