Exchange traded funds: is it time for greater transparency?

Elisa Trovato: In today’s discussion, we will focus on the growth drivers, recent developments and innovation in the European exchange traded fund (ETF) space, as well as potential issues related to product proliferation. Has the financial crisis accelerated the use of ETFs in Europe?

Eleanor Hope-Bell: The financial crisis was a catalyst event. We saw a shift from active to passive, post 2008. At the time, there was also a shift in terms of ETF types of structures, and counterparty risk came to the fore. Liquidity constraints came to the fore too and ETFs provided intra-day liquidity which many other produts did not. The more investors use ETFs the more sophisticated the uses will become.

ETFs – and we can broaden the category to ETPs – have really disrupted the status quo. They are pushing the boundaries in terms of distribution, cost of distribution and cost of product management, as well as uses of financial instruments.

Kim Hillier: We have seen a strong move towards more investors using ETFs, partly because ability to access different sorts of asset classes and possible exposures has also proliferated.

The asset choices that were on the table only three, four, five years ago were far more limited than now; for instance, many investors may not have been able to consider commodity-types of exposure in their asset allocation, but now, through the exchange traded commodities (ETCs) and the echange traded notes (ETNs), they can gain more efficient access to those non-traditional asset classes which are typically more lowly correlated, and which may in turn improve overall risk budgets.

Christian Goldsmith: While we manage derivatives-based portfolios, such as the Global TAA, for clients who are comfortable with these instruments, in dynamic asset allocation, which is a primarily long-based approach, we mainly use ETFs across a range of asset classes; this was driven by the concerns on short positions and leveraged uses of derivatives that a lot of our clients had, leading up to the financial crisis. ETFs suited them and suited us, as they are a flexible way of implementing our asset allocation views.

However, in some clients’ portfolios we are moving away from a purely ETF-based approach within dynamic asset allocation. In commodities, if a client is willing to let us use a derivative, rather than buying an ETF that buys a commodity swap, we can buy that commodity swap and do that in a more cost-efficient way. There are some asset classes where we do find difficult to obtain a suitable ETF, such as in cash high-yield, local currency emerging debt or small cap equity.

Elisa Trovato: ETFs do not offer retrocessions to distributors. Is that still a barrier to the growth of these passive instruments in the wealth management space? And in which asset class do you use them the most?

Enrique Marazuela: MiFID (Markets in Financial Instruments Directive) requires that we are completely transparent with clients and disclose them the commissions we receive. That will force us to pick the best instrument, as the idea is to charge the customer not indirectly through rebates, but directly through fixed fees. Clients are going to judge us by our results and our performance.

Huge tail risks in active management were something investors were not aware of before the crisis. Now, they want to have a combination of passive strategies, to optimise cost and have a low tracking error, as well as active strategies.

ETFs assets, sourced from both BBVA and third-party providers, represent around 20 per cent of clients’ portfolios, but in the future this percentage will grow. We prefer to invest in the physical, rather than swap-based ETFs. It is very important to assure our customers that they get what they want to buy, such as low tracking error and low cost, and are not running other risks. There may be a lot of factors to analyse in an ETF, but at the current stage of development in Spain, customers are looking for a simple structure they can be confident in.

David McFadzean: We are an active, multimanager business and one of the issues that I have is that we use ETFs the most in niche areas but what I find is the niche areas tend to be the areas where the ETFs are not as liquid. So, just when you need them to provide that liquidity, they do not. I would question whether ETFs are necessarily more cost-effective than actively managed funds. In terms of performance, it is a fact that 100 per cent of ETFs underperform after fees.

Charles Morris: If the underlying is illiquid, then the ETF should avoid that asset class. They should not be in small cap, or exotic emerging markets; they should be in mainstream asset classes.

Where ETFs have missed a trick is to launch products in mainstream asset classes that are still unavailable. For example, you cannot trade most local government bond markets either in their natural form or hedged into a series of currencies. You can buy the US and the UK bond market and some other major markets, but you cannot select duration or anything like that. Emerging market debt and currencies are still unavailable in Europe. These are big themes that investors are looking to allocate money to and they are not offered by providers.

Olivier Paquier: ETF providers are perfectly able to reproduce benchmarks in niche markets; the issue remains the costs. At Amundi ETF, we have decided to launch a product tracking the global emerging debts in dollars which makes sense for any bets, through a liquid and cost-effective structure. If you launch an ETF in emerging market debt, in local currencies, costs would include hedging on each currency and also accessing such markets. An ETF tracking a niche or hard-to-reach market can be liquid, but the liquidity will come at a higher cost. As an ETF provider we look at what is in the best interest of our clients. Is it in their best interests to pay more than 1 per cent in total expense ratio for an ETF? I am not so sure.

In terms of innovation, the “exchange-traded” label has brought many questions to the ETF market. We had to explain to clients that today they can find exchange-traded products on single commodities such as gold, precious metals, or energy, but these would be notes or certificates, and not ETFs, which remain funds that comply with UCITS III diversification rules.

Eleanor Hope-Bell: ETFs are still a very nascent product set and there is a lot of innovation still to come. A lot of the providers are looking at these kinds of topics. Regulation has a big part to play. In Europe, Ucits is more flexible in terms of the underlying instruments you can use compared to the 1940 Act in the US, which does not allow the same use of derivatives. Investment banks have now entered the ETP space in Europe because they are able launch UCITS swap-backed ETFs. Little changes like that can drive dramatic changes in innovation.

Elisa Trovato: What are the main issues that need to be addressed to improve transparency and clarity in the European ETF industry?

Kim Hillier: The label ‘ETF’, in terms of many people’s expectations of what an ETF is, is probably a bit of a misnomer. Not all ETFs are created equal. In the States, ETFs have now been around for about 20 years and are mostly accessed through registered investment companies. This has kept them simpler, relatively straightforward and easier to understand – something like 50 per cent of retail investors in the US now use ETFs.

However, in Europe the approach is different with most ETFs falling under the Ucits umbrella. The fact is that different providers have increasingly harnessed different methodologies to replicate the returns of their chosen benchmarks. You can have ETCs, ETPS, ETNs, and ETFs and you need to evaluate how the structure is working. Some structures are passive and offer physical index replication, while others are synthetic or swap-based and use derivatives- which means an investor takes on and needs to be aware of a whole plethora of different risks.

While Ucits gives a huge ambit in terms of innovation and provides an ability to deliver different types of structures and different types of risk for clients, understanding the underlying index is of paramount importance. Some retail investors may not seek advice and thus might not buy what they thought they had bought. Misunderstanding can lead to a mismatch of expectations between the buyer and the institutional seller. Investors here are still wary of ETFs so there is a reason why only 10 per cent of retail customers buy them in Europe.

Although many clients may understand the distinction between the physical and swap ETF types (and the preference tends towards physical ETFs), even when you buy a physical-based ETF do you actually know that you have an ETF comprised of the underlying physical – or is it an optimised basket? Likewise, when you purchase swap-based ETFs, different providers can use different methodologies to reset their swaps in terms of timing and trigger points. This will impact tracking and performance.

Additionally, disclosure of the swap counterparties and composition of the collateral basket is not always easy to find; some providers may not declare who their swap counterparties are, and in certain cases the ETF may hold an underlying basket of securities as collateral which differs greatly from the index being tracked. It is important to read the documentation as I do not think that there is always as much transparency in terms of some of the ETFs out there that people might think.

If 2008 taught investors anything, it was to be much more operationally aware than they were before. This is what is driving this demand of information and transparency.

For the industry, the onus has to be on the providers to provide more investor education and to have the ability to be quite open about what the real risks are. With RDR (Retail Distribution Review) coming at the end of next year in the UK, ETFs might be utilised far more by IFAs in the coming years.

Given that in the UK and the US, the regulators are concerned that retail investors are not financially sophisticated in the way that institutional investors are with regards certain ETFs, there will surely be renewed regulatory focus to ensure any such advice is suitable and appropriate. Something has to happen on this front. It is probably better if the ETF providers in the industry decide what that ‘something’ is, rather than having it decided for them.

Christian Goldsmith: There is very little reason for us to invest in an ETF that does not give us that transparency because there are so many options available to professional investors. But retail or private investors cannot do due diligence, and they are at a disadvantage.

Olivier Paquier: Nowadays, we observe that more and more due diligence is conducted on ETFs. The performance of ETFs is not limited to the return of the benchmark minus the total expense ratio. In order to measure the quality of the net return, many components – namely the set up and risks to name but a few – are taken into account and scrutinised in due diligence requests. In the markets where ETFs are most widely used - the UK, France, Germany and Italy for instance – the debate has gone beyond swap-based versus physical.

All in all, the debate has moved to the risks taken by the funds and their disclosures. What clients want to know is, is there stock lending in a physical-backed ETF? If so, who and what at lies underneath it? What is the collateral level? Is there any use of optimised certificates? What do we do with the dividends? For a swap-based ETF, who is the investment bank providing the derivative product? What is their rating? What is the quality of the assets within the fund?

Explaining liquidity is sometimes difficult towards both retail and institutional investors, as the levels of trades effectively done on an ETF are not being published and they are not being reported through the stock exchange. This is not an obligation in Europe contrary to the US, although Mifid II may change that.

Today the bulk of trades is dealt over the counter and does not appear on an exchange. This means that investors are not able to see the real liquidity of a product when it comes to intra-date trading. The only real measure of liquidity remains the liquidity of the underlying.

Elisa Trovato: Can ETFs really be used as or building blocks to construct diversified portfolios?

David McFadzean: The term ‘building block’ implies some level of uniformity. Before they can be fully used as building blocks, there needs to be a greater level of transparency, consolidation and homogeneity. On an active mutual fund, 80 per cent of the due diligence is focusing on the investment expertise of the provider, whereas it is totally flipped for ETFs. It is more like the due diligence you would perform on a hedge fund, it is operational due diligence.

If you order a lot of bricks and you do not know whether they are going be blue or red, or red on the outside but actually blue in the middle, you are not going to have a very nice building. That is one of the things that is holding them back from being purely commoditised building blocks. Now, the ETF providers might not want to be purely commoditised product providers because how do they differentiate themselves, apart from market share?

Olivier Paquier: The answer to that is the quality of the return ETF providers deliver to their clients for the same risk level. Once they understand the risks, the cost structure, the replication method and the underlying index carefully chosen, what is the actual return? Those are what differentiates an ETF provider from another.

Elisa Trovato: Where should innovation take place in the ETF industry?

Christian Goldsmith: Being a multi-asset provider, innovation is in the idea of managed funds of ETFs, in order to ensure that the underlying investors get their asset allocation decision right before they actually worry about which ETFs to use. That is something that we see, for example, in our dynamic asset allocation strategy which has a total return approach. We also see it in so-called new balanced, where the client still wants to have their strategic asset allocation, around which we do some tactical asset allocation, but they want the underlying to be indexed funds or ETFs.

Something the industry could help with is the concept, which is becoming increasingly popular, of smart indices. We are all allocating, for example, to the S&P 500 as a way of accessing US equities, potentially US economic growth, and yet we are investing in an index that is very much dominated by a relatively small number of the largest and potentially the most expensive companies.

This is opposed to an equally weighted approach, and it is an area where passive investors might want to get something that is a bit different.

Eleanor Hope-Bell: The reality is, until institutional money starts benchmarking itself against those indices, it is hard to see the actual demand. From an ETF provider’s perspective, unless we can see that there is a sustainable product and long-term demand, then it makes sense to develop in that area.

Charles Morris: The next big innovation surely is to open up to broader industry innovation via white labelling. For example, provided the underlying assets are liquid, the ETF platforms could be used to market intellectual capital from active managers to style based indices. The index can be anything; it could be Warren Buffett’s top 20, for example. However, one of the hurdles that must be overcome is faith in the transactional process.

Given successful due diligence, it is not the ETF provider that I would have a problem with, nor the intellectual property they are trying to track, it is the investment bank that trades in the ETF. Will I be able to transact? Will I get a good price when the time comes in the required size? Our trades can be quite large and trading ETFs is not always as simple as it may seem. Reassurance, knowledge and faith in the system, in order that we can execute at a reasonable cost, is my number one concern. You will see a whole load of products that are great ideas, but can we be sure that we can buy and sell at fair prices? You may well be very comfortable putting £100,000 to work, but would you put a £100m? No, you would not.

The headline rate of how much is charged to own an ETF each year is generally good value, but the trading costs are unknown and they can be much larger than one might expect. People have also forgotten about good old fashion passive index funds. You can buy a passive index fund much more cheaply than you can buy an ETF. If you want to buy and hold an asset class for the long-term, you do not need intra day liquidity. An innovative, transparent, liquid and competitive market is what I would like to see.

Kim Hillier: In Europe, the market is still in an early growth phase, so even in terms of the simpler, broader products there is quite a long way to go to attract new investors. A number of ETF providers are forecasting between 20 per cent and 40 per cent growth per annum for the foreseeable future in Europe. Already the number of ETFs in Europe is higher than that in the States, but assets under management are still relatively small.

Currently, product advancement is being driven by customer demand - more on the institutional side than the retail side. There is still huge scope with regards new innovation – for instance foreign exchange hedged ETF products were only launched probably about six or so months ago. But innovation means we could see simple products potentially become more complex.

We can all probably use existing ETFs or ETPs more cleverly than we do at the moment. While we ourselves do not short ETFs as yet, that feature and options on ETFs could be a hedging innovation that may have legs to manage downside risk.

David McFadzean: Tax is probably what is driving the gaps I see, because we are not able to consistently globally invest in the same sort of things for our clients. You can always find somewhere in the world the sector, the product or the asset class that you are looking for, but you might not be able to implement it globally.

Enrique Marazuela: We see all this innovation in the ETF space, but we will have to see a divorce between the retail and private banking customers who demand something that is simple, tracks an index, low cost, with no operational risk, and the institutional investors who ask for more innovation and for gaps to be filled.

I do not know what is going to happen, because private investors are not interested in new products with potentially operational risks, while an institutional investor can carry out the appropriate due diligence.

Eleanor Hope-Bell: What is interesting is that you see the road diverging. When I think of the history of ETFs to date, from 1993 to where we are today, those funds that have been the most successful – so the largest; the most liquid funds – are those where retail and institutional investors are actually cohabiting very nicely. It is traditional building blocks and I think that both retail and institutional are buying and trading these funds because it does exactly what it says on the tin. If the roads do diverge I actually think you are taking away the part of why it has made the industry so successful

The devil is in the detail with ETFs and any commoditised product. From my perspective providers need to remain true to the key tenets of why ETFs have been so successful and it is those tenets that we have talked about, it is the transparency, low cost and liquidity.

Consolidation will be an interesting one to watch because if innovation is attracting new providers and new products, will those providers and products be there in the medium to long term? It is the sustainability of products that is the interesting question to ask and as an investor, I think you care whether the provider is actually going to be in existence in the future. Looking at the provider’s indexing history and portfolio management expertise is critical to the selection process.

Olivier Paquier: We have witnessed much demand on basic exposures rather than hedge fund exposures for instance. I do not think we want to deviate from the fundamental role of ETFs. To me, it takes away the essence of the ETF itself, which is to track a transparent index that is being published in real time and accessible, even for retail investors, on the internet.

We do not believe there will be consolidation of the ETF market on these plain vanilla exposures. Ucits IV will be a catalyst for cross-listing products thus making them available to more categories of clients. It will take only 10 days for an ETF provider to make a product available in a foreign market within the European Union. This will make it simple for investors to access the product, as they will be registered locally with the local regulator, which brings comfort for any investor, especially retail investors.

Participants

Christian Goldsmith, Investment specialist, balanced solutions, BNPP Investment Partners

Kim Hillier, Director, Stonehage Investment Partners (multi-family office)

Eleanor Hope-Bell, Head of Northern Europe Intermediary Business Group, State Street Global Advisors

Enrique Marazuela, Chief Investment Officer, BBVA Private Banking

David McFadzean, Head of Investment Solutions, RBC Wealth Management UK

Charles Morris, Director, Head of the wealth opportunities strategy, HSBC Global Asset Management

Olivier Paquier, ETF Product Specialist, Amundi Investment Solutions

Moderator: Elisa Trovato

Deputy Editor, Professional Wealth Management