“What I think we are going to see is a redefinition of what asset classes mean in terms of beta and a re-expression through portfolios so that you when you buy an ETF it tracks what you actually think it should be tracking. That’ll be the next big change over the next five to 10 years,” says Lee Kranefuss (pictured), Executive Chairman of ETF provider Source when discussing the evolution of the ETF market.
Think about how ETFs work. They are baskets of securities that track a specific index and give investors diversification benefits by providing exposure to myriad asset classes ranging from plain vanilla equities all the way through to rare earth metals. Pick any standard global index, however, and the ETF basket has some degree of interest rate risk built in to it, some degree of FX risk. And, crucially, what it does not do is provide ‘pure play’ exposure. When you invest in an ETF tracking the S&P 500 Index it is not a pure expression of US equity markets.
What Kranefuss wants to see as an updating of indexes to create “an index for the modern world”.
“The example I use in the US is that people think the S&P 500 is reflective of the US equity market. Twenty or 30 years ago that was probably true in the sense that it moved with the US economy. Today, if you look at the constituents and add up them to create one company, well over half the revenues come from outside the US. Well over half the costs are outside the US.
“The total leverage (debt:equity) would be around 2:1 so it’s neither equity exposure nor US exposure. What it really is is a list of companies that have their corporate headquarters in Delaware. It would be far more interesting if you could take apart the pieces of the S&P 500 and pick those that do actually rise and fall with the US economy.”
It is an intriguing point. When an investor buys an ETF tracking the Indian or Chinese economy is that what they are really getting? A large number of western companies outsource to these countries where labour costs are cheaper. Many of the larger fast growing companies in these economies have western connections, all of which is very beneficial to local Indian or Chinese investors as it gives them diversification benefits outside of their respective countries. On the flipside, US or European investors investing in the same index are not getting exposure to the full dynamics of India.
This is really a consequence of the globalisation of the markets. Everything is intertwined and interlinked. For ETFs to deliver pure asset class exposure, those links to be untangled.
Without question, ETFs/ETPs have been one of the major success stories of the last 15 years. Europe’s market is nearly EUR500bn whilst assets in the US – which has a longer track record dating back to 1993 – are nearly USD2tn.
“If you go back and you chart ETF assets domiciled in Europe year by year, and you call year zero 2000, and on the same chart plot ETF assets domiciled in the US starting from 1993, Europe is at or above the level of the US every year,” says Kranefuss.
In 2000, only about 5 per cent of the money in wirehouses/ broker-dealers was done on a fee-based advisory model in the US. By 2010, that figure was close to 50 per cent “and there’d been no regulatory change!” enthuses Kranefuss. “It was simply customer awareness and to their credit the wirehouses were aware of this.”
Right now, regulatory change in Europe is acting as a catalyst and driving behaviour to resemble that seen in the US in the early noughties.
“If you take into account the time adjustment, Europe is actually rapidly adopting ETFs,” adds Kranefuss.
ETFs are modular building blocks for getting asset exposure as part of an investment strategy – that’s pretty well known by the registered investment adviser community. What is often lacking, though, is how to utilise ETFs in the right manner. How do you use a specific sector? How do you use exposure to a specific part of the world? These are educational challenges that European financial advisers, private banks, are still getting to grips with.
The first step in helping investors build their portfolio is to develop a clear thematic idea from the top down. What are the investment objectives? The risk tolerances? Once this has been determined, one needs a granular bottom-up process whereby the right investment products are identified.
This is not always straightforward when different ETFs in different countries provide exposure to the same underlying assets but do not necessarily track the best, most liquid indexes. For example, Kranefuss observes that most Eurozone exposure held by American ETFs is not based off a Stoxx index. “At Source we’ve just launched our first US ETF – Source EURO STOXX 50 ETF. The aim is to help US advisers understand that the EURO STOXX 50 is the liquid reference basket of the Eurozone.”
Going forward, Kranefuss thinks that there is certainly potential for further consolidation among European ETF providers where four of five big names dominate the market. Indeed, iShares, which Kranefuss developed, currently represents 48 per cent of the European market, followed by Deutsche Bank X-trackers with 12 per cent of the market.
“There should be some consolidation though to be honest I wouldn’t be surprised if we see more players entering at a faster rate than consolidation,” says Kranefuss.
There have been mergers and acquisitions in the industry but not all would have been viewed as such. SPDR was originally a product of the American Stock Exchange. State Street was just the trustee. A re-arrangement then followed that put State Street into more of a Manager role. Since 2000 there have been about 12 or 14 acquisitions, roughly one a year, according to Kranefuss who concludes:
“Europe needs another big provider with long-term potential and the ability to operate with a different model which is not restricted to generating investment strategies internally and can partner with anyone who can offer significant value to its investors. Source has that open architecture model.”