The future of ETFs in private client portfolios

Participants

1. Marc de Kloe
Head of Alternatives and Funds, ABN AMRO Private Banking 

2. Alan Higgins
Chief Investment Officer, Coutts

3. Eleanor Hope-Bell
Head of UK Intermediaries Business Group, State Street Global Advisors

4. Alan Miller
Co-founder, SCM Private

5. Lance Peltz,
Director, Julius Baer

6. Philip Philippides,
Head of ETF sales, Amundi

7. Eric Verleyen,
Chief Investment Officer, SG Private Banking Hambros

Moderator: Yuri Bender,
Editor-in-chief, PWM

Yuri Bender: If we look at the factors driving the expansion and proliferation of ETF product ranges, is it really customer demand, or is it mainly innovation from product-manufacturing groups?

Eleanor Hope-Bell: It is a combination of both and the dialogue we certainly have with the different users – whether they are existing users or new entrants into the market – has created and fuelled a lot of the new growth, particularly here in Europe, which faces different challenges than the US in terms of the ETF market.

Most of the investors today are institutional, incorporating the wealth management industry. If we go back even 10 or 15 years, these were a lot of the early adopters of ETFs in Europe. The great thing for the industry is that the ETF is one share and that share typically is based on a Total Expense Ratio (TER) which is the same whether you are the largest institutional investor or the smallest.

Lance Peltz: In regard to whether product is being demand-led or producer-led, I am afraid to say I believe that most of it now is producer-led. People are looking to differentiate to create and exploit new niches. I think the use of those is limited and somewhat transitory.

Yuri Bender: What have been the key regulatory challenges facing the wealth management industry, and how have these contributed to the growth of ETFs?

Alan Miller: A year or two ago a lot of people said the Retail Distribution Review (RDR) regulations would transform the industry, but RDR has not transformed it at all, in my view. What it has shown is the sum of the unbundled layers now actually costs more than the bundled layer was before.

The thought that in the UK ETFs would be picked up more by advisers has not been realised. Some pension fund consultants do not have a clue about the real costs of ETFs compared to index funds. They are not looking at the underlying costs of actually buying and selling. So usage has evolved and is continuing to grow, but nothing like at the rate people probably would have expected a couple of years ago.

In terms of regulation, the biggest change is MiFID II. This is something which the trade bodies are trying to deny because they can see how it transforms things to a different level to anything contained in RDR. There is a small amount of text in a 464-page document which says that all investment firms will have to reveal all the costs from beginning to end – so it is all the different layers added together, including transaction costs – in one aggregated number. This is something nobody has ever seen before and it will transform things more than anything else.

Eleanor Hope-Bell: I do not think the need for advice or access to product, whether on an advisory or a discretionary basis, has gone away because regulation has changed. What regulation has changed is that it is the manufacturers and the distributors who are having to evolve. The end investor is benefiting the most.

The traditional passive world, ETF or otherwise, has not had to go through the amount of change I have seen for active managers. Leaving regulation aside here, we have a whole new investment strategy being adopted very quickly, which is what we call ‘advanced beta’. Most of the market calls it ‘smart’ but that carries the implication that the market cap way of investing was somehow dumb. So we say it is evolving and has become more advanced.

From my perspective, there is more than just regulation going on, which I think is ultimately to the benefit of the retail investor, but it is the active managers who are having to adopt and change the most, as opposed to the ETF or passive industry. There is another element creeping into it, which will also challenge active management from an investment perspective, as opposed to regulatory and distribution and manufacturing.

Yuri Bender: How do you make the transition from being a ‘Master of the Universe’ hedge fund manager, second-guessing, timing and analysing stocks and markets to setting up a slumbering camp in a new era of passive investing?

Alan Miller: I would say that you can be active using index funds. Look at George Soros: he made his billions shorting sterling, using essentially a low-cost instrument. Research, shows asset allocation tends to account for more than 90 per cent of overall returns.

If you look at the number of big names leaving the industry, almost every week there is another name who takes a sabbatical that they never seem to come back from or goes into retirement. Now you have to question why it is that so many people seem to be either leaving or retiring. Is it because they recognise the odds have moved quite a lot over the last 10 or 20 years?

The fact that the information is now disseminated in a much more efficient way means the information-edge, which has been one of the big advantages of being an active manager, seeing the company early and making the decisions early, is reduced substantially. A lot of the edge which active managers had has gone away.

The trends are still there. Think what Warren Buffet said recently. How did the most successful fund manager in the world want his legacy invested? He wanted 10 per cent in short-term bonds and 90 per cent in the S&P 500 index fund. Now, that is the most astonishing thing, is it not? The most successful fund manager in the world is saying that he wants to invest 90 per cent in a passive, index fund.

Yuri Bender: What sort of investments are ETFs most suitable for?

Alan Higgins: The US is the best example, because it is where index investing is most popular, but also where alpha is harder to find, especially for a big cap manager. In the US, we will own typically the index, but quite frankly it is expensive. I would much rather replace it with S&P 500 futures, which are effectively free to buy.

We may have an inclination towards dividend-type strategies, which I am not sure is smart beta, it is just a bias in the market towards what used to be called ‘value’. There is no panacea in investing so you are picking up some kind of bias there. The way we use ETFs is that some low-cost index products are not low-cost enough but are a lot lower now that Vanguard has come over.

And there are some strategies where, for example, rather than buying an income fund over here, or in the US, we are buying an ETF that does pretty much the same thing; it is well-constructed and makes sense to us. That tends to be where we invest, but we are looking at more esoteric areas – areas you cannot get access to easily, such as Master Limited Partnerships (MLPs). These might include oil infrastructure plays, where US taxation gets in the way of an easy investment from a UK base, so putting those in an ETF sometimes makes sense.

Where I am most negative is fixed income, especially credit-orientated ETFs. They tend to be 100 per cent invested and therefore very vulnerable to outflows, unlike actively managed funds which can keep big cash buffers. We keep our corporate credit-orientated ETFs at very low levels, mainly in the equity space.

Yuri Bender: Over the last couple of years you have very much identified dividend-paying companies as a key plank of your portfolios. Are you happy with the type of ETFs available to invest in this area?

Alan Higgins: Broadly, yes. The issue is, are those companies now too expensive? I think they work pretty well and I am sure they are very good longer-term investments because they are not just high dividend; they are also dividend growth, which is key. They tend to get cut.

But you get some really bad portfolio construction if it is not carefully weighted. I think in the US one we had, Pitney Bowes, was about to cut, and therefore the ETF providers having huge weights became huge potential sellers. So you get some distortions in the market because of the popularity of these potentially becoming a huge seller overnight, when they switch the dividend off or cut the dividend. So they need to work hard at these type of market issues.

But yes, we are a fan; the only question is whether that is now a relatively mature story.

Yuri Bender: The great divide has typically been between physical replication and swap-based ETFs. What is the current state of this debate, and which side is winning today?

Philip Philippides: I do not think that it is entirely a matter of winning. We have had this debate in the industry and ETFs tend to be amongst the most transparent investment vehicles that investors have access to. European regulators have looked at these formats and have come to the conclusion that there is not much difference between them, they both comply with all of the EU regulations and are therefore suitable for investors.

There are risks inherent in any type of investment, from an operational as well as from an investment perspective, and the regulators have come up agnostic between the two.

The investment community has a somewhat different outlook. There are certain investors that prefer to go physical while others will go synthetic; there are advantages and disadvantages to both. Ultimately, having that education, understanding how you get that exposure and, as long as the product does what it is meant to do, then I think that is what the investor is looking for.

What you have seen throughout this debate and through what happened in 2008 and later on is that regulation has moved on and the disclosure levels in both physical and synthetic ETFs have come to a level where the information is at the fingertips of the client.

The level of transparency you now see in synthetic ETFs, is that people can, on a daily basis, look through the exposure the fund is providing via the swap and see exactly the physical substitute basket that the fund is holding.

In many cases, you may actually have more liquid substitute basket than the exposure you are gaining. In a stress scenario, that could actually be an advantage.

On the other hand, from the physical replicating fund, if there is securities lending, you now know the amount of the fund they are lending out, which gives you confidence in terms of the counterparty risk that you are taking.

This level of disclosure is often above what regulators require and I believe, superior to any disclosure that you are likely to get from most other funds you invest in. I think that this is good for the industry. It is good that regulation has pushed that information out there and resulted in better products.

Marc de Kloe, ABN Amro Private Banking

Marc de Kloe: Maybe I could offer some different experiences. You mentioned that the regulator has agreed that no matter what format the ETFs are in, they are all okay.

Actually what we tend to find is that regulators in different countries have different views. There doesn’t seem to be a ubiquitous answer on that. For example, in the Netherlands, where we are based, we see the regulator gives a sort of agnostic view to the style, but in fact, when you look at their recommendations, they say if a client has been advised, then it does not matter if it is physical or swap-based. If a client is self-guiding then they should only invest into physical because they are not able to understand the complexities behind a swap-driven product.

This links back to the original question about whether product development was being producer-led or client-driven. Again, it depends on who the client is. If we are looking at private banking clients, the majority of which are high net affluent, you scare a lot of people off when you start having to talk about swaps, collateralisation and over-collateralisation. It scares not only the client, but also the wealth advisers. They had so many scares in the last few years that they would just be driven away from that idea.

If I look at our European presence, we see that in Germany, they are relatively agnostic; in France, they prefer swap-based for tax reasons; and in the Netherlands they prefer physical. The problem is, if I went to the Dutch market, there are certain tax advantages to be had from having Dutch-based vehicles for Dutch investors.

None of the industry has really paid attention to that. As a result, what we have only seen in the last year or two is that some providers now are creating specifically targeted Dutch, transparent tax vehicles for passive or ETF investments which have been completely forgotten about because the market has been producer-led and pushed onto clients.

Yuri Bender: The Bank of England decided nearly three years ago in its financial stability report to question the use of this product, suggesting synthetic ETFs exhibit more of the characteristic that might contribute to the build-up of systemic risks and some wealth managers have indeed decided to ban the use of synthetics in their portfolios. Are you conscious of the risks the regulators identified?

Eric Verleyen: There are some advantages with both types of ETFs. If you go for a synthetic ETF you may have less costly structures, which may help the performance. Of course, you may have some counterparty risk.

What is important is to know what you are investing in. The level of transparency has been increased so much now that on a day-to-day basis you check the collateral of any swap that is done through an ETF. Transparency is key.

But the popularity of ETFs is not really changing the way we manage our portfolios for private clients. It is a new vehicle, a new ‘wrapper’ that we use. It is very convenient. Instead of creating a basket – we used to do some basket tradings for some accounts – now we buy an ETF, which does not cost a lot and we know what we are buying. We usually want something with a very low tracking error, so that is why we use ETFs.

We also continue to use funds as we think that there are some portfolio managers who are able to generate some alpha. We want those portfolio managers to have a high tracking error. I think the popularity of ETFs is killing those portfolio managers or fund managers who are in the middle – those who are doing index tilting, meaning that part of the portfolio was indexed with very low tracking error, and some of the stock selection was very high.

I think this model is going to disappear and we are going to see more and more high tracking error portfolio managers coming in.

Lance Peltz: From the due diligence and research we have done, swap-based ETFs – and it is a bit of a generalisation here – do give better statistical results in terms of tracking error and tracking deviation, although that reflects partly the embedded cost structure, which still, in some firms, is very rich.

When you look at categories where the pricing mechanism of the underlying is OTC (over the counter) or matched bargain, rather than a continuous two way disclosed price market, or where the underlying trades across multiple time zones, or when you have both factors, swap-based tends to give you better results.

The differentiation, in terms of swap or its weaknesses, has narrowed considerably in transparency of the collateral basket, the structure of the collateral arrangements and what is in the collateral basket, which probably now bears a tighter, though not perfect, relationship to the underlying.

There is a demand. I think there is a really good use for swap-based ETFs. The problem is a PR issue, because, in the wealth management world, clients still are very biased and inclined towards physically-backed, irrespective of whether it is less cost effective in terms of a total round trip exposure.

Philip Philippides: In terms of the swap and physical, sure it is PR, but it is also education that needs to happen. Investors have been educated to use ETFs in their portfolio. That has gone on, and we have kind of opened the hood, looked at things and made them better. Over time, there will be some education. If you need an ETF exposed to a less liquid asset in Europe, it may be more efficient to get a swap to mitigate that risk.

Ultimately, it is good for these products to be judged on their merits and what they actually do, rather than focusing entirely on whether they are swap or physical, on how they get their exposure. It is part of the mix, and the performance and everything else are obviously a lot of the factors.

Alan Higgins: On counterparty risk, I really think we are fighting last year’s battle. It is the legacy of Lehman. It is ridiculous, because actually, in PWM magazine, where we look at the asset allocations guides, there are all kinds of leveraged swaps in Ucits funds. Our clients in funds managed by companies such as Standard Life are exposed to swaps all over the place in Ucits funds, so it amazes me why people are so hung up about it in ETFs.

Yuri Bender: I remember, pre-crisis, one of the largest wealth managers, UBS, very much tried to set a new trend in their discretionary portfolios, saying they would invest up to 50 per cent of discretionary portfolios in ETFs. They expected this to really catch on as a trend among the private banks. Do you think that will happen?

Eleanor Hope-Bell: From my perspective, ETFs are just a wrapper, and they give access to an underlying asset class in a very liquid way; that is it. It is not a binary decision; it is not an either/or. It is: what are the choices you have at your disposal? If you have retail clients that have a preference and understanding around physical, that will dictate what choices you have and, if you decide to go passive, what is in that passive toolbox.

It is a very strange phenomenon that the ETF is somehow an either/or or very binary decision. It is not. In a portfolio context, there are other choices. ETFs fit in that portfolio for different reasons for different investors, and that is part of the beauty, in that they are very flexible in the ways in which they are being used.

It never ceases to amaze me how that continues to evolve, in and of itself. Again, it is not just the product innovation, but how ETFs are being used, whether it is a European multi-asset manager or a pension fund in the United States that acts more like an asset manager, they contrast greatly to how other wealth managers across the continent are using them.

Yuri Bender: Is that choice really there for the likes of you, Alan? Your portfolios, if I am not wrong, are more or less dominated by ETFs for cost purposes.

Alan Miller, SCM Private

Alan Miller: We only invest in ETFs. It is not just cost, but flexibility and liquidity.

But I will tell you one thing. I saw recently some very big private wealth manager presentations to a prospective client – three were US and one was UK. It was very interesting.

The portfolios of the three US companies – some of them I was astonished by, because they are very, very big companies – seemed to be almost identical. They were mainly ETFs, apart from a large allocation to hedge funds, so they had typically 10 or 15 per cent in fund-of-fund hedge funds, and the rest in ETFs.

The UK company doing the same thing had it, if you like, the old fashioned way. When you work through the costs, they varied from top to bottom between 1.5 to 3 per cent-plus all-in.

In terms of hedge-fund returns and a simple index strategy, I think you could get much higher return than that 10 per cent allocation to hedge funds by investing in a smarter way via ETFs with a split of bonds and equities.

These were big, big companies in the US with substantial UK operations, where they tell everybody every day how they have these huge research departments and thousands of analysts, and in the end they were buying a very limited number of ETFs, most of which were manufactured by just one household-name ETF.

Lance Peltz: We still view them as access vehicles that have their role in portfolio construction and advice. There is no hard and fast 50 per cent threshold that we must or must not have in portfolios. Each market, each opportunity, is judged in its own merits.

In terms of their growth, I think, as RDR spreads across Europe and maybe to Asia, one of the powerful factors in their favour – costs – will start to diminish, but, at the moment, active management is working, whether it is factor driven such as size, working in favour of active managers or not. That also predicates against the acceleration of growth of ETFs. I am sure that will change at some point in the cycle.

What I would like to see in Europe is a much greater transparency and visibility, and the capturing of off exchange information and data, which would help us as selectors and implementers to be able to make better and more informed choices.

Eric Verleyen: As a wrapper on which there has been a transparency focus, ETFs are pushing down the price of fund management. Going forward, because they are very popular, there will be more and more active strategies within ETFs, and fund managers are trying to leverage in and come into the ETF space. At the moment, we are still talking about indexing and non-indexing, when we talk about ETFs. Very soon, I think it is going to be a mix of everything, and we will realise that it is just the wrapper at the end that is more transparent.

Eleanor Hope-Bell: The sustainability of the industry is here to stay, though, we are still tiny in relative terms to mutual funds and the financial services industry as a whole, and it is remarkable to me just what impact it has had in a relatively short period of time within the history of financial products in the market.

For that, I applaud the industry, and I think it is phenomenal. In terms of the uses and the investor base, ETFs are one of the few products where pretty much any investor has access to, and that is part of the innovation and the beauty of that product, which has made it so successful.

So I think we will be here in 21 years’ time talking about the same tenets we talked about 21 years ago, when we first launched. There will be some new uses and new investors; we will look back and say, ‘It is crazy that we did not see that in 2014.’ 

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