Several milestones in the exchange traded funds (ETF) industry are expected in 2010, with global assets under management having recently passed $1trn and the 1,000th product likely to launch soon
ETFs have yet to achieve mainstream status among UK retail investors and advisers since the listing of the first European product back in 2000 but momentum is now increasing.
Many commentators have cited lack of commission as a reason for slow take up and expect significant additional demand, driven by changes coming in as a result of the Retail Distribution Review.
Meanwhile, another key factor behind the rise of ETFs is growing demand for passive products, with many active managers struggling to generate consistent performance.
ETF increase
We expect to see a significant increase in ETF providers across Europe this year, which will threaten the hegemony of the current market leaders.
This influx will include asset managers looking to defend their traditional fund business whilst new entrants will no doubt be tempted because exchange traded products have had the impact of significantly lowering barriers to entry in to the investment industry.
While launching and running mutual funds requires major infrastructure, ETFs are relatively easy and quick to launch and in large numbers.
Increased competition in the ETF space will not have quite the same effect as it might do if so many new firms entered the mutual fund industry.
All ETFs are typically cost efficient, so price is not a differentiator like among active managers, where price is less important than results.
In the exchange-traded world, the costs are relatively low and fairly uniform. The advantage for the popular names is in the ability to use their volume to encourage efficient pricing.
Potential impact
Potential impact on products is also difficult to gauge although there are room for more providers to come in to the market which may dilute the market shares of the prominent brands.
These groups have large ranges across most indices but wide coverage is only an advantage when there is little competition – and a wider choice of specialist firms means investors will no longer have to rely on a single provider for all their ETFs.
The market will start to fragment into specialist areas with new entrants encouraging differentiation by leading on a particular strength within their offer.
Greater competition should also mean more innovation and a higher level of awareness, with more of a focus on exploiting new distribution channels and increasing the mass market appeal of ETFs as a way to invest.
In recent years, the UK and Europe have proved a fertile area for ETF firsts, with the Ucits regime allowing groups to launch products linked to money markets, credit indices, interest rates and hedge funds for example.
Several houses have also brought short and inverse funds to market and growing rivalry could see providers fall back on their particular investment expertise.
At HSBC for example, it would be natural for the firm to reflect its strong focus on emerging markets and the Bric economies in its ETF offer in the same way that it does in the general business strategy. Clients expect HSBC to be an expert in emerging markets and the ETF business is no different.
Difficulties
Despite positive developments on the product front, innovation and competitive advantage are difficult to maintain in the tracker world, with low barriers to entry making it easy to match offerings quickly.
In fact, it may often be more of a cause for concern if competitors are not copying your products – where an ETF’s peer group is small, it suggests that particular index is not attracting investor attention.
Active versus passive
Of course, the main competition element for exchange traded products lies in the active versus passive debate, and greater choice in the latter can only put more pressure on the former.
One direct impact ETFs are likely to have is to change the way active fund managers use benchmarks, as investors can buy index returns very cheaply.
Several groups offer core funds looking to beat their benchmark by 1% or 2% a year and charge annual fees of 1.5% for that.
Even if the manager meets the objective, investors will get little more than index performance. With this result reliably available for a much lower cost from an ETF or a tracker, why risk the potential for under performance and accept the volatility inherent in an individual fund manager’s style?
Many groups are now using cash benchmarks for active products or even doing away with benchmarks completely and those old core active funds with undemanding performance targets are likely to be merged away in due course.
This will further polarise the investment market into true alpha – where the best managers are paid for top returns – and cost efficient beta, with advisers blending the two approaches to diversify and to meet return objectives.
Building blocks
Most providers position ETFs as portfolio building blocks, playing into the increasingly accepted wisdom asset allocation determines the bulk of investment returns.
Advisers can use them as part of a core-satellite investment approach alongside favoured active funds, either for the typically low cost or because it is more convenient to use an ETF to make tactical changes.
For a low-cost passive core to portfolios, ETFs can provide cheapest effective exposure to more mature lower growth markets, freeing up the adviser’s time to focus on seeking out active managers who can genuinely add value in specialist areas.
Meanwhile, if advisers have favoured funds where they believe managers can perform,
ETFs can also instead serve as satellite plays to express particular sector or geographical preferences in client portfolios.
Some commentators have suggested greater ETF choice may bring further pressure
on the tracker fund market but several groups, including HSBC, see both as part of their passive proposition.
In the past, ETFs were widely seen as cheaper than trackers but recent price cuts on the latter have largely bridged this divide.
A beta buyer simply wants to replicate the markets and the choice between tracker products now basically comes down to which is most convenient to access.
Most advisers still deal with funds rather than listed securities, as a stockbroking account is needed to trade in shares. This means ETFs are currently more difficult to access unless the client uses a whole of market wrap while trackers are listed on most of the major platforms popular with advisers.
Fund platforms currently take commission rebates from groups but will no longer be able to do so when the remuneration system changes under the RDR.
This means we will likely see a rush to change their models to a wider wrap, including the ability to offer share dealing. This will make ETFs more widely available to advisers through preferred distribution channels.
Who loses?
Overall, the main losers from increased ETF competition are poor-performing active funds giving little more the than benchmark return for large fees. Expensive index tracker are also looking increasingly out of line given the low cost of ETFs and the big price cuts seen by several index fund providers in 2009.
Certain tracker providers still levy annual fees above 1% on funds and it is hard to see them prospering against a rapidly evolving and easily accessible ETF marketplace.
David Chellew, head of market proposition, HSBC Global Asset Management
