What’s the next step for the local ETF market?
Exchange traded funds (ETFs) are amongst the most popular and cheapest investment vehicles available in the world, with a global market value exceeding $200 billion.
As at the end of January 2002, the total global value of ETFs exceeded $205 billion, and the industry was dominated by the five largest ETF managers with over 92 per cent global market share.
In the Australian market, a small number of retail products have been launched by BNP Paribas Asset Management (BNP), Salomon Smith Barney (SSB) and State Street Global Advisors (SSgA).
The level of market penetration is currently low, with SSgA the only local ETF manager to capture a significant scale of assets under management.
With the exception of SSgA, the fee levels for local ETFs are relatively high considering the strategies pursued.
These fee levels can be primarily attributed to the distribution channels targeted for these products. For example, the BNP and SSB products are distributed via advisers that can generate trailing commissions.
The SSgA ETFs on the other hand are distributed directly to investors and institutions and do not offer commissions.
Distinguishing between real ETFs and other exchange traded products is important in understanding the growth of these products.
The strong growth of ETFs offshore has been driven by their favourable characteristics, but these are only expected to be derived from real ETFs as compared with other exchange traded instruments.
A key advantage of ETFs is that they offer the investment efficiency of a traditional unlisted index fund but with additional liquidity through real-time market trading.
The existence of the dual trading mechanism is meant to ensure that premiums and discounts to the underlying net asset value (NAV) are minimised.
Of the funds offered in Australia, the streetTRACKS range most closely fits the definition of a real ETF.
Stellar Capital conducted a premium/discount study of State Street’s ETFs (streetTRACKS50 and streetTRACKS200) to consider the NAV efficiency.
In general, the creation/redemption process is working effectively with NAV performance for these funds, usually tracking the benchmark performance within one basis point. In other words, their trading performance has closely mirrored their respective benchmarks.
Active ETFs, that is, ETFs with actively managed portfolios, have been launched by DWS in Germany (November 2000) and BNP in Australia (July 2001).
In the US, the Securities and Exchange Commission (SEC) has delayed approval of active ETFs to consider how these funds can operate effectively.
The SEC’s concerns relate to ensuring a transparent and informed market exists for trading in active ETF shares.
The normal operation of ETFs depends on continuous disclosure of portfolio holdings that are quoted and calculated in real time. Transparency is critical to investors and institutional market participants that can transact in-kind to arbitrage between the ETF shares to remove any significant NAV discount or premium.
An active ETF, therefore, represents a conundrum for its manager because it needs to disclose holdings (and possibly trades) in real time to ensure the market is informed and the ETF trades close to its NAV.
An active ETF manager, therefore, would be required to continually disclose its active positions. This could result in other market participants ‘front-running’ on trades rendering the active decisions ineffective.
Program trading and immediate electronic reporting can reduce this problem.
Managers can also use redemption or subscription baskets that add or remove securities from the fund to achieve the desired strategy. While investors imitating the ETF are likely to increase market demand for the securities the ETF holds, this is only of concern where the ETF has not set its positions quickly.
Actively managed ETFs will be expected to realise capital gains much more often than a passively managed index fund.
Therefore, active ETFs would not offer the same level of tax efficiency as passive index funds, but would not be any worse than unlisted active funds.
Notwithstanding these aspects, it remains unclear why an investor would buy an active ETF if it can transact on its own account based on the manager’s announcements.
On the other hand, it is unlikely that the manager would wish to provide insights into its proprietary trading strategies.
Significant growth in the ETF market and continuing investor acceptance of the structure may allow the launch of products that use tailored or screening benchmarks. It is likely this would incorporate best practice in the areas of socially responsible investment (SRI) and corporate governance. These are of particular interest to trustees of large superannuation schemes.
Martin Gold and PaulAli are both principals atStellar Capital, a boutique investment firmspecialising in innovativeinvestments.
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