Are ETFs really the next big thing?

ETFs have been growing at a rapid pace in the last few years, but as Janine Mace writes, this might be due to their potential, rather than the recent and current achievements of this sector.

When it comes to trending topics, exchange-traded funds (ETFs) are right up there. 

But for all the hype and promotion, Australia’s fledgling ETF market still has a long way to go before it reaches anything like the size of the $1.2 trillion market in the US, which consists of 1,216 funds and currently represents around 15 per cent of all market trades.

As Tim Murphy, Morningstar Australasia’s co-head of fund research notes: “Australia is a drop in the ocean.”

According to BetaShares data, the market cap of the Australian ETF market was only $5.7 billion at 30 September 2012, despite having grown 15 per cent over the past 12 months.

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Amanda Skelly, SSgA’s head of SPDR ETFs, agrees we have a long way to go.

“The ETF market in Australia is incredibly small. It is worth $40 billion in Canada – which is a similar-sized market – but here it is less than $6 billion, so there is a lot of room for growth.”

In fact, much of the hype around ETFs in Australia seems to be more about their prospects than what is actually going on in the market.

“Australia is now where the US was 10 years ago,” Skelly says. “There is a lot of growth potential.

Vanguard’s head of product and marketing, Robyn Laidlaw, believes volumes and interest will continue to grow.

“In comparison to the US market, Australia is still in the early stages of adoption,” she admits.

Slow start for ETFs

Since their initial launch into the institutional market over a decade ago, ETFs have failed to capture the imagination of Australian investors in the same way they have in overseas markets.

Offshore, institutional investors led the push into ETFs followed by the retail market, but here the reverse has occurred.

“The Australian market is primarily driven by retail and individual buyers, but elsewhere it is institutionally driven,” Skelly explains.

Despite the slow start, there are now 81 ETFs listed on the ASX, with new ones appearing regularly.

“Lots of new providers came in three years ago and the market experienced considerable growth, going from $2 billion to $4 billion in 18 months. But then it slowed and the total market is now worth around $5.9 billion,” Skelly notes.

The current sluggishness in the ETF market is due to several factors.

“There are a number of things going on, with a structural shift to lower cost and transparency and the desire for a more direct approach. These are all favourable for ETFs,” Murphy explains.

“However, the other things are more cyclical, with very few people investing into risk assets, so there are no real flows occurring at the moment.”

FUM (funds under management) growth has definitely slowed, Laidlaw says. “Investors are not really investing in the equity market at the moment. Once there is greater confidence in the markets again, investors will look to ETFs.”

Although investors are wary, ETFs have fared better than other investment vehicles, according to Drew Corbett, head of investment strategy at BetaShares. 

“Despite the challenging environment, the increase in assets in ETFs is in positive territory, which can’t be said for managed funds,” he says.

“It is a difficult market out there for everyone, but we are getting positive inflows every month. Inflows are dripping into the ETF market and BetaShares has been one of the best in terms of inflows this year.”

In September, the Australian ETF market grew 4 per cent, with the month-on-month trading value rising 5 per cent.

Corbett believes increasing trading volumes will lead to greater interest and usage, as “turnover begets turnover”.

Financial advisers take a look

Growth is also likely to continue now that the interest has spread from direct investors and SMSFs to the adviser space.

“Development of the Australian market has been different, as take-up has initially been with retail direct investors and then advisers. More advisers are now looking at the product and saying they are thinking about using them,” Laidlaw says.

Skelly agrees the reluctance of advisers to embrace ETFs has restrained growth: “The commission focus slowed ETF growth, but this is changing now.”

Murphy believes changes in adviser remuneration will push things along. “For advisers, it is an opportunity to focus on lowering costs and to strip out some of the traditional embedded costs in investment products,” he notes. 

“Some practices are building themselves around an ETF approach and adding a fee on top for implementation. In the US, advisers are taking a more tactical approach but using ETFs to implement it.”

Murphy believes the Future of Financial Advice (FOFA) regime is a turning point for the ETF market.

“In the current environment with all the issues around FOFA, embracing a new style of investing is well down advisers’ list of priorities. But with the shift away from commissions they will have to address it,” he argues.

Fixed interest and model portfolios 

Aside from the push factors, the ETF market is also likely to continue growing due to the appeal of its new product offerings, with the introduction of fixed interest ETFs an important part of this.

Skelly believes the launch of these products is “critical”, despite their slow initial take-up. In the medium-term, she expects fixed interest ETFs to play an important role in the market, as globally 20 per cent of all ETFs are based on fixed interest indices.

“We expect Australia to move in a similar direction. Investment grade fixed interest is where most ETFs are focussed, so we expect to see growth in them as the market becomes more familiar with the product,” she predicts.

Murphy agrees the launch of fixed interest ETFs is important, despite the low asset volumes and headline liquidity to date. 

“Since their launch the cash rates available to investors have still been high and that has made them less appealing. There has also been some concern about the make-up of fixed interest benchmarks used in ETFs, so it has not been the greatest time to launch them,” he explains.

However, Murphy believes the launch is a valuable development for investors seeking more defensive asset options. “They are a good thing and we expect to see more variations on the indices emerging.”

While agreeing they are important, Corbett believes their time has not yet arrived. 

“We still have relatively high cash rates, so Australia is different from the rest of the world. In the US interest rates and cash deposits rates are very low, which means fixed interest ETFs are popular as you get a pickup on the available rates. There will come a time when this will change, but we are still not there in Australia,” he says.

A significant opportunity flowing from the introduction of these products is the potential to construct model portfolios based on ETFs.

“There is real interest in the construction of ETF model portfolios by local adviser groups,” Skelly says.

Murphy agrees: “The launch has been very important for the ability to build out a full multi-asset portfolio with ETFs.” 

For Laidlaw, fixed interest ETFs add to the list of building blocks available for use in portfolio construction. “Advisers have got way more in their toolbox now.”

Access all areas

The choice of potential ETF building blocks is only likely to grow, according to the experts.

Skelly believes there is growing interest by advisers in ETFs providing global exposure, and ETF providers are likely to cater to this demand with new offerings.

“Recent flows have moved towards global ETFs, as they allow you to get a basket of equities for one trade at a reasonable cost. Global ETFs offer good opportunities – especially for getting broad exposure (including US), rather than sector specific.”

Providers are also expected to provide investors with increased access to smaller asset classes or sectors that traditionally have been hard for the retail market to reach.

“Investors are now able to access things they were not able to access before – especially in fixed interest – and this is important,” Skelly explains.

Corbett sees ETFs as vital for retail portfolio construction as they provide access to previously inaccessible assets. “ETFs deliver institutional-style access to everyone.”

He points to a number of new sectors which are now cheaply available to advisers and retail investors. “Access to high-interest cash, physical gold bullion, fixed interest and agricultural and rural commodities is now available cost effectively.”

Corbett expects this new availability to allow retail investors to include new assets in their portfolios. “In the rest of the world the average allocation to commodities is 6 per cent, so we launched an ETF that offered low-price access to commodities.” 

A range of other options is also likely to appear.

“There are some sub-sectors which will be launched as all the mainstream asset classes are available. We will probably see products based on different sectors within asset classes as they do internationally, where some ETFs have a narrower focus on sectors,” Corbett says.

Skelly agrees there are a number of options to explore. 

“Global REITs and global natural resources ETFs are offered in the US and they may be of interest here,” she notes.

Murphy believes there are many styles of ETF yet to appear in the local market. 

“Overseas you are seeing lots of rules-based products being launched. There is a big trend to expand the type of rules used,” he says.

“We expect to see rules-based ETFs that do not necessarily track a market-weighted index, but rather use other rules to develop their holdings – such as a dividend-focussed ETF.”

These more unusual exposures give ETF providers an important point of differentiation. 

“There is great potential for innovation in the market, as these types of ETFs provide a competitive edge,” Murphy explains. 

ETF investors are also likely to be offered wider portfolio solutions. 

Skelly expects to see multi-asset ETFs start appearing in the Australian market within the next two years. “These products could have appeal for certain investors looking for broader exposure. There has been a lot of talk about active ETFs.”

Although Laidlaw believes new products will continue to appear in the local market, she believes the most important offerings are already available.

“There are Australian and international equity, fixed interest, commodities and currency ETFs, so there is a reasonable choice available to investors,” Laidlaw notes.

“It is really interesting that from a US market perspective, more than 40 per cent of assets are in the top 10 products – all of which tend to be broad-based index products. We think the scale will be in the broad-based products.”

Cost drives growth

Whatever happens in terms of product development, one factor likely to ensure continued growth in ETF usage is cost – both from the adviser and client perspective.

Skelly believes this factor is highly significant in a market largely dominated by retail investors.

“ETFs are a really attractive option. People are trying to lower their investment costs and this includes advisers who are trying to deliver investments with greater cost efficiency to clients,” she explains.

Laidlaw believes cost is under the microscope at every level.

“Cost is really very significant as many advisers are looking to transform their business model and investors are now very cost sensitive. It is one of the key drivers.”

It is also important for providers.

“In the US there is something of a race to the bottom to be the lowest-cost provider, with Vanguard recently being undercut by Schwab one basis point. It will be interesting to see the response,” Murphy says.

Corbett believes investment market conditions are helping create more pressure on costs, because in a lower-return environment the percentage of total return devoted to costs becomes increasingly important.

“While you are in a low-growth environment and returns are not as high, the focus on cost is acute,” he says.

“Cost is very important, as the average ETF is one-third the cost of most managed funds and can be substantially cheaper. With 80 per cent of managed funds not outperforming their benchmark, investors don’t want to be paying three times the cost for the same performance.”

However, there is agreement cost is not the only driver for ETF market growth. 

“It is not just about saving money, as the other core benefits of ETFs are transparency of the portfolio and knowing what the NAV [net asset value] is on a live basis. Liquidity and the simplicity of being able to buy and trade on the ASX all day are also important,” Corbett notes.

“ETFs also give you low-cost diversification with regular rebalancing when the index changes.”

Murphy agrees: “Cost is not the only issue, but it is a very important one.”

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