Investment experts argue that ETFs aren’t flavour of the month, they’re a fundamental part of a client’s investment portfolio
Huge flows of money into ETFs have proved the ever-growing popularity of the investment vehicle, but also led to worries about them becoming ‘flavour of the month’ investments. Over just five years, the amount of money invested globally via ETFs has more than doubled. According to figures from data provider ETFGI, in July 2013 a monthly record of $44 billion was invested into ETFs and exchange traded products (ETP), taking total investment to $2.16 trillion. In July last year, a new record was set as total ETF and ETP assets under management tipped $5.12 trillion.
A report by EY predicted that assets in ETFs globally could reach $7.6 trillion by 2020, fuelled by digital platforms, low yields on investments, and the move towards self-investing.
The Fight Against Fees
It is undeniable that investment into index-tracking funds has also been fuelled by a growing discontentment with high active fund fees and lack of consistent performance from active managers but has the pendulum swung too far the other way?
John Barrass, Deputy Chief Executive of the Personal Investment Management and Financial Advice Association (PIMFA), questions whether or not the huge amount of money going into ETFs is an issue.
‘Is there a risk that ETFs have become too much of a flavour of the month, and how have professional advisers and their teams been taking account of that potential concern?’ he asks.
However, far from offering up a ‘flavour of the month’ investment, advisers recommending clients to invest in ETFs are aiming to provide them with an opportunity to better understand their investments.
Christine Cantrell, Director of ETF sales at BMO Global Asset Management, says: ‘ETFs have a new advantage over active managers in regards to the MIFID II requirement of 10% depreciation reporting within the same business day. At least with ETF holdings, an adviser can clearly look at how the ETF has performed and what has caused that.’
She says this is ‘different to active managers as they can drift away from their task because they can, then it’s less transparent for the advisers to tell their client what happened and why’.
Cantrell says that while ETFs are undeniably popular, and becoming increasingly so, there should not be any concern about the way they are shaping markets.
‘ETFs are only a small part of the overall investable market,’ she says. ‘An area that’s even more misconceived is fixed income; they’ve always dealt over-the-counter not on a transparent exchange, but fixed income ETFs bring more transparency to that investment class.’
Cantrell says advisers have ‘utilised’ ETFs in volatile markets over the past decade. It is possible they will get to utilise them more if the predicted economic slowdown and subsequent return to a bear market after a decade of growth happens.
‘The beauty of an ETF is that the price is live and you can compare it to the underlying holdings; evidence shows that the difference between the ETF price and NAV has stayed very much consistent, very close to zero, even during volatile periods,’ she says.
‘Volumes of ETFs traded have really increased during those volatile periods, and this encourages more players into the field who are increasing competition and price discovery.
People have had bad experiences with some active high yield funds in the US and during the Brexit referendum aftermath there were closures in certain property funds, so to be able to have a structure of a vehicle that’s constantly accessible, that’s very appealing.’
A Force For Good
Howie Li, Head of ETFs at Legal & General Investment Management (LGIM), does not believe ETFs are just flavour of the month investments but a part of the range of good index investments which can help mitigate risk and provide diversification for clients.
‘What’s been clear in the last five years is that more money is moving towards index investing,’ he says.
‘What that means is with more money flowing in tracking major benchmarks, you have this portfolio turnover where everyone is buying and selling stocks around the same time…There’s more demand for a short period so that causes a short price volatility.’
He admits that this is a problem for ETF investors but he believes LGIM has identified a solution which helps to mitigate the risks.
‘We have a new fund range that gives you core exposure to the largest companies in a particular country but we’re avoiding the crowds that are trading the underlying stocks. We’re moving the rebalancing periods to mitigate opportunistic activity that comes with more money tracking indices. Why do we all buy and sell at the same time?’
He adds that LGIM also looked ‘at identifying risks in certain companies’ and mitigate those through mild exclusions and using voting rights and shareholder power to be a force for good in markets.’
‘You can construct investment strategy where you can anticipate risks and mitigate them. ‘For stocks that we hold, we can use our voting power in companies owned by the ETF to say that we don’t like their approach on things like executive pay or corporate governance,’ he says.
‘If index investments are run well, this active voting power and engagement with companies can help preserve the value of passive investments’.
The huge inflows into ETFs have encouraged swathes of new launches and advisers are under pressure to keep on top of the different investment options available to clients. Research is imperative to an adviser’s (and paraplanner’s) job and just like doing due diligence on active funds, advisers will have to employ a similar level of due diligence here.
Jeannette Cottrell, a Chartered Wealth Manager at Tilney Investment Management, says she works alongside a ‘dedicated research desk’ which is ‘quite relative to our peers’.
‘They put together an approved list for what we can buy, which includes ETFs,’ she says. ‘Really, we’re working off that particular list. If there’s something not on the list but we’d like it, we’d approach [the research desk] and they’d do the underlying research.’
This is a contrast to the company Cottrell worked in before Tilney, where ‘you’d go out and see what was available, you’d look at Morningstar, do a universe search, and you make your choice.’
‘You’d typically go for the larger names used before… It wouldn’t be based on cost, it would be based on how specific it was to the objective we had,’ she says.
‘We’re not just looking for exposure to a market, we’re looking for a specific theme or objective.’
She adds, however, that one problem that advisers face in the expanding universe of ETFs is the domicile.
‘One of the confusions I’ve had is that a lot of ETFs are domiciled in different places and this has tax implications,’ says Cottrell. ‘It’s not clear to investors what the tax implications are. People don’t know and the risk warnings aren’t clear enough.’
Li says that ETF due diligence is the same for any fund but some advisers are looking for research that helps them to make asset allocation decisions.
However, he notes that wealth managers and discretionary fund managers have more tools at their disposal when it comes to research but ‘if you’re an individual IFA, sometimes these tools aren’t available as you might be looking at a paid subscription service that individuals might find difficult’.
‘[IFAs want to see] if the ETF or mutual fund is delivering, how closely is it tracking the index and what are [the] fees?’ says Li.
‘You’re seeing more and more businesses that are able to explain to investors which (funds) are doing the best job of tracking the market or keeping fees low. I expect this to continue to grow to help educate the retail side of the market.’
Advisers relying heavily on ETFs for client portfolios could come under fire for failing to add value in the same way an adviser picking active funds is but Cantrell disputes this.
‘On the research side, maybe in the past people would have thought if their adviser is filling their [clients’] portfolios with ETFs then they’re not doing their job but it’s almost the opposite,’ she says.
‘You’re thinking about [whether] the objectives have been achieved and you’ve selected more value-add solutions to the client, that’s what you should be judged on. It can be much easier because there’s more data available; ETFs have to make everything transparent.’
She adds that ETFs make adviser research easier when it comes to calculating costs for clients.
ETFs make adviser research easier when it comes to calculating costs for clients
It’s easier to quantify the total cost of ownership with ETFs,’ she says. ‘There’s a lot of research that goes into the selection of different ETFs. When you come to some ETFs with similar objectives, or if they’re in a similar category, you can see diverging performances or volatility. The more they evolve, the more apparent the value-add that’s being delivered.’