The sleeping giant

The sleeping giant

After spending more than a decade in a slumber, exchange-traded funds seem to be finding a home in client portfolios. Tim Stewart takes a look at a sector on an upward trajectory

Financial advisers have been hearing the same mantra about exchange-traded funds (ETFs) for over a decade now: they’re liquid, they’re transparent and they’re low-cost.

The low-cost part of the equation is easy to explain: ETFs are typically straightforward beta products that seek to replicate an index.

For example, the iShares S&P500 ETF (IVV) will set a client back seven basis points. In other words, a $100,000 investment will only cost them $70.

On the transparency front, investors can see exactly what the ETF holds at any particular time by looking at the relevant index.
And the transparency of ETFs also makes them highly liquid.

The ASX and ETF providers jointly employ ‘market makers’ to create ready markets for buyers and sellers of each ETF.

These market makers provide quotes throughout the day to reflect changes in the underlying securities of the relevant ETF.

Market making participants receive trading and clearing fee incentives when they enter into contracts with the ASX and ETF product providers.

The main market maker in Australia is Susquehanna Pacific, which is active in the market for almost every ETF available on the ASX.

Other participants include Citigroup Global Markets Australia, Deutsche Securities Australia, UBS Securities Australia and Optiver Australia.

One of the commoner questions from advisers tends to be along these lines: What happens if a big institutional player decides to sell a large parcel of the ETF I am invested in?

The answer is that the market makers mentioned above will leap on the arbitrage opportunity, returning the ETF’s price back towards its net tangible asset (NTA) figure.

Direct to the source

ETFs are often lumped together with listed investment companies (LICs) – particularly when people are talking about the trend towards direct investing.

There are a few important differences though. ETFs, for the most part, are passive index-replicating vehicles – whereas LICs are actively managed.

LICs also tend to trade at substantial discounts (or premiums) to their NTA, which affects the investment decision.

While the transparency of ETFs allows them to trade very closely to their NTA, the portfolio of a LIC is closely guarded by the fund manager lest other people replicate their fund (but for a cheaper price).

As a result, the Susquehannas and Citigroups of the world cannot make markets for LICs – hence the deviation from the NTA.
As State Street Asia Pacific chief operating officer James MacNevin says, if you want to buy a LIC you have to be aware of where it is trading.

“People say, ‘Great! It’s trading at a significant discount – I can buy it cheap’,” explains Mr MacNevin.

“Well, that’s OK as long as you understand that at the point in time you want to go and sell the LIC you may be in a position where you’re selling it at a discount,” he says.
It is the presence of a secondary market for ETFs that makes them liquid as well as accurately priced, Mr MacNevin says.

Slow burn

To appreciate the rapid rise of the ETF industry, it’s worth casting your mind back a decade.

Between 2004 and 2008 the market hovered around the $1 billion mark.

It has only been in the years since the global financial crisis that ETFs have really taken off. Talk to a product provider today and they’ll happily reel off the latest statistics for you.

For example, the sector rose by 50 per cent in the 2014 calendar year, from $10 billion to $15 billion, while in the first two months of 2015 alone, total ETF funds under management increased by 13 per cent to $17 billion.

It should be noted that at least half of the increase was down to the staggering growth of investment markets.

While this kind of growth is very impressive, there is an important caveat – it’s coming off a very low base.

The funds invested in ETFs still represent less than one per cent of the superannuation market, which according to APRA was $1.93 trillion as of 31 December 2014.

To put that into context, the $2 trillion US ETF sector currently sits at almost 10 per cent of total pension assets.

Canada, a country with an economy similar in size to that of Australia, has a $70 billion ETF sector.

MSCI’s vice-president for ETF client coverage, Tim Bradbury, reckons the Australian ETF sector will pass the $40 billion mark within three years and will reach $100 billion by 2020.

“So for people who said it’s been a slow train coming, it’s been growing rapidly but from a low base,” Mr Bradbury says.
“It’s really moving. If anyone’s business grew at 50 per cent for the last three years it would be a nice problem to have.”

State of the nation

The ETF pie is divided up between four major players in Australia: BlackRock (via iShares), State Street, Vanguard, and BetaShares.

The ASX monthly managed funds report shows that as of February 28, BlackRock was the biggest of these players, with a $6.2 billion slice of the $17 billion sector.

State Street came in at second, with $4.3 billion, followed by Vanguard ($3.2 billion) and BetaShares ($1.8 billion).

Russell Investments, ETFS and UBS were next in the pecking order, followed by Market Vectors.

The top ETF by assets traded was State Street’s SPDR ASX 200 (STW), with 37.6 per cent of the market.

BetaShares’ Australian High Interest Cash ETF (AAA) came in second, with 22.2 per cent.

Breaking the ETF industry into asset classes, 29.5 per cent of the sector is made of Australian broad-based products and 36 per cent is international broad-based products.

Australian strategy-based ETFs account for 10.8 per cent of the market, while fixed income ETFs now make up 8.8 per cent of the market.

Around the time at which ifa went to press, there were 108 ETFs available on the ASX.

Mr Bradbury says the current product universe is diverse enough to provide the building blocks for advisers and investors for most portfolios.

“There are still a couple of gaps, but I suspect they’ll be filled in the next 12 to 18 months,” Mr Bradbury says.

“I think people would like listed infrastructure as well as overseas bonds – hedged overseas bonds in particular.”

The other significant trend set to affect the ETF industry is the rise of so-called ‘smart beta’ products, he says.

‘Smart beta’ or ‘active beta’ is a type of indexing that uses factors other than market capitalisation to assign weightings.

For example, the index can be based upon fundamental measures of company value such as price/earnings ratios.

This type of ‘factor-based’ index could be a cheaper way for advisers to fill the actively managed section of their client portfolios, Mr Bradbury says.

Current ‘passive’ ETF usage is limited to about 4,000 advisers, but ‘semi-active’ smart beta ETFs could appeal to a much larger pool of around 20,000 advisers, he says.

Going passive

ETFs in Australia are, for the most part, vanilla, index-tracking passive instruments.

Magellan’s exchange-tradable version of its flagship global equities product is the only genuine active ETF currently available to investors.

And the jury is still out as to whether so-called ‘smart beta’ or ‘active beta’ ETFs qualify as active or passive instruments.

The fact is that the vast majority of the $17 billion ETF product universe is invested in passive investments.

State Street’s James MacNevin says that, globally, there is much discussion about active ETFs.

“But in the Australian context, they’re a passive, index replication vehicle,” Mr MacNevin says.

“That goes right to the heart of the benefit of that product. It’s very transparent and clear – investors know what they’re getting,” he says.

Market Vectors managing director Arian Neiron says Australian investors have an active bias, but at the same time they want to lower client fees by going down the passive route.

“They’re not convinced to go passive the whole way. Where we’ve captured that appetite is within the strategic beta,” he says.

So-called ‘smart beta’ or ‘factor-based’ strategies sit at the intersection of active and passive investing, Mr Neiron says.

Market Vectors has launched six products on the ASX so far, including the factor-based Australian Equal Weight ETF and the MSCI World ex Australia Quality ETF.

Heading overseas

One of the key trends in asset allocation throughout 2014 was the move to international equities.

ETF flows into global equities rose from $1.74 billion to $3.9 billion during the calendar year, according to Mr MacNevin.

“SMSF investors in particular are identifying ETFs as that cost-effective access point into international markets,” Mr MacNevin says.

“You get in that one single transaction a very efficient, broad, diversified exposure to either international markets or a more nuanced exposure there,” he says.

Over half of the investors in State Street’s World Dividend Fund ETF (WDIV) are now SMSFs, says Mr MacNevin.

“With the growth of international ETFs that’s certainly been an emerging trend. I expect that will only accelerate from here,” he says.

Vanguard Australia’s principal for market strategy and communications, Robin Bowerman, says the two most powerful aspects of ETFs are their low cost and their diversification benefits.

“For people who have an Australian share portfolio of eight or 10 shares, they can add one ETF and add significant diversification benefits,” Mr Bowerman says.

“Where ETFs are most powerful is where people use them as an asset allocation tool.”

Platforms and APLs

At the moment, about 4,000 advisers are using ETFs, according to research by Investment Trends.

BlackRock’s Jon Howie, who heads up the iShares business in Australia, says the biggest take-up of ETFs has tended to be in the non-aligned financial advice space.

“When I started this business four years ago our key focus was on IFAs,” Mr Howie says.

“That was really where we were getting the most traction. It was really the more forward-thinking of the IFAs we were talking to.”

This makes sense for a couple of reasons. Planners who are unconstrained by an institutional parent typically have more control over their business model – particularly when it comes to investment decisions.

In addition, IFAs tend to be less limited by platforms and approved product lists.

In theory, it should be no harder for an adviser to put a client into a vanilla index-tracking ETF than it would be to buy them some BHP shares.

But Vanguard’s Robin Bowerman says some platforms have better direct share capabilities than others.

“It’s often a matter of what platforms an adviser uses, and how seamless it is. [The question is:] Does it make the business more efficient, or does it make the business less efficient?” he asks.

Stockspot founder and chief executive Chris Brycki reckons the big bank-owned wrap platforms that have been around since the 1990s are becoming redundant.

“They will sort of go out of fashion pretty quickly because they’re really bulky and really expensive,” Mr Brycki says.

“They have so many bells and whistles that the fee the client ends up paying in the end is too high,” he says.

Along with the platform stumbling block, another factor limiting the up-take of ETFs in recent years has been the lack of products available in the market, says Mr Bowerman.

“Advisers didn’t want half of the portfolio in funds and half in ETFs. Administratively that was problematic,” Mr Bowerman says.

MSCI’s Tim Bradbury says ETFs can be problematic for dealer groups because they tend to fall into the grey area between managed funds and direct equities.

“So there needs to be some level of approval at the dealer level, whether it’s big or small,” Mr Bradbury says.

That said, things are changing – and there are more ETFs going into APLs than there were three, four or five years ago.

According to Mr Bradbury, there are two main reasons why dealer groups are warming to ETFs.

First, most licensees have research on ETFs these days, he says, and second, internal researchers used to “overthink” ETFs.

“At the end of the day, it’s a vanilla beta product – almost all 108 [ETFs] are,” Mr Bradbury says.

On top of that, ETFs are backed by fully collateralised securities; they have market makers to give the investors a price close to the net asset value; and they’re traded and settled through the ASX, he says.

“So the internal research teams are more accommodating when it comes to putting ETFs on APLs now – which is letting more advisers have a look at them,” Mr Bradbury says.
The other major investors in ETFs tend to be SMSFs, which account for about half of all assets in the sector.

Embracing automation

‘Robo-advice’ is a term being bandied around more and more in the financial services sector – it conjures up visions of artificial intelligence displacing financial planners.

But the facts are somewhat more benign. For starters, there is no ‘advice’ involved – or at least not in the sense that advisers use the term.

Instead, robo-advice is more about the application of a logical set of asset allocation rules based on a client’s risk appetite.
A typical client experience involves completing a short online questionnaire about their financial goals, current circumstances and risk tolerance.

The computer will then spit out a suggested portfolio, typically comprised of ETFs, which the robo-adviser will manage, rebalance and report on for a minimal fee (on top of the ETF fees).

Robo-advice has been gaining very significant traction in the US, while the main player in Australia is Stockspot.

The Stockspot website’s home page features a video that portrays advisers as unscrupulous product pushers who are only interested in hiking client fees.

Over the phone, Stockspot’s Chris Brycki is a little less strident.

“Advisers are now using robo-advice services to outsource a piece of their business that they don’t really need to do,” Mr Brycki says.

“A lot of advisers in Australia have seen themselves as stock pickers or asset allocators, and it’s not an area where they’re adding much value for their clients,” he says.

The basic idea, according to Mr Brycki, is that advisers should focus on what they do best – helping clients plan for their future.
“The actual implementation of the investment piece is something that over time more and more of the advice industry will use services like ours to do,” he predicts.

BlackRock’s Jon Howie tends to agree that advisers are selling themselves short by presenting themselves as investment gurus.

“For advisers, investment management is such a tiny part of their business,” Mr Howie says.

“They’re doing estate planning and dealing with the frailties of the human mind when it comes to investing – they’re counsellors as much as they are investment managers,” he says.

“It doesn’t make a lot of sense to spend 80 per cent of your time doing something that’s only 20 per cent of the proposition to clients.”

Portfolio construction

Once advisers are convinced about the benefits of ETFs, the question quickly becomes: How do I implement them in my practice?

When MSCI’s Tim Bradbury talks to advisers about the subject, he asks them to go back to basics.

“If you tell me how you run your business and how you charge and how you build portfolios, that should then help you understand how to use ETFs,” Mr Bradbury says.

No one wakes up in the morning and decides “today’s the day to buy an ETF”, he says.

Instead, the idea tends to “creep up” on advisers as a result of a combination of factors.

“Advisers may want to be more direct, be off-platform for some clients, lower costs, get more precise with portfolios, or make their business simpler,” Mr Bradbury says.

State Street’s James MacNevin’s advice for advisers contemplating using an ETF is to start with a simple, inexpensive option.

“Choose a plain vanilla ETF, one that has a long track record, one that has good secondary market liquidity and one that is reasonably straightforward,” he recommends.

One relatively easy way for advisers to implement ETFs in their practice is to take advantage of the model portfolios offered by research houses and product issuers.

Globally, assets in ETF managed portfolios – that is, managed accounts that are made up of ETFs – are edging their way to US$90 billion (AU$118.76 billion).

In Australia, the research houses Morningstar and Lonsec offer advisers model ETF portfolios.

Lonsec launched a suite of five model portfolios for advisers looking to implement ETFs in March 2014.

According to the research house, the portfolios “aim to provide a diversified portfolio solution using quality ETFs”.

The portfolios “deliver a simple, highly liquid, low-cost diversified portfolio solution using ETFs” and “provide a tax-efficient and transparent portfolio solution”, says Lonsec.

Morningstar offers advisers six ETF model portfolios that range from ‘Conservative’ to ‘Very Aggressive’ settings.

“After identifying the highest-quality ETFs in the available universe through qualitative ETF analysis, the final stage of the ETF selection process is blending the ETFs appropriately, considering potential risk/return outcomes for the portfolio as a whole,” says Morningstar.

“To contain costs, we minimise the number of ETFs in each portfolio while keeping in mind the competing need to diversify across ETF issuers and ETFs,” says the research house.

The big ETF issuers also offer model portfolios but, somewhat unsurprisingly, their portfolios tend to be limited to their own products.

BlackRock’s Jon Howie says iShares provides model portfolios for free to advisers via its website – although it is up to the individual adviser to implement the portfolio.

One relatively new feature is BlackRock’s consulting service, Mr Howie says.

“We do have adviser groups come to us and say: ‘Here’s my portfolio, tell me what you think’,” he says.

BlackRock might, for example, suggest that two of the ETFs in the portfolio are highly correlated, and that having both of them might be inefficient, Mr Howie says.

“We are actually doing a little bit of portfolio construction, where for larger groups they’ve come to us and said, ‘Can you help us build a portfolio?’” he says.

This service, being rolled out later in 2015, is aimed at the larger independent dealer groups.

Treading carefully

One of the biggest stumbling blocks that inhibits the wider take-up of ETFs in Australia has been a suspicion of new products on the part of advisers.

Vanguard’s Robin Bowerman points out that it is hardly surprising that advisers chose to eye ETFs warily after their experience with new products during the global financial crisis.

The way Vanguard’s Robin Bowerman sees it, advisers deserve credit for exercising caution when it comes to new product structures.

After all, he says, a lot of products failed to deliver what issuers said they would when markets came tumbling down in late 2008 at the height of the global financial crisis.

“ETFs were starting to come along at that point, and advisers were saying, ‘Hang on, we want to see a track record’,” Mr Bowerman says.

“But they can now see cash flows going into ETFs. They can see people using them in the new business models post-[Future of Financial Advice],” he says.

At the same time, the growth of the industry has seen the introduction of slightly more ‘exotic’ products – smart beta, leveraged ETFs, geared ETFs and synthetic ETFs.

On the one hand, innovation is a sign of the strength of a sector; but on the other, it risks undoing the years of adviser education about the ‘plain vanilla’ attraction of ETFs.

To ASIC’s credit, it has kept a pretty tight rein on the kinds of triple-leveraged ETFs that saw some US investors become unstuck, Mr Bowerman says.

ASX senior manager for funds and investment products, Marcus Christoe, says there are three main areas regulators want to keep a grip on: product construction, disclosure and liquidity.

“In the last decade and a half, the ASX, [ASIC and the RBA] have worked in consultation with the industry to develop a rule framework which sets down appropriate guidelines in [these three] areas,” Mr Christoe says.

Mr Christoe has overseen the introduction of the two synthetic ETFs in Australia – both of which are BetaShares products.

“One’s a commodity basket and the other one is an agricultural currency-hedged product,” he says.

“The reason why they were synthetically created was because the underlying instruments being agricultural products aren’t something that you can hold physically.”

BlackRock’s Jon Howie openly admits he is concerned about some of the more complex products available on the ASX.

“As the largest issuer of ETFs in the market, the honest truth is we worry about some of those more ‘sexy’ exposures,” Mr Howie says.

“First of all, as an investor you’ve got to be thinking about who is the issuer. Do I trust that they’ve gone through the process to actually make sure that this is as robust as it possibly can be?” he asks.

Mr Howie also warned investors to do their due diligence on product issuers.

“Using something that gives you a levered exposure or gives you an inverse exposure or gives you a synthetic exposure just complicates things,” he says.

Alex Vynokur, chief executive of BetaShares, is responsible for Australia’s only inverse ETF (BEAR) and one of the two leveraged products in the market (GEAR).

“It’s fair to say that early on, the use of ETFs was been more simplistic in nature,” Mr Vynokur says.

The market is now moving away from the “broad-based” index-replicating ETFs offered by the big product providers, he argues.

“Advisers are starting to use ETFs not just for the broad exposures, but also starting to get a bit more tactical,” Mr Vynokur says.

The sleeping giant
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