ETFs create new middle ground

The growth rate of exchange traded funds (ETFs) in the past few years has moved the sector from the sidelines into the main game, with funds under management (FUM) and investor numbers spiking since mid-2012.

According to recent Investment Trends research, the number of investors using ETFs was around 150,000 at the end of 2014 and is set to reach 185,000 by the end of this year, with the same research indicating that around 7000 financial advisers provide advice on ETFs to at least some of their clients.

At the same time, FUM in ETFs grew by $5 billion in 2014 alone. FUM grew by a further $2.8 billion in the first three months of 2015 to sit around the $18 billion mark, according to research by market participant BetaShares.

Entering the mainstream

Keeping in mind many of those invested in ETFs are self-directed investors using self-managed superannuation funds (SMSFs) or have accessed them directly without advice, it may be tempting to conclude that ETFs have yet to hit the mainstream.

However, BetaShares managing director, Alex Vynokur, said defining mainstream uptake of ETFs was not a numbers issue but was more closely linked to how they were being perceived in the minds of both investors and advisers.

"I don't think this is a quantitative measure but more closely tied to education and information," Vynokur said.

"In any conversation about ETFs five years ago, a lot of time was spent explaining what ETFs were but now in those same conversations people are talking about how to use them to add value to a portfolio."

Zenith Research senior analyst, Dugald Higgins, said the suggestion that ETFs have moved into the mainstream means they were once fringe products but in recent years they have not been fringe players or products, despite the ongoing shifts in the status quo of global asset management since their introduction.

"It might be better to ask at what point a market segment hits maturity. I believe that market maturity is when we reach a point of having a full suite of tools to enable adequate portfolio construction," Higgins said.

"At present, the Australian market is missing several valuable asset classes and strategies; in particular, global credit, listed infrastructure and alternatives outside simple commodity/currency products."

ETF does not equal DIY

It is likely these products will appear over time based on consumer demand and overseas experience, but the continued appearance and growth of ETFs will lead many financial planners to query how they should assess and use them in client portfolios.

BlackRock head of iShares, Jon Howie, said it is key to remember that ETFs, while based on an index approach, are far from a single group, and they are also far more than a commercialised do-it-yourself approach to buying stocks across an index.

"The mechanics of an ETF are actually very hard to perform as a single DIY investor, given the level of stock management, rebalancing and dividend reinvesting in line with fund positions, while also keeping the cost at a few basis points," Howie said.

"At the same time, ETF managers will vary widely and are not homogenous in the way they handle tax outcomes in a fund, their transaction costs and tracking errors. Advisers need to compare upfront costs with internal costs and develop a sophistication in their understanding of the offerings."

Howie admits that as the market opens up and more products enter the ETF space, this will become harder for advisers to do without specialist help. Yet so far advisers have not been left alone, with the major research houses all offering ETF research, and major ETF providers offering model portfolios, education sessions and roadshows.

New products but same old rules

None of this is new to advisers, with active managed fund providers promoting the use of their products in the same way.

MSCI Vice President of ETF client coverage, Tim Bradbury, said this established method of assessing an investment product also holds for ETFs, and planners should consider how they fit with both their business model and client base.

"Planners need to get the inputs they need, the feedback they require, whether from the ETF provider or from research and know what ETF exposure they are looking for while being aware of the costs, tracking error, assets under management and the trading spread," he said.

Five years ago, a lot of time was spent explaining what ETFs were but now in those same conversations people are talking about how to use them to add value to a portfolio

"Typically, once they have this information, advisers develop a relationship with a provider but they must have a clear understanding of how to use them in constructing a portfolio."

According to Higgins, current use among advisers is a core and satellite approach, or even a pure ETF portfolio for clients with low balances or who are low cost and low touch, with the former strategy producing good outcomes for investors.

"The way in which they are being used will depend on the adviser and their clients' requirements but Zenith has found that we can potentially reduce overall portfolio costs by between 20 per cent and 40 per cent (based on specific risk profiles), by substituting ETFs in those asset classes where market efficiencies make it more difficult for active managers to deliver," Higgins said.

Howie said while it can be tempting to allocate heavily to ETFs, they are still only a passive vehicle in most cases and passive investing only works in conjunction with active management.

"If the market is efficient and active managers can pick the eyes out of the market it would make sense not to use an ETF where active managers outperform. At present we are still seeing advisers work out what the appropriate ratio is between ETFs and active management, and work around finding that balance is still playing out," Howie said.

Yet as Australian advisers start to come to terms with what could be termed the first generation of ETFs, which typically follow a market cap segment of a major index, the second generation of ETFs are already starting to come to the fore.

Smart beta: what's in a name?

Many of these next gerneration ETFs are no longer tied to an index. Rather they provide investment in a subset of an index or specific assets that can be bundled into an ETF and sold as a listed investment resulting in ETFs across equities, cash, fixed income, commodities, currencies and strategies.

However, it appears the next big thing in second generation ETF products will carry the title smart beta even if this term has yet to reach universal acceptance, with some calling it fundamental indexation, alternative beta or factor-based indexing.

Even more vexed are the questions: what is smart beta, and should it be considered an overlay on passive investing, a middle ground between passive and active funds management or even a subset of active management?

ETF managers will vary widely and are not homogenous in the way they handle tax outcomes in a fund, their transaction costs and tracking errors. Advisers need to compare upfront costs with internal costs and develop a sophistication in their understanding of the offerings.

Pure active managers would shudder at that last definition, given that smart beta still relies on an index at the heart of its process with many active managers offering value in their ability to pick stocks without reference to the index.

Market Vectors managing director, Arian Neiron, said smart beta, like many aspects of ETFs is not homogenous and is actually a range of different index strategies that includes equal weighting, cap weighting, factor-based investing and fundamental indexation.

"In its basic form it has been positioned as the intersection between passive and active management," Neiron says.

"Globally, smart beta strategies have been capturing investors' attention and a lot of flows have been directed towards these strategies. One of the key reasons for that is smart beta has a demonstrable track record in achieving alpha. Index innovation has now showed how outperformance can be achieved without the cost, portfolio turnover and manager risk that is indoctrinated in active management."

The prospect of an ETF strategy producing alpha may indeed sound strange and inconsistent with how that whole model is supposed to work but in essence smart beta applies systematic rules, driven by a base factor, over the top of an index to capture sustainable risk premiums as well as index returns.

AXA Investment Management director of Australia and New Zealand Craig Hurt said there is some confusion around this model because smart beta has been ‘recruited' to the passive side of the argument while ignoring it has opened a third space in the landscape.

"It has come to be seen as another passive rules-based system but it is not a reworking of an index. It has moved out of the index space and into the areas between passive and active and we can expect it to eat the market of those active managers who have been closet index huggers," Hurt said.

"Smart beta will be able to account for risks that are not compensated for in passive investing and does not require 70 to 80 basis points in fees seen in active management. This is a fundamental shift in the way funds are managed, and when we look back in the future, we will see how fundamental it really was."

Deutsche Asset and Wealth Management head of passive asset management Sam Manchanda said this shift was already taking place with institutions and pension funds in Europe adopting smart beta as a mid-way point between active and passive strategies.

“They are moving from the benchmark in a systematic way which, while not promising performance, provides exposure to a factor desired in the portfolio. Fund managers may not be able to know the outcome but they will be able to document the process.”

Boom…or boom?

According to Neiron, the rise of smart beta will add further strength to the tail wind driving ETF development and uptake but where will it end?

Well the good news, according to most product providers, is that it will not end soon and its ongoing run is a boon for advisers and their clients.

Manchanda said current ETF growth was not cyclical and was likely to continue across the world with product offerings becoming more sophisticated in line with investors and their use and demand for ETFs.

“Unlike other products passive investing is well understood and investments in ETFs did not drop away during market downturns indicating that once investors begin to use ETFs they continue to do so,” Manchanda said.

Recent Investment Trends data points supports this view with more advisers set to take up ETFs, with indications larger licensees will add them to their platforms and approved product lists if they have not done so already.

At the same time Neiron points out that while ETFs are growing in the minds of investors at present they have been round for more than 25 years and have around US$3 trillion in assets under management globally and the Asia Pacific region will likely see ETF growth that follows other markets such as the US and Canada.

Vynokur said all this is good for local advisers and their clients who will have more asset allocation tools and products to negotiate future markets.

"As the market develops and matures we will see new players come, which is important because even in the 110 products on offer today there is a lot of overlap with at least five broad base funds and five large cap funds from a handful of providers," Vynokur said.