ETFs offer more than cheap beta

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ETFs offer more than cheap beta
Pexels/Guillaume Meurice

The exchange-traded fund market has enjoyed tremendous growth and currently has more than $9tn (£6.6tn) in assets under management, of which $1.6tn is in Europe. 

Bank of America recently estimated global ETF AUM will reach $50tn by 2050, with the growth coming at the expense of mutual funds, despite their currently having the lion’s share of global AUM.  

So, what are ETFs and why are they so successful?

They are a wrapper to deliver an investment strategy to an investor, which is effectively the same as a mutual fund.

However, the ETF wrapper is an improvement on the mutual fund similar to how mobile phones are an improvement on landlines and electric cars are an improvement on petrol or diesel vehicles. 

One of the major improvements is that ETFs are tradable, so an investor can get 'Amazon Prime' gratification from buying and selling instantly on a stock exchange as opposed to having to complete a form, attach a cheque and wait a week to get a price.

They also tend to be cheaper, with total expense ratios as low as 0.02 per cent annually and rarely above 1 per cent, while mutual fund charges range between 1per cent and 3 per cent.

ETFs are also transparent with regard to the assets they hold and publish this information daily, compared to mutual funds that tend to only disclose holdings monthly, which means the information is out of date, and usually only publish the top 10 holdings.

The first stage of the ETF market has been what is commonly termed as passive. Passive ETFs track well-known indices like FTSE 100, S&P 500 and Eurostoxx 50.

Investors quickly warmed to passive ETFs and used them as core holdings in their portfolios. This adoption meant that investor portfolio costs fell dramatically.

Lower cost portfolios bring massive benefits to long-term investors and saving 1 per cent in fees each year over decades will multiply performance considerably.

Many academics believe that lower fees are the most effective way to grow investments in the long term.

The growth in ETF and passive investing has shone a light on active managers who stock pick rather than use an index to select investments.

They have tended to charge higher fees and on average have underperformed the main indices. This has led to many of the worst performers being weeded out and only the active managers who can demonstrate true alpha surviving. 

The success of ETFs in the passive market has made them hugely popular, but it also means many people conflate passive and ETFs; the reality is that an ETF is just a wrapper.

As a result, ETF investors over the last few years have started demanding more types of investment strategies in ETF form. 

This most notably includes smart beta, thematic, active and niche strategies. I believe that eventually all new funds that have daily liquidity will end up in the ETF wrapper.

ETF investors want to be able to add all investment strategies and that has happened over the past five years, with many of the new ETFs being developed moving away from passive.

The rise of thematic ETFs

Thematic ETFs have been a major area of innovation. 

Lots of investment products can be intimidating and complicated for investors and talking about smart beta, value or growth investing does not help.

However, most people have an opinion on thematic investments as they are usually part of their everyday lives or interests. They include e-commerce, cloud technology and health care to name a few.

Thematics may not be suitable to replace the majority of someone’s core portfolio, but they can provide a nice 'sleeve' on top of the core to deliver some long-term growth and upside.

The great beauty of thematics is that you can excite your imagination.

Our current range includes space technology; medical cannabis; 5G infrastructure; energy infrastructure; e-commerce; solar power; clean energy; cryptocurrencies; online gaming; travel and airlines; software; ESG gold miners; decarbonisers; cleaner living; cloud technology; and health care innovation.

We and our competitors are planning many more and innovation is key. 

Other providers offer exciting themes such as semiconductors; healthy food; cybersecurity; robotics; battery technology; alternative transport; big data; social media; and blockchain technology.

This is not an exhaustive list but is a great indicator of the wave of product innovation coming to the ETF market.

It is important investors know the risks when investing in ETFs. A strong portfolio is diversified and that will be dominated by core beta, including equities and bonds.

More esoteric investments like thematics should be a smaller part of the portfolio – commonly termed 'satellite' exposures.

As these are growing trends, they can be volatile, although a good thematic is usually a long-term trend, so investors need to consider that when investing. 

ETFs: the next frontier

Active ETFs are probably the next frontier for the European ETF market, as what happens in the US tends to be followed here. Typically, the US is three to five years ahead in AUM growth and product innovation.

If this is the case, then it is only a matter of time before active ETFs become commonplace in Europe.

Over the past two years active ETFs have gone from nowhere to being the main battleground for providers in the US and we expect that to happen in the UK and Europe. 

The US Securities and Exchange Commission changed their rules around two years ago to allow active ETFs to be issued en masse.

That enabled active managers to provide minimal holdings disclosure and made them comfortable about issuing ETFs. Until that change was made they had to give full daily disclosure of holdings. 

Following the rule change, many traditional asset managers who avoided the US ETF market rushed to issue ETFs.

The result is that 2021 has been the first year where active ETF new-product filings at the SEC have exceeded passive. Asset managers like JPMorgan and Dimensional have converted billions of dollars of mutual fund AUM into ETFs. 

In Europe active ETFs exist, but the market is still nascent. Pimco led the way with a range of bond ETFs and we have issued the world’s first Shariah global equity ETF, and a sustainable ESG global equity active ETF.

It is still early days for active ETFs, but watch this space. My prediction is it will be the hottest growth area in two or three years’ time.

It will mean European regulators having to follow the SEC and allow flexibility to active managers around disclosure. 

The ETF growth story will continue and has a long way to run.

Hector McNeil is co-chief executive at HANetf