In the wake of the two years of financial turbulence and market upheavals, exchange-traded fund providers are looking to ride the upswing in confidence by stressing product innovation, taking
In the wake of the two years of financial turbulence and market upheavals, exchange-traded fund providers are looking to ride the upswing in confidence by stressing product innovation, taking the sector far beyond its original roots as a channel for investment in the world’s best-known and most liquid stock market indices.
To be sure, funds that track leading indices still account for the lion’s share of the global total of just over USD1trn in ETF assets. What is generally agreed to be the first-ever US ETF, the SPDR S&P 500 launched in January 1993, remains the biggest of the more than 4,000 ETFs now traded worldwide, with USD70.1bn in assets at the end of February, according to BlackRock, more than double the USD33.2bn of its closest rival, the iShares MSCI EAFE Index Fund. It is also the most liquid with an average daily trading volume of some USD25.5bn, nearly six times the USD4.45bn volume of the PowerShares QQQ Trust (which tracks the Nasdaq 100).
But industry members say there’s no future in trying to attract investor assets with new funds that track the S&P 500, the Euro Stoxx 50 or the FTSE 100. Instead providers of ETFs and other exchange-traded products are looking at other asset classes, including notably commodities and increasingly alternatives; alternatives to market capitalisation as a means of weighting index constituents; leveraged, short and leveraged short ETFs tracking recognised indices; ever more specialised sectors of national, regional and global economies; products that track indices conforming to Islam’s Shariah principles; and emerging and frontier markets. And in the past year or so a handful of providers have launched ETFs that do not passively track indices but have an actively managed portfolio.
Long gone are the days back in 2003 when iShares, then part of Barclays but now owned by BlackRock, started a revolution by launching the first ETFs that tracked bond indices. “If you go back to the beginning, fixed-income ETFs were quite late to the table,” says iShares senior fixed-income portfolio manager Alex Claringbull. “At that time people assumed ETFs to be an equity thing, and thought the ‘E’ stood for equity.”
Today, though, fixed-income ETFs are solidly part of the industry mainstream – especially since the financial crisis sent many investors running back to more conservative asset classes. “To see how far we’ve come since 2003 and how accepted these products have become over that period of time is incredibly rewarding for me as someone who has been involved with iShares fixed-income ETFs really from the start,” Claringbull says.
“If you’re going to build a proper toolkit of investor choices, you need fixed income at the heart of it, certainly in continental Europe. And the events of the past couple of years have really brought fixed income to the fore. It’s been a safe haven for a lot of investors, and in 2009 it was an incredible investment opportunity as well.”
Claringbull says the acquisition last year of iShares as part of BlackRock’s purchase of Barclays Global Investors has not had a direct impact on the ETF business but offers great potential on the distribution side. “BlackRock made it clear from the beginning they wanted to buy an ETF business and their intention is to grow that. Over time the ETF products will have a greater distribution network as we’ll be able to employ the services of BlackRock not only in Europe but globally.”
Discussions are constantly underway with the iShares product development team to examine whether and how client requests can be turned into viable products. “We are hearing about strong demand in areas where we currently don’t have products at the moment, such as high-yield, emerging markets and broad local indices,” he says. “Our job is to take those ideas on board and see if we can produce something that works in the ETF space.”
But Claringbull cautions: “It’s important that you don’t just launch a product for the sake of it. It needs to have something tangible underneath, robust portfolio management, and a clear message and client understanding. There’s no point in a product following a trend that’s here today, gone tomorrow. It’s not about what people want to invest in now but in two or five years’ time.”
Not all investors are retreating to the safety of fixed-income products. Koei Imai, head of Nikko Asset Management’s ETF Centre, notes that around 10 per cent of assets in the firm’s ETFs are held by non-Japanese investors, mostly European institutional investors. The firm is also seeing an increase in the share of assets held by individuals in Japan.
“Traditionally banks have been the largest holders of Japanese ETFs, accounting for about 70 per cent of assets,” he says. “But last year, because of the environment, a lot of banks had to reduce the risk assets on their books, so the proportion of bank investment in our ETFs has declined in relative terms. However, we have been actively promoting ETF products to retail investors through events known as ‘ETF festivals’, and we are getting more response. We hope that the spread of ETF products into retail sales will increase in the future.”
A great deal of innovation in the industry takes place at the level of index providers such as Stoxx, which is now exploring the opportunities opened up its new ownership structure following the purchase of the stake previously held by Dow Jones by existing shareholders Deutsche Börse and Six Group. According to Konrad Sippel, responsible for global product development and sales at the firm, the change not only allows Stoxx to absorb the index businesses of its two shareholders into a combined business but will enable it to extend its focus, previously limited to Europe under the agreement with Dow Jones, to the global market.
“When developing new indices we usually work very closely with the market and with our in-house experts,” he says. “We have a group of financial engineers that continuously bring up innovative ideas, test them in the market and develop them further in collaboration with market participants. We also listen to what market participants need and create custom and branded solutions for our clients. The best example of that is probably the series of optimised sector indices launched in the past year.”
Sippel believes the shift toward ever-greater customisation is set to intensify. “Index development trends are constantly moving toward individualisation,” he says. “The time of the big benchmarks has passed in some respects – those areas of the market are well covered. However, we see increasing demand from clients seeking individual solutions in terms of risk/return profile, specific market exposure and specific risk exposure, and we are working hard to provide our clients with the right framework for these indices.”
Among the most active developers of new products is db x-trackers, the ETF business launched by Deutsche Bank. “We have been very innovative over the past year, for instance with the launch of our hedge fund ETF,” says Simon Klein, head of db x-trackers sales for continental Europe. “We were the first ETF provider to launch a product based on hedge fund exposure, and we are now bringing leveraged long and short ETFs to the market.
“We will also focus on illiquid asset classes such as the EPRA real estate indices, and create more unique products such as our recently-launched China A-share ETF, which was the first Ucits III-compliant ETF investing on China A-shares. In addition, we also recently launched our exchange-traded commodity platform, and we plan to list another 30 ETCs by the end of the year.”
Exchange-traded commodities have been a major growth area during the crisis period and more providers are coming into the market (another recent entrant is UBS). However, pride of place is held by ETF Securities, whose founders launched the ETC concept in Australia in the early 2000s and which now has an extensive commodities platform spanning Europe, the US, Japan and Australia.
While its ETC platform continues to expand geographically, ETF Securities has also been active in other areas, such as the launch of ETF Exchange, an ETF platform backed by a consortium of banks. “So far we have Barclays, Citibank, Merrill Lynch and Rabobank on the platform,” says head of sales Scott Thompson. “The banks increasingly want to get involved in the growth of ETFs, but it’s an expensive business with a high fixed cost base. Joining a platform allows those costs to be shared and the banks to leverage their distribution capabilities.
“Separately, we have made a whole new asset class available in ETF form with our foreign exchange platform. This gives investors the ability to trade foreign exchange on-exchange for the first time. It has proved very popular in the light of the fiscal problems faced by countries such as Greece, and even the UK.”
Thompson says users of the platform include investors that are looking to get into foreign exchange as the ultimate macro asset class, but are concerned about trading sovereign debt given the increased perception of default risk. “Instead they will trade on macro views through the foreign exchange market,” he says. “We’ve had clients who primarily have been shorting euros, sterling and yen. As we’re partnering with Morgan Stanley, clients have also been able to hear Morgan Stanley’s ideas and research.”
Amundi, the investment business created at the end of last year by the combination of the asset management arms of Crédit Agricole and Société Générale, sees 2010 as a year of expansion in the ETF sector, especially to extend the group’s market strength beyond France to other key European markets. Says head of ETF product development Matthieu Guignard: “We currently have a range of 78 products covering all asset classes including equities, fixed income, money markets and commodities, and we intend to have around 100 products by the end of this year.
“We are looking to position Amundi ETF by offering cost-efficient products – on average they are 20 per cent cheaper than those of our competitors – as well as the quality of our ETFs and the solid credit rating of the Crédit Agricole Group, which acts as the swap counterparty of all our equity ETFs. We are also innovative, with a number of exclusive offerings such as global sectors and the short fixed-income range that we launched in January.”
Amundi, whose establishment was announced by the partners in January 2009, spent much of last year developing products for listing on Euronext Paris, but the firm has been highly active abroad in the first months of this year, listing ETFs on European exchanges including Deutsche Börse and Borsa Italiana. Says Guignard: “Our ambition is to become one of the top five ETF issuers in Europe by 2012 with more than EUR10bn in assets.”
Another new entrant to the market is Source, which is owned by a consortium of international banks and capital markets players. “We plan to continue to grow and expand the range of products that we offer to investors,” says chief executive Ted Hood. “But equally we intend to remain focused on the things that brought us into this business in the first place. There is still a lot more work to be done in terms of enhancing liquidity, creating transparency around counterparty risk, delivering performance and getting the message out to investors.”
Hood believes that ETFs will continue to attract assets from investors that have been disappointed with the performance of active management during the crisis. “We continue to speak with investors that have not used ETFs in the past but have come around to the idea,” he says. “They are stepping away from actively-managed funds, using more of a tactical asset allocation strategy to generate value, and using simple products like ETFs to express their investment preferences among different benchmarks.
“It’s inevitable that ETFs will continue to take market share away from active managers, particularly those seeking to generate alpha over very liquid and well-covered benchmarks. Numerous studies over the years have shown it is extremely difficult for an investment manager to pick stocks that outperform their benchmark year in, year out. When you factor in the relatively high costs, expressed in the form of management fees, it’s even more difficult to outperform the benchmark. We will continue to see ETFs take money away from those managers.”
However, Klein argues that rather than being in competition, active and passive management is increasingly complementary, and notes that in fact active managers are among the most substantial users of ETFs. “It’s not a question of active versus passive,” he says. “We will see very active managers increase their ETF holdings. Because ETFs are very liquid, they can use them to change their asset allocation.”
Tim Mitchell, head of specialist funds at Invesco Perpetual, adds: “There’s a big debate in the industry about whether active will be replaced by passive management, but that’s not really the right question to ask. What we will see is a continuation of the separation between alpha and beta. There is plenty of room for great active managers to charge premium fees for delivering truly great active products, but there’s also plenty of demand for beta products. We see increasing use of asset allocation strategies that beta fits into very neatly.
Mitchell says the group’s ETF provider, Invesco PowerShares, offers an alternative way to provide that beta exposure through its fundamentally-weighted products, which use a combination of four ‘fundamental’ factors – total cash dividends, free cash flow, total sales and book equity value – instead of market capitalisation as the basis for weighting index constituents.
“The big, well-known indices are incredibly well catered for by the big providers,” he says. “Invesco PowerShares continues to offer products that can be considered niche but offer real value to investors, with very exciting strategies. The concept of alternative beta is completely underrepresented in the ETF world.
