Exchange-traded funds have
swollen in popularity in the past years branching out into many
different asset classes. As the increasing complexity of these
passive products draws scrutiny from regulators, Charles Davis
talks to Aite analyst John Jay about the growth in fixed-income
ETFs.
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The rapidly expanding
exchange traded fund (ETF) industry has new and existing players
trying to capture new money by broadening their product range.
Yet, a recent Financial Stability
Board (FSB) note has flagged up growing concerns about the
potential financial stability issues arising from recent trends in
ETFs.
Traditional ETFs are pooled assets
that represent both widely known and customised indices.
The ETF market overwhelmingly
operates in a passive management style in which the fund sponsor
seeks to merely mirror the performance of the selected index.
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By GlobalDataETFs are less actively managed than
mutual funds, but ETFs can transact during the trading day, while
mutual fund transactions must rely on end-of-day net asset value
calculations to transact buys and sells.
Increasing risks around new
ETFs products
Although the large majority of ETFs
track traditional, market cap weighted indices, providers have
extended their product development to more specialised areas, by
using their existing proprietary benchmarks or building new ones
in-house or in collaboration with external index providers.
Overall, though, increasing client
demand for passive products is pushing bank-owned firms to accept
lower margins, rather than see investors go elsewhere, and point
them towards their new and improved ETF products.
From the beginning of 2010, the
number of US-based ETFs in all their forms has nearly doubled. ETFs
have grown from their birth in the early 1990s to becoming the most
traded stocks in the US as their sheer simplicity and cost
effectiveness made them a compelling method of investing not just
for the professional but for individuals as well.
This supposed simplicity is one of
the FSB’s concerns. The FSB noted that there are signs that the low
interest rate environment may be leading investors to search for
yield in more complex non-standard market segments that increase
exposure to liquidity risks.
Synthetic ETFs raise new
challenges
The increased popularity of
“synthetic” ETFs (which use derivatives) raises new challenges in
terms of counterparty and collateral risks.
Fueling the growth of passive ETFs
has been the breadth of coverage of different asset classes being
included, from equities around the globe, commodities,
infrastructure, private equity and property.
This has made it possible to build
a broad range of asset types in portfolios made up solely passives
and ETFs.
Investment managers are freed up to
focus on the asset allocation process and do not have to fret over
the less than predictable performance and operations of the active
fund managers.
There is a growing belief that some
markets, including the US and UK equity markets, have become so
efficient that active managers will find it hard to add value.
US ETF investors pass $1trn
mark
If asset flows are any indication,
passive strategy seems to be winning the day. US investors have
warmed to ETFs in a big way over the past five years and their
growing familiarity with the expanding variety of products
available helped pushed the total value of US ETF assets over the
$1trn mark last month, according to a report from State Street
Global Advisors.
In February alone, investment into
these funds grew 3.5%, or $34.9bn and investors added more than
$6bn to ETFs than they withdrew in February.
This is a clear sign that many
financial advisers and broker-dealers recognise that the growing
variety of ETFs and the tax efficiency of these investment vehicles
make them a viable alternative to mutual funds, annuities and other
traditional investment products.
“ETFs gravitate naturally toward
stocks because that is where the passive investment market has
moved, but fixed-income has been around in all sorts of other
vehicles and is now really growing in the ETF market,” says John
Jay, an analyst at Aite Group and author of the recent report,
Fixed Income ETFs: Just Another Fad, or Here to Stay?
“For the do-it-yourselfers, for
wealthy investors, unless you are a real expert, you have mutual
funds with limited liquidity to the end of each day,” says Jay.
“You are picking up your
investments out of a basket, or you turn to a fixed-income ETF that
gives you needed liquidity for 15-20 basis points less than
comparable products.”
Popularity of fixed-income
ETFs soars
Within the past few years, Jay said
the fixed-income ETF has evolved into a viable investment
instrument. These ETFs were a scarce breed on the fund landscape as
recently as the middle of the last decade, but have multiplied by
about twentyfold since then, with assets under management
increasing by a factor of three since 2007.
While the outlook is positive for
fixed income ETFs, which meet many goals of the investment
community – including offering diversification across asset classes
and serving broad investment strategies – obstacles exist. These
include the need for relatively large amounts of capital to launch
new fixed income ETFs and potential difficulty in developing fixed
income strategies.
“It is not a given that
fixed-income will take off,” Jay says.
“A lot of it has to do with whether
advisers can do a good job of translating to the investor. Still,
we will see a lot of innovations in fixed-income, and a lot of new
launches in the next few years.
“Some will work, and some will not, but it is clearly a wealth
management play that resonates at the moment.”
