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James Williams, Hedgeweek

Innovation and improving markets could drive ETF market to USD3tn in 2014


There was a palpable sense of optimism at this year’s etfexpress Awards event, held in London’s Mayfair at the end of February this year. Across the entire food chain, from ETF sponsors and investors to exchanges and administrators, interest in ETFs continues to gain momentum.

In turn, this is pushing product evolution as sponsors work closely with index providers to develop new ways for investors to access markets: smart beta ETFs, for example, doubled in 2013.
According to figures in Deutsche Bank’s SYNDEX Outlook Report 2014, smart beta AuM grew from USD6.6bn to USD12.58bn.
Deutsche Bank’s global ETF research team (winner of this year’s Best ETF Research Provider) estimates that ETF assets could reach the USD3tn milestone by the end of 2014. This comes on the back of 28 per cent growth year-on-year in 2013 with AuM reaching USD2.25tn. “Our base case scenario is that ETFs reach USD2.7tn and pass USD3tn in a bull market case based on rising markets and retail growth in Europe. In the US, for example, retail participation is close to 50 per cent whereas in Europe it’s still quite low,” says Deutsche Bank’s Ari Rajendra.
The US continues to dominate inflows. And with more mutual fund managers looking to use the ETF wrapper to attract new investors, the potential for administrators like State Street Global Services, winner of this year’s Best North American ETF Service Provider, to expand their offering is enticing.
“We’re having ongoing conversations with mutual fund managers interested in the ETF space,” says Frank Koudelka, senior vice president and ETF product specialist, who delivered the keynote address at the Awards. “On the one hand, allowing their equity portfolio to be shown to the market on a T+1 basis could be problematic, depending on the manager. Those that are thinking of launching actively managed ETFs have to decide whether to do this in an equity strategy; to date we’ve seen mostly fixed income or alternative strategies, because front-running is a lesser concern.
“On the other hand, there have been filings for non-transparent ETFs, which would utilise the ETF structure but ensure that an equity portfolio is not shown to the public markets on a daily basis but rather a quarterly basis, like mutual funds,” comments Koudelka.
This could present challenges to Authorised Participants (APs) who need to see the full holdings of a portfolio in order to keep the market price in line with the underlying price of the ETF.
“The regulators are looking at the possibility of launching these types of products but none has been approved yet. If they do get approved, many more mutual fund managers will look to replicate their strategies within an ETF wrapper. It’ll provide another level of growth for ETFs that we haven’t seen in the past. State Street is actively designing different service models that would deal with the unique aspects of these filings,” adds Koudelka.
Robert Rushe is Head of ETF Servicing at State Street Global Services in Ireland – winner of this year’s Best European ETF Administrator. One of its core strengths is the level of interaction with ETF sponsors and APs. One area State Street Global Services is looking at is how to marry up mutual fund-type infrastructure with market infrastructure.
“One of the interesting things we see in the ETF space currently is a potential blending between ETFs and mutual funds as to how they distribute. We see more ETFs moving on to mutual fund platforms and more mutual funds trying to get access to investors through stock exchanges. The idea being that an investor would be able to buy a mutual fund on an exchange alongside other securities. There is definitely a blend starting to occur which we are very conscious of and it’ll be interesting to see how that develops going forward,” says Rushe.
Another growth area is that of active ETFs as the industry starts to shake free from the shackles of passive investing. As Shawn McNinch, Global Head of ETF Services at Brown Brothers Harriman – winner of this year’s Best North American ETF Administrator – confirms:
“We are working with some of our existing mutual fund clients who are looking to launch such products. We are educating them on how the ETF product works and what an active ETF could mean for their overall product strategy. Firms like T. Rowe Price, John Hancock, Principal Global Investors have all made inroads in the active ETF space. From an administrator’s perspective it’s about how to best educate the client on the ETF structure and help them think about how to tweak their existing operating models to support ETFs.”
This dynamic of actively managed ETFs – which involve portfolio managers actively adjusting market weightings within portfolios as opposed to ‘alternative beta’ ETFs which use alternative rules-based factors but which are still nevertheless passively managed – shows how the space is fast evolving.
Index providers are certainly doing their bit to push and support product innovation. Last May, for example, NASDAQ OM – winner of this year’s Most Innovative Index Provider – helped Guotai Asset Management, one of China’s largest asset managers, bring the first ever China ETF to market. The Guotai NASDAQ-100 Exchange-Traded Fund, listed on the Shanghai Stock Exchange, gives Chinese investors access to the NASDAQ 100 index and as Robert Hughes, Managing Director of Index Services at NASDAQ OMX says, “getting this product to market, which took a little over three years, was a tremendous accomplishment for Guotai and we were excited to have supported their efforts.”
Thematically, China is gaining traction as more domestic Chinese fund managers look to partner up with western firms under RQFII, a quota-based programme that gives global investors the opportunity to invest offshore RMB into China’s capital markets. BBH, for example, established a relationship with KraneShares to bring such products to market.
“KraneShares has partnered with Bocera, a Hong Kong-based manager and there are two other ETF sponsors that we are working with to launch similar RQFII products; we are seeing a lot more demand for this type of product,” confirms McNinch.
Deutsche Bank’s Rajendra says that China A shares could potentially be included in major global benchmarks: “A shares are being increasingly opened up to foreign institutional investors. Broad benchmark providers (FTSE, MSCI) are monitoring this; it’s on their watch list. If this does happen then it will be a massive event,” says Rajendra.
In the SYNDEX report, Deutsche Bank notes that Chinese equities remain underrepresented in major global benchmarks such as the FTSE and MSCI indices; for example, the FTSE All World only assigns a 2 per cent weighting to China. The report states: “Assuming FTSE decides to make the change, FTSE may implement China A inclusion in its All World index series in March or September 2015. On a neutral basis, China could eventually see up to USD180bn of inflows if both MSCI and FTSE include China A shares with the full weight.” MSCI have proposed a potential partial inclusion of A Shares in May 2015.
One firm that is busy capitalising on interest in Asia Pacific markets, in particular Japan, is Nikko Asset Management – winner of this year’s Best Asia Pacific Equity ETF Manager. The firm is busy ramping up its marketing efforts in Europe to support its line of 14 Japan Equity ETFs. Its two flagship products, the TOPIX and Nikkei 225 ETFs, have USD7.5bn and north of USD9bn of AuM respectively. Couple that depth of liquidity with the fact that its investment team in Tokyo only uses physical replication to minimise tracking error in its products and the firm is well placed to give investors efficient market access.
“Investors can buy European-listed Japan ETFs but they find that the majority of products do not have significant size and liquidity. As specialists in Asia we have a tremendous opportunity to bring Asian expertise to western institutional investors.  Marketing our Japan Equity ETFs in Europe over the last nine months has seen a very healthy level of interest,” comments Geoffrey Post, Head of International Product Development, who adds: “Gaining broad beta exposure in Japan through a low cost ETF is now on the agenda for institutions. Investors can also obtain specialist sector exposure through one of our small or mid-cap ETFs, our J-REIT ETF, or the TOPIX Ex-Financials ETF, which we launched last September.”
Robert Hughes at NASDAQ OMX says that smart beta indices is “100 per cent” a focus for the firm.
“Investors are looking for more effective investment opportunities than traditional cap-weighted indexes, and smart beta has been delivering in a variety of ways.  At NASDAQ Global Indexes, we’ve been leading the way in smart beta, including offering products such as US Rising Dividend Achievers Index and International Buyback Achievers Index.
“We’ll continue to build out our brand and leverage our expertise to bring innovative indexes to market, particularly within equities but also within commodities and fixed income where we see tremendous opportunities in bringing new products to market,” says Hughes.
 One European ETF provider that continues to bring innovative products to market is London-based Source – winner of this year’s Best Global Equity ETF Provider & Best Fixed Income (ex-cash) ETF Manager. Early in 2014, the Source Goldman Sachs Equity Factor Index World ETF, launched with USD225m and represents the firm’s latest ‘beta plus’ product and the second largest global ETF launch this year.
“It tracks an index based on five equity market factors: low beta, momentum, size, value and quality,” says Michael John Lytle, chief development officer at Source.
One area of interest among investors in 2013 was financials, says Lytle.
“We have the Eurostoxx optimised banks ETF (EUR235m), the US Financials Sector ETF (USD310m) and the STOXX optimised banks ETF (EUR450m). Between the three we have nearly EUR1BN in assets – clearly there is strong interest among investors to gain exposure to European and US financials.”
One other notable theme was the use of currency-hedged ETFs, something that UBS Global Asset Management – winner of this year’s Best Mixed ETF Manager – was quick to leverage with the launch of six unique products: four in November 2013 and a further two in January. They cover MSCI indices on Japan, US, EMU, Australia, Canada and Switzerland. Aside from the Japan currency-hedged ETF, all of these products are unique to UBS.
“There will be times when investors want to ride what they expect will be an appreciation in a particular currency. But that aside, there are an increasing number of investors now who want to get clean exposure to an underlying market index e.g. Japan, without having to worry about currency risk,” says Andrew Walsh, Head of UBS ETF Sales, UK.
Active fund managers (aka ‘stock pickers) are increasingly using ETFs as an effective instrument to manage cash to avoid straying off their benchmarks and as Walsh concludes: “ETFs are an exciting part of the overall investment landscape, if not one of the most exciting. There is an increasing appreciation amongst institutional investors of the benefits of ETFs, even for those running active portfolios.”

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