ETFs: Soon to be an adviser’s best friend?

“Our base case is that the ETF [exchange-traded fund] industry will exceed $100 billion within the next five years, and perhaps even $150 billion should growth continue as it has been.”

A bold claim by BetaShares’ head of strategy, Ilan Israelstam, perhaps, considering the Australian ETF market is currently worth less than half that at $45 billion, but one that looks set to be proven true.

The ETF market overtook that of listed investment companies midway through last year, with its liquidity, ease and diversification benefits combined with lower fees proving too promising for many investors to say no to.

Indeed, according to Investment Trends, the number of ETF investors in the year to last October was up 23 per cent, going from 314,000 to 385,000. The research firm believes this will hit a whopping 437,000 by this October.

So where is this growth set to come from?

Developing stalwarts

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To start, the market’s development won’t come at the cost of the ‘traditional’ ETF offerings that are becoming the mainstays of the new ETF-dominated investment landscape.

According to ETF Securities’ chief executive, Kris Walesby, we will see continued popularity from simple offerings such as those tracking the ASX 200, as the investor market isn’t yet fully saturated in terms of its exposure to those offerings. The markets that have turned to more specialist ETFs, such as the US, have done so because they hit a point where most people looking to invest in general index trackers already had.

BetaShares launched its Australia 200 ETF last year, for example, and, according to FE Analytics, it already has $545.8 million in funds under management (FUM) despite there already being other options on the market for investors wanting exposure to the ASX 200.

“So, while the move toward specific areas will continue, it won’t be to the detriment of those basic [portfolio] building blocks,” Walesby says, suggesting that in the next six months we will even see price wars between ETF providers for that type of offering.

The more ‘traditional’ ETF products also include those offering general exposure to global investments, and Pinnacle Investment Management’s director of listed products, Chris Meyer, believes Australia should expect to see more growth of these.

“It is easier to invest in global equities than directly in foreign shares … there are 300,000 Australian investors who have brokerage accounts that can invest in global equities, of which only about 50,000 are active,” he says.

The three major reasons for this – expense of investing abroad, disengagement from investors as most major global equity markets operate in our night-time and American tax forms – don’t apply to global ETFs, meaning interest in them will likely continue.

Further, the market’s present reticence to accept risk will strengthen the appeal of these more general offerings: “We’ve just come from a risk-off period – whereas before there were more risky ETFs looked at, that’s changed in the last six months,” Walesby says.

Table 1: Top ETFs by 12 month flows to 10 May, 2019

Source: ETF Securities Weekly ETF Market Monitor

Not a tech head? No worries

Of course, the continued growth of general ETF mainstays doesn’t mean specialised ones won’t keep growing too.

For investors or clients wanting exposure to niche asset classes, they provide appealing exposure while keeping the need for expert knowledge to a minimum. Where once riding off the rise of Apple would’ve required insight into the development of both the design and personal technology markets, buying into an ETF focused on technology, for example, allows investors to buy into a range of growing companies without needing to research any.

Walesby believes that this is why ETFs (and funds) are the best way for Australian retail investors to invest in technology trends. It’s near-impossible to predict what specific companies will take off without specialist knowledge, so an ETF allows consumers to spread their chances of having exposure to the unicorns like Apple.

And they want this exposure. “People want access to disruption and structural change in how we live our lives, such as robotics, technology and AI [artificial intelligence],” Walesby says. “They see these as likely to fuel growth in their portfolio.”

So, while 70 – 80 per cent of the typical portfolio is in standard offerings, the ETF Securities CEO says that there’s a 10 per cent bucket that’s being invested for accelerated growth to which specialised ETFs are often well-suited.

Fixated on fixed income

In what may be a surprising development for Australians, who are used to their retirement income being at least somewhat taken care of by superannuation, fixed income ETFs are rising in popularity globally.

According to BetaShares, fixed income products accounted for 68.2 per cent of total ETF flows for Q1 2019 in the US, compared to 30.3 per cent from equities. In stark contrast, in Q4 2018 they amounted to just 28.2 per cent of flows, with equities filling 70.8 per cent.

In Canada, fixed income ETF inflows were double that of equity ETF inflows in March alone this year.

“Fixed income was most definitely the flavour of the quarter, as investors moved into a decidedly risk-off position in their portfolios,” Israelstam says.

This trend looks set to contribute to the growth of the Australian ETF market, too. In Q1 2019 domestically, fixed income ETFs received over $500 million in new flows. From March 2018 to March 2019, the share of the total ETF market that was fixed income products went from 11 to 15 per cent.

“This reflects both the introduction of innovative new fixed income ETFs into the market place, an ageing investor population seeking relatively reliable sources of income return without undue equity risk, along with a growing sense that the long global equity bull market is “late cycle” and at increasing risk of turning down,” Israelstam says.

Further, Israelstam believes ETFs have made it much easier for investors to gain access to the Australian bond market, as well as being the subject of “particularly strong growing interest in defensive exposures such as cash and fixed income products”.

Fixed income ETFs’ growing popularity also may lead to a broader suite of products on the market. Meyer notes that in Canada there are specialist fixed income ETF offerings, such as ones specialising in environmental, social and governance (ESG) investments, while Walesby says that in the US there are already lots more options for fixed income ETFs than here, such as ones in municipal bonds.

The paradox of active ETFs

Active ETFs, offering a hybrid of ETF-style tracking and fees with active management, have been lauded as the next major player on the Australian ETF landscape for the last year. They are currently only worth $3.5 billion here but most of the ETF industry believes this is set to grow strongly, as investors seek an open-ended and low fee alternative to actively managed funds.

Looking again across the Atlantic, the path that growth may take is visible. Active ETFs currently account for 21 per cent of Canada’s total ETF market – one of the few countries other than Australia to allow active ETF trading – compared to nine per cent in Australia, which hasn’t had them for as long.

“These figures suggest there is upside to the growth of the Australian ETF industry in terms of overall industry penetration (active and passive) and even more growth potential, off a much lower base, for active ETFs,” Meyer says, pointing to the increased adoption of the product type by planners, stockbrokers and direct investors of this predicted growth.

Walesby warns however, that the growth may be stymied at first by poor offerings.

“We’re seeing many companies come to the market with active ETFs but without a business plan on how to gather the assets within that,” he says.

These companies may have the adviser networks needed to garner interest in their offerings, but not the relationships with stockbrokers or sales teams that creating an active ETF requires. There are just a couple on the market who have both of these – Walesby points to Magellan and Platinum.

While some of the predicted growth in the active ETF market will be realised, Walesby believes that it will then contract again unless the current approach by providers changes.

Building on the trend of adding a bit of management to ETF offerings, managed accounts and ETF managed portfolios are also on the rise – indeed, the managing director and head of SPDR ETFs Australia and Singapore, Meaghan Victor, believes that they will be “a key driver in the growth of ETFs over the next year”.

“Managed accounts incorporating ETFs can provide investors with access to professional funds management at a fraction of the cost and demonstrate the numerous ways ETFs can be incorporated into investor portfolios,” she says.

Chart 1: Top ETFs by YTD (10 May, 2019) total return

Source: FE Analytics/ETF Securities Weekly ETF Market Monitor

An educated adviser’s game

According to Walesby, ETF usage in Australia is predominately still in the adviser space, particularly for those with clients with self-managed super funds (SMSFs) or investment accounts. While some people are starting to invest independently, “the big money is still in advisers managing investments for their clients”.

The use of ETFs by advisers is gaining momentum. The 2018 BetaShares/Investment Trends ETF Report found that 53 per cent of planners were providing advice on ETFs last year, up from 45 per cent in 2017.

According to the study, ETFs’ low cost, diversification and ability to help bring down fees in clients’ portfolios (particularly pertinent in a fee-focused financial services landscape) were key benefits of ETFs for advisers.

The main barrier to ETF investment for investors and advisers alike however, according to the industry experts interviewed in this piece, was education, which clearly needs to be worked through if their growth potential is to be tapped into.

“Despite gaining significant traction and popularity over the last ten years, investors are still faced with a barrage of myths about the risks ETFs and index investing,” Victor says.

“These myths can deter investors from exploring the countless benefits, such as lower total cost of ownership, transparency and liquidity, that ETFs can bring an investment portfolio … To break these myths, it is essential that advisers and investors have access to the right information to evaluate how ETFs can be used to support and achieve their goals.”

Indeed, many of the barriers to using ETFs cited by advisers in the BetaShares/Investment Trends study could be overcome with education, such as a preference for actively managed funds or individual shares.

An example of the benefits of education lies in the increased use of shorts to neutralise downward market moves in portfolios.

According to Walesby, “advisers are getting smart on playing recovery trades” and, instead of trying to select stocks in recovery stages, are increasingly buying ASX 200 ETFs and seeing the recovery play out through those. In this, advisers and investors can access the opportunity of market movements without risking the burn of poor stock selection, a short-term trading strategy that is already “a big, big part of what’s going on with ETFs in the US”.

While the practice used to be relatively unknown in Australia, as education around it increased so did its adoption. The same could prove true for utilisation of the multitude of ETF options, from fixed income to active to specialist tech offerings.