Regulation is laying the foundations for funds of ETFs and greater adoption of these products among IFAs, writes Matthew Craig.
Greater use of ETFs by fund of funds managers and those running multi-asset portfolios could well be the next stage in the ascent of ETFs. Regulatory changes have strengthened and will continue to bolster the case for ETFs within the fund-of-fund structure and multi-asset investing.
The Ucits III rules increased the maximum a Ucits-approved fund could hold in another fund from 5% to 20%.
Another important regulatory development on the horizon is the Retail Distribution Review (RDR) in the UK, which will encourage financial advisers to look at a wider range of products, including ETFs.
Gary Mairs, founder and partner of TCF Fund Managers, says: “The RDR is going to have big implications for the investment management world. It is going to push the industry in the direction of doing the right thing for investors. I think we are going to go through a paradigm shift in the industry and there will be a lot of interesting things happening over the next two to three years.”
At present, there are three main categories of fund manager who are making use of ETFs as an underlying investment tool. These comprise ETF issuers, product providers using ETFs as part of a fund of funds or multi-asset strategy, and new entrants to the investment market who are using ETFs to position themselves as a fresh alternative to existing players.
Issuers such as db x-trackers and iShares are putting together a selection of underlying ETFs in order to offer investors swift means of access to a range of funds. Using ETFs in this way also promotes the idea asset allocation, rather than manager selection, is the critical decision in determining the performance of an investment portfolio. This means gaining access to the right sources of market return, or beta, should be the main consideration rather than attempting to obtain alpha, or the additional return produced by manager skill. In any case, it is extremely hard to consistently identify which active manager will outperform the market.
Manooj Mistry, head of db x-trackers UK, says: “It is a way for retail investors to access ETFs, as there is someone making the right asset allocation decisions and that is wrapped up within the product, so they can access a portfolio of ETFs quite easily.”
Mistry says db-x trackers launched the first ETF of ETFs in December 2008 in conjunction with Quirin, a private bank in Germany. In 2009, another part of Deutsche Bank created a fund of ETFs for distribution through the firm’s retail network in Italy and other parts of Europe. The fund offers cautious, balanced and growth portfolios, each with a different volatility target and asset allocation set by a quantitative approach. Mistry adds another Deutsche Bank client is planning to launch a similar product in the UK.
ETFs for the UK
Another major ETF provider, iShares, is exploring the idea of launching a fund of ETFs in the UK. Helen Gaidatzis, head of iShares portfolio solutions, says: “We are thinking about doing it in the UK ourselves, as we have already done something in Europe with target risk funds.”
Gaidatzis adds there was client demand for overall solutions, which ETF providers could address through funds of ETFs.
In the case of iShares, its suite of target risk funds launched in Europe aims to maximise returns for a given level of risk, by investing in a wide range of assets through iShares ETFs.
The underlying asset classes include fixed income, developed- and emerging-market equities, commodities, infrastructure and private equities.
For ETF providers, a fund of ETFs represents a step up the value chain and this means an additional fee for asset allocation and managing the portfolio can be charged, but with an overall cost that is still competitive with other packaged fund products.
As well as ETF providers, other fund managers are making use of ETFs in collective investment vehicles that offer an asset allocation strategy and then a selection of underlying funds and assets. One such example is T. Bailey Asset Management, which has launched the TB Growth Fund Lite. This multi-asset fund follows the same investment process as the firm’s flagship Growth fund. However, the Lite version uses passive investment vehicles, such as ETFs and tracker funds, rather than actively managed funds. T. Bailey head of sales, marketing and communications Philippa Gee says the firm decided to offer a passive investment version of the Growth fund for investors who do not want exposure to active funds.
Perhaps one reason for this is cost. Gee says the Lite version of the Growth fund has an annual cost of 99 basis points (bps) compared to 223 bps for the active version. However, Gee adds: “It is possible to get trail commission loaded on, making the cost 149 bps, so it would be not much different to the Growth fund and we feel the original version will deliver outperformance after charges.”
Some new entrants to the investment market are taking a tough approach to investment costs. An example of this is Tideway Investment, which aims to give investors with around £100,000 in self-invested personal pensions (Sipps) a discretionary investment service. Tideway Investment partner James Baxter says: “Our concept is to offer a portfolio management service for £50 a month, which equates to 0.6% a year on a £100,000 fund. It works out at about half the cost of a portfolio of unit trusts.”
As well as ETFs, Baxter says investment trusts and individual shares will also be used. He adds: “Having a fixed price is quite radical for our industry.” Tideway is also in talks with several IFAs who are interested in its approach.
However, chartered financial planner and Informed Choice managing director Martin Bamford commented on new funds of ETFs and similar approaches: “We always want to see at least a three-year track record for any fund before we are comfortable recommending it to a client, and this will be no different”. On the concept of a fund of ETFs, Bamford added: “Certainly it will appeal to investors looking for lower-cost active management, yet performance and value continues to rule many investor decisions rather than cost.”
The cost factor
Yet others think if investors were aware of the total costs incurred in asset management, there would be more pressure for lower charges. Mairs at TCF Fund Managers says a portfolio of actively managed funds costs investors around 4%, far more than the stated total expense ratio (TER), which is the standard industry measure of investment fund costs.
Mairs says: “The TER should be called the ‘some of expenses ratio’ as a lot of expenses associated with turnover in a fund are not included. For an active manager, trading costs can be big. I am amazed more customer-centric observers have not mounted a campaign around TER because it is not the total expense”.
He explains eliminating cost is in the interests of long-term investors, as costs are a certainty whereas active manager returns are not. TCF Fund Managers aims to do this with multi-asset investing using passive vehicles. At present, the firm is taking on segregated mandates, although the launch of some risk-graded funds is planned for later this year, possibly at the start of the second quarter.
While ETFs are usually cheaper than actively managed funds, those running fund of funds and multi-asset portfolios say care is needed in picking the right ETFs. Armstrong Investment Managers is a multi-asset manager and its joint managing director, Patrick Armstrong, says: “It is a mistake to assume ETFs are always very good value – at times they can be expensive.” Armstrong also says funds purely of ETFs would be limiting, as swaps, for instance, could provide a more effective way of investing at times.
Due diligence in screening fund managers and products is also seen as vital when using ETFs as an underlying asset in a fund. ETFs can use a range of techniques and structures to deliver returns. Mairs says: “ETFs can be sold as one thing but they may actually be something else. There can be a lot of risks that need to be analysed and understood.”
The widespread use of ETFs within packaged funds could be one development stemming from what is currently happening in the market. In an environment where returns may be uncertain and trust in the financial services industry has fallen, ETFs could help both retail and institutional investors when used in Fofs and multi-asset portfolios. If it leads to lower costs being passed onto customers and a greater focus on asset allocation in the investment process, this could be a welcome change.
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