ETFs pass their Covid test with flying colours

It took 10 years for the European exchange traded fund (ETF) industry to breach the  $250bn assets under management barrier, following its first product launch back in 2000. It took another five years for this to double to more than $500bn, and then only four years to double again to $1tn. Today that figure is just shy of $1.5tn, according to ETFGI.

Throughout their history, the resilience of these vehicles has been called into question, with critical voices claiming that they have never really been tested, despite more than holding their own during events such as the global financial crisis and its aftermath. The volatility sparked by Covid-19 has provided perhaps their greatest test, and it is one they appear to have passed with flying colours.

“As liquidity in underlying markets deteriorated during the sell-off [in early 2020], especially in fixed income, ETFs continued to trade efficiently, playing a leading role in price discovery for investors and banks as they gave transparency to the values at which investors were prepared to exchange risk,” says Nick Hutton, head of UK iShares and Wealth at BlackRock, which continues to dominate the European ETF market (see table).

“Past experience shows us that each time ETFs are tested and pass, more investors learn about and become open to the role they can play in portfolios, and become first time users,” he says.

The scale of last year’s events mean detractors can no longer show ETFs have not justified their worth, says Brendan P Ashe, head of ETFs at HSBC Wealth and Private Banking. “Through the crisis, ETFs proved resilient with all redemptions being met and tracking quality being maintained. Record trading volumes also showed investors increasingly turned to ETFs to adjust positions and transfer risk.”

Much is made of the intra-day liquidity offered by ETFs, but it is the presence of a secondary market that is more valuable to investors, claims Matt Tagliani, head of product and sales strategy at Invesco EMEA ETFs.

“In a traditional fund structure, inflows and outflows are only ever processed through trading the underlying security, but ETFs always had this advantage that you could trade the whole thing,” he explains.

So in the stress scenarios that characterised the early part of last year, while trading in underlying securities might have brought questions of liquidity, ETFs provided a very clear guide as to where the market was, says Mr Tagliani.

Moreover, while equity ETFs saw outflows at certain points, fixed-income products picked up the slack. “There is now a sufficiently diverse range of products that people can sit in the ETF world and move between equity, fixed income, commodities and more, and have all the tools they need,” he adds.

Turning point

Indeed, 2020 will go down as a turning point for global client adoption of fixed-income ETFs, says BlackRock’s Mr Hutton. “We estimate that over 100 asset managers and asset owners globally were first-time adopters fixed-income ETFs in 2020,” he says. Yet, in spite considerable growth, bond ETFs represent only about 1 per cent of the $100tn global fixed-income securities market, so there is considerable room for further growth.

Covid-19 has been a catalyst for many to rethink their fixed-income allocation, says Mr Hutton, with investors increasingly focusing on investment outcomes and utilising fixed-income ETFs to drive portfolio efficiencies and overall portfolio resilience through diversification. 

“With ETFs driving structural changes in bond markets, including greater transparency and the rise of electronic trading, we believe fixed-income ETFs will form an increasingly important part of an investors’ toolkit over the years ahead,” he adds.

While fixed-income products have been enjoying healthy growth, the real standouts were those in the environmental, social and governance (ESG) sector, which have attracted roughly 50 per cent of assets in 2021 and are seeing huge amounts of innovation (see View from Morningstar box).

“I would say close to half of all new launches are ESG products, and this is only accelerating,” says Mr Tagliani. “In our case it is more, building out the range to ensure we have different levels of ESG product for different investors.”

He splits these strategies into “dark green”, where ESG principles are rigorously applied, and “light green”, where the worst-scoring companies are excluded.  

“Last year there were a lot of flows into darker green strategies, which was fine for a lot of investors because it was underweight energy, which in March was getting hit. No one was filling up their cars or taking flights.”

But now some of the lighter green strategies are doing well, he reports, where there is less of an obvious sector bias. “Going for the most green concept is not always best. Not everyone wants dark green. It may have exposures certain investors cannot justify,” he adds.

The biggest area of growth at Legal and General Investment Management (LGIM) is in thematics, says its London head of wealth management sales, Steve Gray. 

“We are seeing interest right across the piste, be it cyber security, robotics, clean water, anything that is high growth, then also in ESG. Indeed thematics and ESG actually fit hand-in-hand.”

More than $11bn was invested in European domiciled thematic ETFs last year, according to Morningstar — a trend which has continued into 2021, with themes that look to address environmental concerns driving much of these flows. 

“ETFs providing exposure to the energy transition, electric vehicles, and renewable energy, like battery technology, are resonating with investors,” says Ravinder Azad, head of UK sales at WisdomTree. 

On the back of this energy revolution, metals have seen a resurgence in demand, he reports. “Copper, nickel and silver — all integral components for various ‘green’ initiatives — have been growing across wealth management portfolios, sitting alongside ‘traditional’ gold holdings.”

Gold always proves popular during spells of market volatility, and there are several  benefits an exchange traded product (ETP) has over traditional ways of investing in the precious metal, says Mr Ashe. 

“ETPs provide transparent exposure to the wholesale gold spot price and the exposure can be accessed in relatively low investment amounts. For example, a ‘Good Delivery’ gold bar must weigh 400 troy ounces,” he says. “At the current gold spot price [$1,893.15 as of June 8] a Good Delivery bar will only be available to an investor able to commit $757,260 to the trade.” 

However there are no minimum sizes imposed on trading ETPs in the secondary market, so investors of all sizes are able to access gold, while all the costs of holding gold are bundled into a single expense ratio. This includes the investment management fee, and the storage and insurance costs that would need to be borne separately by an investor investing directly in physical gold, while the economies of scale that come with investing via a pooled structure helps keep these costs low. 

While many thematic ETFs, and indeed ESG strategies, will tilt their weightings to certain factors, they will tend not to be termed “smart beta” strategies. These funds, which use rules-based systems to try to enhance returns, were all the rage a few years ago, but seem to have since moved down the pecking order. 

But after a fairly lacklustre 2020, this year has seen something of a revival for this part of the ETF market, says Vipul Faujdar, responsible for SPDR ETFs’ UK distribution, with record inflows enjoyed by the likes of value exposures, followed by size and dividend factors. 

“The innovation we are seeing is largely through ESG overlays on well-known traditional factor plays. This is proving popular already with low-vol ESG strategies gathering significant flows, and the next place to watch could be the innovation we are seeing in the dividend ETF space from an ESG perspective,” he says.

Smart beta has definitely had a resurgence, agrees Mr Tagliani, with 2021 seeing a big rotation into this area following a quiet period.

“One of the knock-on effects of any period of market uncertainty is a pull back towards simpler beta-type strategies,” he says. “That has started to wash out of people’s systems now and we are seeing a big uptick in interest around smart beta strategies. These are not necessarily the same ones that were popular five years ago, but certainly looking at what is the weighting scheme and why.” 

Smart beta strategies have struggled in recent years as increasing competition and low-cost computing power have commoditised the smart beta model, argues Michael Loukas, CEO and principal of TrueMark Investments, a provider of actively-managed ETFs. “It’s harder for them to stay ahead of the competition with so many people chasing the same factors that have generated alpha in the past, ultimately competing away any advantage in a relatively short time frame.”

He argues that instead of using rules-based passive products, active ETFs are a better way of finding alpha, and gives the example of dividend products which have been a popular way of gaining exposure to a corner of the equities market that has tended to outperform over time. Mr Loukas claims most passive-dividend ETFs either do not generate sufficient yield or have too much volatility to be viewed as a realistic alternative to bonds in the current market.  

“The benefits of an active ETF is that we can provide an attractive yield with less volatility than many passive alternatives,” Mr Loukas says. “The investment process for passive dividend funds is akin to driving by, looking through the rear view. They are buying companies with high yields without analysing the potential to maintain or grow the dividend in the future.” 

There seems to be no sign that the exponential growth of ETFs will slow any time soon, nor that innovation in the sector will ebb away. Indeed, there is some evidence that providers seem to be exploring new strategies in an ETF wrapper before other vehicles.

“One anecdote I will share is that a client had recently come to us. They were new to ETFs, and they said we want to speak to you about [them] because we are starting to realise that there are some newer strategies that are going into the ETF wrapper that we can’t find in mutual funds,” says Howie Li, head of ETFs at LGIM. 

“When that happens, then you know that you can’t just ignore ETFs. It is, after all, just a wrapper. ETFs are just mutual funds that happen to be listed.” 

Robo-advisory

The growth in ETFs has been a crucial factor underpinning the development of the robo-advice industry, many of which use these products to construct their portfolios. 

UK-based online wealth manager Nutmeg uses only ETFs in its portfolios, and its director of investment risk, Pacome Breton, reports that they have been working “brilliantly and exactly in line with expectations”.

“There has been an explosion in them and you can create a very diverse portfolio only using ETFs,” he says. He points to the growth in ESG product. When Nutmeg launched its SRI offering a couple of years ago, there were interesting products out there, but not that many of them. 

“But since then, things have evolved a lot and we now have the ETFs available to get exactly the exposure we want. And the size of ETFs increased significantly as well, so we can trade them with very, very tight spreads. That was not the case before.”

While their low-cost nature and intra-day trading have proved popular, as ETFs have broadened their scope to include not just index tracking, but also commodity tracking and thematic and ESG-focused investments, robo-advisers now have the breadth to meet client demand, says Thomas Lowe, head of product at Winterflood Business Services, which builds and maintain the technology and infrastructure behind several robo-advice apps.

“By leveraging tools like fractional trading of ETFs, the robo-adviser has the advantage of fully investing customer cash across portfolios, while still remaining responsive to market stresses like Covid-19 by strategically utilising things like fixed-income ETFs to rebalance holdings and manage risk,” he says.

VIEW FROM MORNINGSTAR: ESG strategies embrace ETF wrapper

Most sustainable funds are actively managed, but passive sustainable funds are growing in number, size and complexity, and are making their own mark on the landscape. 

According to Morningstar data, ESG ETFs have reached record inflows in Q1 of this year. In Europe, this amounted to €25.8bn ($31.3bn) in the first quarter, up from €21.3bn in the last quarter of 2020, and represented more than half (almost 54%) of total flows in ETFs in the period. Assets in ESG ETFs grew to €17.9bn from €87bn at the end of 2020 and already account for 10.2 per cent of all money invested in ETFs in Europe. There has been a significant increase in flows into ESG products in the past two quarters and this is expected to continue.

While sustainable exchange traded products (ETPs) usually do not match the fees of the lowest-cost traditional index funds in their Morningstar Categories, on average, they charge similar fees to ETPs that do not focus on sustainability. The number of passive ESG funds has also increased dramatically in recent years, and these low-cost options can be a great way to tap into sustainable investment themes. The environment — climate and energy transition, in particular — remains a strong theme in Europe.  

Those looking to profit from the structural shift towards renewable energy might use the thematic iShares Global Clean Energy ETF, which invests in 30 of the largest players in solar and wind power, and has been the best-performing ETF in Europe year-to-date. The narrow focus of the fund means that it is not suitable as a direct replacement for a core holding, but may fit snuggly with existing ex-energy funds. 

The UBS(Lux)FS MSCI EMU SRI EUR Adis fund uses full physical replication to track the performance of the MSCI EMU SRI Low Carbon Select 5 per cent Issuer Capped Index. It achieves this by holding all index constituents in their prescribed weightings. The fund has comfortably outperformed eurozone large-cap equity peers on an absolute and risk-adjusted basis over the trailing three and five years. 

This fund has also outperformed the MSCI EMU Index by a considerable margin over the same periods. This outperformance has been driven by an overweight in technology stocks and an underweight in the energy sector. Looking forward, the main outperformance thesis rests on ESG’s implicit “quality” play. This suggests that well-governed and fit-for-the-future firms are well insulated from the growing reputational and regulatory risks associated with unsustainable practices.

Investors looking for large- to
mid-cap exposure to a lightly
ESG-screened portfolio of US equities at an attractive fee might use the iShares MSCI USA ESG Scrn ETF USD Acc. This fund’s low fee, and broad and representative cap-weighted exposure, make it a standout option for investors in US large-cap equities. 

This strategy leverages research provided by MSCI ESG Research team to apply a basic ESG screen based on business involvement in controversial and nuclear weapons, civilian firearms, thermal coal, oil sands and tobacco. In practice, this excludes around 40 stocks out of the 600-plus holdings in the parent index. Despite how small of an exclusion the ESG screen makes, the strategy has managed to offer an improved ESG profile relative to the non-ESG equivalent. 

Kenneth Lamont, senior manager research analyst, passive strategies, Morningstar