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Beverly Chandler

ETFs face exciting and challenging future

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Speaking in the spectacular venue of The Reform Club's library at the etfexpress Awards 2016 in London, Townsend Lansing, Executive Director – Head of ETCs, ETF Securities (UK), commented on the exponential growth of ETFs. "They are here to stay," he said. "They are essential building blocks in a portfolio."

The growth is well documented. Lansing reported that European ETFs alone have seen growth of 780 per cent since 2005 and that their future growth is predicted to take them up to USD7 trillion under management by 2021.

Certainly across the sector, globally, assets in ETFs have continued to soar with industry data provider ETFGI reporting that 2015 saw global ETF/ETP net new assets reaching a record level of USD372.0 billion, a 10 per cent increase over the prior record of USD338.3 billion of net new assets gathered in 2014. 

In less than 20 years since their inception, ETFs have proved increasingly popular with both institutional and retail investors due to their transparency, liquidity and low cost base. 2015 saw them overtaking hedge funds in terms of assets under management as the more active funds struggled to provide returns that would justify their high fees.

Curiously, 2015 saw net new assets into US ETFs drop, while European funds saw net inflows climb to USD82.0 billion, representing a 45 per cent increase on the record set in 2014, according to ETFGI.

However, their growth has not gone unnoticed by regulators and a somewhat sceptical financial press. In his speech at the ETF Awards, Lansing commented on a recent letter, published in The Financial Times that sought to address the bad press the sector receives. 

"Fears that ETFs are the next crisis are all misplaced," he said. "More active managers are looking to ETFs, and more retailers are continuing to move into the sector." 

Smart beta continues to be popular, bringing the attributes of the active investment management world to the traditionally passive ETF sector. ETFs that can pick and choose factors to achieve performance put them firmly in the absolute return arena, away from their benchmarked index tracking plain vanilla cousins.

As technology improves, Lansing predicted more disruption of the traditional distribution channels and also an increasing pressure on fees. "It's an exciting and challenging future," he concluded.

Fee pressure was a subject also brought up by WisdomTree Europe's co-CEO Hector McNeil, who recently published a note on this very issue, predicting that the coming year will see a greater focus on performance in ETFs. 

"The pricing of core ETFs has already arguably won the battle with mutual funds when it comes to the provision of passive trackers. Now we are seeing a shift in focus in terms of investor expectations as they become more aware of the opportunities and breadth of asset management benefits the ETF wrapper can deliver for them," McNeil says. 

"We are yet to see this focus on performance after fees in the ETF space to the same extent as exists in the US, but as smart beta picks up momentum in Europe, we believe it to be the direction of travel over the next few years."

McNeil believes that rather than focusing on whether they can get US equity exposure for 4bps or 5bps from different providers, it will be the type of exposure investors are getting which will become more important.

The audience for ETFs in the US has traditionally been more retail while in Europe, it is increasingly an institutional play. There is currently a 50 per cent retail and 50 per cent institutional investor base in the US, while in Europe, retail is just 20 per cent and investors are predominantly institutional. 

A recent study, ETFs in the European Institutional Channel, from Greenwich Associates and commissioned by BlackRock, found that the next 12 months will likely bring increases in both adoption rates and the overall amount invested in ETFs. 

The study also found that roughly a quarter of Continental European institutions and 20 per cent of UK pension schemes invest in ETFs, and 17 per cent of institutions on the Continent not currently investing in ETFs, plan to start using the funds in the next year. Over the same period, more than a third (35 per cent) of investors in Continental Europe plan to increase their investments in ETFs.

In Europe, particularly again in the UK, ETFs face infrastructure issues with independent financial adviser platforms often designed to cater more for mutual funds or unit trusts. 

This is changing and the change was partly inspired by the UK's 2013 Retail Distribution Review which was designed to encourage transparency on the cost of investing by the investor, and to stop financial advisers being remunerated through commissions rather than fees. 

If an IFA is being paid a fee for advice, rather than taking a commission, ETFs and mutual funds move onto a level playing field.

However, the RDR hasn't happened across Europe, and ETFs on the continent face criticism from traditional investment houses that offer only pooled funds to retail investors, through networks of financial advisers. 

Criticism of the sector here always comes down to the question of transparency within the ETF and liquidity, an issue that has risen its head during the recent periods of market volatility.

The flash crash of August 24th saw US ETFs suffer, with the SEC reporting in its Equity Market Trading Volatility Report that ETPs as a class experienced a larger number of extreme price declines than corporates, or individual stocks. The cause has widely been laid at the door of the trading limits imposed in the US and the consensus is that it could not happen in Europe.

Some firms and some exchanges have taken the liquidity issues on and are actively seeking to ensure that pricing remains close to the underlying assets in an ETF whatever the market conditions.

Benjamin Fussien, head of ETFs at Euronext, comments that it could not happen on Euronext. "We have already proper safeguards in place, that we even voluntarily reinforced last year, months before the Flash Crash in the US last August. We'll never compromise on client's protection," he says.

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