The age of ETFs

David Chellew at HSBC Global Asset Management looks at the growing popularity of beta and the different market access vehicles on offer

Since 2000 the European ETF industry has expanded from a handful of products listed on two exchanges to be part of a worldwide industry with more than 1,500 listings. Growth has been driven by demand which has seen the number of Exchange Traded Products (ETPs) including exchange traded notes and commodities, increase by some 600% over the same time horizon. This is fantastic for investors, giving professionals and self directed retail investors an opportunity to create diversified portfolios and keep total costs below the magic 1%.  

In the UK, a renewed emphasis on investment charges, linked to the much debated Retail Distribution Review, has breathed fresh life into the lungs of the index fund market. Broadening out of the demand for market access products in Europe, from a predominantly institutional offer to encompass a wider range of client target categories, has resulted in changes in the landscape. Notably, major firms have moved in to claim their share of the fast expanding and potentially lucrative market access category, which has resulted in increased price competition and efforts among providers to differentiate their approaches. 

Market access products: what are the differences?  

So, with beta popular, how do clients choose from the range of available instruments? To start, many benefits are shared across all market access products generally, not just ETFs. Some of these universal characteristics include relatively low charges and well managed expenses, clear objectives, the elimination of underperformance, and transparency of portfolio holdings especially in the case of ETFs. Stock diversification is also an obvious advantage of ETFs in preference to direct equity securities. It is potentially faster and cheaper to build a portfolio of ETFs than it is to create and manage a portfolio of directly held securities.   

Taking price, there are nuances that separate the approaches of ETFs and index products. ETFs publish their total expense ratio (TER) as opposed to just the annual management charge which means ETFs give investors a better idea of costs than traditional funds. Even the TERs of index funds don’t include the costs of trading by the fund manager as he or she buys and sells stocks over time. 

This is where ETFs are very different by design, since subscriptions and redemptions are handled through the transfer of stocks into or out of the fund. This keeps trading volumes low in comparison with a traditional fund, where the manager places trades to convert cash flows going in the fund into stock, and vice versa. This makes trading costs in a traditional fund much higher, particularly if subscriptions and redemptions are high. 

In an ETF, however, because there is a bid/offer spread on the share price, you pay slightly more than the net asset value (NAV) to buy an ETF and get slightly less than the NAV when you redeem. This spread can be very small, but if you trade a lot then this cost can mount. What this approach means is that investors who choose to stay put in an ETF do not pay for other people’s trading. In a traditional index fund, the costs of trading are spread across the fund so those who don’t trade typically end up paying a bit more than they should.

There are also some differences in portfolio implementation. The tracking error of an ETF is derived from expenses and mismatches between the index and the portfolio composition. ETFs are generally able to match the index very accurately because of the low annual management fees, trading costs and other expenses and also because they can keep the ETF portfolio in line with the index by transferring stock without trading.  

Convenience in the eyes of the buyer is also a significant factor when selecting ETFs or indexation. The differences here come about because ETFs are listed. Unlike index funds, ETFs can offer ‘real time’ pricing as opposed to a single valuation point. It is possible to trade ETFs exactly when required while there is less paperwork involved in comparison with buying index funds. Tactical asset allocation trades can be opened or closed with immediacy not possible with traditional indexation approaches. There are other applications which are inherent in ETFs for professionals. These include the ability to short, gain market exposure to cover cash, transition management or to ‘de-bulk’ large trades. 

Still room for index funds

Does this mean that index funds have had their day? Far from it. The two are not mutually exclusive. In fact, what is happening now is the expansion of the beta category in Europe, not the replacement of traditional indexation with ETFs. Index funds have a lot going for them. While the retail price may seem higher than ETFs generally, for those with significant sums to invest they may work out to be the cheaper option. If you are a long term investor and you don’t have stock broking arrangements in place, buying an index fund can avoid issues with owning shares. From an adviser’s perspective, it can be more difficult to recommend ETFs when many popular UK platforms are still working on making ETFs generally available. This can make index funds a more practical recommendation.  

In the long run, ETFs have a lot to offer and we expect competition to encourage specialisation and a broader range of strategies. This can only increase the choice available for advisers and investors. In terms of differentiation among the providers, we expect investors to favour providers that offer strong governance, to differentiate on the basis of financial strength and the integrity inherent in the manufacturing process of the ETF issuer. Businesses with stable processes and rigorous controls in place, that are capable of differentiating the investment experience they offer to best suit the needs of their target customers, will have most success gathering assets.