The exchange-traded fund industry has evolved dramatically during the past few years and ETFs have gained a tremendous amount of assets. That said, providers still have a lot of work to do to ensure all clients understand the merits and applications of these modern investment tools.
Within the overall ETF market in Europe, the vast majority of investors allocate to ‘plain-vanilla’– or market-capitalisation weighted – ETFs, which represent more than 90% of the total sector in the region.
The adoption of plain-vanilla ETFs has been very strong in the US, especially on the retail side, as those tools provide a tax advantage that is non-existent in Europe.
As a result, the split between retail and institutional ETF investors in the US stands at around 50:50.
In Europe, institutional investors are still the ones driving ETF assets, although this is changing, thanks to regulations such as the UK’s Retail Distribution Review creating a more level playing field for ETFs.
ETFs are now part of the wider investment landscape and represent an additional option for clients to use alongside more traditional investments, and come in a variety of types.
The benefits of ETFs
Market-capitalisation weighted ETFs track an index that is built using the size of a firm as the main criteria. The bigger a company, the bigger the weight in the portfolio.
When an investor buys an ETF that follows one of the large-cap indices then they can expect to own some of the biggest companies in the world.
From a retail investor’s point of view, ETFs can be a simple and effective tool. Because they are transparent and low cost, an investor can build a very efficient and diversified portfolio by owning only a few of the funds.
Investors who work with the best trading apps UK has to offer used to stock trading will find ETFs intuitive as they trade like a stock. The advantage is you will be able to buy a basket of stocks in one go, reducing costs and making the trade more efficient and diversified.
The challenges of ETFs
Although there are some clear benefits in using those relatively simple indices built on market capitalisation, there are also some challenges investors should be aware of:
- The market-cap indices tend to be backward-looking.
- Market-capitalisation weighted indices can also be counterintuitive as the index keeps buying what is already expensive and selling what is potentially cheap.
- Indices may lead to concentration risk in some countries or sectors and should be looked at closely to better understand what risks are being taken.
The issues are even more acute on the fixed-income side, where bond indices are issuance weighted according to the size of the debt. This means the more debt a company or government issues that meets index criteria, the larger the relative weight it holds in the index. Again, this can seem counterintuitive.
A new generation of ETFs
In an attempt to try and solve the challenges faced by traditional ETFs, such as concentration risk, a new generation of ETFs emerged a few years ago, called smart beta or factor investing.
Factor investing has been around for decades and research on the topic can be traced to the 1930s, when the criteria of quality and value were first looked at.
This early research tells us something pretty straightforward: companies with good balance sheets, good profitability and continuous earnings growth perform better. It also shows that stocks with lower price/earnings or price/book ratios outperform growth stocks.
Up until recently, very few strategies were leveraging that research and some ETF providers, including Franklin Templeton, identified a gap.
The idea is to benefit from anomalies such as quality and value that we see in the market and capture those ‘premiums’ using a very efficient and transparent vehicle such as the ETF.
We are also now seeing increased demand for multi-factor strategies that aim to serve a specific objective of either risk reduction or return enhancement.
In this case it is not just about looking at one criteria but trying to select the companies that score the highest across multiple attributes. Research shows that selecting the right criteria or factor proves difficult and timing those criteria can be challenging. As a result, combining metrics resonates much better with many investors.
Smart beta ETFs are still relatively new to the market and some investors are just getting to grips with single factors. Now multi-factor strategies have started to enter the market there is a whole lot of education to be done to make investors comfortable with them.
What’s next for the ETF sector?
We believe the next development will be around active ETFs. This is a comparatively new sector and assets are only about 1% of the overall ETF market in Europe.
Interest is growing, however, especially as investors are faced with challenges when it comes to investing in fixed income.
An active ETF exhibits the features of a traditional ETF, such as transparency, low cost and flexibility, but instead of following an index it is ‘benchmark aware’. This means it uses the underlying holdings from a certain universe but the ultimate objective is to beat the performance of that universe.
These tools can be a great complement to other ETFs if an investor has high conviction in certain areas and/or wants to overcome some of the pitfalls.
They also represent a cost-efficient means of access to an active manager who will be able to use his/her judgement, skills and expertise to potentially offer better risk-adjusted returns.
We are living through exciting times as more solutions come to the market, giving investors a wide array of tools to choose from.
Providers must offer education and guidance as to what investors are looking to achieve and which strategies are best placed to implement their views, either via traditional market-cap ETFs, smart beta, active ETFs or traditional active mutual funds.
The world of investing is no longer about active or passive, nor is it about smart beta versus market cap. It is about portfolio construction and ultimate objectives.
ETFs at a glance
Proxy for market: ETF typically tracks broad, market-cap weight index (traditional)
Target specific investment income: ETF tracks alternatively designed index (currency hedge, fundamentally or equally weighted, ESG or SRI, smart beta, style-tilted)
Seek to outperform: ETF is measured against benchmark index (actively managed)
The benefits of ETFs are: liquidity, daily transparency of full holdings, cost-efficient, trades on an exchange
Further reading:
Active ETF threat to mutual funds draws sceptiscism
By Caroline Baron, head of ETF sales, EMEA, Franklin Templeton
