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ETFs destined to overtake mutual funds, predicts Reality Shares

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US-based Reality Shares specialises in dividend growth and to that end, recently launched an innovative ETF, DIVY, which isolates dividend growth from stock market.

CEO Eric Ervin (pictured) says: “It turns the concept of dividend investing on its head. Over time we want to deliver the dividend growth so it is more like a stock investment but without the ups and downs of the market.” 

He takes as an example a company such as Coca-Cola whose dividends grow over time. “At times, stock price is based more on opinion than the reality of the underlying company. Focusing on dividend growth is a way to look past that noise. If Coca-Cola’s dividends grow, we want to capture that instead of share price fluctuations, which is what everybody else’s performance is based on.”

Ervin comments that increasingly companies are issuing ETFs with different approaches to investing in stock or the bond markets that are more sophisticated than early products. “Back at the beginning, the typical ETF was based on mimicking the S&P 500, but now you can take the 500 index, shake it up and invest in different weightings and create smart beta.”

The rapid growth in smart beta products has caused lots of debate as to whether it is something new or just a different way to buy stock. “You can make an argument each way, but we don’t think it adds much value. It’s putting lipstick on a pig,” Ervin says. 

“That concept of investing in companies that have better fundamentals and overweighting them now has a cute name for it – smart beta. It’s a catchy name and a hot topic but essentially, it’s portfolio management.  Many institutions have adopted that as a simpler and cheaper way of hiring portfolio management.”

Ervin says true innovation lies where the ETF is a wrapper for a vehicle such as liquid alternatives, or merger arbitrage or hedge fund replication strategies where the institutions can invest in an ETF so it still offers liquidity.

“That’s where the bulk of the innovation will come from going forward,” Ervin says. “There are only about USD2 trillion dollars in ETFs against USD15 trillion in mutual funds at the moment,” he says. “Those two will swap over some day – the ETF is the more modern mutual fund.”

Things are a little more certain in the bond space, where ETFs have really taken off in terms of institutional investors, big pension funds, endowments and foundations in the US because of their advantages of lower cost and better transparency and liquidity. 

Through February 2015, bond ETFs took in more than USD32 billion in assets globally this year, in what has been the strongest start to any year since their introduction in 2002. More than half of those assets – nearly USD20 billion – came from institutions such as insurers and endowments, and in some larger funds, institutional investments have more than doubled in the past few years.

“Year to date in the US we have seen outflows from US stocks and inflows into US fixed income,” Ervin says. “On a daily basis you can see where the money is going and what it is doing – fixed income has been a wild ride but it has grown in the industry because more and more institutions are using the fixed income ETF as a vehicle.

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