Tumultuous love affair with ETFs set to continue

Participants

1. James Bevan
Head of Investments, CCLA Investment Management

2. Eleanor Hope-Bell
Head of UK SPDR ETFs, State Street Global Advisors

3. Alan Miller
Chief Investment Officer, SCM Private

4. Tim Miller
Senior Relationship Manager, Amundi ETF

5. Rupert Robinson,
Head of Wealth Management, Signia Wealth

6. Gene Salerno,
Head of Asset Allocation and Equities, Kleinwort Benson

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

8. Niamh Wylie, 
Director and Portfolio Manager, Coutts Investment Office

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

Yuri Bender: Our subject today is the proliferation of exchange traded funds (ETFs), the sometimes controversial issues surrounding them and their use in private client portfolios. If we look at the ETF story during the 1990s and the first five years of this millennium, the news was very much coming from the US and there was not very much interest on this side of the Atlantic. What has changed to drive the unprecedented expansion of ETFs in Europe?

Eleanor Hope-Bell: A lot of growth in Europe has been driven by the private client, though institutional money is also using European domiciled ETFs. A large part, in terms of the need to have a localised product, has been tax-driven. Fast forward, looking at regulation, there is concerted effort among advisers and providers to look at the benefits of having a Ucits vehicle, compliant with EU regulations on marketing of cross-border investment funds. A lot of numbers are being thrown about, including one from Cerulli of $3.5tn (€2.6tn) in worldwide ETF assets by 2015. ETFs are used for multiple purposes and the growth will come from new investors coming into the industry as well as existing investors using it in new ways to improve the efficient portfolio management technique.

James Bevan: It seems the demand for passive investing in a global context is still on the up. That is going to be a key ongoing driver in demand for ETFs, not least because the capacity to trade obviously gives people the opportunity to asset allocate efficiently and quickly. The other change in the industry writ large is a drift towards recognition that active value added is very often the product of precise style risks, which can be replicated efficiently within ETFs, as opposed to people trying to pick active stocks.

Tim Miller: I do not think investors have lost faith in active management. There has been greater awareness of the asset classes ETFs can offer investors. It used to be that they were thought of as basic index trackers and the context of how to use them was not fully appreciated. Something we saw around 2007/2008 during the crisis was that a lot of investors realised they needed to add a liquidity element to their portfolio, especially the intraday liquidity that ETFs could offer. As that has grown, the acceptance and understanding of using ETFs has continued apace. The active/passive debate has died down; a lot of people, particularly on the private wealth side, are looking to use the best in breed of both. They are willing to pay for a good active manager, but at the same time they are willing to look for the lowest cost passive alternative and the most transparent one. Quite often ETFs tick these boxes.

Rupert Robinson: Regulatory reform is going to provide a more even playing field between ETFs and mutual funds. Investors will become even more discerning when comparing the fees of ETFs with active funds. The US industry introduced a fee-based model over 10 years ago and it has unquestionably increased the use of ETFs in client portfolios. The advent of RDR (The Retail Distribution Review) will have a similar impact in the UK. The fee-based model will undoubtedly motivate the inclusion of cheap instruments like ETFs as investment managers strive to control their total expense management ratios, particularly in a low interest rate and low growth environment. ETFs have also allowed investors access to asset classes like commodities and sectors not previously accessible to them.

Yuri Bender: Why have so many talented, active managers – yourself included, when you were something of a legend at New Star – deserted active traditions and become advocates of passive disciplines and ETFs?

Alan Miller: Many clients want multi-asset portfolios but which are actively managed in terms of their asset allocation. In terms of transparency, liquidity, cost, choice and performance you cannot beat ETFs. You can actually be active using index products. It is not really black and white – active vs passive; it is about being active but in the most efficient way. The real issue in fund management, magnified in the hedge fund industry, explaining why so many big name stars are retiring – is that the information advantage they used to have has virtually gone. Nobody talks about it, but if all the information is now disseminated to everybody at the same time and you are running a large amount of money, first of all you do not have the information advantage you used to have and, secondly, you have a liquidity disadvantage running against you. The industry might not like it, but a private investor looking at a stock properly is probably going to have more time, more focus and be able to actually deal at a better price than a big fund manager trying to do the same thing. In terms of the law of odds, the odds are on the private investor’s side. It is just that the industry cannot be bothered to tell people what
is in their best interest or adapt to it.

Eleanor Hope-Bell: What I am hearing is there are clearly two investor types – the retail investor or individual and the institutional investor. What has always impressed me about the ETF industry is that you now have a vehicle where the two invest in the same product. Where traditionally a retail investor would invest in ‘this’ share class with ‘this’ portfolio manager, the institutional one would get a different share class, meaning price, with a different vehicle, but potentially the same portfolio manager with asset sizes of very different quantity. Size is clearly a benefit, but an active manager is using ETFs in maybe a very different way than the retail investor, which is what makes this so unique. All of a sudden, you have a vehicle serving two groups and doing very different things for those investor types. As an industry, that is something to applaud this vehicle for.

Eric Verleyen: At the same time for private investors, it might open the door for some disappointment, especially when mentioning commodities. If not properly advised, you can have a private investor investing in an oil tracker, for example, and being very disappointed not to have the performance of the spot price. It is good that private investors have access to this often technical structure, but they need to be properly advised. Otherwise some of them are buying something they do not really understand.

Yuri Bender: Do the economics of advice necessitate that high street customers are channelled into passive products and is this the best solution for them?

James Bevan: If an investor articulates a requirement to invest in a particular market, the challenge is to deliver the certainty the customer anticipates the bank is going to provide. On that basis, low-cost delivery of index products has much to recommend it and that should continue to be a hallmark of sensible and prudent investment advice in the UK market. Against that, one of the problems for the active industry in the 1990s was the expectation you could charge a great deal simply because everybody else was charging a great deal. I look at the hedge fund industry with 2 plus 20 per cent and I see certainty of cost and yet uncertainty of return. It worries me that only 3 per cent of hedge funds have a 10 year track record. So even looking with the benefit of hindsight, you are left with the challenge of: what are you going to buy and what are you reasonably going to get? What I like about the ETF world is the relatively high degree of transparency as to what you are going to let yourself in for and that there is full transparency on the underlying positions, even in active ETFs. That is incredibly important for informed choice.

Niamh Wylie: Although we do like ETFs, we realise they are not a panacea and that there are index funds out there that are lower cost. Capacity is also very important, purely because of our fund size. Many very interesting ETFs exist, but if they are not big enough then they are not investible for us. We do use a combination of passive and active. We use active where we feel the markets are slightly inefficient and offering opportunities. Japan is  an example of that at the moment. In terms of passive exposure, our core position in emerging markets – which is considered an inefficient market – is actually an ETF, primarily because when we looked at it, many active funds failed to outperform in this space. Therefore, we cannot justify the fees and it is just much better to buy the index in that regard. We see ETFs as attractive because of the low tracking error, but we also have to look at things like pricing, the intraday volatility and the tracking error of the price versus the Nav. At Coutts we tend to wait until the market has normalised before we invest. We like to see good volumes going through so that we are not hit on the price.

Yuri Bender: Providers are increasingly launching physical replication ranges as investors have shown a preference for this over swap based funds. Would you say physical replication in ETFs is now a pre-requisite for private clients?

Eric Verleyen: I would not say so. I would say that just as we have the risk/reward in any asset, it is the same in the ETF sphere. If you buy an optimised ETF, there are some strategies that can be swap based that may actually help you to recoup first the management fee, ending up with a better performance for the ETF. Also, if you buy a very large ETF investing in an emerging market, you may not be able to buy all the stocks to make a physical replication, so you are making a partial replication. If you have the swap based product, you may be able to lower your tracking error because of this technology. It is just different technology; some might consider it a little bit riskier, but it usually delivers better results.

Eleanor Hope-Bell: What the ETF industry has done very well once again, because of the level of transparency around what is inside it, is the discussion, the education and awareness with the investor. It has really posed some interesting conversations that actually apply at the Ucits level. This is where the conversation needs to happen, not at the ETF level. What the ETF industry vis-à-vis this discussion has done is actually raised the awareness to such a degree that questions are now being asked of the entire Ucits fund industry in Europe, which I think is appropriate.

Rupert Robinson: I recently saw a statistic that 90 per cent of all inflows in 2012 were into physically backed ETFs. There is no doubt that synthetics that use derivatives have suffered in popularity following criticism by the regulators.

Yuri Bender: Will Amundi’s efforts also be moving more in that physical direction? You did very well pre 2011 because you were concentrating on the much cheaper, synthetic ETFs, but are you now going to develop a physical range as well?

Tim Miller: We do have some legacy physical replicated ETFs, but the vast bulk of our range is synthetic. We believe in the offering; we believe that the cost effectiveness and the low tracking error lend themselves towards synthetic replication. Growth has been across all ETFs in 2012, whatever the replication method. This validates the fact that there is room for both as it was reaffirmed by the Esma guidelines in July and December. We welcomed this debate as it has positively led the ETF world to improved transparency and a better understanding by investors of the related risks and advantages. Everyone talks about counterparty risk. There is counterparty risk at some point in the chain in any funds you would invest in. With ETFs, as long as you are able to look under the bonnet and really see what is going on, then you can make an informed decision about whether that fits your investment criteria or not.

Alan Miller: Dinosaurs in the fund management industry raised this synthetic versus physical issue to the surface because they are scared about the growth of ETFs impinging on their future profitability. It is a great shame because actually you cannot say one is worse or better than the other. It is just a matter of what is best for whichever index or whichever market. That got completely lost in the frenzy together with no reasoned comparison with mutual funds where even to this day you see people saying, ‘ETFs are  dangerous’. However, for example, there is a very substantial absolute return fund which is the most complex product I have ever seen. It has countless complicated strategies and counterparty risks, and often the same people investing in this fund are the same ones saying, ‘I can’t be bothered with ETFs’ or ‘I’m not interested in investing in ETFs because of counterparty risks’. A lot of it hinges from nonsensical statements from regulators. Because they had missed every disaster they decided on a new strategy of trying to spot and name the next 1,000 potential disasters, no matter how remote, one of which was ETFs. This gave the excuse for a lot of advisers to completely bypass them. With RDR, the whole point was to encourage advisers to look across the market, at investment trusts and ETFs. Unfortunately I think most advisers now do not look at ETFs at all.

Niamh Wylie: When it comes to physically backed or synthetically backed we own both types of ETFs. Clearly there are risks and benefits to both, so we are fairly agnostic. We will always select the route to market that is most appropriate for the client. Our due diligence process is important. In terms of securities lending we will only invest in the physically-backed ETFs that return at least 50 per cent of the securities lending revenue to the client. Then on the synthetic-based we clearly look at counterparty – that is extremely important. We tend to go with national champion banks and we look at the quality of the collateral, whether it is over collateralised and we run various stress tests as well. We feel there is still sufficient choice out there for the types of investment strategies that we are trying to utilise.

James Bevan: Securities lending is a risk factor one needs to take into account when contemplating what route to follow and, if we go back to the issue of market access and liquidity, it would certainly worry me if one were dealing in ETFs in relatively illiquid markets. A significant non-recordable loans programme will frustrate the capacity to access price at the appropriate moment and acceptable term. Therefore, I think the devil is inevitably in the detail. Equally, in the world of large cap index tracking, loans programmes are an extremely sensible way of constraining net costs.

Yuri Bender: State Street is vigorously defending itself against two US lawsuits not related to ETFs, alleging securities lending revenues contributed to investor losses.Rival firm BlackRock is contesting allegations about securities lending revenues related to ETFs. Should investors start avoiding certain strategies accordingly?

Eleanor Hope-Bell: Securities lending is a portfolio management technique that is not unique to ETFs; it is also a technique applied in other areas, including mutual funds and collective trust funds, but in the ETF space in Europe it was thrown into the synthetic versus physical discussion. Within Ucits and the Esma guidelines it can be additive in terms of tracking error and so on and so forth. I would also concur that the devil is in the detail, meaning not all ETFs are the same. Looking under the bonnet is absolutely critical because, yes, Ucits has certain safety nets, but not all ETFs are the same. Currently, 12 of our 45 European SPDR UCITS ETFs engage in securities lending. The 12 SPDR Ucits ETFs that engage in securities lending have a fully indemnified contract. Securities lending within SPDR ETFs directly benefits shareholders, as the income it generates for shareholders can improve index tracking after expenses. Therefore, all in, it is absolutely another area that investors need to be aware of, but that is not just unique to ETFs. I think this is a fantastic discussion where now, suddenly, investors know what the term ‘securities lending’ is and know what questions to ask. RFPs five years ago did not have a question on securities lending. Today they do and that is absolutely right, so I think it is positive for the industry to have had that sort of education process and learning.

Yuri Bender: It appears new guidelines from European securities regulator Esma require asset managers to return all securities lending revenues net of cost to investors. Is this a good thing and how will this affect revenue streams to ETF providers?

Gene Salerno: I hope costs come down dramatically. Being from the States, where you see ETF costs substantially lower than they are in the UK, I find some of the high charges almost offensive. Therefore, I think it is great to see competition come into the market, and I am sure that price will drive a lot of the selection.

Eric Verleyen: There is the cost, but there is the performance as well, especially if you invest in a tracker that will optimise, as we mentioned. We have talked about technologies which can help this, such as securities lending and maybe a physical plus a swap. You may have better performance, so even if you are paying a little bit more than the pure physical, it might be a good decision to select this one. Therefore, it is not only the cost; it is also about the performance that is delivered.

Eleanor Hope-Bell: I go back to what I opened up with, which is that ETFs are used in lots of different ways. There is no question that an ETF in lots of situations plays a very important role in portfolio management and, indeed, in implementation of investment ideas. Within the beta space, if you open the beta toolbox, there are lots of ways that an investor can access beta. Lest we forget we also have the derivatives world, which does not usually lend itself in terms of access to the private client or the retail world, but for lots of different investor types that beta toolbox is pretty deep and wide. Therefore, putting the macro hat back on here, let us raise the issue, which is if we look at US versus Europe ETFs, I think again this becomes a Ucits conversation, because Europe is more expensive than the United States in terms of fund management, irrespective of ETFs or non-ETFs. ETFs throw a new dimension into it, because then you also have a very fragmented exchange environment, there is a lot less transparency in Europe, MiFID will change that, we hope, over the next phase from 2015.

Yuri Bender: James, you set up the wealth side at BZW all those years ago. If you were starting up a wealth arm today, would you have a radically different take on managing portfolios and your model, knowing the ETF armoury that is now available to you?

James Bevan: Most certainly: the choice is much greater; cost of implementation is much less; the capacity to be more tactical in one’s thinking is higher.

However, I do think there is still no substitute for having a fundamentally well-designed plan to meet an investor’s end objectives and I worry there are a number of participants in the broader industry debate who confuse the choice of vehicle with the reality that they have to have an asset allocation of underlying investment exposures that is fit for the investor’s end needs.

Alan Miller: A lot of individual investors want an old-fashioned, well balanced, efficiently invested, low cost, liquid portfolio and the best way to construct this is via ETFs. Whether the client wants a fixed asset allocation or whether the client wants it flexible and managed on their behalf is up to them. Different people want different things. We actively manage, but there are going to be other clients who just want a fixed allocation, X per cent into bonds and Y per cent into equities. ETFs are a great way to invest for clients, because clients want more performance, more liquidity, more diversification and less cost. That is why the ETF industry has grown and why it is hated by the old-fashioned mutual fund industry, because it satisfies the key demands of the modern investor.

Yuri Bender: Do you feel that active management has really failed us and that is why ETFs are becoming so popular or do you feel it is more through the increasing sophistication of the ETF industry?

James Bevan: There is a much greater understanding that returns within markets are often associated with factors and risk characteristics that can be replicated cheaply and quantitatively and delivered via an ETF and that is an important step forward for the industry. I do worry, however, that the rising appetite to consider passive exposure to bond markets leads to the risk that the investor’s greatest exposure is to the entity that has issued the most debt rather than the company that is deemed to be the most valuable. That I do think is an accident waiting to happen and investors need to think about these things with care.

Gene Salerno: There is clearly a trend toward greater use of ETFs, and I would be foolish to bet against that continuing. Regarding whether or not we use them in portfolios, keep in mind that we always work to incorporate our clients’ views. Some clients have very strong views and are adamant that we use ETFs. Other clients are just as adamant that we seek out active managers, and some clients are still adamant about using hedge funds, despite them having been out of favour of late. As investment advisers, we always have to work within the constraints that our clients place upon us. It is our responsibility to advise what we think is best, but regardless of what we think, we cannot force our own philosophical views upon clients, and so there will always be a mix, I think, for quite some time into the future.