ETF: The low-cost revolution

ETFs lay in the shadow of other investment vehicles for almost a decade, but the last two years have seen their value skyrocket. Could it have anything to do with regulatory reform or is the Australian market just slowly following its international counterparts? Melina Gouveia investigates.

The exchange-traded fund (ETF) market has been expanding at a rapid pace in the last two years and cash inflows into the sector show no signs of abating.

A surge of interest from independent investors and advisers has seen the value of the market grow from $4.7 billion to $11.1 billion in the 24 months to April 2014. 

But this recent boom – and the interest from advisers particularly - is a fairly new phenomenon. 

Although first launched on the Australian Stock Exchange (ASX) in 2001, ETFs were initially slow to gain traction. For ten years, they significantly lagged their investment counterparts and scored little attention from advisers. 

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So why did ETFs experience years of subdued growth and what are the drivers behind their recent popularity?

Interestingly, the rise of ETFs coincided with structural changes in the market, including the regulatory juncture in the financial advice space and the rise of self-managed super funds, analysts say. 

Morningstar research analyst Alex Prineas said an outcome of the Future of Financial Advice (FOFA) legislation that came into force last year was that financial advisers must now include a Fee Disclosure Statement (FDS) with their advice plan. This has increased educational awareness and demand for low cost products such as ETFs, he said. 

The FOFA move towards a fee-for-service advice model has also forced innovation and evolution in platforms and the advice business model, as planners look to profit from greater practice efficiencies and adopt tools and technologies to improve their revenues, he added. 

Prineas further attributes ETF growth to the more diverse product range now offered by issuers which provides investors access to different asset classes, strategies and geographic markets in a single trade.

The demand for ETFs in the retail market has also been buoyed by the growth of self managed super funds (SMSFs) according to Vanguard head of market strategy and communications, Robin Bowerman. 

He said advisers can employ ETFs to mitigate concentration risk often inherent in an SMSF which may typically hold between eight to 18 stocks. The addition of an ETF allows an adviser to buy the whole market in a single trade, providing diversification at a low price.

“In the first quarter of this year there was more than $700 million of cash inflows into ETFs. That suggests net cash flow for the year will be something like $3 billion. That is extremely positive growth and mirrors what we have seen in the US and other parts of the world,” Bowerman said.

“I have no doubt that the growth in SMSF assets and the growth ETFs are definitely aligned.”

While FOFA has arguably created administrative burdens for advisers, it has created new opportunities on the ETF front according to Bowerman, who refers to the US ETF experience foreshadowing trends that may gain local traction.

“Looking at the US advisory market, ETFs were reasonably slow to take off. Then once advisers began to build out core satellite type portfolios and going more to fee-for-service ­– that is where strong growth came over the last 15 years,” he said.

“Advisers have been dealing with a lot of regulatory change. As FOFA settles down, you will see more people looking at what are the new technologies, what are the new product structures that can actually help my business in a post FOFA world, what will the right business and administration structures look like for an adviser business in 2015-16.”

In the pre-FOFA world ETF growth was constrained both by adviser business models and the distribution methods product providers used to reach the retail advice market which favoured managed funds.

“Advisers have traditionally been users of managed funds through platforms. Some advisers would have their business models set up in a certain way,” Bowerman said.

The new regulatory frontier
ETF Consulting managing director, Tim Bradbury concedes platforms are the best way for an adviser to run their business but they are not always best for the client. 

As regulatory reform hastens the advice industry evolution and costs remain at the forefront, Bradbury said picking unlisted managers in an overall active portfolio could be last millennium’s business model.

“More advisers realise the business model they had 10-15 years ago – that they are still employing isn’t going to meet their needs or their client’s needs,” Bradbury said.

He noted that vertically integrated and institutional dealer groups were slower to get comfortable with ETFs.

“It’s partly that they are hardwired to do managed funds through their in-house platform. That is why you see the big channels not doing huge amounts [of ETFs], but they are getting bottom-up demand from their advisers and the advisers are getting bottom-up demand from their bigger clients,” Bradbury said.

“Platforms will continue to evolve to meet the needs of advisers and the industry. Platforms have not been particularly good until more recently in doing listed investments and have not been particularly cost effective. Platforms will improve around being able to buy and sell ETFs on the exchange and you are going to see advisers use ETFs in platforms increasingly.”

Bradbury said as platforms get better at handling on exchange investments such as ETFs and direct equities – a lot of the growth is going to move towards the exchange away from unlisted funds and that will increasingly put the spotlight onto ETFs.

The earlier adopters of ETFs look to be non-aligned boutique type advisers, according to Bradbury.  He said the reason for this is that non-aligned planners usually have more control over running their own business and the need for efficiency is of high importance.

“They think about things like cost of delivery of advice, compliance, profitability of their practice, they think about whether their business is too complex, they think about whether they are spending too much time on research of active managers. Often the ETF comes into the frame as part of the solution,” he said.

According to Bradbury, advisers can position ETFs to clients as part of their advice recommendation which will reduce the cost, offer diversification and not compromise the outcome of the portfolio in order to reach long term financial goals.

“The way ETF issuers talk to advisers is different from the way advisers talk about ETFs to their clients. Most advisers don’t talk about the portfolio in great specifics. The good advisers add their value through strategy and support for the client in terms of mapping out a financial future,” he said.

“However cost is a big issue. Cost is certainly one area that advisers do talk about with their clients.”

Cost is certainly a compelling reason to incorporate passive investments into an overall financial advice plan according to Partners Wealth Group director Mathew Cassidy, who uses ETFs in his financial advice practice for several reasons.

“One being they are so cost effective,” he said.

“We are always looking to add value to clients on the basis of strategic asset allocation. A lot of the times we are looking at a cost effective way to create exposure to a preferred strategic asset allocation. ETFs are important as they give you the allocation you want, that is cost effective. I think quite clearly, costs across the advice market will be under continued scrutiny.”

Whilst ETFs have their advantages in the right circumstances, Cassidy does caution about the need to be selective in their use when trying to achieve a desired financial objective for a client.

“Sometimes people can look at costs as opposed to benefits and that is really dangerous,” he said.

Bowerman shares Cassidy’s sentiments on choosing the best investment tool when implementing asset allocation.

 “Advisers who are changing their business models to be more about ‘what is the best decision I can make for my client in terms of asset allocation’. 

“That is probably the preeminent decision the adviser makes for the client,” he said.

“Adviser businesses under FOFA move to fee-for-service, it really opens the door for people to become much more about asset allocation decisions rather than stock picking or fund picking.”

How advisers actually execute their asset allocation, whether that is through an unlisted fund or an ETF structure, will be dependent on advisers understanding how ETFs actually work. 

Smarten up about beta
For State Street Global Advisers (SSgA) relationship management managing director, Peter Mitchell, education has been instrumental to recent growth in the ETF space.

“What we have done is taken time not only to educate advisers on the use of ETFs but also how a particular strategy or sectoral play can help with their asset allocation. Advisers are taking a great interest in that and I would say this has been a contributing factor to the market growing from $4.7billion to $11.1 billion in two years, “Mitchell said.

Both Bradbury and Vanguard’s Bowerman agree with Mitchell that asset allocation education on how an ETF fits in an overall client portfolio will be a key driver in wider ETF adoption amongst advisers. 

 “I get the sense that a lot of advisers are not as clear as they should be around their investment construction methodology. Conversely, the advisers who are very clear on it often use ETFs,” Bradbury said.

Bowerman said his firm addresses skills gap by conducting adviser workshops.

“I think all the major providers are in their own way trying to educate advisers. We run a lot of portfolio construction workshops – it’s about getting that portfolio asset allocation and core satellite approach right and explaining how ETFs can be part of the solution if not the full solution,” he said.

Product Proliferation
Indeed, the growing product suite over the last two years has seen the number of ETFs available on the ASX increase to almost 100. These ETFs encompass distinct asset classes, sector exposures and semi active strategy-based solutions which allow an adviser to build a complete investment portfolio.

“If you think about from the investor’s perspective and you step back about 5 or 10 years – if you were an Australian investor looking at the ETF capabilities available, it was fairly vanilla. The sophisticated strategies were only available to the institutional investor,” said SSgA’s Mitchell.

Bowerman agrees that the ETF product suite available to Australian investors was limited in the past.

“If you went back a couple of years there were no fixed income ETFs, so if an adviser would have had to have used funds for the fixed income piece and ETFs for equities,” he said.

“As the industry has built out more products and over time as more products come to market, advisers will be able to build complete portfolio solutions – 100 per cent using ETFs if they want to.”

However for SSgA’s Mitchell when it comes to choosing between active managers and ETFs, it is not an either or conversation.

Room for both?
“ETFs can be used in tandem and very much lock step with unlisted funds,” said Mitchell.

Despite being a strong proponent of ETFs, Bradbury concedes that there are some asset classes that are probably more able to be actively managed and outperformance can be delivered.

Partners Wealth Group’s Cassidy certainly sees Bradbury’s view in practice. 

“While ETFs have their benefits, I think they need to be combined with some other strategies. You do limit your upside if there is an ability to be active in markets if you are purely tracking an index,” he said.

Bradbury stressed an adviser needs to be clear on how they build portfolios and therefore where the active and passive and ETFs fit into those portfolios.

“If I am a core satellite portfolio construction advocate, does that mean core is 30 per cent or 80 per cent? Advisers need to have guidelines for what that means for the risk profile or client type,” he said.

The Future
According to Bradbury, the ETF segment in Australia has grown in the past five years at about 40 per cent per annum and has forecasted this growth trend to continue.

“It will continue to grow at those numbers which means in three years FUM will be $25-30 billion, in five years it will be closer to $60-70 billion,” he said.

Bradbury believes the as the ETF industry innovates, new product lines will present opportunities to a wider audience of advisers and capture a bigger segment of the advice market.

He also predicts advisers who are in between the 25 and 45 age group demographic will be much more open to ETFs. 

“The reason is now a lot of the education is around using passive investments as a starting point for a portfolio – these advisers read about it more, hear about it more and get more online education. They are not as jaundiced by the past in the advice industry,” Bradbury said.