Morningstar’s inaugural ETF Invest Europe Conference, which was held last month in Milan, provided participants with valuable insights into how exchange-traded funds (ETFs) and exchange-traded products (ETPs) can be used to capitalise on a variety of investment themes. The conference brought together investors and representatives from the ETP industry to discuss the most important topics facing investors today. As the event’s agenda was crafted by Morningstar’s own ETF analysts, the theme was ‘investors first’.
Let’s recap on the top 10 topics covered at the conference and the consensus response.
1. ETF growth has slowed down recently. Are ETFs just a one-hit wonder?
No. Despite their small market share (4%-5% of total European fund assets), ETFs are an important tool for investors. While not everything about the European ETF market nowadays is great, experts agree that we are currently going through a correction rather than a full-blown long-term contraction. "Nothing has gone wrong and there is no doubt the ETF growth story will continue," said Scott Burns, director of fund analysis at Morningstar. Thorsten Michalik, head of Deutsche Bank’s ETF unit db X-trackers, pointed out that ETFs have done very well compared to equities and other investment products: "Unlike active funds, we still see net inflows," says Michalik. The consensus is that the difficult macroeconomic environment has weighed on sentiment in Europe, scaring off investors.
2. Will ETFs be used more frequently in investors' portfolios going forward?
Yes, but though there are several reasons for the proliferation of ETFs, opinions on the key drivers of this phenomenon differ. Morningstar’s Scott Burns expects the industry will receive a boost from regulatory changes in Europe. "The new advisory model--away from commission-based to fee-based compensation--gave the US ETF market a boost after 2004," said Burns. He expects a similar development in Europe over the coming years. ETF providers stress that institutional investors will continue to drive the ETF market. The consensus is that it will be increasingly difficult for active fund managers to avoid ETFs. Whether via direct investment or indirect avenues such as being included in funds of funds and other asset management products, everyone in attendance agreed that ETFs’ success story will continue.
3. Is the war between providers of swap-based ETFs and physically replicated ETFs finally over?
Yes and no. Due to the difficult market environment, the “war” between iShares on the one hand and Lyxor and db X-trackers on the other has perhaps been put on hold rather than to rest. Perhaps the question needs to be re-phrased, since all large ETF providers have by now opted to offer both replication methods. The question should be: "Is competition between ETF providers over?" The answer here is simple--of course not!
ETF investing is all about finding the right balance between the quality of replication, market risk and counterparty risk.
The ETF market is highly competitive and will be even more so as more providers (i.e. Vanguard) enter the European market. Competition is bound to intensify and ETF providers will arguably use every trick in the book to strengthen their position. Make no mistake, iShares, db X-trackers and Lyxor will fall back on the old synthetic vs. physical replication debate if they deem it necessary. For investors, however, it is important to understand what it all boils down to: ETF investing is all about finding the right balance between the quality of replication, market risk and counterparty risk. Investors should not pay too much attention to the noise made by the marketing departments of the competing providers.
4. Do we know where the ETF industry is heading from here?
Apart from the above-mentioned moves by Lyxor and db X-trackers into the world of physical replication, there are signs of consolidation on the horizon. At the forefront is Credit Suisse, which has put its ETF business up for sale. Dwindling fund flows could become an issue for many small- and medium-sized providers in Europe. Investors should closely observe how their ETFs’ assets under management develop. Prolonged stagnation at low levels could encourage providers to close funds, at least in the medium-term. Investors should also pay close attention to whether ETF providers leave their comfort zone. Just because ETF Securities is a market leader in exchange-traded commodities (ETCs), does not mean that they will be equally successful in managing equity ETFs. In fact ETF Securities has had to close some equity ETFs due to a lack of assets. Like Russell Investments in the US, Spanish provider BBVA recently delisted most of their ETFs due to a lack of investor demand. Consolidation in the European market is still at an early stage but should be seen as a normal development in a dynamic market. It is however no contradiction that new providers will continue to enter the market. In this context, it will be interesting to see what impact Vanguard’s entrance will have in Europe given its size and aggressive cost-cutting measures in the US.
5. The macro backdrop and the search for yield
Sluggish global growth and the on-going sovereign debt crisis will continue to weigh on market sentiment. "It will be difficult for the eurozone, but it can be done," said Andrew Bosomworth, head of portfolio management at PIMCO Europe. Changing market conditions will continue to influence investors’ decisions, said Stephen Cohen, chief investment strategist at iShares EMEA. He expects this year’s developments to set the framework for the equity and bond markets going forward, one marked by much shorter investment cycles as a result of sluggish growth and loose monetary policy around the world. "We see the consequences already in the bond markets: real yields of safe bonds slipped into negative territory", said Cohen. Therefore, yield-seeking investors are hunting for higher-yielding assets; in particular corporate bonds, but also emerging markets bonds and dividend strategies are on their radars. Cohen also mentioned that in this era of so-called "financial repression", ETFs will benefit from their low costs.
6. What does the future hold for the development of ETPs?
Bonds, bonds and bonds seem to be the consensus. Scott Ebner, head of global ETF product development & research at SPDR ETFs, expects investors to focus in particular on fixed income ETFs over the next decade, especially those based on high-income indices. However, this is also due to a more general shift in the ETF industry, which has historically been focused on equities. According to Ebner, this does not reflect the typical composition of an investment portfolio in Europe, which is usually dominated by bonds. Nizam Hamid, deputy head of Lyxor ETF, added that investors are currently positioned defensively, despite potentially higher risks in the fixed income space in light of ultra-low yields and lofty valuations. "Nowadays, investors want to manage risk and that is also why they invest in dividend ETFs," added Hamid.
7. Will the ETF industry grow its investor base by issuing new bond ETFs?
No, ETF experts expect that this won’t be the case. "Existing ETF investors are the ones investing in fixed income ETFs while traditional fixed income investors prefer direct investments over ETFs," said Blanca König, director of fixed income at BlackRock. "Institutional investors are more willing to use equity ETFs as opposed to venturing out into the world of bond ETFs," said Michael John Lytle, managing director at Source. One thing is clear: actively-managed fixed income funds have been having an easier time than active equity funds of late, with the former seeing continued inflows. The majority of net inflows to the high-yield bond space is currently going to actively-managed funds rather than ETFs. Fixed income ETFs still represent only a small part of the overall fixed income fund universe. This is true for government bonds and particularly true in the case of corporate bonds and high yield. The reason? Fixed income markets are much more illiquid and less transparent than their equity counterparts; hence investors see active managers as having an advantage in this space.
8. How large is the playing field for fixed income? Is there a need for new products?
Given the strong demand for fixed income products, the sky is the limit; at least in theory. Given the bond market’s relative opacity and illiquidity, Source’s Lytle sees a lot of room for innovation within the fixed income ETF space. This does not come as a surprise as Source has been quite successful in launching niche products in collaboration with PIMCO. During the conference, investors also expressed the need for new fixed income products. "I still see room for more fixed income ETFs such as corporate bond ETFs covering emerging markets by sectors," said Markus Kaiser, manager and CEO of Veritas Investments. Another hot topic was that of fundamentally-weighted bond indices, which could steer around the oft-cited risk of market cap weighting of having the largest index constituent being the largest debtor. However, there are limits with alternatively weighted bond indices, especially in the sovereign space. Just imagine if everyone were to start investing only in the remaining 'AAA'-rated euro government bonds: while the German finance minister would be quite happy, his Finnish colleague could face problems given the much smaller size of Finland’s bond market.
9. What about actively managed ETFs? Are they the future?
Not necessarily. Even representatives of the ETF industry believe that the pace of innovation for active ETFs will be rather slow. There was general agreement on this topic on our industry panel with Lyxor, db X-trackers, iShares and State Street Global Advisors. In short, an active ETF is simply a re-packaging of an active fund managers’ strategy in an exchange-traded product. In the US, a clone of the successful PIMCO Total Return Fund has accumulated $3.3 billion in assets in a short time period. "I'm not a fan of active ETFs," said Thorsten Michalik, head of db X-trackers. Trading issues are a key obstacle for active ETFs, according to Michalik. Moreover, active managers are reluctant to publish their portfolios on a frequent basis.
10. Will “smart beta” products compete with active managers?
Yes and maybe.
"Yes" with respect to the fact that these products and their more basic counterparts already compete with active fund managers for investor capital. A key trend in index and ETF development is towards “smart beta”, based on systematic strategies. There are plenty of examples: fundamentally weighted indices have existed for years. Research Affiliates Fundamental Indices (RAFI) and the products from Lyxor and PowerShares that are based on them tend to be value oriented. Since 2011, minimum-variance, equal weighted and dividend strategies have also come to the market in ETF wrappers. Therefore, ETFs are clearly increasingly hunting in the territory of discretionary managers.
"Maybe" is the answer to whether or not these ETFs will actually deliver better returns than market capitalisation-weighted indices and actively managed funds dealing in similar markets. The timing of these products’ launches creates some additional question marks. These products are usually launched in response to a market crisis…after it has occurred. Therefore the question is: will the next crisis follow a similar pattern? For example, ETFs based on RAFI indices were launched in response to the extreme valuations seen during the TMT (dot-com) bubble. What might have worked in 2001 and 2002, disappointed in 2004. Products based on RAFI indices have also suffered since 2007 as they struggled to deal with the momentum driven on the way to the top and were stung by some “value traps” during the financial crisis in 2008. By way of comparison, equal-weighted strategies struggle when blue-chips outperform small caps. Since many ETFs based on equal-weighted indices were launched, the market has turned. Blue chips equities have been in demand over the last 18 months which explains why many traditional indices have outperformed their corresponding equal weighted cousins over this span. "Investors should therefore use ‘smart beta ETFs’ not as a short-term tactical investment but rather as a core holding within a portfolio. They should be used as a diversification tool", said Douglas K. Gratz, associate director at Research Affiliates.
