Move up a gear. /44 Kit and Caboodle: ETFs

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1 /44 Kit and Caboodle: ETFs Move up a gear The development of the exchange-traded fund market has shifted into a new stage and investor interest remains strong. But while the industry has followed a two dimensional evolutionary path, there is some debate on its future direction, writes Christos Costandinides at Deutsche Bank the markit magazine Autumn 20

2 Kit and Caboodle: ETFs /45 A new chapter is opening for the exchange-traded fund (ETF) industry. This year, the value of the market is approaching the $1,500bn mark, reflecting increased product recognition with investors globally. From a product perspective, the ETF industry is now entering its third stage of development. Following the creation of ETFs tracking all major asset classes and the creation of a sufficiently diversified product continuum within each asset class, the industry is now witnessing the creation of products that further unlock portfolio building potential. Stripping away price movements and looking at net cash flows, the industry continues to match growth rates seen in recent years, as measured by relative cash flows. Asia and Europe lead growth this year, at 1.6 per cent and 9.6 per cent respectively, while the US has grown 5.7 per cent. Investor support for ETFs is also evident in their increasing use in the overall asset management industry. In the US, ETFs represented 7.7 per cent of the mutual fund industry at the end of 2010, and 2.6 per cent in Europe. ETF adoption rates in the US have historically been higher than in Europe; but there are signs pointing to improved adoption rates in Europe. Autumn 20 the markit magazine

3 /46 Kit and Caboodle: ETFs Figure 1: Global ETF Industry Historical Evolution AUM ($ Billion) 1,400 1,200 1, US ($) Europe ($) Asia Pacific ($) Number of ETFs* ** Year AUM*** ** US ($) A number of big US asset managers, including Vanguard, State Street, Pimco and VanEck, have begun a strong push into Europe. In addition, there are signs that a number of European wealth managers have accelerated transition from mutual funds into ETFs. ETFs have also remained a favourite with cash equities investors. While numbers vary depending on the asset 3,000 2,500 2,000 1,500 1,000 51% 34% 39% 36% -6% 36% 27% -5% Number of ETFs* ,049 Europe ( ) % 77% 60% 28% 14% 59% 34% -4% Number of ETFs* ,076 1,192 Europe ($) % 55% 79% 42% 8% 64% 25% 3% Asia Pacific ($) % 7% 13% 24% -13% 23% 30% 5% Number of ETFs* Rest of the World ($) % 90% 23% 179% -62% 154% 32% -5% Number of ETFs* US, Europe & Asia Pacific ($) , , , % 34% 40% 40% -7% 43% 27% -2% Number of ETFs* ,173 1,586 1,947 2,465 2,855 US ETF share 72% 73% 74% 73% 71% 72% 68% 68% 66% European ETF share 10% % 13% 16% 16% 19% 22% 22% 23% Asia ETF share 17% 13% % 9% 8% 7% 6% 6% 7% ROW ETF share 1% 2% 3% 3% 5% 2% 4% 4% 4% * Number of ETFs at the end of the period net of delistings ** As of 19/08/ *** Pre-2006 numbers represent best estimates Number of ETFs 500 type, in the US, ETFs comprised 28.1 per cent of cash equities turnover as of May 20, up 2.5 per cent from the beginning of the year. In Europe, ETFs comprised 7.3 per cent of cash equities turnover for the same period, an increase of 1.3 per cent from the start of the year. Investment trends So far this year, the global ETF industry 0 has accumulated flows of $87.9bn, some 16 per cent higher than for the same period last year. Much of that growth came in the first quarter, when cash flows of $36.8bn were 50 per cent higher than the same period last year. This outperformance continued into the second quarter but third-quarter activity is 73.3 per cent down, primarily because of a slowdown in US equity ETF flows. While the level of cash flows this year is significantly stronger than last year, the investment trends are distinctly different. Equity cash flows have been more muted, with the exception of those into ETFs tracking the DAX, representing the biggest global cash flow trend of the year. The second-biggest equity trend was MSCI Japan and the third was MSCI EAFE (Morgan Stanley Capital International Europe, Australasia and Far East). The biggest equity ETF cash flow loser was the Russell 2000, with outflows of $3.8bn, while MSCI Emerging Markets and Euro Stoxx 50 experienced $2.8bn and $2.1bn of outflows respectively. Fixed income has accounted for nearly one third of the cash flows year to date, with most materialising in the US. The three biggest fixed income ETF inflow trends occurred in the US (Barclays Capital US Aggregate Bonds: $2.6bn, Active ETFs: $2bn and Treasury bill benchmarked ETFs: $1.8bn) and the three biggest outflow trends occurred in Europe. Strategic direction Though industry real growth has been good this year, the most important longterm strategic trend is a distinct shift pointing to the ETF industry entering a new chapter in its development. This shift relates to ongoing changes that will likely impact the industry as well as product usage over the next five years. ETFs are transitioning from a core beta trend towards becoming an integral multifaceted portfolio building block. With close to 3,000 ETF products globally, there is a great deal of debate about what investment strategy characteristics an ETF benchmark should the markit magazine Autumn 20

4 Kit and Caboodle: ETFs /47 Figure 2: Global ETF Cash Flows by Region 1 $ Million 120, ,000 80,000 60,000 40,000 20, Jan Europe US Asia 4 Feb 4 Mar 1 Apr possess. The complexity of strategies employed by ETFs currently varies, ranging from ETFs that track pure capitalisation-weighted diversified beta indices to more active strategies that aim to generate improved returns against a benchmark by relying on the fund manager s discretionary expertise. According to our estimates, 95.5 per cent of assets under management in the ETF industry comprise pure beta while the remaining products track indices beyond the classic tracker realm. We consider the ETFs outside the beta space to exist on a continuum rather than a single strategy category, falling primarily in three categories, as described by Figure 3. Passive-plus strategies, mainly in the form of ETFs that track leveraged and short indices, have also gained traction. While they remain popular with certain investors primarily active traders these products, which mostly offer daily exposure, have yet to register the same level of interest of their long-only cousins, and their turnover remains proportionally higher than their assets. This is currently the largest of the three non-beta ETF investment strategy categories, holding ETF assets of $27.6nm. Beyond the classic beta capitalisation-weighted indices, several new index construction ideologies offer alternative 29 Apr Date 27 May 24 Jun 22 Jul 19 Aug ways to extract value from beta. We classify these strategies as semi-active. These indices weigh constituents in a number of ways, ranging from pure average to using metrics that the index provider believes are the best variables other than capitalisation to measure Figure 3: Roadmap from Alpha to Beta Beta Beta Passive Diversification rules apply Long only exposure Weighting based on market capitalisation Composition based on pre-determined rules Representative of a pre-defined market segment Return profile: Match very closely index return profile Risk profile: Match very closely index risk profile Passive plus (leveraged, long/short) Diversification rules apply Long, short and/or leveraged exposure Weighting based on market capitalisation Composition based on pre-determined rules Representative of a pre-defined market segment Return profile: Amplifies index returns Risk profile: Amplifies index risk profile Beta Multiplied 1 Asia ETF cash flows post July not yet available the potential for capturing value. While the debate is still open as to whether these can be classed as beta products, a growing launch calendar signifies that the ETF industry is proving to be fertile ground for these products. These semiactive benchmarked products currently total $12.2bn. We consider ETFs that track benchmarks that incorporate an element of discretion in extracting returns and do not fit in the other two non-beta categories as active. Currently, this category hosts assets totalling $10.9bn and is the smallest strategy segment. The ETF wrapper concept is gaining traction with active managers; however, the complexity of constructing an exchangetraded active product will continue to slow construction of such ETFs. Furthermore, while active ETFs generally offer more transparency than their traditional fund counterparts, there is a disclosure threshold that, when crossed, can put an active manager at a competitive disadvantage. While the ETF wrapper has proved to be an asset magnet over Alpha Active Diversification rules do not typically apply Long, short and/or leveraged exposure Weighting not based on market capitalisation Composition not based on pre-determined rules Not Representative of a pre-defined market segment Return profile: Aims to generate positive returns Risk profile: Dependent on investment decisions Semi-active Diversification rules might apply Long only exposure Weighting not based on market capitalisation Composition based on pre-determined rules Representative of a pre-defined market segment Return profile: Aims to generate positive returns Risk profile: Dependent on investment decisions Beta Adjusted Alpha Autumn 20 the markit magazine

5 /48 Kit and Caboodle: ETFs the past decade, it remains to be seen if its benefits will outweigh the threat of yielding competitive advantage. The big debate around investment strategy in the ETF industry is whether ETFs should only continue to exist in the form of tracking classic beta indices or whether there is merit for new strategies that could give investors more choices. This consideration is especially relevant in an environment where consistently positive bread and butter equity beta returns are becoming increasingly scarce. At this point, 4.5 per cent of ETF assets are benchmarked to non-classic beta indices. The next two years will be key in determining the survival of the fittest of these new strategy entrants. Asset allocation In addition to investment strategy, asset allocation product diversity has also increased over the past two years. Diversity is a bedrock characteristic of the stage-three industry development phase, through the launch of ETFs tracking more niche exposures. These products have a very important role to play in portfolio construction as they afford investors the opportunity to better customise their investment strategies. Such ETFs track sectors, single non-bric (Brazil, Russia, India, China) emerging markets (such as frontier markets) and volatility indices. In the fixed income sector, a characteristic example of this trend is ETFs that enable tracking of only credit risk, by stripping duration risk, which is a fundamental component of second-stage fixed income ETF products. A development that makes niche products even more effective is the creation of ETFs that offer enhanced return targeting capability by combining niche product index characteristics, such as market type and sector. Such hybrid asset allocation product profiles are likely to remain an important differentiating parameter among ETF providers. ETF asset allocation product focus continues to be the major differentiator for big supermarket ETF providers. It also currently provides the best opportunity for smaller providers with lack of access to major investor networks to enter a market that rewards economies of scale. Currency risk: a growing consideration Currency returns can significantly alter an asset s returns, especially in the current economic environment where developed and emerging country exchange rates are shifting. Therefore, Christos Costandinides, European Head of ETF Research & Strategy, Deutsche Bank the markit magazine Autumn 20

6 Kit and Caboodle: ETFs /49 ETF investors have become increasingly vigilant of currency risk. This is an issue that mainly relates to equity ETFs, as most fixed income ETFs target indices that offer hedged returns. We estimate that, in the equity ETF market, 40 per cent of products carry currency risk and are benchmarked to indices whose returns are generated in markets outside an investor s native currency. The majority of these ETFs are benchmarked to indices that track assets denominated in currency baskets (US: 75 per cent; Europe: 66 per cent) and the remainder track indices that are denominated in a single currency, in both developed and emerging markets. Just under 50 per cent of the equity ETFs that carry currency risk are denominated in developedmarket currencies, some 40 per cent in emerging market currencies and 10 per cent in broad currency basket indices. There are currently 15 equity ETFs (seven in the US and eight in Europe) that offer currency-hedged returns, representing less than 1 per cent of global equity ETFs in terms of assets. The majority of these have been launched in the past two years. We expect this currency hedging trend to continue through increased product launch activity. ETF investor demographics the next piece of the puzzle Over the medium term, there are two areas to watch: changing product creation parameters and a transforming profile of the ETF investor. These two areas are linked as ETF providers will generally respond to investor demand as well as market conditions when creating new products. The next two years will be decisive about which direction the industry takes in its current stage of evolution. Market participants estimate that the level of institutional investor participation Figure 4: ETFs by Strategy Type Full discretion Active, $10.9 bn 1.0% Tracker Passive, $1,087.2 bn 95.5% in the ETF industry is upwards of 90 per cent in Europe and close to 50 per cent in the US. Other types of investors including retail make up the remainder. The European market investor profile is The ETF product is gaining increased penetration with retail investors. more concentrated, but there are signs that its composition is shifting. One factor that is becoming more important in the current environment is that, on many occasions, the attraction of ETFs is not their increased product functionality but cost effectiveness. There are signs that more retail-linked investment managers, such as financial advisers, pension fund managers and discount brokers, are increasingly using ETFs. The recent regulatory scrutiny is also a sign that the ETF product is gaining increased penetration with retail investors. With continuing structural changes in the European asset management industry, in terms of both cross-country integration and increased competitiveness, as well as regulation through Mifid, we expect these new participants to provide a major boost to ETF interest. While comparisons are often made on the growth of the ETF industry versus the traditional fund management industry, we believe that the two are not in direct competition. ETFs are not a new market competing with an existing market. Instead, ETFs are the asset management industry evolving to take advantage of technological and capital market innovations by generating more transparent and flexible products. In that respect, tracking this transition is key to understanding the future of the ETF industry. Career in brief Fundamental weighting Semi-active, $12.2 bn 1.1% Passive plus, $27.6 bn 2.4% Leveraged Christos Costandinides is European head of ETF Research & Strategy with Deutsche Bank s Global Markets Group. Prior to joining Deutsche Bank, Christos was a London-based rating analyst with Moody s Investors Service, publishing rating opinions on a variety of EMEA fund strategies. Before Moody s, Christos worked for Mellon Capital Management in San Francisco, California, where he managed global tactical asset allocation and currency overlay strategies. Christos holds an MBA from the Haas School of Business at the University of California Berkeley, USA. He also holds a BA Hons in Industrial Economics and Accounting from the University of Nottingham, UK. Autumn 20 the markit magazine