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Taste for ‘smarter’ funds kicks passives into shape

Taste for ‘smarter’ funds kicks passives into shape

The passive sphere is evolving as fast as it is growing. Exchange traded products (ETPs) only entered the UK and Europe in 2000, and already assets under management have soared to $350 billion.

Although ETPs are a mere blip compared with the broader Ucits fund industry, their rate of growth has been dazzling. The high level of investor interest has prompted a plethora of new market entrants, as well as the creation of innovative product types.

In their simplest, traditional form, exchange-traded funds (ETFs) are physical, index-tracking funds traded like shares on the stock exchange. Over the years, however, different product types have emerged from this blueprint, including the synthetically replicated version, pioneered by Lyxor in 2001.

Access all areas

Since then the advent of exchange-traded commodities (ETCs) has been another major development, helping to revolutionise the commodities space and providing smaller investors, or those other than big institutions, access to this asset class for the first time.

New products are still coming to market, with the launch of active ETFs and multi-swap based vehicles in the past few years, to name just two. However, much like a double-edged sword, innovation carries with it attractive benefits as well as drawbacks.

‘It’s not about offering one suite of products, it’s about having a whole offering. It’s important we have the plain vanilla ETFs as well as the innovative smart beta products,’ says Michael John Lytle, managing director of Source ETFs. ‘If we just offered the niche products, yes, they’re interesting, but you have to do a lot of due diligence, which can be challenging from a time-management perspective.’

Source recently listed its ‘best broker’ ETF on the London Stock Exchange. The Man GLG Europe Plus ETF tracks a benchmark that replicates a long-only portfolio of European equities, constructed from ideas given by around 65 brokers. The strategy has been devised by MSS, an in-house research team formed following Man’s acquisition of GLG Partners in October 2010.

Since 2005, GLG has used a systematic process to select the highest-quality broker ideas and run a liquid, diversified portfolio, which is why the firm decided to make it available in an index format through the ETF. Ted Hood, CEO of Source, says: ‘Investors looking for smart beta outperformance products that have chosen the Man GLG Europe Plus ETF have enjoyed excess returns over MSCI Europe.’

This launch exemplifies how these vehicles are providing access to different types of unique and bespoke underlying asset classes, which sets ETFs apart from other index-tracking products. Although many investors note that traditional index trackers can be cheaper and provide similar exposure, the range is still limited compared with the vastly expanding spectrum of ETF products coming to market.

Another form of innovative product type stems from the way in which the underlying indices are constructed and adapted on an ongoing basis. IShares, for example, announced it would cap its high-yield bond fund to ensure investors are not overly exposed to certain countries amid the eurozone crisis. The issuer put a 20% cap on country weightings to prevent investors ending up with significant exposure to, for example, a country such as Spain if their bonds get junked.

IShares also placed tighter caps on the exposure to individual issuers, lowering it from 5% to 3% to mitigate concentration risk. ‘In high yield, we are putting caps and constraints on the raw index. We want to make sure we do not get an oversized position in some companies,’ says Alex Claringbull, senior fixed income portfolio manager at iShares.

The move should allay investor fears that the ongoing eurozone debt crisis, which has recently been alleviated by the European Central Bank’s bond-buying proposal, could result in a number of bonds being junked and indices overexposed to certain indebted countries as a result.

If the cap fits

Wealth managers have also aired concerns regarding passives based on fixed income, in the view that cap-weighted benchmarks leave them invested in indebted companies. ‘It’s not always the case that fixed income products leave you with exposure to the most indebted countries or companies,’ says Claringbull,
who cites the changes in the high-yield ETF as an example.

He says: ‘We carefully construct the underlying indexes to ensure liquidity, among other factors. For example, if Vodafone has 15 bonds, iShare selects the ones based on relative value and liquidity, for example. The fund is managed based on sampling rather than full replication.

‘Also, people say they don’t want a product that is overweight Italy and Spain. We think it’s changing so that the eurozone isn’t homogenous and investors are looking at individual countries. So we have launched individual country ETFs, for example, Italian government debt – the investor is in control.’

Indeed, issuers have started to address investor concerns about fixed income-based ETFs by launching products that track alternatively weighted benchmarks. At the same time, alternatively weighted indices are also gaining traction in the equity space as a way of gaining ‘smarter’ exposure to underlying markets.

Earlier in the year, Source launched an ETF designed to provide value-focused exposure to the European equity market. The MSCI Europe Value Source ETF is designed to give investors a European value strategy by tracking a diversified index while offering intraday liquidity.

The underlying MSCI Europe Value EUR Total Return (net) index is a subset of the MSCI Europe benchmark and focuses on stocks that show value as opposed to growth.

The index comprises some 214 stocks, representing around half of the market capitalisation of MSCI Europe. The factors used to access a stock’s value include
book value, 12-month forward earnings and dividends.

Source says the launch comes at a time when many companies in Europe are considered undervalued amid the sovereign debt crisis. Rather than pay higher active management fees, however, the ETF is a passive investment that charges 0.35% a year.

‘Value investing has been popular since the 1920s,’ says Hood. ‘This ETF allows investors to implement a European value strategy quickly and easily, while maintaining diversification and high liquidity.’

Critical mass

However, as more issuers launch niche products, some of which may struggle to gain traction, more industry consolidation is expected. This means investors need to be wary about the products they opt for and avoid seeing their fund delisted and closed.

‘If you launch funds, some are not going to succeed,’ says Lytle. ‘Part of being an ETF issuer is some will do better than others. But it doesn’t mean if some don’t amass assets that you’ll close them.

‘A lot of what we do is identify existing clients who use our products, who come to us and say, "I really like this and if you did this, then I’d buy it". We then go and find a critical mass of people who want the same thing. This critical mass is the basic building block of a successful fund.’

Only a few weeks ago it was alleged that Credit Suisse would sell its ETF arm, with reports suggesting that State Street Global Advisors or BlackRock will snap it up. Indeed, the future of the industry will be shaped, to an extent, by consolidation.

‘Consolidation is inevitable and we are proponents of it,’ says Joe Linhares, European head of iShares. ‘We have a fractured industry with more than 40 providers, which means liquidity is fragmented. We think consolidation is good for investors over time because it will lead to greater liquidity and more focus on a handful of fund groups.’

The issue with the broader ETF environment is that more than 20 providers have less than $5 billion in assets under management, says Linhares. ‘I can’t see how those operations are profitable. In a tight economic environment the question is how viable are they?

‘Investors need to be smart about choosing an ETF. There is a lot of choice, so you need to look for a strong parent company that has a track record of building and growing its franchise. I would be less interested in an investment in a subscale ETF.’

Nonetheless, despite the importance of selecting the types of products that are able to gain traction, investors are increasingly searching for more granular exposure to asset classes or smarter ways to access markets.

The industry will continue to evolve, but with new product development comes the need for education. With the RDR around the corner, more retail investors will start using ETFs, which will also spur on trading volumes and liquidity. However, the danger is that some of these products carry new risks, of which investors must be aware.

The future, then, is one that will likely see fewer product providers who are able to meet demand and launch some of these more niche products, and continue to back them. By combining assets and bringing more scale to ETFs, it will bring more trading volume and, ultimately, enhanced liquidity for end-investors. The prominent positions of the likes of Vanguard and BlackRock will still be challenged, however, by other providers and the ongoing fee competition, which should continue to lower costs for investors.

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