The universe of passive investments has grown exponentially in recent years. By the end of April, 1678 exchange traded funds (ETFs) with assets of $706.87bn (E525bn) were listed on 43 exchanges around the world, and while year to date assets had fallen by 0.5 per cent, relative to other investments, the sector has grown and the 0.5 per cent decline is markedly less than the 3 per cent fall in the MSCI World index.
“The reality is that there has been a seismic shift in the use of passive vehicles, not only because of lower costs but also because of regulatory change,” says Eleanor Hope-Bell, head of wealth sales at iShares. “Investors are looking at the level of transparency, in both the underlying investment and the fees, and whether there are any kickbacks payable to the distributor by the asset manager. This is something of a slow burner but it is a factor in ETFs becoming more and more prevalent.”
Disappointment with active funds has also prompted a re-think, particularly as active funds are often thought to outperform in bear markets. According to a Standard & Poor’s study issued in April , this is a myth, and in reality in the five years 2004-08, the S&P 500 outran 71.9 per cent of active large cap funds, the S&P MidCap 400 outran 79.1 per cent of mid cap funds and S&P SmallCap 600 outperformed 85.5 per cent of small cap funds. These results are similar to the previous five year cycle from 1999 to 2003.
Style differences do not appear to help much either. The majority of active funds in eight of the nine domestic equity style boxes lagged the index in 2008, and benchmark indices also outperformed the majority of active fixed income funds in every category over a five-year horizon.
The current focus is the rally in shares, and there have been particularly big inflows into emerging markets, notably China and India which are recovering fast, and for certain markets such as Korea and Taiwan where an investor would otherwise need foreign investor status.
“A lot of investors feel they have missed the equity rally in the last two to three weeks,” says Dan Draper at Lyxor. “Suddenly they are not content with low interest rates and low yielding returns on risk-free assets like Gilts. Therefore, they are rushing to put some portion of their cash to work. ETFs give them immediate access to the broad equity markets. The Lyxor FTSE 100 ETF has gained 41 per cent additional assets in the last three months, and other big benchmark indices have also seen huge inflows. It is clear that investors do not want to be too granular in their investment decisions now. They prefer top-down macro investing over stock picking.”
Efficient diversification
ETFs are used by asset managers to achieve a high level of diversification quickly and efficiently. “You can do great things with just a few trades,” says Charlie Morris, manager of the Absolute Return Service at HSBC Global Asset Management. “If the driver behind a trade is 90 per cent due to the market and 10 per cent due to the manager, then an ETF will win every time, particularly if the time horizon is a year or two. You may as well get the certainty, lower fees and ease of transaction,” he says. His funds have used ETFs for exposure to a range of markets such as South Africa and Taiwan.
“In Europe, the large private banks are using ETFs in their multi-manager funds, and more recently funds of ETFs. Some are being developed in a systematic way and some are available on a bespoke basis. These funds often involve strategic asset allocation, and sometimes more active tactical asset allocation, as switching between markets is clean, quick and simple,” adds Ms Hope-Bell.
Barclays Wealth, for instance, launched its Global Beta funds last September offering a range of globally diversified portfolios that invest in ETFs, while the Guinness family has launched a fund of ETFs to the retail public that replicates its own asset allocation.
“For the private wealth segment, ETFs continue to gain in popularity, and we increasingly receive calls about providing educational materials to support the use of ETFs in wealth managers’ asset allocation models,” says Lyxor’s Mr Draper. “The first wealth managers to use ETFs widely were family offices and ultra-high net worth individuals because they are typically highly influenced by charity and endowment sectors, which were pioneering ETFs in the US about a decade ago.
“There is a huge opportunity in the lower wealth management end, what we might call the core affluent market, which might include those with E1-2m of liquid assets or less,” he adds. This is the sector seeing rapid growth. ETFs are particularly useful in obtaining the full asset allocation required for multi-asset class portfolios. Some institutional funds have minimum investment sizes and various buying and selling restrictions.
