By Simon Gray – The past year was another complicated and at times painful one for the global investment management industry, but amid all the turbulence exchange-trade funds continued their seemingly irresistible ascent in all major world markets, confirming their emerging status as building blocks of investment strategy for institutional investors and increasingly individuals too.
Like other sectors of the investment industry, ETFs have been subject to greater scrutiny from regulators and legislators than ever before, in part down to the proliferation of products based on complex or highly specialised indices, or that use techniques such as leverage and synthetic shorting more usually associated with hedge fund strategies.
The past year has also seen further fund management groups explore the possibilities of so-called ‘active’ ETFs, combining the liquidity offered by exchange trading with traditional alpha-seeking fund management approaches, although of course without the rock-bottom total expense ratios that have been one of the most appealing characteristics of the sector.
Still, the numbers speak for themselves. At the end of February, the global industry consisted of 3,149 ETFs from 160 providers and net assets of USD1,522.9bn, with 6,994 listings on 50 exchanges, according to ETF Global Insight, the new research and consultancy firm just established by Deborah Fuhr (pictured), the celebrated former Morgan Stanley, Barclays Global Investors and BlackRock ETF guru, and two longstanding analyst colleagues.
Including other related non-fund products, notably exchange-traded notes, exchange-traded commodities and investments offered through partnerships or grantor trusts, the combined ETF/ETP industry comprised 4,497 products from 194 providers with net assets of USD1,725.5, with 9,055 listings on 54 exchanges. The first two months of 2012 saw the launch of 157 new ETFs and 16 other exchange-traded products; in February ETFs enjoyed inflows of USD11.6bn and other ETPs inflows of USD5.1bn.
Stephan Kraus, senior vice-president of institutional equity at Deutsche Börse, winner of the ETFexpress award for Best European Exchange for Listing ETFs, says Xetra’s XTF market segment performed well despite last year’s difficult environment and has begun 2012 even more strongly. “We’ve added 40 new products in the first two months of the year and are well on the way to 1,000,” he says. “Issuers continue to list new funds to address investor demand for markets and niches not yet available in the ETF space.”
Addressing guests at the ETFexpress Awards presentation ceremony Ted Hood, chief executive of Source – winner of the awards for Best Commodity ETF Manager, Most Innovative European ETF Provider and Most Innovative North American ETF Provider – noted that last year the challenges of the marketplace were such that one might have imagined the sector placed under the famous Chinese curse, “May you live in interesting times.”
In fact, Hood argued, the ETF industry was not cursed: “I would argue it is blessed,” he said. “Against a background of unprecedented regulatory scrutiny and an equally unfriendly market environment, ETFs continued to attract investors in 2012.
“Last year, net new assets for European ETPs exceeded EUR20bn, in an environment where traditional Ucits funds had net outflows of nearly EUR100bn. Over the past four years, their share of the European investment fund market has grown from less than 1 per cent to more than 4 per cent, and the trend looks set to continue.”
So ubiquitous are ETFs today that it’s often forgotten that the sector is little more than 20 years old. The world’s first ETF, the Toronto 35 Index Participation Fund (known as TIPS), was listed on the Toronto Stock Exchange on March 9, 1990, tracking the exchange’s benchmark TSX 35 Index, but it was not until nearly three years later, in January 1993, that what is generally agreed to be the first-ever US ETF, the SPDR S&P 500, was launched.
It was really only in the past decade that the sector made its way into the investment mainstream, pushing a former industry staple, the traditional passive fund, into a backwater. At the end of 2000 (the year that saw the launch of the first ETF in Europe), there were worldwide just 92 ETFs with assets totalling USD74.3bn and 14 other ETPs with assets of USD5.1bn.
Since then product numbers have grown steadily year after year, and ETF assets dipped only during the annus horribilis of 2008 – which in turn sparked a boom in other ETPs, especially exchange-traded commodities, whose assets nearly doubled the following year. While to some extend the industry’s growth is governed by developments in the overall global investment market, there seems not unreasonable to expect ETPs as a whole to pass the USD2trn milestone if not this year then shortly afterward.
As the statistics make clear, while the number of providers in the market continues to grow, the three biggest players – BlackRock’s iShares (542 funds and USD671.1bn in assets), State Street Global Advisers (154 funds and USD300.8bn) and Vanguard (75 funds and USD200.1bn) – continue to dominate the industry, accounting for 67.9 per cent of worldwide ETF and ETP assets. The next largest provider, Invesco PowerShares, had USD57.6bn in assets.
In February Vanguard ETFs enjoyed the largest net inflows with USD5.7bn, followed by iShares with USD4.1bn and PowerShares with USD1.3bn, although SSgA experienced the largest net outflows with USD1.3bn. There is also concentration among index providers, where MSCI (USD357.7bn), Standard & Poor’s (USD348.3bn) and Barclays Capital (USD1256.3bn) supply the underlying indices for products representing more than half of all industry assets (56.4 per cent).
Nevertheless, others are coming up fast, like Stoxx, winner of the ETFexpress award for Most Innovative Index Provider, whose indices provided the underlying basis for 290 ETFs with assets of USD97.5bn at the end of February. Overall the firm has launched more than 1,200 new indices, including a global benchmark and an extensive palette of various country, region and industry indices, according to chief executive Hartmut Graf.
Already 2012 has seen substantially higher asset growth in the ETF sector than the whole of last year, but Fuhr points out that even in 2011, when assets grew by just 3.1 per cent, net new asset flows were up slightly from the previous year. “By comparison, net new inflows into mutual funds were negative last year,” she says.
One important change she saw in 2011, reflecting in part the fact that as the sector has grown larger and more diverse certain products are becoming increasingly complex, is that investors were conducting more due diligence before using ETFs. “That’s partially because there is such a growing array of products,” she says.
“People find they need to do some work to understand the benchmark for the product. Many benchmarks appear similar but may be quite different, in addition to issues relating to questions around the domicile jurisdiction and structure of the product, the asset class or classes it invests in, and what’s actually inside the fund.”
Still, the development of the industry has meant that products areas that would once have been considered exotic are now fast entering the mainstream, including many emerging markets. Lyxor, which won the ETFexpress award for Best Emerging Markets Equity ETF Manager, offers investors exposure to places countries and regionsincluding Brazil, Kuwait, Eastern Europe and South Africa.
According to hHead of ETF sStrategy Nizam Hamid, there is particular investor interest inLyxor’s single country exposures, where Lyxor often offers “the dominant ETF in terms of size of funds, exchange trading liquidity, tightness of spreads and low trading costs”. Currently its biggest emerging market ETF is the Lyxor ETF MSCI India,which had EUR1.15billionbn in assets under management in mid-February.
One of the issues that has preoccupied both investors and regulators in recent months, especially in Europe, is the relative merits of physical ETFs, which hold the assets of the benchmark index the fund is tracking, and synthetic products, which use swap transactions to obtain the economic performance of the index, using a basket of securities as collateral.
Fuhr sees a dichotomy between the number of funds of the different types being established and the volume of assets they have attracted. “At the end of last year, 63 percent of products in Europe were synthetic ETFs, but 61 percent of European assets were in physically-backed ETFs,” she says.
The preference for physically-backed ETFs reflects in part investors’ new found awareness of counterparty risk with products based on derivatives. “In 2008, when Lehman Brothers collapsed, the underlying asset markets were negative, yet ETF assets in Europe grew by 11 per cent that year. A lot of new money went into ETFs because investors were concerned about counterparty and issue risk in buying certificates, swaps or structured products. They were concerned whether they would be able to get their money out.”
She adds: “One of the challenges of Europe is that, unlike in the US, many products use the same benchmarks, and there are many small ETFs. That creates a chicken-and-egg situation – it’s hard for small ETFs to get bigger, because investors tend to gravitate toward funds with larger asset volumes.
“To put it in perspective, ETFs in Europe account for about 3.5 per cent of all Ucits assets, which is pretty small compared with the US, where ETFs are about 9 per cent of mutual fund assets. However, over the past 10 years ETF asset growth in Europe has averaged 47 per cent a year, versus 5 per cent per annum for Ucits funds.”
Another significant difference between the European and US markets is that retail investment represents a sizeable proportion of US ETF sales. Fuhr notes that at the end of last year, brokerage Charles Schwab had custody of a total of USD122bn in ETF assets.
In markets dominated by distributers remunerated through commission, such as the UK, this has been a hurdle for retail ETF investment, but the impending retail distribution review, which will outlaw commission arrangements for advisers describing themselves as independent, could change all that.
“This links in with more people seeking more details on ETFs, including professional users as well as retail investors,” she says. “It’s important to make sure you’re looking at the right product set, for instance whether a fund has the right tax status in the UK, which will be very important with RDR.”
Hood pointed out that while the curse of living in interesting times is widely known, it has a less prominent corollary, “May you come to the attention of those in authority.” If not necessarily in their sights, ETFs have certainly been under the microscope of an alphabet soup of national and international regulators and other official bodies involved in oversight of the financial industry.
They include, said Hood, the Bank for International Settlements, the International Monetary Fund, the European Securities and Markets Authority, the US Securities and Exchange Commission, the UK’s Financial Services Authority, Germany’s BaFin, France’s AMF and the central banks of the UK, Ireland, France and Italy.
According to a report last month, the SEC is looking at any possible link between high-frequency trading in ETFs, including by hedge funds, and failed trades, and the possible impact on asset price volatility and systemic risk. The investigation is said to have grown out of a wider examination of complex ETF products offering leveraged or inverse investment strategies (or both), and that may not offer investors the liquidity they expect.
There is also concern about the systemic impact of shorting of ETFs by investors, not only as a hedging tool but as a bet on falling markets. For example, Reuters reported that the SPDR S&P Retail ETF has a short interest of nearly 200 percent, meaning that short trades represent three times the total number of the fund’s outstanding shares. However, State Street said in a report that analysis of SPDR S&P Retail and 19 other ETFs indicated that high levels of short sales did not affect the ETFs’ ability to track their respective indices.
There is evidence that ETS with high levels of shorting also figure highly for reported settlement fails, but industry members say that the problem is partly one of perception. While a trade that settles after the fourth day is classified as having failed by the National Securities Clearing Corp., the market-making firms that account for the majority of ETF trading have seven days to clear trades.
The widening of the SEC’s enquiry was reportedly prompted by failure to settle a substantial trade in a large and liquid ETF within four days, but the products were already under scrutiny by the US regulator following their suspected involvement in the so-called ‘Flash Crash’ of May 6, 2010, when US share prices plummeted nearly 10 per cent in just half an hour, then rebounded just as quickly. The SEC later found that ETF transactions accounted for a disproportionate number of trades cancelled for being out of sync with previous prices.
The issue of ETF complexity is also being examined by the EU securities regulator Esma, which at the end of January published a consultation paper proposing future guidelines for exchange-traded funds established as Ucits and other issues related to the retail cross-border fund regime.
The consultation paper proposes regulatory requirements covering both physical and synthetic ETFs and other index-tracking Ucits, as well as efficient portfolio management techniques, total return swaps and indices that seek to replicate a quantitative or trading strategy.
Esma seeks to impose additional obligations regarding collateral where any Ucits funds, not just ETFs, use total return swaps, to tighten the eligibility criteria for investment by Ucits in strategy indices, to oblige Ucits ETFs to identify themselves as such, and to facilitate the redemption of ETF shares by investors directly with the fund’s provider or on a secondary market.
Chairman Steven Maijoor says Esma has drawn up the proposals in response to concerns about the increasing complexity of ETF products marketed to retail investors, involving investment strategies and risks far removed from the simple replication of well-known indices covering highly liquid markets.
However, on the issue of distinguishing between complex and non-complex Ucits, Esma says it will await the outcome of negotiations on the revised MiFID directive, on which the European Commission has proposed removing structured Ucits from the scope of instruments automatically categorised as non-complex.
Fuhr believes it’s too early to assess the full impact of Esma’s proposals. “They are trying to take on board advice from a lot of different constituents, and looking at new issues like tracking,” she says. “We have to see what final guidance they issue at the end, because the proposals are slightly changed from Esma’s original paper and the advice it had received from industry stakeholders.
“Having clarity on the names of products is very important, because people often use the term ETF for products that can have very different tax and regulatory implications for the end-client. In addition, greater transparency on products and how they work and what’s inside them is important. Something isn’t necessarily more complex just because it is synthetic. Nor should it be said that one is good and the other is bad, but it’s not good when investors buy something they don’t really understand.”
In the past couple of years there has been concern about the number of products being launched, in some cases with fairly narrow investment premises, that have subsequently struggled to gain traction in terms of asset mass and liquidity. Says Fuhr: “Providers that are bringing products to market also need to do their homework, to figure out who the users of the product will be, whether it is a long-term potential product or more short-term, and whether there is a sufficient user base to warrant it being structured as an ETF as opposed to a note or certificate.
“However, it isn’t always appropriate to judge a product simply on whether it has reached critical mass in terms of asset volume, whether that’s USD100m or whatever the cut-off point is. In the case of a family of sector products, it is unlikely that all sectors will be in favour at the same time. Even though asset levels may fluctuate, if you view ETFs as building blocks for tactical asset allocation, you need to keep all the sectors available rather than closing a particular fund because its assets have fallen below a certain level.”
Another issue that won’t go away is the question of active ETFs, however much they appear to contradict the principles underlying the product class. In February Alpcot Capital Management, which has more than USD300m in assets and offices in London, Moscow and Kiev, launched the physically-backed Alpcot Active Greater Russia fund, billed as Europe’s first actively-managed equity ETF.
The fund is a Luxembourg-domiciled Ucits with an ETF share class listed on Stockholm’s Nasdaq OMX exchange. According to Alpcot, the portfolio is separated into disclosed and non-disclosed portfolio securities. The former, which should typically amount to as much as 80 per cent of the portfolio, will be disclosed daily, but not the remainder. Alpcot says partial disclosure will enable it to carry out effective active investment management and mitigate the risks of being exposed to front-running and portfolio replication.
Alpcot will also provide a real-time indicative intra-day NAV as an estimate of NAV per share over the course of the trading day, which it says should improve the price mechanism on the secondary market. The fund’s management fee will be 1.4 per cent a year, although the manager argues that this level is very competitive for actively-managed Russia-focused equity funds.
Meanwhile, in the US analysts are watching with interest to see whether Pimco’s Total Return Exchange-Traded Fund – an ETF version of the more than USD250bn Pimco Total Return Fund, the world’s biggest bond fund – and the star quality of the fund’s manager Bill Gross, attract investors that hitherto have been unwilling to put money in active ETFs, which currently account for less than USD5bn in assets.
Few managers have been willing to risk outsiders seeing their trades in real time and front-running them, but Gross says he expects the Pimco fund to demonstrate that active management of ETFs does work. At 55 basis points, the fund’s management fee is barely half the level of the mutual fund.
Despite Gross’s enthusiasm, Fuhr is not yet convinced by the active ETF concept. “It’s difficult to find any products that consistently deliver alpha,” she says. “Just because something is called an active ETF does not necessarily mean it will do so. It’s telling that most of the news you read about active products is about the gathering of new assets, not about their success in delivering alpha. You’d think they would be discussing their performance.
“At the end of the year there were 67 active ETFs, but they had less than 1 percent of global industry assets. The challenge is that if someone is able to create alpha, they will not want to deliver details of their portfolio to the market every day. The way ETFs work does not really suit portfolio managers who are concentrated stock-pickers and don’t want to tell people their secret sauce.”
Fuhr also points out that the majority of European investors in ETFs are institutions that use them as building blocks for tactical asset allocation or to equitise cash, and that organisations that are themselves active managers are unlikely to be keen to buy another manager’s active fund. In addition, active ETFs may find themselves stuck in a vicious circle trying to meet the three-year track record and USD100m in assets required by many institutional investment gatekeepers without having access to institutional investment.
“I’m not sure that active ETFs work,” she says. “It’s hard to see why they should be a lot less expensive than mutual funds or traditional Ucits, because if the manager is really delivering alpha, they should be paid accordingly, especially in the equity space. Combined with the question of transparency, I don’t see how active ETFs will be a long-term success in Europe.”
But overall Fuhr is confident that ETFs will continue to broaden their appeal to investors of different kinds. “The early adopters in the US were in fact institutions seeking to equitise cash, although retail investors subsequently became very active ETF users,” she says. “Institutions will continue to use ETFs a lot, while retail use in Europe is moving in a similar pattern to the way it did in the US.
“Institutions are going back to the old idea that getting your asset allocation right is a better proposition for delivering alpha than trying to pick individual securities in asset classes and markets around the world. A survey last year in Asia found that about a third of institutions were using ETFs internally because they were liquid and easy to use for asset allocation. It is one of those unique products that work for both retail and institutional investors. But I’m hoping that 2012 sees the growth of 15 to 20 per cent we were expecting last year before sovereign debt and other things got in the way.”
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