A panel of experts gathered at the Four Seasons hotel in London to discuss the key concerns and challenges faced by investors using ETFs, as well as where the key opportunities are in this market.
Charlie Parker, director, Citywire Wealth Manager: Today we are going to look at the trends among investors in increasing their use of beta-based products.
We use this phrase widely, because it includes more than just exchange traded funds (ETFs) or more than just index funds. It is a whole spectrum of different ideas that are making their way into portfolios.
There is an environment where people are thinking about how they introduce beta-based products into their portfolios. But it also throws up a lot of challenges: what are the portfolio construction problems that emerge? What are the opportunities?
Ana Armstrong, chief executive, Armstrong Investment Managers: ETFs can present a very important part of a client’s portfolio. ETFs are improving, becoming smarter, while investors are becoming more and more aware of some of the shortcomings of ETFs. I can see them developing further and making their way into portfolio construction.
Mario de Bergolis, head of operational due diligence, Vestra Wealth: We still have some clients who have the active versus passive argument. So, traditionally what we’ve got is the core of portfolios in actively managed strategies and then only satellite in other passive funds.
Ben Smaje, managing director, Kennedy Black Wealth Management: We manage portfolios almost exclusively from a beta point of view. We don’t try to time the market, and we don’t believe in stock picking.
Rebecca Murphy, business development director, North Investment Partners: John Husselbee, who is our lead fund manager, has always actively used passives within his portfolios, predominantly ETFs initially, but also latterly index funds. It is primarily to access asset classes and for tactical asset allocation as well.
We are seeing a greater demand from the IFAs that we’re working with to use these sorts of passives within our portfolios more actively. Also, to access more and more asset classes, while reducing the overall cost of the proposition.
Mark Harris, multi asset fund manager, Eden Financial: I’ve used ETFs for quite a long time now in a wide range of roles, including all the items just mentioned, but mainly it’s thinking about efficiency within the portfolio, in terms of liquidity and cost, as well as using them sometimes for tactical purposes, albeit there are other mediums that can be used.
Edward Allen, Thurleigh Investment Managers: We have used ETFs and index funds as a core part of our portfolios for the last decade and we’ve seen the variety explode from really nothing to the huge different groups that we have today, of which smart beta is one.
Andrew Whiteley, investment director, Provisio: We built our own range of modern portfolios using predominantly ETFs about four years ago.
Parker: Can the indices we are most familiar with do the job in terms of portfolio construction? How far do people think these indices go in providing the right sort of exposure, the right building blocks?
Dan Draper, global head of ETFs at Credit Suisse: Looking over a couple of decades, some recent research shows that indexing in terms of ETF funds under management and mutual funds, as well as trading volume, has just grown so much.
But you do see rising correlations. You just don’t get the diversification of the S&P 500 that you did probably 10 years ago.
So how can you better get lower volatility or can you maybe get some form of risk premium from smaller companies or maybe value? How can you do it in a smarter way and in a systematic way?
We’re looking at long-term trends, but maybe with short-term conditions, we're also helping the fund managers try to find this free lunch for diversification.
Emma Dunkley, Citywire: Are there some asset classes where you don’t think traditional ETFs or beta products are efficient? For example, some wealth managers have said they do not like passive vehicles to access fixed income. Do you opt to use active managers in this space instead?
Murphy: If we were creating a proposition for an intermediary who wanted to use primarily passives or ETFs within the portfolios, how would we actually replicate our asset allocation to strategic funds?
The way in which we would have to do that is to actually use ETFs and then look to create some sort of overlay where we had an asset allocation of that particular asset class ourselves. We’ve brought in some ETFs to do that or we actually prepare it within the team.
The alternative is to use an active manager, but then, of course, you are increasing the cost of the portfolio, which is often the primary reason for putting together a proposition of this nature.
Parker: Has anyone ever bought a fixed income ETF?
Harris: Yes. I wanted exposure to the US high-yield market. It was quick. It was well diversified. It was physical, rather than a swap. And it suited my purposes at the time.
Dunkley: With regards to the ETFs you choose, is there still a debate as to whether investors go for physical or synthetic ETFs? Or has the debate moved on?
Armstrong: There’s a lot of debate about physical exchange traded commodities (ETCs). JP Morgan, for example, has filed to launch a physical copper ETF – that makes no sense. First because of the storage of copper and what this costs – one cannot image what that would be.
Clearly, providers are looking to overcome the disadvantages of contango and now there is a development for ETCs tracking oil, to mitigate the costs of contango. So ETFs and ETCs are getting smarter.
Isabelle Bourcier, head of business development, Ossiam: One thing that has struck me is the use of the label ETF across a range of products that aren’t actually funds operating under the Ucits IV directive.
There is a lot of talk about transparency and understanding risk, but ETFs and ETCs are two different products in terms of risk and in terms of regulation.
For example, there’s no way you can have an ETF just on oil, because it’s not diversified. This is something that’s part of a wider debate: how all these products are just put into the same bucket.
There needs to be a clear distinction between products, because otherwise we will end up with the potential situation where, if something goes wrong with an ETC for example, the whole ETF market will be seen as the bad guys.
Parker: There has been reaction against swap-based ETFs in the market in recent months, due to a couple of controversies that have sprung up. Is this reaction over the top?
Draper: It’s all about transparency. We’ve gone through a lot of investigation now over the past year or two.
But, I think, just the mentality, you’re the risk manager, if something does go pear-shaped, if you have a physical product, even if it had securities lending most of the physical providers, can turn off securities lending within a reasonable amount of time.
But if you’re a swap provider you need to think: worse case, can I access another swap provider if there was collateral?
Parker: The big money in swap ETFs is when you are the manager and counterparty. That’s where the real benefit is and, of course, that’s where the biggest risk lies.
Draper: We’re only talking about extreme cases here. I mean, that’s the point that you really understand from [the] risk manager perspective what happens. That question wasn’t asked until 2008. Then regulators all investigated that pretty thoroughly in the last year.
I think that’s where if I was sitting in with my manager I would ask what happens in each market case? Tell me what happens with the swap provider, what happens with my collateral, for example. It’s just those types of questions you ask to tick the box in due diligence and then hopefully you can move on.
Murphy: It’s not even so much that you can’t make them comfortable with it. It’s this perception. It’s the same sort of perception that exists with structured products and things like that and how you explain those to your private clients and how they actually benefit from using them.
I think that there is a responsibility to make sure that you can clearly articulate what’s going on in the portfolios, particularly for advisers to speak to their clients. But for investment managers constructing each proposition, they’ve got to be able to clearly explain that and show their due diligence.
Parker: Moving on to another topic: are we getting close to a time where commodity exchange traded products (ETPs) can be truly efficient?
Draper: If you look at the historical period of time, the broad-based commodity index that uses futures is really used for passive allocation purposes and diversifying. Normally, you do have backwardation in a broad-based commodity index.
Generally, most broad-based commodity indexes are positively correlated with equities. But, I think in the longer terms they go back to historical relationships and provide the hedges to either inflation or, on the other side, deflation.
Parker: What innovation do people want in the ETF market?
Anna Sofat, Addidi Wealth: One of the areas I’m interested in, from an ETF perspective, is actually the ethical one. A lot of my clients would rather have ethically responsible portfolios if they had the choice. But the investment world tells us this is not popular.
I do think the world has changed over the last few years, and I think it’s good to see more products coming into this space of low cost funds. And that’s an interesting area.
Parker: Isabelle, which of your products are you seeing as popular at the moment?
Bourcier: The strategy that has attracted a lot of feedback from clients in response to the systematic rise in volatility across global asset classes and the need for liquid investment tools is the Ossiam Minimum Variance.
For the ETF and the indices we have initiated, their volatility is reduced by an average of 30% compared to the S&P 500, S&P IFCI index (for emerging markets), Stoxx Europe 600 and the FTSE 100, with a significant reduction in drawdowns.
So, we’ve seen a lot of interest in this type of strategy due to the big swings in the market, because it minimises risks.