Cheap and easy to set up, ETFs are seen as a major breeding ground for innovation over the coming years
With the basic proviso of finding a suitable index to track, ETFs can effectively provide liquid access to any asset class desired. Despite this, the products have yet to achieve mainstream status among UK advisers since the first European listing in 2000.
Commentators cite their lack of commission as a key reason for slow take up and expect additional demand to come from changes in the Retail Distribution Review, as advisers shift to fee-based models. Most providers position their products as portfolio building blocks, playing into the increasingly accepted wisdom that asset allocation determines the bulk of investment returns.
According to several academic reports down the years, it is responsible for as much as 90% of performance.
As financial planning becomes more sophisticated, many see ETFs playing a key role as investors seek to separate alpha and beta in their portfolios.
In a report for US firm Index IQ, the group’s chief investment strategist Robert Whitelaw says the rise of index funds has shown beta is cheap and easily achievable
“For most investors, alpha and beta are inseparable when you buy a mutual fund for example,” he adds. “But the most sophisticated are now decoupling the two, separating alpha and beta decisions.”
According to Whitelaw, the most important investment decision most people make is simply to put money into specific markets.
“We may spend hours trying to figure out how to beat the market but the most important thing from a return perspective is making sure we are in it - getting market-level returns for market-level risks, preferably at low cost,” he says.
ETFs have established themselves as a cheap and liquid way of achieving this beta, offering access to most of the assets and sectors required.
Looking to the future, Tim Mitchell, head of listed fund sales at Invesco Perpetual – which sits alongside ETF specialist PowerShares within Invesco – says these products should present a major area for innovation.
“Investors are coming to appreciate the value of asset allocation and ETFs can be traded actively across the full asset class spectrum without investors being penalised financially,” he adds.
Mitchell believes the market is gravitating towards expensive alpha – where investors will pay more for the best active managers – and cheap beta from products like ETFs.
PowerShares has been at the forefront of using more ‘active’ indices for its funds, whichMitchell claims can enhance returns.
This is based on the view that market cap is an inefficient way of indexing, as share prices are largely sentiment-led and not driven by fundamentals.
“Traditional benchmarks ride all the way up and down with bubbles and leave investors overweight in overvalued stocks and underweight in undervalued,” adds Mitchell. “This can be fixed by breaking the link to share price.”
As an alternative, PowerShares has launched several products that track the FTSE RAFI series of indices, which do exactly that. These are based on four fundamental stock factors, namely cashflow, book value, sales and dividends, thereby breaking the connection with sentiment-led market fluctuations.
Mitchell said this generates improved beta rather than alpha and should not be seen as active management as no investment decisions are actually being made.
“In my view, an index with some element of tracking error is still a passive entity as there is no active decision making in the process. It might be deemed passive plus but that does not automatically make it active,” he adds.
These products are more expensive than traditional ETFs – around 50 basis points against 30 for a basic UK tracker – and also obviously carry a higher tracking error. But Mitchell points to much improved performance as justification.
Compared to a basic UK ETF going back to 1984, the fundamental-based fund would have generated additional performance of 270bps a year, which many active managers would struggle to achieve.
On a risk-adjusted basis, this alpha goes up to 280bps, suggesting the shift to fundamental benchmarking can improve returns while actually lowering volatility.
Apart from these fundamental benchmarks, ongoing innovation in the ETF space has focused on short and leveraged products plus more and more niche areas.
ETFs now cover every conceivable equity index, with growing numbers of bond, cash and commodity linked offerings and with options to short all of these and gear on the up or downside.
In the UK, groups such as Lyxor, ETF Securities and DB x-trackers have launched several commodity offerings into the market, with many giving short and leveraged exposure.
These give access to areas as diverse as corn, cotton, coffee and lean hogs via single stocks should investors want such bets.
But several ETF players have had to withdraw products in recent months, suggesting launches must be determined by investor demand in such a low-margin industry.
Meanwhile, recent regulatory events in the US may further hinder innovation, with the Financial Industry Regulatory Authority calling leveraged and inverse ETFs unsuitable for retail investors. In view of the greater volatility of leveraged products, Finra is set to raise margin requirements for these from 1 December.
While conventional wisdom always puts the US far ahead of Europe in ETFs, the latter has actually seen several firsts in the exchange-traded world.
Manooj Mistry, head of db x-trackers UK, says: “The Ucits regime has given more scope to launch different products and we have seen ETFs linked to money markets, credit indices, interest rates and hedge funds, all before the US.”
In the US, major ETF players such as State Street Global Advisors believe the next stage of innovation for the product lies in how it is packaged.
While exchange traded products are well used in the retail space, they are yet to penetrate huge investment areas such as the 401k market for example.
The group is one of several working on ways to distribute through this channel, focusing on ideas such as annuity wraps for ETFs as well as funds with target maturity dates for the retirement market.
