ETFs: bringing passive into mainstream

The meteoric rise in the popularity of exchange traded funds is undeniable but it has its naysayers. Meanwhile, there are abundant opportunities for planners, Malavika Santhebennur writes. 

As a passive investment vehicle, the growth of exchange traded funds (ETFs) has jolted active fund managers, and much has been written about the downsides of this investment vehicle and its potential impact on the stock market. Of course, ETF providers vehemently deny the validity of these arguments, emphasising that ETF investing still represents a tiny proportion of the investment market.

Nevertheless, the rise of the Australian ETF industry is undeniable, and is on track for its biggest year thus far. According to the Vanguard ETF Quarterly Report for the 2017 September quarter, total Australian ETF cashflows for 2017 stood at $5.7 billion, surpassing the $3 billion received in 2016 and closing in on the $6.1 billion received in 2015.

According to the BetaShares/Investment Trends ETF Report 2017, released earlier this year, the number of ETF investors in Australia grew at an annualised rate of 31 per cent in the 12 months to September 2016 to 265,000 investors. A survey of almost 600 financial planners revealed that at the end of 2016, 43 per cent of financial planners recommended ETFs to their clients, which has tripled since 2008.

The BetaShares Australian ETF Review for the month ending September 2017 revealed total industry funds under management (FUM) at the end of the month was $32 billion, a growth rate of 3.5 per cent. The majority of the gains (around 65 per cent) came from new money flows ($687 million).

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BetaShares managing director, Alex Vynokur said the growth of ETFs had coincided with the growth of managed accounts, with strong adoption rates of ETFs amongst advisers who utilised managed accounts in their portfolios.

“ETFs have always been known as very efficient building blocks for client portfolios and I think when it comes to managed accounts, where the objective is really all about efficient access to diversified portfolios, ETFs certainly deliver in spades there,” Vynokur said.

“We think that will continue for some time.”

Vanguard Australia head of ETF capital markets, Damien Sherman said investors were becoming increasingly aware of the benefits of investing through ETFs, such as diversification and the ease of accessing international equities to reduce home bias at a low cost.

“If you’re an investor and you want to invest outside of Australia, which is a very wise thing to do because our market here in Australia is highly concentrated, a lot of investors want to extend their risk profile and extend their investments to include international equities,” Sherman said.

“Now, if you are to do that by direct stocks, then you have to go to your broker and apply to be able to invest in international shares. That’s a very expensive option. And then you need to know about which international shares to buy.”

A key benefit of ETFs is that investors can go to their local exchange and buy international shares, or international fixed income by either placing an order with their online broker or full-service broker to gain the benefits of diversification more easily.

A peek into sectors

Other than international equities and domestic equities, fixed income ETFs are growing in popularity, although the growth is from a lower base. Fixed income ETFs have existed since about 2012 while other ETF products have been in existence since before 2009. 

Sherman said the ETF market had benefited from more liquidity, while fixed income offered another avenue for diversification in investor portfolios.

Head of ETF Securities Australia, Kris Walesby, said Australia still lacked a wide range of fixed income offerings but the products that had been launched had been successful in accumulating assets quickly. 

“That makes sense because if you look at a well-run, normal, diversified portfolio you’d expect it to be something like 60 per cent in equities and then something like 30-35 per cent in fixed income and then five per cent in commodities or something else,” Walesby said.

“But in the ETF asset space right now it’s about 85 per cent of the assets are in equities, and then probably about 10 per cent is in fixed income, and then the rest is in other stuff like gold so it’s ripe for fixed income to be the big mover in terms of accumulating assets.”

iShares head of wealth, Alex Zaika, said international fixed income was launched in December 2015 but had already seen $126 million of inflows from January through to September this year, and was one of the most rapid areas of growth in the Australian ETF market.

With over 160 ETFs in Australia, advisers could now create complete portfolios by using ETFs and populate the global fixed income sleeve of the portfolios with fixed income ETFs, he said.

“Investors could buy plain vanilla government bonds, they could get exposure to investment-grade corporate bonds and then there’s one ETF that has 5,500 global investment grade bonds and it’s only 26 basis points, which is incredibly low cost,” Zaika said.

Naysayers of ETFs – who are they?

The rise of ETFs comes with its fair share of detractors, with much being written about its impact on the stock market, and the impact of passive investing on market efficiency.

Grant Samuel Funds Management (GSFM) director and head of distribution, Damien McIntyre, wrote in a Money Management column earlier this year citing various studies to argue that even though passively managed funds comprised only over a third of US equity assets, the high level of trading in those funds had had a negative impact on the pricing efficiency of the stock market.

Trading costs had risen, stocks were more correlated with each other than they used to be and valuation was now partly impacted by whether a stock was in a widely traded index or not, he wrote.

Walesby disagreed on various points, firstly arguing that trading costs were, in fact, plummeting.

“Unless something’s happened over the last two years to make them go up again, my experience of ETFs and the stocks that are the underlying for ETFs is actually the prices of trading have gone down massively,” Walesby said.

“There are more market makers market making the product and then also people trading the underlying stocks by definition, which means that there’s more competition and therefore spreads are tighter.”

Walesby said that perhaps because ETF funds intended to buy certain stocks that were in the index, those prices were potentially being pushed up above their fundamentals but their trading costs, that is, the cost to execute that was not changing.

“What I would say is that there’s a lot of press and it’s almost all negative on the ETF industry getting bigger and affecting trading costs, maybe from active managers,” he said.

“If you’re a good active manager, if you have passive-based funds buying stocks passively, because that’s what the clients who are buying ETFs want, they want basically the simple strategies to get exposure. If you’re a good active manager, then those inefficiencies, that is your pay day.

“When there are inefficiencies in the market that is what you as an active manager can take complete advantage of and you can be off-benchmark because you’re not really tracking the benchmark anyway,” Walesby said. 

“You can do whatever it requires to actually make sure that your fund is performing over and above what the relatively simplistic, blunt instrument of an ETF is doing.”

Zaika said it was important to utilise facts and figures to address misconceptions around the impact of passive investing and ETFs on the stock market. He said ETF assets globally totalled $4.4 trillion while the world’s market capitalisation equalled $165 trillion ($100 trillion in fixed income and $65 trillion in equities).

This meant ETFs currently comprised just 2.6 per cent of global markets. 

“In terms of trading, there’s a paper published by Blackrock very recently and in that we show that for every dollar of trading in an index fund or ETF, there is approximately $22 worth of trading activity in unlisted or actively managed funds. So there is far more turnover and far more trading that takes place within unlisted or active funds,” Zaika said.

“As Uber has been a disruptor for the taxi industry, ETFs have already been a disruptor for the asset management industry. With the popularity of ETFs, there are certain segments of the market that may feel threatened by the continued appeal of ETFs.”

Sherman agreed the source of the arguments against ETFs was active managers, who he said may be “threatened” by the rise of indexed products.

“We don’t believe that they distort the market and that’s because despite the fact that ETFs have seen dramatic growth in the last six or eight years here in Australia and 10 or 15 years in the US, indexing itself is still a very small part of the entire market,” Sherman said. 

“Here in Australia it’s 18 to 20 per cent of the market. In the US it’s getting up to 25 or 30 per cent.”

He said there may be many other factors that could be contributing to variations in correlations across stocks such as globalisation, and global monetary policy.

“We see the impact of ETFs on the market as being very positive for investors and we believe that a lot of this information about distortion of the market being caused by ETFs is not borne out in fact,” Sherman said.

Cracking through bank APLs 

At the release of the Investment Trends/BetaShares report on ETFs earlier this year, Vynokur had said the ability for planners to access ETFs was a “tale of two sides”. He said independent financial advisers were more receptive to including ETFs on their approved product lists (APLs) as they were part of an independent establishment where they could access products that they believed were in the clients’ best interest.

“I think the issue with bank aligned planners, and that’s really the other side of it, is that awareness is reasonable because obviously our education effort and the industry’s education effort is certainly applicable across both independents and aligned,” Vynokur said.

“But the dealer groups, which are bank-aligned and conflicted in many instances, are continuing to hold back the option of ETFs because they have their own products to sell.

“Most of the big banks have an affiliated platform which they control and that platform has a strong preference for selling affiliated products.”

Vynokur had added that while the Future of Financial Advice (FOFA) reforms had sought to introduce best interests duty to curtail this practice, a large number of advisers in that space “are product sales people; they sell products for the large banks”.

More recently, Vynokur stood by his stance that IFAs had more rapidly adopted ETFs due to the fact that they had on average more flexibility and were nimbler, and had access to an unrestricted list of investment solutions for client portfolios.

However, in the bank space, Vynokur said things were moving in the right direction with large banks beginning to add ETFs more to their investment menus.

“There are significantly more ETFs that are now available on those platforms than 12 months ago and 24 months ago and 36 months ago. So we’re definitely seeing a positive trend there. Having said that, of course, there is still a lot of room for growth in that option of ETFs in those channels,” he said.

Sherman said financial planning organisations and banks undertook a comprehensive due diligence process, and supported the rigorous process.

“As they should do because they need to understand the products that they’re putting on their APLs. And we have dedicated people here that explain our products in that process of due diligence,” Sherman said.

“Is it difficult? Yes. It’s a hard job. Should it be difficult? Yes it should be. Can we do it? Yes we can.”

Zaika also said dealer groups and banks had comprehensive research and review processes, but said iShares had strict compliance and risk management processes in place. 

“What we’ve now found is that the researchers, they’re looking beyond just the headline management expense ratio,” Zaika said. 

“They’re looking beyond the fee. The first thing they consider is the manager: who are they partnering with? Does the manager have size, skill, and expertise? How long have they been doing this? What experience do they have?

“Then they consider the exposure of the ETF – what is this ETF actually tracking? If it’s global equities or a particular sector does that exposure actually make sense for advisers, and the clients of that particular dealer group or bank or institution? They’re becoming a lot more specific in what they require.”

Zaika added the Big Four banks recently conducted a review of all smart beta ETFs, and the word count of the research document stood at 22,000 words.

Investment Trends’ research director, Recep Peker said advisers who could not access products they desired were working with dealer groups to aid their understanding of those products and increase its availability and accessibility for planners.

“Hopefully planners encourage more dealer groups to also deliver the products they’re after.”

Opportunity galore for advisers 

Peker said ETF investment presented a significant opportunity for planners to advise investors on the investment vehicle. 

Of the 265,000 investors currently investing in ETFs, only 21 per cent said an adviser or financial planner was involved in the decision-making.

“This is something that’s growing quite significantly in adoption among investors. For financial planners, if they want to remain relevant, if they want to continue to remain relevant, if they want to follow where investors are putting their money and tap into opportunities, then advice will be very important,” Peker said.

“With more and more ETF investors using ETFs, that’s going to create a greater number of opportunities specifically for planners who can advise on ETFs,” he said.