This “search for yield” has been complicated further by the ongoing collapse in government bond yields in major markets and historic low returns on cash. The German government’s latest issue of 10-year bonds with a negative yield is a powerful illustration of a) how traditional sources of income have shifted and b) how hard it has become to find investments offering decent income.
So in the context of “income”, much of the conversation has moved away from government bonds and into equities or higher risk fixed-income asset classes (see chart below).
As markets have become more uncertain and returns have come under pressure, there has also been a significant focus on fees and charges and the performance of funds. Traditional actively managed products have been criticised for, by and large, underperforming benchmarks and indices and charging large fees for doing so.
Perhaps unsurprisingly, this has now become a regulatory issue, with the focus on so-called “closet trackers” becoming a high-profile subject of discussion.Another major market trend over the past few years, one not unrelated to the above, has been the staggering rise of passive investment products – in particular, Exchange Traded Funds (ETFs) tracking simple broad “beta” benchmarks and the development of “smart beta” ETFs tracking indices that break away from simple market-cap weighted benchmarks but in a systematic rather than a discretionary way.
The growth in ETFs has been driven at least in part by the fact that they offer lower fees and charges than actively managed products.
Morningstar data shows that, as at the end of July 2016, there was $548bn invested in “strategic beta” or smart beta ETFs globally (which accounts for just under one-fifth of all ETF assets). This is still only 1.3 per cent of global fund assets, underscoring the significant growth potential still in ETFs and smart beta products.
The growth rate of smart beta ETFs has been astounding and the momentum is still there: smart beta ETFs have grown assets by 27 per cent a year since 2010 on a global basis.
| Smart beta ETF growth - global | |||||||||
| AUM ($bn) | 2010 | 2011 | 2012 | 2013 | 2014 | 2015 | Jul-16 | % growth 2010-current (annualised) | % of current smart beta ETF AUM |
| Dividend | 35.2 | 54.1 | 76.3 | 126.3 | 154.9 | 161.1 | 179.8 | 34% | 33% |
| Value | 32.7 | 31.9 | 40.7 | 61.6 | 77.2 | 81.3 | 92.9 | 21% | 17% |
| Growth | 37.7 | 39.3 | 45.5 | 66.3 | 80.7 | 95.1 | 94.3 | 18% | 17% |
| Other | 41.4 | 40.5 | 60 | 91.8 | 122.8 | 148.6 | 181.2 | 30% | 33% |
| Total | 147 | 166 | 223 | 346 | 436 | 486 | 548 | 27% | 100% |
| Source: Morningstar | |||||||||
A growing number of smart beta ETF products have been designed to meet the need for increasingly scarce income, specifically focusing on high dividend-paying stocks screened to favour sustainable income. ETFs focused on dividends have grown 34 per cent a year since 2010 and now make up one-third of smart beta assets.
As IFAs focus their clients’ portfolios on income, ETFs are set to play a growing role in this. In the UK, the focus on passive funds and take-up of ETFs has become very strong. Recent Investment Association figures published in August, for instance, showed that tracker fund assets have hit £126bn, equivalent to 12 per cent of all UK fund assets.
A recent report from PwC stated that the European ETF market is expected to grow 27 per cent per annum over the next five years ― more than the 23 per cent forecast in the US and 18 per cent in Asia. Overall, the firm stated that assets under management in ETFs globally are expected to more than double in size over the next five years, to $7trillion by 2021.
I firmly believe that, in the UK, ETFs will continue to take further market share, both from actively managed funds and fund managers but also traditional tracker passive funds – and that financial advisers will play an increasingly large part in this market growth. Advisers will be all too aware of the focus on income and the fallibilities of many actively managed funds. In contrast, the evidence around long-term outperformance, lower charges and – in the context of smart beta – innovation, will continue to be very compelling.
It is likely that interest in agile, income-focused investment products will remain significant and relevant over the foreseeable future, particularly as current central bank philosophies and policies suggest that downward pressure on rates is unlikely to go away any time soon.
This was evidenced most recently in August by the Bank of England lowering the base rate to 0.25 per cent and increasing the use of quantitative easing tools, among other things. In such an environment, being smarter about income remains vital.
Chris Mellor is executive director, Product Strategy at Source
