Demand for smarter, more sustainable ETFs on the up

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Fuelled by rising equity markets, along with the central bank’s quantitative easing programmes, assets invested in ETFs and ETPs globally have more than doubled over the past five years, reaching a new high of $5.25tn at the end of September, according to research and consultancy firm ETFGI. 

But with correlations between asset classes breaking down in this late bull run, and selectivity becoming more important, will the demand for smart ETFs increase, perhaps at the expenses of traditional, passive products? 

The rise of smart beta

ETFs have transformed access to smart beta investing, capturing factor exposures using systematic, rules-based approaches, believe our panellists, although the complexity of these instruments and their short track records remain key issues.

While research on factor investing has been around for a few decades, ETFs have provided a very efficient structure for investors to gain access to factors, says Bernhard Wenger, head Switzerland at SPDR ETFs. “We are seeing increasing interest in ETFs to implement exposures that were traditionally the domain of active managers, like factor, thematic or smart beta strategies,” he says.

Income seeking strategies represent the bulk of assets in smart ETFs, or non-market cap weighted index ETFs, with five of the 10 largest smart beta ETFs in Europe following a dividend-oriented benchmark, according to Morningstar analysis. 

But it is important that such strategies track indices that provide stable dividend growth. “You want to make sure you only have stocks in the index that provide long-term dividend growth,” says Mr Wenger. This is the index methodology applied in the SPDR Dividend Aristocrat ETF range, only making eligible those stocks that have generated increased dividends, for the past 20 years in the US, and 10 years in Europe.

A bull market with limited volatility, combined with disappointing performances from active managers have certainly driven demand for ETFs, and smart beta funds are “natural tools” in the armoury of a portfolio manager, says Christophe Leroy, head of Discretionary Portfolio Management, Switzerland, at BNP Paribas Wealth Management.

 “Smart ETFs should not be opposed to actively managed funds, they complement them in portfolios, as they help you navigate and get a quicker access to specific themes or factors, provided you do proper due diligence on the index methodology used,” he says. 

These strategies offer opportunities but also new challenges. “Portfolio managers need to be very disciplined in their investment process to identify which factor to favour at which stage of the cycle,” adds Mr Leroy.

When you have a “proven macro approach, and a view on which cycle of the economy we are in, these instruments are very useful,” states Jacques Lemoisson, head Global Macro and Alternative Investment Solutions at CBH Bank. 

For example, such ETFs were helpful in playing the rapid growth of US small caps, following Donald Trump’s presidential election victory, with its key pledge of putting “America first”. 

Today the divergence in performance between different styles, growth and quality, is huge, with growth having been the sweet spot for smart ETFs. But political and market uncertainty, combined with trade wars, are shifting the focus on low volatility strategies, believes Mr Lemoisson. 

In the current late bull run, low volatility or market neutral factor ETF strategies could be most suitable, says Romy Cuadras, global head of Fund Solutions at Deutsche Bank, adding that the bank’s key recommendation to clients is “to stay invested but hedge”. But it is unlikely that private investors will flock to these hybrid strategies as they have done with long beta ETFs, she adds.

“Smart ETFs are complex, as the algorithms behind them are complex. We need education, but how do we educate our clients to understand they can, and should, use smart beta ETFs?

These solutions often show fantastic simulated track records, but the evidence is not there yet. We’ve been in a bull market, so we haven’t really tested them,” explains Ms Cuadras.

On the discretionary side, however, portfolio managers can use them as a risk management tool, more as a hedging instrument than to take a bet or view on a specific factor. 

Also, with new factors and strategies being launched all the time, it is important to rethink the way ETFs are selected. 

“It’s almost like doing due diligence on a CTA or a managed futures manager; it’s a very quantitatively focused due diligence test, and that adds another layer of complexity,” states Ms Cuadras.

ETFs need to be transparent and easy to understand, and this is even more important for retail investors, explains Felix Niederer, co-founder and CEO of digital wealth manager True Wealth. The core of the firm’s client portfolios sit in liquid asset classes covered by market weighted asset ETFs, although more sophisticated clients may want to deviate from these standard solutions, he ventures. 

Multi-factor strategies

If individual factor strategies have some appeal, multi-factor strategies are more controversial, as they are even more opaque.  

Academic research suggests individual factors tend to outperform the market over the long-term, but they can go through long spells of underperformance. By combining factors, multi-factor funds aim to smooth out the ride. 

“I use only single factor ETFs, because I want to use a passive vehicle,” says Mr Lemoisson, explaining that in this case due diligence on the index methodology is straightforward.  “When you buy a multi-factor ETF, you buy an active strategy, which is difficult to understand. Transparency is key, I don’t want to buy a black box,” he adds. 

ETF provider SPDR has also its reservations on multi-factor strategies. “We do not currently offer multi-factor strategies in the ETF wrapper, we provide efficient building blocks in the single factor space, such as value, low volatility and size,” says Mr Wenger. 

While equities are the largest asset class targeted by smart beta strategies, using different criteria other than just size in fixed income ETFs is drawing interest.

Applying factors such as duration to bond indices, and leverage to a certain extent, instead of traditional debt weighting, is useful. GDP weighting is also quite an interesting approach, believe panellists, as it gives exposure in portfolios to higher growth countries such as India and China.

Sector bets

While in a bull market the trend is to invest in large blue chip indices, sector ETFs, which give a granular exposure to specific industry sectors, are growing in popularity. 

“In a late cycle, sector ETFs probably become even more relevant,” explains Mr Wenger. Investors wanting to invest with a cushion can look at defensive sector ETFs, for example. If they believe in growth, they may overweight growth sectors such as the communication services, a new sector recently introduced in the S&P500. It is already in great demand, including
high-profile names as Facebook, Alphabet and Netflix, which were moved out of the technology and consumer discretionary sectors into the new sector, a bulked-up version of the former telecommunications sector. 

Also, return dispersion between sectors has been significant in the last couple of years, strengthening the case for sector ETFs. 

Our panellists are passionate users of sector ETFs, as they enable fine tuning of portfolios. 

CBH’s Mr Lemoisson, one of the first sponsors of the first sector ETF in Europe is a “big fan” and is now pushing for new product launches in Asian sector ETFs, seeing for example a China healthcare ETF as highly desirable. 

Sector ETFs are appealing because they are easy to explain to clients, and provide very clear building blocks, enabling the customisation of portfolios, says True Wealth’s Mr Niederer. “With a sector ETF, you can tell a story, you just say ‘healthcare’ and it works, they have a picture in mind.” 

Another reason to like them is that usually stocks remain in the sector, so investors do not have to pay for the movements in and out of an index. 

While there are several sector ETFs covering Europe and the US, Mr Niederer would welcome sector ETFs in additional markets, believing there is still room for growth.

A recent survey on wealth managers conducted by State Street Global Advisors found that healthcare and technology are the most popular sector ETFs. 

“ETF sectors will continue to grow,” expects Ms Cuadras, observing that actively managed funds in specific sectors like fintech have not added additional value in this space. “But there are risks from the index construction and liquidity perspective,” she says. 

Technology used to be a tactical bet, but is now a structural bet in client portfolio, explains Mr Leroy at BNP Paribas, and while the trend is very strong it will not last forever, he expects. 

But there is more and more competition between sector ETFs and thematic ETFs. “I think in 10 years the spectrum of thematic ETFs will narrow down on just the ones that are very powerful; it’s an evolving process,” he says, while Mr Wenger at SPDR ETFs explains that thematic ETFs should invest in mega trends, and not just short-term ones.

Playing on emotions

In line with global trends, ETFs tracking environmental, social and governance (ESG) indices greatly appeal to private investors’ emotions and values, and demand for these solutions is growing. Also, most research studies also show ESG investments add value to portfolios from a return perspective over the long term.  

“We have clients asking for ESG ETFs every day. The rationale for including them in portfolios is not just performance, it is the emotional benefit for certain clients,” says Mr Niederer.

But what ESG means to one person may not be the same as it does to another. So, how do fund analysts and providers go about selecting and building these solutions?

There are two essential steps, says BNP Paribas’ Mr Leroy. It is important to classify ESG ETFs as best in class, exclusion and impact. “It is important to be aware of the strategy and philosophy behind each ETF, and the impact the client wants to have in his portfolio. It is really a bespoke approach that you have to put in place for them.”

It is, however, important to measure the strength of the client’s conviction, he adds. “Because right now, you have to make a compromise between the purity of the strength of your conviction and the liquidity, the cost, the efficiency of the strategy. All these aspects must be discussed with clients.”

Sustainable strategies are today mostly the exclusionary types, with ETFs easily lending themselves to the screening process, says Deutsche’s Ms Cuadras. 

But with growth driven by the next generation of investors, ESG ETFs will have a stronger focus on championing companies that have a stronger environment, social and governance impact, she adds, mentioning the SPDR Gender Diversity Index ETF, SHE, which tracks a market cap-weighted index of US large-cap companies, with a relatively high proportion of women in executive and director positions.

Because many investors have a different views of ESG, it is challenging to build an ETF solution that can meet all client needs and draw substantial flows, says Mr Wenger. 

“As an ETF issuer, we try to bring products that are relevant to the market, for as many investors as possible,” he reports, stressing that size and liquidity are important to all. 

While there are lots of ESG ETFs available, they are in the early stages of development, he adds. 

Wary of the high reputation risk which may be intrinsic in niche or concentrated strategies, panellists expressed their preference for broad ESG ETFs, replacing, for example, a core holding such as an S&P 500
fund.

Illiquidity fears

There are concerns the rapid growth of ETFs has created a situation of
extreme illiquidity for many of the underlying stocks, and ETFs may not fare well in an event of a sustained sell off. Due diligence is key to facing these fears.

With the bull market coming to an end, and with more and more people thinking that ETFs are always liquid or safe, a crisis could bring liquidity challenges for some small issuers, believes Mr Lemoisson. 

There may be a spiral effect if investors’ expectation of liquidity in ETFs is not met, which drives him to focus on large, broad-based ETFs, noting that some ETFs lend up to 90 per cent of their assets, “squeezing the market”.

“From a logical perspective, I have never understood this argument. Why should ETFs suffer more than active managers, on aggregate?” wonders Mr Niederer, believing fears have been fuelled by active managers. 

“Of course, when there is a market crash, most ETFs will suffer, some more, some less. You have to do your homework before investing and do due diligence on the issuer.”

There are specific segments of the market, which need to be assessed carefully, such as some thematic ETFs, observes Mr Leroy, where there may be a disconnection between liquidity of the ETF versus the liquidity of the underlying. 

“Liquidity is a huge challenge with regard to specific sector ETFs,” observes Ms  Cuadras. “The fear we have is that liquidity dries up. When everyone is short and everyone needs to sell or market-makers need to hedge their index, where is that liquidity going to come from?” she asks.

It is crucial to consider the structure of ETFs, the issuer, and the quality of the setup of the product, believes Mr Wenger. Lending should be done in a conservative way. “In a crisis, the more conservative and
the safer the product set up, the better.” 

The most risky products structure-wise are probably inverse or leveraged ETFs, predicts Mr Wenger.