THE VALUE OF PER­SPEC­TIVE

Deb­o­rah Fuhr brings years of in­de­pen­dent think­ing and in­sight to the rapidly chang­ing, global ETF land­scape

Investment Executive - - CONTENTS - BY JADE HEMEON

An­a­lyst Deb­o­rah Fuhr of­fers her views on the use­ful­ness of ETFs — and their fu­ture.

In­vest­ment Ex­ec­u­tive con­trib­u­tor Jade Hemeon re­cently spoke with Deb­o­rah Fuhr, widely con­sid­ered the voice and face of the global ETF in­dus­try. Fuhr is manag­ing part­ner and co-founder of ETFGI LLP, an in­de­pen­dent re­search and con­sul­tancy firm in Lon­don, U.K., that fo­cuses on global ETFs. She also is a co-founder and board mem­ber of Women in ETFs, an in­ter­na­tional group.

Q What jumps out at you as the key defin­ing trends and themes for ETFs?

A : ETFs now are viewed as a so­lu­tion, not as the en­emy or some­thing to be frowned upon, as they may have been in the past. In­vestors want to in­vest in more as­set classes and more mar­kets, so there’s a move to­ward in­dex prod­ucts such as ETFs be­cause peo­ple find that it’s dif­fi­cult to gen­er­ate al­pha or out­per­for­mance rel­a­tive to bench­mark in­dices by them­selves. It’s also hard to find mu­tual funds that de­liver al­pha con­sis­tently.

We also see that hedge funds, on av­er­age, are not beat­ing the S&P 500 com­pos­ite in­dex — and that’s been the case for the past seven years. [As­sets un­der man­age­ment (AUM)] in ETFs, glob­ally, sur­passed hedge funds in June 2015 — which is im­pres­sive, given that the first ETFs were launched in Canada in March of 1990 and hedge funds have ex­isted for more than dou­ble that num­ber of years. At the end of 2017, the AUM in hedge funds was less than global ETF AUM by US$1.6 tril­lion.

Q: Has the long-run­ning bull mar­ket led peo­ple to be­lieve the best so­lu­tion is to “buy an in­dex” and not to pick in­di­vid­ual se­cu­ri­ties?

A : It’s dif­fi­cult for any­one to pick stocks that will do bet­ter than the mar­ket con­sis­tently, or to pick a mu­tual fund that’s go­ing to do bet­ter than the mar­ket all the time. And cost weighs in on this. ETFs are more cost-ef­fi­cient for an in­di­vid­ual than buy­ing all the un­der­ly­ing se­cu­ri­ties. To­day, you can buy ETFs that al­low you to choose other in­vest­ment strate­gies be­sides just buy­ing the whole mar­ket. Al­though, when we looked at which ETFs brought in the great­est amount of net new AUM last year, they tended to be broad-mar­ket, core, low-cost ETFs based on mar­ket cap-

weighted in­dices rather than strate­gic beta or ac­tively man­aged ETFs.

Q: What do you fore­see be­ing the most pop­u­lar types of ETFs?

A : Many in­vestors still go for the plain, old build­ing blocks — and that’s best rep­re­sented by SPY [SPDR S&P 500 ETF] in the U.S., which just cel­e­brated its 25th birth­day. That prod­uct is now the world’s largest ETF with more than US$300 bil­lion in AUM, and it’s the most ac­tively traded ETF. I think the trend will con­tinue to­ward core build­ing blocks, driven by the fact these plain-vanilla prod­ucts are not com­pli­cated. They’re also cost-ef­fi­cient, rel­a­tive to fu­tures con­tracts, for large in­sti­tu­tional in­vestors that want to ob­tain par­tic­u­lar ex­po­sures.

Q: Where’s the ETF in­dus­try head­ing with new prod­uct in­no­va­tions?

A : Smart beta and fac­tor-based ETFs will be pop­u­lar, but we’re also see­ing a real pickup in [en­vi­ron­men­tal, so­cial and gov­er­nance (ESG)] fac­tors in the con­struc­tion of spe­cial­ized ETFs. Peo­ple are look­ing for eth­i­cal, sus­tain­able gov­er­nance be­cause what you’re find­ing to­day is that com­pa­nies fo­cused on these is­sues ac­tu­ally demon­strate bet­ter re­sults, which in turn leads to bet­ter stock mar­ket per­for­mance. And so, we’re see­ing peo­ple look at ESG and im­pact in­vest­ing, green bonds and clean en­ergy. Themes also will be im­por­tant, but it’s a mat­ter of the right prod­uct at the right time. Things such as cy­ber­se­cu­rity and other niche ex­po­sures res­onate with some peo­ple.

Q: What is the po­ten­tial of ac­tively man­aged ETFs vs pas­sive ETFs?

A : We’re see­ing robo-ad­vi­sors in Canada of­fer both ac­tive and in­dex-based ETFs, whereas, typ­i­cally, in other parts of the world, robo-ad­vi­sors are em­brac­ing only low-cost, pas­sive ETFs. In Canada, reg­u­la­tions re­quire that ETFs, like mu­tual funds, need only dis­close their hold­ings quar­terly. This makes it eas­ier for ETFs [in Canada] to use ac­tive strate­gies than in the U.S., where the rules re­quire more trans­parency. Canada is a bit dif­fer­ent.

You also have mar­i­juana ETFs in Canada, which are not al­lowed any­where else. You have to re­mem­ber that Canada was first in the world to launch ETFs when TIPs [Toronto 35 In­dex Participation units] were in­tro­duced in March 1990. SPY came out three years later. So, Canada has had a num­ber of firsts [in the ETF space].

Q: What about de­mand for fixed-in­come ETFs?

A : In­di­vid­u­als and robo-ad­vi­sors are us­ing ETFs to build di­ver­si­fied as­set al­lo­ca­tion. So, be­ing able to ac­cess dif­fer­ent fixed-in­come ex­po­sures easily has been use­ful and pop­u­lar for in­vestors. We’ve seen some in­vestors are a lit­tle bit skep­ti­cal and have needed a bit of con­vinc­ing about liq­uid­ity, as fixed in­come is not priced and traded on an ex­change in the way eq­ui­ties are.

There are fewer fixed­in­come in­dex providers and in­dices than on the eq­ui­ties side, but we’re start­ing to see more. Some in­vest­ment fund com­pa­nies, in­clud­ing [Cal­i­for­nia-based] Pa­cific In­vest­ment Man­age­ment Com­pany LLC, have spawned some ac­tive fixed-in­come ETF prod­ucts. Com­pared with eq­uity fund [port­fo­lio] man­agers, fixed-in­come [port­fo­lio] man­agers prob­a­bly are more com­fort­able pro­vid­ing reg­u­lar dis­clo­sure on their hold­ings in ac­tive ETFs.

Q: With the evo­lu­tion be­yond pas­sive strate­gies, are ETFs be­com­ing too com­plex and do in­vestors un­der­stand what they’re buy­ing?

A : I do think it’s get­ting more com­pli­cated. It’s easy for peo­ple to see that an S&P 500 ETF gives ex­po­sure to 500 large U.S. stocks. But when it comes to fac­tor-based and multi-fac­tor ETFs, you find that even the in­dex providers have dif­fer­ent ways of defin­ing and cal­cu­lat­ing things such as mo­men­tum and low volatil­ity. So, yes, it takes more work to un­der­stand some of the new prod­ucts that are com­ing to mar­ket. That cre­ates a bit of an ed­u­ca­tional chal­lenge for the in­dex providers that are try­ing to con­vince prod­uct de­vel­op­ers to use their in­dices, and also for the ad­vi­sors who need to help clients un­der­stand what they’re buy­ing.

Q: Do you have any pre­dic­tions for the growth of global ETF AUM within the next five years? Al­though we’ve just come off a record-break­ing year of global in­flows, what in­ning are we in as far as global growth of the ETF in­dus­try?

A : We’re go­ing to see stronger growth for ETFs rel­a­tive to most other fi­nan­cial prod­ucts. ETFs make it easy for peo­ple to in­vest: they’re sim­ple and cost-ef­fi­cient, and in­vestors can trade in small or large amounts. ETFs are uniquely demo­cratic in that in­sti­tu­tions, fi­nan­cial ad­vi­sors and re­tail in­vestors are able to use the same tool­box at the same low cost, even for small in­vest­ments. Peo­ple un­der­stand that other things be­ing equal, prod­ucts with lower costs tend to per­form bet­ter over time.

With [the in­tro­duc­tion of the sec­ond phase of the client re­la­tion­ship model] in Canada and the in­creased trans­parency on fees and per­for­mance, we’re see­ing the adop­tion of ETFs in­creas­ing among re­tail in­vestors. ETF us­age is in­creas­ing rel­a­tive to pick­ing in­di­vid­ual se­cu­ri­ties, rel­a­tive to ac­tive mu­tual funds and to the use of fu­tures. The beauty of ETFs is that they can be used by so many dif­fer­ent types of in­vestors and for many dif­fer­ent strate­gies.

We’re still in the early stages of growth for the ETF in­dus­try, es­pe­cially glob­ally. The first ETF in Kenya was just launched this past year. But even in the U.S., there’s still a lot of room to grow, as ETFs are be­ing used for dif­fer­ent kinds of ex­po­sure. In­vestors are learn­ing that it’s in­creas­ingly dif­fi­cult to find ac­tive funds that can de­liver al­pha con­sis­tently, and that you also can gen­er­ate al­pha through as­set-al­lo­ca­tion strate­gies. ETFs also are be­ing used more for fixed-in­come and al­ter­na­tive strate­gies.

Q: We en­joyed a bull mar­ket for stocks for sev­eral years. In more bear­ish con­di­tions, are ETFs vul­ner­a­ble?

A : Some­times with volatil­ity, you find that ETF trad­ing in­creases. The value of AUM might go down in a cor­rec­tion — if there’s a 10% cor­rec­tion in eq­ui­ties mar­kets, the value of mar­ket-linked eq­uity ETFs goes down 10%. And ETFs would also be im­pacted by as­set flows. But I don’t think a cor­rec­tion is go­ing to cause peo­ple to not want to use ETFs. They showed re­silience dur­ing the 2008-09 global fi­nan­cial cri­sis.

Q: Is the mar­ket be­com­ing sat­u­rated with new prod­ucts and play­ers?

A : Providers are try­ing to dif­fer­en­ti­ate with the new prod­ucts they of­fer. Many of the newer is­suers are try­ing to wrap ETFs into port­fo­lio so­lu­tions, so they’re pack­ag­ing them in dif­fer­ent ways. Smart beta has be­come more preva­lent, along with dif­fer­ent themes and fac­tors. So, providers aren’t just com­ing out with “me too” prod­ucts; they’re com­ing out with dif­fer­ent things.

Q: What are the key risks in the ETF mar­ket?

A : Many peo­ple are not do­ing their home­work on some of the ETFs that de­vi­ate from the plain-vanilla, mar­ket-cap ETFs. They don’t nec­es­sar­ily un­der­stand the fac­tors be­hind port­fo­lio con­struc­tion or re­al­ize that they’re not go­ing to get out­per­for­mance ev­ery day of the week or month. Some fac­tor-based prod­ucts have aca­demic re­search that says the prod­uct has out­per­formed mar­ket cap in the past over long pe­ri­ods of time. But there can be mul­ti­ple years of un­der­per­for­mance. So, peo­ple need to have the right ex­pec­ta­tions.

There’s also con­cern about some of the newer things, such as bit­coin.

And it’s im­por­tant that peo­ple have re­al­is­tic ex­pec­ta­tions around volatil­ity.

“In Canada, reg­u­la­tions re­quire that ETFs need only dis­close their hold­ings quar­terly. This makes it eas­ier for ETFs to use ac­tive strate­gies than in the U.S.”

Deb­o­rah Fuhr, manag­ing part­ner, ETFGI LLP

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