ETFs: ahead of the pack

Conjecture debate

A panel of experts discuss the issues surrounding ETFs and consider their advantages over more traditional investments

Monica Woodley: What are the advantages and disadvantages of ETFs versus traditional collective investments? How are you talking to potential investors about the differences between the two types of products?

Deborah Fuhr: Clearly one of the things that is very important to investors today is they want products that they can trade any time during the trading day, that they can trade with multiple brokers and that are very liquid. I think a very telling statistic from S&P is last year, you had 18 trading days when the S&P 500 moved by more than 5% in one day. If you look at the prior 53 years, that only happened 17 times. So clearly there is an emotional sense of missing out on performance if you wanted to get in and couldn’t, because if you use a traditional fund, you wait until the end of the day when the fund prices its underlying assets. But with an ETF, you can do it any time during the day. 

Another recent survey by S&P looked at performance of active managers versus benchmarks. And you saw that of active managers relative to the S&P 500, 71% didn’t beat the S&P 500. And about the same proportion didn’t for international and emerging markets benchmarks. I think historically investors like to believe in active managers, because they want to do better than benchmarks. But the reality is, when that is not happening, people want the ability to buy a basic product – products they know, they understand, can get in or out, know the cost of and, I think equally important with ETFs, you can see the underlying portfolios every day so there is that level of comfort that you know if you want to invest in thematic exposure like infrastructure, clean energy alternative, which stocks actually are included in that fund, or ETF.

Monica Woodley: As Debbie said, research shows that active managers don’t get it right, quite a lot of the time, yet the majority of assets are still in active funds. How big of a challenge is it to change people’s minds? 

Hector McNeil: It is a huge challenge. Probably the main challenge is that the mutual fund sector is set up to generate a fair bit of marketing money for funds – that is the major issue, that investors open their Sunday money sections and are bombarded by adverts from these funds, simply because they can afford to do it. 

Whereas ETFs by definition don’t have that layer of marketing spend. Saying that though, I think the truth will tell and more and more investors are finding they can self-direct their money. There is also a realisation that most of these so-called active funds are beta plus at most. I think there is going to be a real polarisation in the market. It is happening now where you are going to get true alpha, and people will be willing to pay for that and want that. And whether that is delivered by mutual funds or hedge funds or whatever, time will tell. And then you get pure beta, which I think will be ETFs. 

Reid Steadman: Just to address this issue of calling it passive investing. I think that there is this feeling amongst some investors that there isn’t an element of choice when they hear that terminology, whereas in reality there is a lot of choice. A truly passive fund is holding the full market and not just equities but also bonds. But most investors may actually typically have a core allocation to a broad market portfolio but then also make decisions about different asset classes. So even if you are taking a passive approach, you can still make very important decisions. For example, if you look at the US, through the end of May, the return of the S&P 500 was about 5%. The return of the UK market was around 13%. So you could take passive positions in each of those markets, but if you would have selected to invest more of your assets in the UK, your return would have been better. 

David Bower: We very much look at the market of active and passive - it is the two working in consort which actually delivers an efficient portfolio. What ETFs have delivered is new opportunities for investors where previously perhaps only an active strategy was available for them to access that market risk. 

It is not an enormous jump for an investor who has traditionally used active funds to use both active and passive. Because in fact, if you are in a US large-cap active mandate, you are buying a significant proportion of the market risk that can be delivered through a beta exposure at a beta cost. I think that, through intermediary advice, etc, is understood and people are making that switch to use both. 

Deborah Fuhr: I think the other thing to think about is as people are becoming more multi-asset class, you see that many institutional managers actually are using ETFs to deliver asset allocation because if you get your asset allocation right, you can deliver alpha. So although they are low-cost beta, they can be used in combinations to deliver alpha. I think part of this idea is that we have this huge tool box of globally over 1,600 ETFs that cover equities, fixed income, commodities, currencies. And increasingly you are finding that professional asset managers will even publicly say they use ETFs in different strategies to deliver alpha. 

Reid Steadman: There have been tools that have come out, new ETFs that allow investors to take advantage of certain themes that they hear in the market, where probably five years ago, that really wasn’t the case – infrastructure, the concept of BRIC (Brazil, Russia, India, China). We see in general an interest in these concepts that may cut across country classifications, or country and industry classifications. 

David Bower: In the UK intermediary wealth market, in terms of adoption, we do find a pattern in respect of advisers tactically adopting the vehicle, getting comfortable with the use of the vehicle and then moving to a more strategic use in client portfolios. And I think that is probably one of the key points for the UK intermediary market place. 

It is about education, it is about ensuring that they are comfortable with the products, ETCs, ETFs, other ETPs, before they advise their clients to use that, or use it within discretionary portfolios. And I think post-credit crisis, everybody is asking that question that I know we all should have been asking, what is it, how does it work, what exposure am I at? Through the boom, those questions didn’t get asked as much as perhaps they should have done; now those questions are very much front of mind. 

Reid Steadman: There has been so much development in the ETF space in the past couple of years – not just past couple of years but past six months. There is so much going on that I think sometimes financial advisers may have a couple of years ago looked at the space and thought, maybe there are not enough tools really to use ETFs exclusively. But I think now there are.

Hector McNeil: So far in Europe, I think people have been pretty comfortable using the broad indices and the big products. And some good innovations like cash funds, which have appealed to the market at the right time. But it is going to be interesting to see whether we can actually get penetration for some of the more thematic things. Those products are probably the ones that can add the most value in terms of the active versus passive debate. 

Monica Woodley: We have a lot of questions from our listeners on risk, and with different types of exchange traded products, what the different types of risk are. 

Deborah Fuhr: I think a challenge is liquidity. It is very much misunderstood in Europe. In the US last year, ETF trading volume each month was anywhere from 38% to 43% of all equity trades – so huge volumes. You come to Europe and under MiFID, you are not required to report trading of ETFs on most of the exchanges. So what you find is typically only about a third of ETF trades get reported, which is why your listeners think ETFs don’t seem liquid. 

The role of multiple counterparties is these brokers enter into legal agreements, which allow them to either trade the swap or go and trade the underlying portfolio securities. So the true liquidity in an ETF is, how liquid is the underlying basket of securities? Whether it is bonds or equities, the brokers can go and trade, say the FTSE 100 portfolio of shares, it gets delivered to the custodian and the ETF gets bigger. So the important message is that the true liquidity is the liquidity of the underlying portfolio of bonds, gold, equities, whatever. 

Hector McNeil: Unlike a certificate, an ETF is arbitrageable and the reason why is because it is priced against the NAV and you can always create and redeem against the underlying assets. Also, the more you can incentivise the distribution network, authorised distribution business of market makers, the more you can get liquidity in the products. I think that is really probably one of the Achilles heels there has been in the market today, the commissions that the guys can generate off these products hasn’t been sufficient to get them interested in ETFs.

Monica Woodley: We have a question saying, for example many investment grade bonds are moving to high yield and then perhaps bouncing back up again. With the ETFs that hold these, how can they provide constant returns when they are constantly having to rebalance the constituents of their portfolios?

Hector McNeil: It is interesting you say that because one of the advantages of the swap model is that you essentially get the swap provided to guarantee the index. And all the costs and risk around rebalancing of that index are borne by that party. 

Whereas with an in-specie product, the investment manager has to manage that holding and it has big rebalances and slippage costs related to that. That is essentially one of the major differences. I think it is just a generational thing, the model started there and we are where we are today. But it is an important concept to realise that the risk of that index replication is borne by the swap counterparty, not by the holder of the ETF, which is essentially what happens with in-specie products. 

Monica Woodley: With the rapid innovation in the market place, when we are looking at products such as inverse or leveraged, there have been concerns that without understanding even the basic product, what happens when investors use these even more advanced products? 

Hector McNeil: What people need to realise on the short and leveraged products is that there are daily rebalances. So you only get the fall or rise of the index on that day, and the hedge needs to be rebalanced. Therefore you get a compounding effect on the product, which means actually, from the investor’s point of view, what we should be doing is managing that position on a daily basis. And that makes it slightly more complicated. But I would say that the parallels to this are, if you trade a future or you trade an ETF in the same index, the returns will be different. 

Now clearly people understand the difference between a futures return and an ETF return, and in the same way, people shouldn’t believe that they are actually traded; if they trade the two times leveraged ETF, they shouldn’t believe they are actually trading two times the ETF. They should see it as a separate instrument and try and understand it. We had the same issue with the commodities actually, on the roll yield, the same thing. It is just an education thing really at the end of the day. 

Reid Steadman: There are more complex ETFs, more complex indices these days. And I think actually this creates a challenge, it creates a role for financial advisers to become aware and knowledgeable of different types of indices, different types of products, and with that knowledge, add value to the end investor. There was a time when the ETFs were mostly based upon broad indices when I think, to liken it to buying a house, it might have been sufficient to just walk in and make sure the water is running, make sure the electricity works. But these days, you should probably break out the blueprints and make sure you understand all the wiring. 

David Bower: From our point of view, we see some core exposures that still aren’t available in the market place. So this year we have added duration buckets to the euro government bond which are core exposures for an investor, which maybe don’t get looked on as big innovations. 

I think you need to balance that debate because these core products, the hot water, is still being turned on before the super Lucozade out of the other tap is being delivered as well. 

Deborah Fuhr: Having just come back from doing a nine city road show across Asia, what you are finding is many of the private banks are saying right now they would prefer not to use these because they are concerned that their end investors haven’t read the prospectus. And then get quite upset when performance is not what they expected. 

I have really seen a preference for the back to basics, indices people know and understand, the simple products. I am not saying that innovation is bad but I think right now we have gone through a pretty terrible market environment for many people and they are just looking for simple products that they can understand, explain to their end clients and use within normal asset allocation models.