Navigating the ever-expanding ETF universe

Over the past few years, many private banks have expanded their fund due diligence programme to include exchange traded funds (ETFs) and products (ETPs), as they recognise there is a clear need to guide relationship managers through this ever-expanding, more complex, and in some cases more opaque universe, today worth $2.09tn (€1.6tn), according to consultancy firm ETFGI. Also, client demand for these low-cost and liquid securities has grown significantly.

ETPs range from Ucits-compliant ETFs to non-fund exchange traded notes (ETNs) structured as debt securities. ETFs can physically replicate their indices, when they hold all or a substantial proportion of the index constituents, or they can seek to deliver the performance of an index through the use of derivative contracts, so called synthetic ETFs, where swaps can be fully funded or unfunded.

Counterparty risk involved in swap-based ETFs has been a hot topic for the past few years, but the securities lending practice carried out by some physically-backed ETF providers also brings risks. And then there are inverse, leveraged ETFs and so on.

So what criteria should private banks  adopt when approaching ETF/ETP selection and how different is the process compared to that used for actively managed funds?

“It is critical today to have a very strong and efficient selection process for ETFs as the universe is extremely broad, with more than 3000 ETFs worldwide across different asset classes,” says Lars Kalbreier, global head of investment funds and ETFs at Credit Suisse Private Banking.

Although when selecting active funds the focus is on the manager’s skills, track-record, or consistency of the investment style, with ETFs the emphasis is much more on quantitative analysis, says Mr Kalbreier.

Credit Suisse has selected 10 ETF providers offering a broad range of products, which are quantitatively assessed. For each main underlying index, the top scoring ETF is identified and recommended to clients.

Three main criteria are used to select ETFs, explains Mr Kalbreier.

The first is quality of replication. Physical replication scores higher than synthetic, as some synthetic ETFs have a much more complex structure.

Securities lending is also taken into account. When the performance of two ETFs is equal, the preference is for the provider that does not engage in this activity. If the performance of the ETF provider that lends securities is higher, and it is passed onto the client, then the extra return warrants the slightly higher risk, explains Mr Kalbreier, provided the securities lending contracts are very transparent and borrowers/counterparts are well diversified.

Tracking error, which affects performance, and liquidity are two other key criteria. “ETFs are our vehicles of choice for tactical exposure, and since trading costs weigh heavier for tactically-orientated clients, a more liquid ETF with tighter bid-ask spreads scores higher,” he says.

Declining to comment on whether clients’ portfolios have any bias for the in-house ETF provider, which is currently in the process of being sold to BlackRock, or the impact on clients’ fund flows, Mr Kalbreier states that “the sale of Credit Suisse ETF business is not going to reduce the offering for our clients and the range of providers we use is large enough to accommodate this development”.

Bank Julius Baer included ETFs first and later ETPs in its due diligence programme a few years ago. The institution selected a handful of the main ETF/ETP providers, including iShares, Deutsche Bank and Lyxor, plus Swiss & Global, ETF Securities and Source. More providers are likely to be added to the list.

“In the ETF space we follow a provider approach, while in the active space we recommend funds,”says Patrick Roefs, head of fund selection at the bank.

Organisational setup and track record – providers must have been in the business for at least three years – product range, registration and tax transparency in the bank’s core markets, and service level of the ETF provider are key factors to consider.

It is also important to assess which ETFs clients already hold, or whether the bank’s relationship managers in other regions may have a preference for some local firms. The analysis of clients’ portfolios inherited by Merrill Lynch’s International Wealth Management business, acquired by Bank Julius Baer last year, may drive the inclusion of new ETF issuers in the due diligence programme.

Over the past couple of years, service level has become crucial when selecting ETF providers, explains Mr Roefs, and the bar has been raised significantly.

“Transparency has improved substantially over the last two years, especially on the structure of the product when it comes to the meaning of funded or unfunded swap, use of collaterals or securities lending.”

Where there is room for improvement is on the cost side. “The sum of all costs of an ETF is not that visible for the investor.” The total expense ratio (TER) can be found in the fund factsheet, but it is more difficult for clients to get information on other costs, such as trading cost or bid-offer spread.

At Julius Baer the information relative to the selected providers is put on the intranet, and it is left to relationship or portfolio managers to choose the best ETF for the client.

The selection team gives general guidelines on their preference for Ucits-compliant products, and for ETFs over ETNs, which can effectively be non-collateralised structured products. While Mr Roefs has no particular preference for physical or synthetic replication, portfolio managers at the bank do prefer physical ETFs.

For synthetic ETFs, the unfunded swap-based structures are preferred to funded-based ones, where it is more difficult to access the assets as they are not part of the funds. Clients are also recommended to be aware of inverse and leveraged ETFs, he says.

“We recommend ETFs primarily for tactical investments or when active managers struggle to generate additional alpha. Some clients also use ETFs for longer-term investments, however we generally favour active funds that can better react to market movements.” The low cost is the main reason clients use ETFs, and also as they erroneously assume active managers should beat the market every year, says Mr Roefs.

Major private banks such as Barclays, UBS or HSBC run discretionary programmes where the asset allocation is implemented mainly through ETFs. This is quite an achievement, considering lack of retrocessions is still a major barrier in the uptake of these vehicles in private banks.

At HSBC Private Bank in the UK, an ETF based discretionary programme started in 2010 and has been “relatively successful”, having gathered £2bn (€2.3bn) since launch, explains Daniel Ellis, head of the private bank investment group, UK and Channel Islands. About 80 per cent of the portfolio’s assets are allocated to ETFs, and the remaining 20 per cent is in active funds, as in some cases ETFs are not available to express specific investment views.

Studies show ETF investing tends to outperform active managers over the long-term, because of lower fees, and the majority of returns come from asset allocation, not from stock selection, explains Mr Ellis.

More generally, ETFs are one of the vehicles used to implement the investment themes and views of the global investment committee at the bank. “Today, for example, everybody is
looking at high dividend generating products and there are a number of ETFs available that track high dividend indices,” he says. “Another tactical theme we have been interested in is that of improved performance on US regional banks, and we found an ETF that enables you to express this view.”

The UK bank has an approved list of ETF providers, including HSBC, but also iShares, State Street, Vanguard and other main players, mostly in physical ETFs. “We would consider new providers and determine whether to put them on our list. It is not a set number.

“More than 80 per cent of HSBC Private Bank UK’s client investments in ETFS are in physical ETFs,”estimates Mr Ellis, “as UK clients tend to be more conservative and stick to more well-known providers and physically backed ETFs.”

The fragmented nature of the European market makes it very difficult indeed for new providers to enter it.

Scale is key to the success but as the same fund is listed on multiple exchanges across the continent, there is a proliferation of subscale products. More than 1,200 ETPs in Europe have assets of less than $50m, compared with around 700 in the US, according to ETFGI.

The trend for providers seems to pull back from their ‘list everywhere strategy’ to create greater pools of assets and save costs.

BlackRock’s iShares, the largest ETF/ETP provider both globally and in Europe, is currently looking at “bringing down the number of listings in Europe”, as that would increase liquidity and reduce settlement cost, explains Leen Meijjard, head of sales Emea.

BlackRock’s plan to buy the ETF business of Credit Suisse, currently the fourth-largest ETF provider in Europe with 5 per cent market share, will significantly extend BlackRock’s footprint in Switzerland.

Credit Suisse’s net outflows of $1bn were the largest in Europe in this year’s first quarter.

“Redemptions in Credit Suisse ETFs were clearly due to uncertainty on the future of the business after Credit Suisse announced they had put their ETF business up for sale,” believes Deborah Fuhr, managing director at ETFGI. “Also some investors are reallocating assets elsewhere to maintain a level of diversity and not have all of their assets with one provider.”

Other physical ETF providers may be benefiting from this consolidation. For example, UBS Global Asset Management has picked up $633m of new ETF assets in Q1, more than its total net inflows in 2012 ($494m). The firm, which launched its business in physical ETFs eleven years ago, has $13bn in total ETF assets, of which around $3bn are in swap-based ETFs, a business started only three years ago.

“Currently, we see clients investing in full replication, while three years ago the bias was definitely towards swap-based ETFs,” says Clemens Reuter, head of UBS ETFs. But both methodologies have their advantages and disadvantages, he says. What is really important is to sit down with the client and understand their needs.

UBS, which saw its ETF assets increase by around $8bn over the past five years, completed the largest ETF listings on record in both London last year and Italy in January, with 66 and 61 new ETFs respectively. In addition to Switzerland, where the firm holds the majority of ETF assets (in non-Ucits structures), Germany is also a key market.

The ETF distribution team of 12 people was practically built from scratch over the past two years. “Distribution is extremely important. Even if you have a broad product offering, unless there are specialists or a sales team in place meeting with clients, listening to their needs and presenting the product shelf, you will not raise money,” says Mr Reuter.

Room for growth

ETFs are generally seen as complementary to active funds in portfolios and believed to have huge potential for growth in Europe, where they only account for 3.9 per cent of mutual fund assets – including active and passive, listed and non-listed funds – versus 9.1 per cent in the US, according to ETFGI.

Product innovation is a key factor for the industry growth.  Although the large majority of ETF assets are in products tracking main equity indices, a great deal of innovation has been made on the fixed income side, fuelled by the development of capital markets, and generally across all asset classes.

There is room for innovation for thematic or for ‘enhanced’ ETFs, suggests Credit Suisse’s Mr Kalbreier, where for example ETFs track less concentrated, optimised indices thus reducing exposure to very large stocks and lowering volatility.

To meet demand for yield and for navigating today’s volatile markets BlackRock last December launched four new ETFs on the London Stock Exchange tracking minimum volatility indices – MSCI Europe, MSCI World, MSCI Emerging Markets and S&P500.

“We are seeing a very good take up of these minimum volatility ETFs with private banks, whose clients are still risk averse and are hesitant to invest in equities,” says iShares’ Mr Meijjard.

Regulation also contributes to the industry development. Guidelines by the European Securities and Markets Authority coming into effect in February encourage more transparency on derivatives, management of collateral, securities lending and so on, for both Ucits ETFs and other Ucits funds.

The retrocession ban introduced by the retail disribution review (RDR) regulation in the UK on 1 January 2013 may also favour the use of ETFs.  “We have seen an increased interest in ETFs and have been approached by distributors that up to now have not included ETFs in their product offering,” says Mr Meijjard, who looks at the Netherlands, where an even more comprehensive RDR will be introduced this year.

“Retrocession still plays a major role in the use of ETFs in the markets where RDR is not implemented, but we see some changes in Switzerland and Germany in particular, where distributors are moving to a fee-based model,” he says.