Do ETFs have the perfect recipe for rapid growth?

Despite its relatively small size, solid growth in recent years has made the exchange-traded fund (ETF) space the envy of managed funds and some of the other sectors. Freya Purnell explores the reasons why the recipe may be right for the rapid growth of ETFs.

The secret to the success of exchange-traded funds (ETFs) is a ‘perfect storm’ of post-GFC investment themes – investors seeking low-cost vehicles, transparency in both product and pricing, and a preference for listed investments.

Over the last five years, as traditional managed funds have floundered, ETFs have posted a compound annual growth rate of 33 per cent per annum, according to figures released by the Australian Securities Exchange (ASX).

ASX-listed ETFs attracted over $500 million in net inflows during 2011, to reach an overall market cap of $4.3 billion (as at February 2012).

While it’s still early days in the Australian market, the number of ETFs on offer has increased significantly – from 45 to 61 during 2011, and to 68 by the end of March – and with new ASX regulations opening the door to fixed income ETFs for the first time this year, you have a recipe for rapid growth.

Build it and they will come?

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According to the Australian Securities and Investments Commission (ASIC), there is currently a high level of retail investment in the sector – between 50 and 75 per cent across most products, with SMSFs accounting for up to 30-40 per cent of the member register of Australian ETFs.

By contrast, overseas, institutional investors are much stronger in this space, holding approximately 80 per cent of ETF assets in Europe and around 50 per cent of ETF assets in the US.

The June 2011 BetaShares/Investment Trends ETF report also found that while early adopters of ETFs were primarily self-directed, 30 per cent of investors were discussing ETFs with their financial adviser.

Around 27 per cent of planners surveyed were already using ETFs, with a further 27 per cent planning to implement them in future.

So what is driving interest in these vehicles?

According to iShares director Tom Keenan, there are both top-down and bottom-up factors at play. As the performance of many asset classes remains lacklustre, investors have increasingly expressed a preference for passive, low-cost investment vehicles, and ETFs offer management expense ratios of half or even a third of those charged by actively managed funds.

Drew Corbett, BetaShares’ head of product strategy, says its own research indicates that investors are increasingly focused on fees.

“Investment expectations have been diminished a little by the volatility in the markets over the last 18 months. People see that the number one thing you can do to improve your returns in an investment portfolio is to lower your costs,” Corbett says.

The GFC also made investors focus more on the value for fees, and why they were paying higher fees for proposed outperformance that was not being delivered.”

While high net worth investors are favouring direct securities and off-platform products, Tria Investment Partners senior consultant Oliver Hesketh and director of Russell Investments' Australian ETF business Amanda Skelly see this trend particularly among self-managed super fund (SMSF) trustees. 

“About 40 per cent of our investors are actually running their own SMSFs, and from our research it was quite clear that they have a preference for control and transparency, which trading on the share market provides,” Skelly said. 

In fact, liquidity and transparency are key concerns across the board for retail investors.

“Since the GFC, investors have become far more worried about the liquidity of the investments they are using and far more concerned about understanding those products,” Keenan says.

ETF Consulting director Tim Bradbury also says the appeal of the transparency of ETFs extends beyond just what is in the investment portfolio, to “who is getting paid to do what”.

Another aspect of the appeal of ETFs – which may be going under the radar at the moment – is their tax-efficiency, according to Morningstar co-head of fund research Tim Murphy. 

“The ETF structure is much more tax-efficient for the investor than a managed fund or unit trust structure,” Murphy says. 

In addition to these strong consumer drivers, on the other side of the coin, impetus is coming from the structural change afoot in the intermediary market.

The move towards fee-for-service is accelerating the process of adoption of ETFs, as financial advisers look to demonstrate value for clients, and the commission-free structure of ETFs fits well within this new proposition. Keenan says this transition was also critical to the growth of ETFs in the US.

With these drivers at play, the managed fund sector could be forgiven for feeling a little threatened by the new kid on the block – and perhaps with good reason, if the overseas experience is anything to go by.

“Looking at the US, mutual funds have been in net outflow or small inflows for some bond funds. ETFs have continued to gain a share of wallet among investors during that time.

"In 2008, there were huge outflows across the board in all asset classes, including managed funds, but ETFs saw net inflows of around $200 billion,” Murphy says.

Despite this rosy view, there are some barriers to the growth of the sector. Distribution is a “critical hurdle” for all ETF issuers, according to Bradbury.

While the 2011 Investment Trends ETF survey said that 63 per cent of planners reported that they would use Australian equities index ETFs over the next 12 months, with proposed adoption numbers also high for international equities, fixed interest and commodities ETFs, there was a big ‘if’ attached – that is, if these products were available on their approved product list (APL).

Bradbury also draws the distinction between the general level of awareness of ETFs, currently high, and real ETF knowledge, which is low, and points to the need for improved education across the industry.

And if the nerves and jitters continue to affect investors in 2012, they may also avoid any perceived “riskier” path, preferring to stay invested in cash and “safe haven” options, Bradbury says.

This would hinder the local ETF market from reaching its medium-term targets – though he admits this is less likely as cash rates decrease.

Opening the floodgates on fixed income 

From a regulatory perspective, 2012 has already brought the Australian ETF market a major win.

The long-awaited changes by the ASX to the AQUA rules which cleared the way for fixed income ETFs to be listed came into effect on 9 January 2012.

By the end of March, seven new cash and fixed income ETFs had already been launched, by Russell Investments, iShares and BetaShares, with more in the pipeline from issuers such as State Street Global Advisers.

This move is important not just because it creates the opportunity to launch new products to the market, but because adding fixed income rounds out the major asset classes offered through ETFs.

“It now enables investors to build properly diversified multi-asset portfolios across the full risk spectrum solely using ETFs. Up until now you’ve only had the risky asset classes like equities, commodities, and property,” Murphy says. 

This could be particularly attractive for those investors who only want to deal with ASX-listed securities.

“Historically that meant using direct equities and hybrid securities, which are far from the defensive investments that people might think they are. Fixed income adds a proper defensive asset class to their investable universe,” he adds.

Importantly, it makes high credit quality Australian fixed income much more accessible, enabling investors to buy bonds in the same way they buy a stock, and transparent, with pricing to be published daily.

“This is a tremendous change from what we have known previously, which is a market difficult for investors to access directly due to high minimums and a cumbersome process.

"This really does change the game, and I think that the ease of use will mean that self-managed super fund trustees and financial advisers will rethink their allocation to fixed income and its role in a portfolio,” Keenan says.

Bradbury believes fixed income ETFs are going to be of greater interest to financial advisers and institutions, who are skilled in portfolio construction and asset allocation, than they will be to self-directed investors.

“That’s mainly because self-directed investors tend to be of an equity mindset. It’s probably a better result for them to think about buying term deposits for the time being, rather than a government bond index or high-yield ETF,” Bradbury says.

Russell undertook research into how fixed income ETFs might be used in a portfolio before launching its bond ETFs, and this clearly indicated that financial advisers, brokers and SMSF trustees were looking for an investment solution that could be tailored and was – surprise, surprise – low-cost.

For investors who don’t want as much control, Russell also created a model portfolio to provide guidance on how financial advisers should allocate to bond ETFs.

And it’s here that the industry sounds a warning. Because in the past, it has been so challenging to gain a meaningful direct exposure to fixed income, some ‘back to basics’ education is required on the asset class, as well as the nuances of accessing it through the various ETFs.

“The introduction of another asset class is exciting and it helps all of us in the market to continue to build on the story,” says Guy Maguire, head, Standard & Poor's (S&P) Indices Australia.

“What is still challenging is how we position these, and how we support the adviser so they can feel comfortable and understand how these different ETFs will work.”

The timing may also be right for fixed income ETFs. There has been a rally in government bonds of late, rendering them less attractive right now, but term deposits, which could be seen as the major competitor for these defensive dollars, are seeing declining yields.

“As people start to reassess their term deposit holdings, corporate bond ETFs are a nice complement to provide liquidity and the comparable yield without equity market volatility,” Skelly says.

There are, however, some pitfalls with fixed income ETFs that investors need to be aware of – for example, spreads potentially blowing out. To avoid this, Skelly suggests financial advisers and investors look carefully at the underlying securities held by the ETF and how liquid they are.

The trouble with synthetics

Despite the good news locally, the last year has actually been a tough one for the sector globally.

The negative press started last April in the US, when the Financial Stability Board sounded a warning about systemic risks relating to ETFs; fears that were compounded when a UBS junior trader generated a $2.3 billion loss through unauthorised trading through ETFs.

International regulators such as the International Monetary Fund, the UK Financial Service Authority and the Bank for International Settlements added to the chorus concerns that investors might not be aware of the risks around ETFs.

These concerns relate specifically to synthetic ETFs, and particularly the counterparty and systemic risks they carry, linked to the use of derivatives and leverage in their structure.

Though synthetic ETFs have been extremely popular in Europe, where they make up almost 45 per cent of the ETF market, new regulation could see this section of the market stopped in its tracks.

The European Securities Market Authority has drawn up new guidelines to improve transparency in the market, consulting publicly on whether ETFs should be divided into complex and non-complex products, and whether the sale of derivative-based synthetic ETFs to retail investors should be restricted.

In Europe, the worries have seen an exodus of investors from synthetic ETFs in favour of those that are physically backed.

European synthetic products had outflows of US$7.3 billion in the three months to October 2011, according to Blackrock's ETF Landscape Summary Report, with US$6.0 billion flowing back into physically backed products during the same period.

Although caution also infected the Australian market, it was unwarranted – in most cases, these issues haven’t even applied to products distributed locally, which are primarily physically backed by assets or cash on deposit.

(Two exceptions were the BetaShares Financial and Resources Sector ETFs, up until October 2011, when the company announced it would move the funds to a physically backed structure and limit their use of derivatives “to an immaterial level”.) 

“I think now, more than a year ago, you can look at the whole ETF segment and say the risks are still fairly low,” Hesketh says.

“ASIC has worked closely with ETF providers to ensure that the products here are next generation ETFs as opposed to those products overseas that did cause some of the concerns,” Corbett says.

This close attention to getting the right rules in place was also the reason it took so long for fixed income ETFs to come to market.

“That has been due to the regulator wanting to ensure that the fixed income ETFs that are brought to market are the right solutions, so not a high reliance on derivatives, not a lot of leverage. They have been quite thoughtful in the rules,” Skelly says.

Many other industry players are supportive of the careful approach ASIC has taken to regulating this emerging market, and particularly in applying the lessons learned from overseas.

“Certainly I think ASIC has done a very good job of spelling out the risks to investors and educating the market, as have the ETF providers in the Australian marketplace,” Keenan says. 

But this is not to say the Australian ETF market will remain at its current level of simplicity.

“Potentially there is a place for synthetic ETFs where the underlying exposure can’t be delivered in any other way.

"A great example of that is a commodity ETF – obviously you need derivatives or futures to deliver that, because you can’t warehouse the underlying commodity,” Keenan says.

Bradbury agrees that greater complexity is coming – partly because issuers are looking to implement new investment ideas, and partly because some exposures can only be delivered synthetically.

In the commodities area, BetaShares launched a raft of cash-backed products towards the end of last year, including oil and agriculture ETFs, as well as a broad commodities basket ETF, aimed at providing access to agriculture, livestock, oil and natural gas. 

They’re not for everyone – Murphy, for one, warns advisers against using commodities exposures in portfolios through ETFs or other vehicles. 

“Particularly where you have index-based commodity exposure, like ETFs are, where they are based on futures curves rather than physical assets, the performance can vary quite a lot from the movement of spot prices.

"There is a whole range of different issues when you are investing in commodities, which is a big leap ahead in education and understanding,” Murphy says.

ASIC’s current view of the regulation of ETFs is comprehensively outlined in its Report 282 Regulation of Exchange Traded Funds, which was released in late March.

The review was undertaken as a result of the International Organisation of Securities Commissions (IOSCO) issuing proposed regulatory principles relating to ETFs for consultation.

Among the principles proposed by IOCSO are a number of disclosure requirements relating to how an ETF tracks an index or basket of securities, portfolio holdings, fees and expenses, and lending and borrowing of securities, how ETFs are sold by intermediaries, management of conflicts of interest, and requirements for regulators to address risks raised by counterparty exposure, collateral management, and liquidity shocks. 

Releasing the report, ASIC chairman Greg Medcraft said that the regulation of ETFs in Australia is in line with these proposed international standards, and reiterated ASIC’s commitment to market surveillance and investor education in the ETF sector. 

The report outlined ASIC’s view that products using ‘funded swaps’ had been identified as the most risky types of ETFs in terms of counterparty risk, and that while no Australian ETF to date has used this type of mechanism, it “would consider carefully the appropriateness of any proposed product using a funded swap”.

It also noted that there are currently no inverse or leveraged ETFs in the Australian market. 

But Bradbury believes this may change. 

“As ASIC and ASX become more comfortable with synthetic exposures [and ways are found to provide retail investor education and protection], we might see inverse funds across broad equity indices this year,” he wrote in the ETF Consulting Australian ETF Outlook report.

“This seems a logical and sensible progression, given the lack of an active market for borrowing ETFs in Australia and the need to provide investors with superior ways to manage down-side equity risk.” 

The role of the financial adviser 

Many would argue that with a new investment vehicle, there is no such thing as too much education – both for financial advisers and brokers and their clients – and the entry of fixed income ETFs is in fact prompting additional efforts in this area.

“That alone I think is really important, because there is still a lot of uncertainty and confusion around what ETFs actually are,” Skelly says. 

Financial advice is also critical for those looking to dip a toe in the water in the fixed income space. 

“Our research in the SMSF sector showed that the number one reason SMSFs seek financial advice is to get advice on bonds,” Skelly says. 

When it comes to including ETFs in their product toolkit, boutique advice practices have tended to be among the early adopters, but this may change in the future, particularly with ETF coverage now extending across the major asset classes, a wider range of options, and products being fully researched and added to APLs.

“I think many more advisers are considering how ETFs might play a part in their business.

"It’s not compromising the value that the adviser provides, it’s simply using additional tools to build better or more cost-effective or more diversified portfolios for their clients,” Bradbury says.

Hesketh believes there may also be growth in ETFs driven by the broker market switching from transaction trading to more portfolio management, while Corbett says an increased knowledge of ETFs among financial advisers could see them used in more sophisticated strategies such as portfolio tilting and constructing core-satellite portfolios. 

“As ETFs become a full suite of products and as issuers increase the offer to the full range of asset allocation tools through ETFs, advisers will recognise that there is a role for ETFs in portfolios and in helping investors to achieve their investment objectives,” says Lochiel Crafter, Asia Pacific head of investments, State Street Global Advisers.

“The value of ETFs is if you have a particular view on a particular period, you can get price certainty in executing on that view at the time you want to do it, so it does increase that degree of flexibility.” 

Importantly, it is the implementation that is the greatest departure from what financial advisers might be accustomed to with managed funds. 

“The underlying investments are often largely the same, sometimes exactly the same as the investment exposure you are getting in a managed fund,” Murphy says.

“But the implementation is quite different – and over time, as advisers get more confident and more understanding of that, then you would expect to see the use of ETFs among advisers growing.” 

What’s next for ETFs?

If ETFs over broad-based indices are at the vanilla end of the spectrum and synthetic and actively managed ETFs are at the highly structured end, then fixed interest ETFs, commodities ETFs and ETFs over tailored indices are somewhere in the middle ground – and it is these type of funds which will flood the Australian market over the coming year, as well as possibly some active ETFs by the second half of the year, according to Bradbury.

“That’s a natural progression, because as the market starts to grow, and regulators become more comfortable that retail investors are adequately protected and informed, you are going to see variations of ETFs that aren’t simply the standard asset classes we have seen up until now,” Bradbury says. 

And if managed funds are starting to feel the squeeze from ETFs, there’s another option – they could take their funds onto the ASX. 

“If you look at the trends out of the US, some of the biggest managers there are moving their product on exchange,” Bradbury says.

“The recent ASX listing of the DIGGA Mining Fund demonstrates how new specialist entities could emerge and take market share in funds management, with the help of AQUA listing rules and relatively low barriers to entry.”

As the saying goes – if you can’t beat them, join them.