Exchange Traded Fund Opportunities And Risks

Australia is a long way from having "biblical" exchange traded funds (ETFs), as the US does, that exclude companies that support lesbian, gay, bisexual or transgender rights. But a rush of new ETFs in this market is creating controversy.

Local issuers expect a massive conversion of investors into ETFs in the next five years, tripling the market's size and disrupting the wealth-management industry. If product promoters are right, ETFs will revolutionise how hundreds of thousands of people invest.

iShares Australia director Jon Howie believes Australia's ETF market could hit $100 billion in assets by 2023, from $29 billion in May 2017. "There's no reason why ETFs cannot account for around 5 per cent of Australia's $2.2-trillion retirement savings pool, in time. We believe ETFs are on the cusp of a faster period of growth."

Howie says the Australian ETF market is poised to "come of age" as the obstacles that have held back ETF growth abate. "The ultimate drivers of ETF growth – transparency, low fees and the benefits of index-investing – will become visible to many more investors."

BetaShares managing director Alex Vynokur believes the ETF market will double in size within three years. About 315,000 Australians will invest in ETFs by this September, from 265,000 in April, estimates the latest BetaShares/Investment Trends ETF report. That suggests the ETF market is adding 10,000 investors each month.

"There will be an ongoing proliferation of ETFs on the ASX and many more investors will use index funds," says Vynokur. "Our research suggests the investor experience with ETFs is overwhelmingly positive."

That growth is creating opportunity and risk for investors.

Five years ago ETFs mostly provided exposure to Australian and global sharemarket indices. These plain-vanilla funds aimed to match the price and yield return of an underlying index, unlike costlier active managed funds that try to beat their relevant index, such as the S&P/ASX 200.

Today the ASX has geared ETFs that use derivatives to magnify gains or losses; inverse ETFs that allow investors to profit from sharemarket falls; active exchange traded products (ETPs) akin to traditional managed funds; ETPs that are hedge funds; ethical ETFs; fixed-interest ETFs; and ETFs over a bewildering number of sectors and strategies.

The terminology is confusing: ETFs for passive index products, exchange traded structured products, exchange traded managed funds and exchange traded hedge funds, for example. Some of these products are worlds apart from traditional ETFs.

That is nothing compared to the US, where investors can use obesity ETFs to invest in companies that benefit from a fatter global population. Or health and fitness ETFs that track companies exposed to exercise trends. Or whiskey ETFs that own makers and distributors of whiskey, bourbon and rye. Or organics ETFs that invest in companies that benefit from rising demand for organic food.

It is hard to know where the US ETF market starts and ends. Some overseas products badged as ETFs are highly geared trading vehicles. Others, such as junk bond ETFs that invest in illiquid assets, have been described as "liquidity time bombs".

Investor class-action lawsuits against inverse and geared ETFs that did not behave as expected, or did not sufficiently disclose risks, have occurred overseas. It is yet to be tested in Australia how leveraged ETFs, designed to rise when markets fall, would perform in a meltdown such as the 2008-09 global financial crisis.

Local warnings about exotic ETFs are emerging. Australia's largest provider of automated financial (robo) advice, StockSpot, this month warned that small ETFs which lack sufficient market liquidity could cause problems for investors when the time comes to sell.

iShares' Howie says there is a risk that too many products are promoted as exchange-traded products (a blanket term that covers ETFs). "iShares is keen to ensure that ETPs remain transparent and track indices or strategies. You start to muddy the waters when people buy ETPs thinking they are an index product, only to get something very different."

The local ETF market is also attracting criticism from active fund managers. Montgomery Investment Management's Roger Montgomery has described index investing as "dumb investing" geared to "know nothing" investors.

Veteran fund manager Geoff Wilson, of Wilson Asset Management, describes the boom in passive investing as "cyclical". Active managers argue ETFs should grow in the late stages of bull market when easier gains are made by tracking rising indicies.

Australian ETF market lagging

For all the hype, the local ETF market has arguably underperformed, something few in the industry will admit.

Product issuers eagerly show graphs of ETF assets zooming to $29 billion, but growth is off a low base and a handful of ETFs dominate trading values. Most ETFs on the ASX are tiny.

For context, the aggregate value of ETFs in Australia is less than that of listed investment companies (LICs) and about a fifth the size of the Commonwealth Bank. ETFs are barely worth 1 per cent of the $2.87-trillion managed funds market.

ETF Securities founder and chairman Graham Tuckwell believes the Australian ETF market is about half as big as it should be by now. "If you look at the proportion of ETFs relative to the Australia sharemarket, and compare it to offshore markets, you have to conclude the Australian ETF market has underperformed. Our ETF market will catch up to its overseas counterparts, but it's going to take time." Tuckwell is a pioneer of the global ETF market.

"ETFs are low-margin, high-volume business. It can take 8-10 years before an issuer gets sufficient scale in an ETF to make it work. A lot of hard work that has occurred in the Australian ETF market over the past decade should start to pay off in the next few years. The ETF industry badly needs more education for investors because so many forces in financial markets are working against the industry because of its lower fees and higher transparency."

Several factors have stunted ETF growth. Chief among them is the size and incumbency of Australia's active managed funds industry and the power of bank-owned financial planning networks. Key product issuers and distributors have shunned ETFs because they risk cannibalising their firm's fee base.

Further, ETF issuers have struggled to reach the $674-billion self-managed superannuation fund (SMSF) sector. ETFs are tailor-made for SMSFs and surveys show trustees have rising interest in them. But the diverse SMSF sector is hard to reach and ETF issuers, many of them small, do not have sufficient scale to deal directly with hundreds of thousands of SMSFs.

Low interest from institutional investors in ASX-quoted ETFs is another obstacle. Fund managers typically use future contracts for index exposure or invest in ETFs quoted on larger offshore exchanges, because of higher liquidity and tighter bid/ask spreads. Institutional trading is a big driver of overseas ETFs volumes, but our ETF market mostly relies on small investors.

iShares' Howie believes these headwinds are easing. "Australian banks are more open to ETFs these days because they recognise they are often in their client's best interests. More ETFs are appearing on bank-approved product lists, which is an important development that could drive rapid growth given the size of bank financial-planning networks."

Howie says fund managers are increasingly using ASX-quoted ETFs. "Index futures contracts have generally become more expensive for investment banks because of regulatory change and ETFs have become cheaper. Also, superannuation funds that are bringing asset management in-house (rather than outsource it to fund managers) are showing greater interest in ETFs."

As large institutions use ASX-quoted ETFs, average daily trading volumes should rise, in turn attracting investors. Low liquidity is a recurring criticism of some ETFs, even though much "hidden" liquidity comes from firms that act as market makers to create and redeem blocks of ETFs from issuers.

Race to win the ETF market

A huge prize is at stake. Assets in global ETFs cracked $US4 trillion at the end of April and a record $US235 billion flowed into ETFs over one year, shows data from industry researcher ETFGI. Almost 7,000 ETFs were available in 56 countries.

The global market's size and momentum explains Australian fund manager angst towards ETFs.

It is not about how big ETFs are now, but how big they could become as they disrupt the wealth-management industry by exposing flaws in incumbent products.

Active funds management's "dirty little secret" – poor returns from too many managers – is marketing gold for ETFs. S&P Global's latest SPIVA scorecard showed much of active funds in all investment categories underperformed their benchmark.

More than 70 per cent of Australian general equity funds and 80 per cent of international funds underperformed their relevant index, despite charging higher fees, according to SPIVA. Put another way, investors achieved higher returns (after fees) by investing in the index rather than relying on professional managers, on average.

Smart beta ETFs, which aim to add value by strategically choosing and weighting securities in indices, are ruffling feathers. These use rules-based screens to achieve a higher return than comparable ETFs that weight index constituents on market capitalisation, for example.

"Smart beta ETFs are enormously beneficial," says Howie. "The lines between index and active management are blurring and smart beta ETFs are bringing down fees." iShares has four smart-beta ETFs on the ASX that attempt to reduce volatility or achieve higher returns by targeting factors that drive higher company returns.

Smart beta ETFs have been criticised here and overseas, mainly because they add an element of active management to index products and have higher risk. In some ways, smart beta ETFs are a halfway house between traditional passive and active managed funds.

But many active fund managers have used smart beta strategies for years in their investment processes. They kept their formulaic process for picking stocks hidden and dressed it up as active management, to earn higher fees. In effect, smart Beta ETFs have made these processes more transparent and available at lower fees.

VanEck Australia managing director, Arian Neiron, says: "Smart beta is here to stay. Globally, about half a trillion dollars is invested in them, but only 10 per cent of the Australian ETF market is invested in smart beta. That suggests significant room for growth."

Neiron has had several meetings with active funds managers who want to partner on smart-beta and actively managed ETPs. "I expect to see more active fund managers launching funds in an ETF structure in the next few years. Some prominent fund managers want to offer their flagship funds in an ETF format, but it's not as easy as it seems because these managers have much higher cost structures."

Flaws in retail investment strategies

ETFs address a longstanding problem of low portfolio diversification in Australia. This market's heavy concentration in banks and resources, two challenged sectors, has become more problematic. Long-term investors seeking exposure to growth sectors such as information technology and biotechnology can have limited options on the ASX.

New ETFs are giving Australian investors access to sectors that are better represented overseas. BetaShares' Global Cybersecurity ETF, which invests in leading cybersecurity stocks, is an example of thematic ETFs that provide index exposure to megatrends.

ETFs are also aiding diversification across asset classes. More ETFs over Australian and global fixed-interest indices, and property and commodities, are expected. An increase in currency ETFs is possible, although it is unclear if enough demand exists.

Another growth driver is younger investors and the advent of robo-advice. The average age of investors who used ETFs for the first time in 2016 was 39, BetaShares/Investment Trend research shows. Five years ago, it was 58.

BetaShares' Vynkour says: "ETFs are rapidly moving from the domain of more sophisticated, older high-net-worth investors to mainstream investors. Younger investors demand transparency and shun products where there are layers of fees."

Lower fees are another key factor. The iShares S&P 500 ETF, the most popular index fund for US equities exposure, charges 4 basis points annually, down from 9 points in 2011. As the fee war between the global ETF giants escalates, local investors can expect even lower fees in the next five years.

The casualties will be smaller ETFs and new entrants that do not have the scale to compete with the likes of Vanguard and BlackRock's iShares division. The probable outcome is a few large ETF issuers dominating core asset exposures, such as Australian and US equities, and lots of smaller issuers fighting over the crumbs with strategy-based ETFs.

As ETFs increase their share of wealth-management products, expect the debate between passive (index) and active funds management to escalate, even though it is nonsensical in many respects: there's no such thing as a "passive" ETF because investors actively decide when to buy and sell; and index and active funds both have a role in portfolios.

VanEck's Neiron says the ETF market will be mainstream when every investor who has an active managed fund in their portfolio has an ETF. "In many respects, the Australian ETF market is still in its infancy. There's a lot of growth and new products ahead.

Tony Featherstone Financial Review 16 June 2017

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