Industry commentators have warned the inclusion of ETFs in the Investment Association's sectors could lead to the mean average returns becoming "meaningless" as passive funds skew the figure, but also noted it will leave 'closet-trackers' nowhere to hide.
Today (30 November), the IA revealed in the paper The Investment Association Sector Scheme Consultation on Inclusion of ETFs it is looking into whether ETFs should be allowed into its sectors, which currently consist of active mandates and tracker funds.
Under the proposals, ETFs that are either UK domiciled or are EU UCITS with UK reporting status and are physically replicated will be eligible to be included in the sectors.
This means over 200 ETFs will be included but exchange traded
notes (ETNs) or exchange traded commodities &
currencies (ETCs) that have different structures and are subject to different regulations will be not be included.
The IA has asked asset managers from across the industry to respond by 1 February 2019 to the consultation and listed a number of potential outcomes to this; "no change to the status quo", "inclusion of ETFs in existing sectors", "creation of separate ETF sectors" or "ability to filter data for inclusion/exclusion of ETFs".
The trade body also said it had assessed the potential impact on a number of sectors, including the effect of a high volume of funds entering the sectors in one day, and the change in quartile rankings on existing funds.
Overall, the paper predicted there would be "small" impact on sector averages. For example, looking at the UK All Companies sector over five years, 122 show, no change in rank, 30 will be 1% lower in ranking and 82 will be 1% higher.
However, for the IA Europe Inc UK sector some funds could move up as much as 7% and down up to 8%. Despite this, the IA added it "does not envisage disruption to the utility of the sectors themselves".
Charlie Parker, head of portfolio management at Sanlam UK, commented the move would result in the mean average across the sectors being skewed, making it less useful for investors to understand performance.
"It does not really work as its makes the mean return meaningless," he warned.
Meanwhile, Darius McDermott, managing director of Chelsea Financial Services, said it was important the IA made sure the ETFs went into the appropriate sectors and warned it may result in ETFs going into the unclassified or specialist sectors, which are "already over-populated".
"This would not actually help advisers or investors make sensible comparisons and choices, so the IA may need to consider more specialist ETFs in more detail."
Ryan Hughes, head of active portfolios at AJ Bell, agreed the move could potentially create more confusion for investors: "ETFs are an investment structure, they are not a way of investing and therefore if you're adding ETFs why are you not adding investment trusts?
"If the IA are doing this for the sake of adding a load of passive funds to sectors then that just adds more confusion for investors."
He added the inclusion of ETFs will mean lots of passive funds will occupy the bottom of the second quartile and the top of the third quartile in a sector, while active funds will sit above and below that.
"That feels like a move that will create confusion for investors."
Meanwhile, James Budden, director of marketing and distribution at Baillie Gifford, welcomed the move as it would provide investors with "the whole picture".
He said active managers "should not be afraid" of this because if they are truly different from the index then it will not matter.
"It will help investors sort out the managers who are actually active from the rest," he added.
Simon Hynes, head of retail distribution EMEA at Legal & General Investment Management, said: "Allowing equivalent investment strategies in an ETF structure to be compared alongside funds would be a positive step in our view.
"As long as the appropriate ETFs are compared a similar fund, sectors and performance should not be skewed. This change would also make it simpler and more efficient for investors to find their preferred solution rather than being steered in any one direction."
The ETF community were also in favour of the inclusion with Adam Laird, head of ETF strategy for Northern Europe at Lyxor and chairman of the IA's ETF committee, saying this was a "game-changing" moment .
"The IA has previously treated ETFs like traditional equities or investment trusts so this is an acknowledgment that they are funds," Laird said.
"It shows ETFs are being used in the same way as traditional funds and bringing them into the sectors is going to make it easier for investors to find ETFs."
Meanwhile, fund buyers have agreed the process for classifying environmental and social governance funds (ESG) is confusing and in need of updating after the IA also announced last week it is launching a consultation on the classification of these type of funds.
Currently, there is no standardised framework to compare them and as well as those badged as ESG, others are labelled ‘impact', ‘responsible' or ‘sustainable' funds.
The IA has created a Sustainable and Responsible Investment committee, chaired by First State's global head of responsible investment Will Oulton, to look at whether the European Union's existing definition of ESG is "fit for purpose".
Guy Foster, head of research at Brewin Dolphin, said: "It is very confusing and the question remains whether it can be improved. People have tried to improve it in the past and not managed to make anything stick. It is worth trying again though as it does need to be improved."
For asset managers, Andrew Howard, head of ESG at Schroders, said the times had changed since ten years ago when ESG was thought of as one thing.
"It is becoming clear ESG is no longer thought of as one and we have to make people understand how broad the field is and the various differences between them.
"The move is going in the direction of creating a classification, rather than if, and we need to make sure it is sensible and robust."
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