Getting more active about ETFs

Despite ongoing competition between passive and active managers driven by fee pressure, changes in the market environment driven by higher volatility, and the potential impact of passive strategies, the Australian exchange-traded fund (ETF) industry remains on track.

Although most managers would agree that ETFs will never be the entire solution for financial planners and their clients and there would be still room for both active and passive strategies, most funds managers offering ETFs said they were satisfied with the current pace of absorption by the financial planner community.

According to BetaShares’ Australian ETF Review – April 2018, Australia’s ETF industry returned to growth and reached a new record high of $37.9 billion in funds under management (FUM), driven by the strong performance of both global and Australian share markets.

Although April saw overall FUM up 3.6 per cent ($1.3 billion), in March overall FUM saw a drop of 0.8 per cent (-$288 million) from its February peak, due to weaker global and Australian equity markets.

BetaShares chief executive Alex Vynokur said the Australian ETF industry continued its growth trend and a rising number of investors, including financial planners, had begun to incorporate ETFs into their overall investment strategies and use them as core building blocks for constructing clients’ portfolios.

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Explaining this trend, he said: “There’s really two parts to that. Part one is that the number of advisers that are using ETFs has increased dramatically and number two is that the proportion of the clients’ portfolio that has been invested in ETFs is also increasing year on year.”

EDUCATION ABOUT ETFs

Higher ETF absorption would also put extra pressure on providers in terms of educating their clients.

With a growing number of client portfolios invested in ETFs, advisers expected stronger support from their ETF providers in educating their clients.

“As more and more of clients’ portfolios are being invested in ETFs, [advisers] require that key ETF provider relationships really support them on educating their clients, so a lot of work that we’ve been doing at BetaShares has been really around helping our adviser clients educate their own clients in relation to the benefits of ETFs.”

For the chief executive of ETF Securities Australia, Kris Walesby, the ETF industry in Australia has now reached the point at which the industry has entered the rapid adoption phase.

“We are at the beginning of the stage where the financial community as a whole, planners, are really understanding what ETFs can do,” he said.

“[It is like] when you begin to launch a product and there’s a lot of education about why people should use the product, like when the iPhone first came out no one knew how it worked then people started to understand them and now everyone wants them.”

Walesby believes that the stage when most planners felt overwhelmed is now gone, as planners have started to see how ETFs can help them deliver solutions for clients. However, he agrees that there was still a lot of education around ETFs that needs to be done.

On the negative side, planners often felt confused when it came to ETF selection as rapid growth had resulted in an increased number of products available on the market.

“With that rapid adoption there is some level of confusion over the broad range of ETFs. There are so many out there so [they think] how can I as a planner know that I’m choosing the right one?”

However, Walesby stressed that, at the same time, the fact that planners were presented with so many ETF options was a positive thing as it would require financial advisers to do proper research and due diligence with respect to ETFs.

Of similar opinion was Damien Sherman, head of Vanguard’s ETF Capital Markets, which won the title of the best ETF provider at the Money Management Fund Manager of the Year Awards this year.

“The knowledge gap is a bit of a problem but I think the risks that we see to the ETF market are really around product proliferation as there are a lot of issuers coming to the market ... We see that as a considerable risk to the ETF industry and it means that advisers need to do their homework,” he said.

“They need to do their homework in understanding what is the transparency of the particular ETF, what the index tracks, what’s in the index, and what’s the investment strategy, as more and more products come to the market.”

NEW APPROACH 

Earlier this year, BetaShares and Legg Mason launched jointly two new active income-oriented ETFs, the BetaShares Legg Mason Equity Income Fund (EINC) and the BetaShares Legg Mason Real Income Fund (RINC), which were expected to be managed by Legg Mason’s affiliate asset management firm, Martin Currie.

Both firms also said they had plans to launch more active ETFs together later in the year.

Legg Mason’s country head Andy Sowerby, who stressed that for his business the partnership with BetaShares was strategic, said it was all about enabling choice for clients and in part to address a strong demand from investors who wanted to be able to access products directly.

“We are focused initially on an income solution to meet that need, particularly for retirees to deliver high sustainable tax-efficient income for them on a consistent basis,” he said.

“There’s a couple of ways you can do that,” he said.

“You can build it yourself or you can do what we have done and choose to partner with a specialist, a major provider who has the skillset and knowledge and the capability and the market presence where we can effectively bring their knowledge of the ETF market and our active management capabilities together and create a solution for clients.”

Sowerby said the inspiration actually came from clients who asked about the availability of the funds’ strategies in the form of active ETFs.

He also noted that there was a growing number of clients who did not want to deal with traditional platforms and would prefer direct access to their investments through the Australian Securities Exchange (ASX).

Vynokur, who stressed on many occasions that there was space for both active and passive funds, said one of the biggest benefits that attracted advisers towards active ETFs was the ability to access active manager strategies with the convenience of the open-ended exchanged fund structure as opposed to listed investment companies (LICs), which are closed-ended actively managed strategies.

Also, an active ETF structure would allow investors to buy and sell investments out or very near at net asset value.

“LICs can sometimes trade at a premium to net asset value and sometimes at a discount to net asset value and sometimes at a very significant discount to net asset value,” he said.

Perennial’s portfolio manager, Stephen Bruce, and Cesar Farfan, head of retail sales, agreed that the market would most likely see a growth in active ETFs, with possibly a higher number of these solutions being offered by fund managers, which might see new partnerships between fund managers.

“I don’t think it’s trend but I think it is perhaps a lower cost entry point for fund managers. I do think that more managers will offer their active strategies as actively managed exchange-traded funds.

“So this will be a trend, whether they partner or will do it themselves like BetaShares or someone else I’m not too sure but there definitely will be more growth in active ETFs,” Bruce said.

NOT A MAGIC PILL

Walesby also agreed that there were two key reasons why active managers might look at ETP products (exchange-traded products) as they offered access to new markets and would increase “tradability”.

“In Australia now this tradability is not actually something that people talk about but in the US and Europe the tradability of ETFs is a really, really big theme because when you were in the GFC [the global financial crisis], for example, or any aggressive really negative period, the ability to sell out of the fund quickly is something that you really, really want,” he stressed.

According to the ETF Securities’ CEO, the market would definitely see a growth in partnerships between ETF providers and active managers who would come together to expand their range of ETFs, in particular to launch new active ETFs.

The active managers have two options: if they are big profitable businesses then they can afford to launch active ETFs by themselves as they can afford to set up the infrastructure and run it themselves. However, in the case of smaller active managers, the better option might be finding an external partner in preference to building their business internally.

“I think it’s just the beginning. There are a lot of active managers who are looking at the space right now,” he said.

However, Walesby warned that active managers must have reasonable expectations and be aware of the fact that such partnerships would necessarily be “the magic pill” in the sense they would not automatically mean higher “floods of monies” unless the manager had a proper strategy in place.

“So, it won’t necessarily grow under their wishes for having floods of money come in – if the strategy is not a good one.”

Following this, fund managers pursuing this strategy need to make sure that prospective investors were aware of the work that needed to be done.

Sherman from Vanguard said one of the strengths of ETFs was undeniably their low cost and ability to provide a good mechanism for investors with active investment strategies.

“We believe that the main theme to active investing is low cost. One of the key headwinds to active management underperformance has been the high fees charged by the issuers of those products,” he said.

“We believe that active products such as ETFs are a good mechanism for active strategies but it’s important that ETFs are transparent, for instance, that they are independent market makers. It’s a very important aspect for both index and active ETFs so that is how we think that active products should be developed.”

He also agreed that groups as big as his do not need to look for partnerships.

“We have our in-house active managers, we develop product that is managed – we develop active product that is managed by those inhouse managers. But I can understand why from the perspective of other issuers why they may want to pursue strategies like that,” he added.

SO WHAT IS HOLDING BACK FINANCIAL PLANNERS?

According to Walesby, one of the biggest obstacles for the community is the fact that most financial planning groups in Australia have either investment committees or chief investment officers in place, which create model portfolios and find it very difficult to break from their natural bias towards active management.

“It’s human nature that if you’ve been in around managed funds for 20 or 30 years and ETFs are new kids on the block, it’s difficult for you to change what you’ve done for a long period of time.”

Financial planners also pointed to the fact that ETFs were absent from platforms.

At the same time, Walesby stressed, independent planners have already started using ETFs as the main co-parts of their portfolios, repositioning their client portfolios entirely, in a way where the ETFs could become the core elements.

“The percentages that you put into these different asset classes [at] different times in the market, that’s what is going to drive most of your returns, so using ETFs as a core is probably the better way to do it than use active managers trying to drive outperformance.”

“Even though it would take a longer time to get there because of the strengths of the aligned dealer groups, the big four banks and AMP over time, I think that right now advisers are really having to make sure they are charging fees that work as primary way to make income.

“You’re going to have more and more discussions around ETFs and in five years time, hopefully ETFs will be something that almost all advisers will be using to some extent,” Walesby said.

According to Perennial, there would be more risks around understanding how some of the market beta ETFs had been built.

“These smart beta ETFs have got different factors that have been used to determine what security is getting bought. So there are risks that can be understood.

“What you’re seeing at the same time is that the research houses now are researching more and more ETFs, so that will help advisers understand how to use them in portfolio construction and how they might suit some of their clients, and how and where some of the risks are as well."