Exchange Traded Funds (ETF)

Developing ETF Trends and Innovations – EDHEC Risk Research

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The most recent EDHEC Risk Institute’s European Exchange Trade Funds (ETF) survey* provides valuable insights into the developing trends and innovation in relation to the use of ETF in a diversified and robust portfolio.

The following Post outlines the key findings of the EDHEC ETF survey, which is well worth reading.

 

The changing Purpose of using ETFS

Increasingly ETFs are being used for tactical allocation purposes. Historically the dominant purpose of ETF usage has been to gain a truly passive investment, a long-term buy-and hold investment to gain broad market exposures via the major market indices.

Results by EDHEC indicate there is now a greater usage of ETFs for tactical allocations rather than their role for long-term positions (53% and 51% respectively).

The survey also noted:

  • Gaining broad market exposure remains the focus of ETF for 73% of users, compared with 52% of respondents using ETFs to obtain specific sub-segment exposure.

 

As EDHEC note, the increasing focus on sub-segment exposures can be linked to product development, “which has led to the introduction of new products for a multitude of sub-segments of the markets (sectors, styles etc.). It also correlates with the growing use of ETFs for tactical allocations, which tend to favour a more granular investment approach over broad exposures.”

 

ETF Use continues to Grow**

The adoption of ETF continues to grow, particularly for the traditional asset classes. “In 2019 91% of respondents used ETFs to invest in equities, compared with 45% in 2006. As for governments and corporate bonds, the result went from 13% and 6% in 2006, to 66% and 68%, respectively, in 2019…”

“Investors prefer ETFs for traditional asset classes over alternative asset classes in line with this expression of conservatism in their use of ETFs, which is mainly focused on gaining access to broad market exposure”….

The Survey recorded a high level of satisfaction by investors with ETF in the traditional asset classes.

The survey also notes:

  • A high percentage of investors (46%) still plan to increase their use of ETFs in the future, despite the already high maturity of this market and high current adoption rates
  • Lowering investment cost is the primary driver behind investors’ future adoption of ETFs (74% of respondents in 2019).
  • ETF investors are planning to increase their ETF allocation to replace active managers (71% of respondents in 2019) and replace other passive investing products through ETFs (42% of respondents in 2019)

 

Future Growth and ETF Innovation Drivers

“Ethical/SRI and smart beta equity / factor indices are the main expectations for further development of ETF products”

Further developments where called for in the following market segments:

  • 31% of respondents wished for further development of Ethical/Socially Responsible Investing (SRI) ETFs.
  • ETFs related to advanced forms of equity indices – namely those based on multi-factor and smart beta indices – 30% and 28% of respondents

 

In aggregate 45% of respondents would like further development in one of the following areas of either smart beta indices, single-factor indices, and multi-factor indices.

 

More specifically, the EDHEC Survey found that “respondents would like to see further development of smart beta and factor investing products in the area of fixed income”……“The integration of ESG into smart beta and factor investing, and strategies in alternative asset classes (currencies, commodities, etc.), closely follow.”

 

EDHEC conclude, “It is likely that the development of new products corresponding to these demands may lead to an even higher take-up of smart beta and factor investing solutions.”

 

Criteria for selecting ETF Providers

The two main drivers of selecting an ETF provider are Cost and the quality of Cost and Quality of Replication. These two criteria dominate the survey results.

The long-term commitment of the provider, range of solutions, and level of innovation also rank highly.

 

Smart Beta and Factor Investing

The EDHEC Risk Survey has a large section on the drivers of using Smart Beta and Factor Investing Strategies.

Motivation for Smart Beta and Factor investing strategies include improving performance and managing risk

Albeit, the adoption of these strategies is a small fraction of portfolio holdings.

 

Concluding Comments

EDHEC found that there was a preference for passive for open-ended passive funds to invest in equity products, and active solutions to invest in fixed income products.

In relation for smart beta and factor investing the “take-up remains partial despite more than a decade of discussion in the industry, with the vast majority of adopters investing less than 20 per cent of their portfolio in such approaches.”

They find that this is partly due to a lack of ‘transparency and difficulty in accessing information about such strategies”….“In the case of fixed income strategies, investors express doubts over the maturity of research results at this stage. They also see a need for further development of long/short equity strategies based on factors, strategies that address client-specific risk objectives, and strategies that integrate environmental, social and governance (ESG) considerations.”

Personally, I see an increasing demand for smart beta and factor investing within fixed income strategies. Whether this is within an ETF structure, time will tell.

 

Therefore, for product provides to capture the growth and innovation outlined above, as EDHEC highlight, there is work to be done “to improve their solutions for smart beta and factor investing strategies if they are to make it into the mainstream.”

This is an area of opportunity for ETF providers, particularly if it includes an ESG overlay.

 

Happy Investing

 

Please read my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

* The 2019 EDHEC survey gathered information from 182 European investment professionals concerning their practices, perceptions and future plans. Respondents are high-ranking professionals within their organisations (34% belong to executive management and 42% are portfolio managers), with large assets under management (42% of respondents represent firms with assets under management exceeding €10bn). Respondents are distributed across different European countries, with 12% from the United Kingdom, 70% from other European Union member states, 14% from Switzerland and 4% from other countries outside the European Union.

* *  At the end of December 2018, the assets under management (AUM) within the 1,704 ETFs constituting the European industry stood at $726bn, compared with 273 ETFs amounting to $94bn at the end of December 2006 (ETFGI, 2018b).

How do Exchange Traded Funds (ETFs) stand up to rigorous analysis?

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Exchange Traded Funds (EFTs) have not been subject to the same level of rigorous analysis undertaken upon actively managed funds.  Yet, ETFs are challenging conventional actively managed funds.

While performance of actively managed funds has been extensively investigated, there is not much known yet about the performance of ETFs.

A recent Paper by Robeco provides insightful analysis of ETF’s performance.

Robeco conclude “that the allure of ETFs finds little empirical support in the data and that ETFs have yet to prove that they can generate better performance than conventional actively managed funds.”

The Robeco paper provides a giant leap forward in bridging the imbalance of analysis between actively managed funds and ETFs.

 

Robeco rightly points out, the growth in ETFs has come with little supporting evidence.

They note there are areas in which to be cautious:

  1. “the main differentiator of ETFs, continuous trading, should be of little relevance to passive investors, since the whole idea of the passive approach is to buy and hold for the long term and refrain from trading altogether.”
  2. “not every ETF involves low costs. Whereas the cheapest ETFs have annual expense ratios below 0.05%, there are also ETFs with expense ratios above 1%, which makes them more expensive than many mutual funds”
  3. “if the purpose of ETFs were to facilitate passive investing, then, in theory, one ETF on the broad market portfolio would suffice. In reality one would expect perhaps a few more funds because of practical matters such as competition between different providers, different asset classes, or different time zones; however, not thousands of funds. While there is a handful of very big ETFs which track a broad market index such as the S&P 500, the vast majority of ETFs track indices that themselves represent active strategies.“

 

The Robeco analysis covers US-listed ETFs investing in US equities. It includes analysis of over 900 ETFs, almost $1.9 trillion in AUM, over the period 1993 to the end of 2017.

The Robeco paper also provides a very good analysis on the breakdown of the ETF market, history, size, and different types of strategies.

 

The Results

Robeco’s analysis is the same as that applied to actively managed funds in the academic literature.

“Based on realized returns, 60% of ETFs underperformed the market, 80% exhibited higher volatility, and 80% underperformed in terms of Sharpe ratios. Such figures do not appear to be much different from what has been reported for actively managed mutual funds.“

Robeco zoom in on the different types of ETFs, they find:

  • the small number of generally big ETFs, which aim to track one of the broad market indices, live up to their promises.
  • The weak overall performance of ETFs turns out to be mainly driven by the large number of ETFs that do not aim to replicate any of the broad market indices. In particular, leveraged and inverse equity ETFs

 

Factor Analysis

Robeco undertook analysis on ETFs invested into common investment styles e.g. size, value, momentum, quality, and low-risk.

Their analysis highlighted that none of them managed to consistently add value relative to a capitalization-weighted market portfolio of all US stocks.

“The magnitude of these alphas again appears to be quite similar to what one might expect from conventional actively managed funds.”

This can be partly attributed to the poor performance of equity factors over recent years. The recent environment has not been favourable for the performance of many equity factors e.g. Value.

As Robeco note, “Given that some factor ETFs do provide large and significant exposures to the targeted factors, they can be expected to add value if factor premiums rebound in the future. A caveat here is that the factor exposures of some ETFs may have been obtained by pure accident, which means that these exposures might change in the future.”

In other words, implementation of the factor exposure is critical, this will determine success or otherwise.  The implementation of the factor approach undertaken by the ETF needs to be appropriately researched.

 

Conclusions

Robeco conclude “the performance of ETFs is not as impressive as one might expect it to be, as investors in these ETFs have collectively realized a performance that does not appear to be much different from the performance that can be expected from the conventional actively managed mutual funds.”

 

This Post is not to be taken as an assault on ETFs, they can play a role in a robust portfolio. As can active management. There are shades of grey in investment returns, as a result the emotive active vs passive debate is outdated.

Nevertheless, the growth in Exchange Traded Funds has been spectacular over the last decade and it is only appropriate they are subject to the same level of rigorous research as an actively managed investment strategy.

All investment decisions should be based on robust, independent, diligent, and thorough investment analysis.

Although this may appear self-evident too many, there are good reasons to be cautious in the selection of ETFs as highlighted by the Robeco analysis.

 

In fact, the future trends in ETFs is rather daunting, as highlighted by a 2018 EDHEC ETF Survey.  EDHEC updated this Survey in 2019.

 

Happy Investing

 

Please see my Disclosure Statement

Global Investment Ideas from New Zealand.  Building more Robust Investment Portfolios.

 

 

 

 

Kiwi Wealth caught in an active storm

/ Kiwi Investor / 4 Comments

We need to change the conversation on investment management fees.

Kiwi Wealth recently released an insightful article on the case for having your money managed actively.

This article has, inevitably, being meet with a passionate defence of Index Management (also referred to as Passive Management). A debate that has been going on for some time, and we really need to move on!

Kiwi Wealth make the following comment in the introduction:

“The “active versus passive” debate has been a fixture in the investment industry for nearly 50 years. Passive investing is one of the cheapest ways to access equity markets globally, and has helped to drive down fees across the board. Passive investment managers and their suppliers have gone further than just offering low cost products however, and have portrayed actively-managed portfolios as a bad option for investors. We disagree, and believe, headlines supporting passive investing are largely driven by passive investment managers and index providers looking to frame the debate to their own advantage.”

 

I can’t disagree with that.

As the Kiwi Wealth paper touches on, there is a role for passive and active in constructing a robust portfolio.

The debate has moved on from black vs white, active vs passive, there are shades of grey in return outcomes (but maybe not 50 of them!).

The black and white debate is evident in this GoodReturns article, Passive Managers Reject Criticism. Also note the comments section as well.

 

I have written a number of Posts on Index management, highlighting their limitations, and risks, albeit I can see a role for them as part of a portfolio, as I can active management.

As with active management, it is important to understand and appreciate the limitations of what you are investing in.

I also hope we don’t follow Australia’s lead as an industry and focus too much on investment management fees. There is an appropriate level of fees, but it is not the lowest cost provider.

We need to change the conversation on investment management fees as recently highlighted by BlackRock, a large Index/Exchange Traded Fund (ETF) provider.

 

Index Funds do buy high and sell low, primarily because companies move in and out of indices.

Analysis by Research Affiliates highlights the trading costs of Index Funds (Passive Funds). Index Fund providers understand this and seek to minimise these costs.

As an aside, passive index funds are not passive, they are actively managed.

Albeit, there are huge trading costs around market index changes over time. These costs are incurred by the Index Funds, yet the costs are not evident given they are also included in market index returns. Index Funds incur these costs.

These costs are high, Research Affiliates estimates the difference in return between a company exiting and entering an Index to be 9.52%. The majority of this performance difference occurs on the day of index changes. It also only occurs on that proportion of the portfolio that is changing.

Stocks entering an Index tend to underperform over the next 12 months, while those leaving an Index tend to outperform over the following year.

For more, see this article on why low cost index investing is not necessarily low risk.

In another Post I highlighted that Index Funds have exposure to unrewarded risks and are often poorly diversified e.g. think when Telecom made up over 30% of the NZX and the US market is currently highly concentrated.

 

These articles are separate to the current issue of overvaluation in sectors of the US market, recently labelled, rather misleadingly, an Index Bubble, by Michael Burry, who was one of the first investors to call and profit from the subprime mortgage crisis of 2007-08 that triggered the Global Financial Crisis.

 

Just on active management, there is a growing level of academic research challenging the conventional wisdom of active management and in support of active management, as I highlight in the Post Challenging the Convention Wisdom of Active Management.

The research Paper attached to this Post is the most downloaded paper from Kiwiinvestorblog.

 

Closely related, and what has busted open the active vs passive debate, leading to the shades of grey, is the disaggregation of investment returns – the isolation of drivers of investment returns.

As the Post highlights returns can be broadly attributed to three drivers: Market returns (beta), factors and hedge fund strategies beta, and alpha (returns after the betas, which can be purely attributed to manager skill).

The disaggregation of investment returns is prominently expressed by factor investing (e.g. value, momentum, low vol) and that investors can now access “hedge fund” type strategies for less than what some active equities managers charge. These are “active” returns.

The disaggregation of returns and technology will drive future ETF innovation, particularly within the Fixed Income space and alternative investments.

As you know, the isolation of the drivers of investment returns is also driving the fee debate, as the Kiwi Wealth paper infers, investors do not want to pay high fees for an “active” return outcome that can be sourced more cheaply.

 

Happy investing.

Please see my Disclosure Statement

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Future trends in ETFs are rather daunting. Are you prepared?

/ Kiwi Investor / 3 Comments

The recent survey by EDHEC-Risk Institute (EDHEC) of European professional investors into their practices, perceptions and future plans for investing into Exchange Trade Funds (ETF) is of interest and well worth reading.

The survey gathered information from 163 European investment professionals. Respondents to the survey were high-ranking professionals within their respective organisations, representing firms with large assets under management (36% of respondents represent firms with assets under management exceeding €10bn). Respondents to the survey are from the United Kingdom, European Union, Switzerland, and a small sample from other countries outside the European Union.

 

What is the dominant purpose of ETF usage?

The survey results clearly indicate that the current usage of ETFs is dominated by a truly passive investment approach. “Despite the possibilities that ETFs offer – due to their liquidity – for implementing tactical changes, they are mainly used for long-term exposure.”

Gaining broad market exposure remains the main focus of ETF users – 71% of respondents use ETFs to gain broad market exposure, versus 45% who use ETFs to obtain specific sub-segment exposure (sector, style).

“In line with this expression of conservatism in their use of ETFs, which is mainly focused on traditional passive management, it can also be noted that investors are largely satisfied by ETFs in traditional asset classes but more reserved about ETFs for alternative asset classes”

 

What are the future growth drivers?

The European ETF market has seen tremendous growth over the past decade or so. At the end of December 2017, the assets under management (AUM) within the 1,610 ETFs constituting the European industry stood at $762bn, compared with 273 ETFs amounting to $94bn at the end of December 2006 (ETFGI, 2017).

“A remarkable finding from our survey is that a high percentage of investors (50%) still plan to increase their use of ETFs in the future, despite the already high maturity of this market and high current adoption rates.”

Why? lowering investment cost is the primary driver behind investors’ future adoption of ETFs for 86% of respondents in 2018 (which is an increase from 70% in 2014).

Interestingly, EDHEC find investors are not only planning to increase their ETF allocation to replace active managers (70% of respondents in 2018), but are also seeking to replace other passive investing products through ETFs (45% of respondents in 2018).

 

How do investors select ETFs?

Cost and quality of replication. Both of which are more easy to identify from a quantitative perspective.

EDHEC argue” Given that the key decision criteria are more product-specific and are actually “hard” measurable criteria, while “soft” criteria that may be more provider-specific have less importance, competition for offering the best products can be expected to remain strong in the ETF market. This implies that it will be difficult to build barriers of entry for existing providers unless they are related to hurdles associated with an ability to offer products with low cost and high replication quality.”

 

A section I found more interesting:

What are the Key Objectives Driving the Use of Smart Beta and Factor Investing Strategies?

EDHEC find that “the quest for outperformance is the main driver of interest in smart beta and factor investing. In fact, 73% of respondents agree that smart beta and factor investing indices offers significant potential for outperformance”

The most important motivation behind adopting such strategies is to improve performance.

Interestingly they find that the actual implementation of such strategies is still at an early stage

EDHEC found that among those respondents who have made investments in smart beta and factor investing strategies, these investments typically made up only a small fraction of portfolio holdings.

“More than four-fifths of respondents (83%) invest less than 20% of their total investments in smart beta and factor investing strategies and only 11% of respondents invest more than 40% of their total investments in smart beta and factor investing strategies”

As they say, ”It is perhaps surprising that almost a decade after the influential report on Norway’s Sovereign Wealth Fund (see Ang, Goetzmann and Schaefer, 2009), which emphasised the benefits of factor investing for investors, adoption of such an approach remains partial at best.

 

Not surprisingly, those that use factor strategies, the use of them is not related to factor timing and more to extracting the long term premia from the factors.

 

In relation to fixed interest, “17% of the whole sample of respondents already use smart beta and factor investing for fixed-income. Some 80% of this sub-sample of respondents invest less than 20% of their total investment in smart beta and factor investing for fixed-income.”

It appears that respondents show a significant interest for smart beta and factor investing for fixed-income. The interest appears to be there, but likelihood of implementation not so much.

Interestingly, from responses “it thus appears that investors are doubtful that research on factor investing in fixed-income is sufficiently mature at this stage. Given the strong interest in such strategies indicated by investors, furthering research in fixed-income factor investing is a promising venture for the industry.”

 

The survey looked into a number of other areas, for example do investors have the necessary information to evaluate smart beta and factor investing strategies? What requirements do investors have about smart beta and factor investing strategy factors?

 

Future Developments

What are investor expectations for further development of ETF products?

The following areas where identified as potential are of further ETF product development:

  • Ethical/Socially Responsible Investing (SRI) ETFs,
  • emerging market equity ETFs and emerging market bond ETFs,
  • ETF indices based on smart beta and on multi-factor indices, EDHEC note that more than two-fifths of the respondents want further developments in at least one of the categories related to smart beta equity or factor indices. “This shows that the development of ETFs based on advanced forms of equity indices is now by far the highest priority for respondents.”……… “We also note that additional demand for ETFs based on smart bond indices is not so far behind”…..

 

Fixed Income and Alternatives

The survey results indicate that respondents desire further development in the area of fixed income and alternative asset classes.

Also there is an increased interest in integration of ESG in smart beta and factor investing, and strategies in alternative asset classes.

“So, there is still a lack of products when it comes to asset classes other than equity, and this lack is particularly critical for the fixed-income asset class, which is largely used by investors.”… “It is likely that the development of new products corresponding to these demands may lead to an even wider adoption of smart beta and factor investing solutions.”

  

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement