Europe v the US: Differing approaches to ETFs and smart beta
The exchange traded funds market has grown explosively over the last few years, with assets under management globally currently standing at more than US$3trn. However, there is more to this story than first meets the eye, Bill Vasilieff, chief executive of the recently-launched offshore intermediary platform group, Novia Global, explains.
The growth of the exchange traded funds (ETF) market recently has certainly been impressive, fueled by such factors as the asset class’s liquidity, price – relative to that of actively managed funds – and innovation. But this growth picture hides a more complex narrative.
For a start, most of the assets and growth in sales have come almost exclusively from the US, where ETFs were first introduced in 1993 and which today accounts for more than US$2.2trn of the total global US$3trn AUM, or almost 75%.
In Europe, the picture is much more negative. In earlier years, ETF sales figures looked very positive and highly promising, with net sales of €32bn in 2010, followed by €13bn in 2012 and even €18bn in 2012. But for the year to date, they’re rather gloomier, with many of the main European ETF providers showing net outflows.
This has been put down to two factors: volatile equity markets and this month’s referendum in the UK on its continued membership of the EU.
‘Thus far failed to take off’
While these two factors are undoubtedly affecting sales, the general point remains: far from being a “game changer” for the European asset management industry, as some have predicted, thus far at least, ETFs have failed to take off in Europe on anything like the scale that has been seen in the US.
Why is this?
In addition to the reasons stated above, the slow uptake of ETFs on this side of The Pond can also be explained in part by some recent, very aggressive pricing strategies from traditional fund managers, who have been drastically reducing the cost of their passive funds, in order to better compete with ETFs.
The problem for them is that ETFs actually provide many opportunities for passive investing in asset classes not currently offered by traditional fund managers, in addition to such new, innovative approaches to investing as ‘smart beta’.
‘Smart beta’ is a bit like ‘robo-advice’; a handy label that is used far too broadly by most people, and doesn’t really do what it says on the tin.
Investment managers who follow a smart beta investment strategy look to passively follow indices, while also taking into account weighting strategies other than pure market capitalisation, such as value, volatility, momentum etc.
Smart beta strategies are, however, implemented like a typical index strategy, in that the index rules are set, are transparent and don’t change.
Smart beta strategies differ from a traditional market cap-weighted index, and attempt to focus on factors that deliver added performance – that is alpha rather than beta!
That smart beta is a success is not in doubt, of course, and in fact, it has been the biggest driver of growth in ETFs in recent years. For example, smart beta assets under management in the UK have grown by a hugely impressive 150% per annum since 2012.
In the US the picture is very similar, with passive investing (including smart beta) grabbing market share at the expense of actively managed funds, which are experiencing net outflows.
And it is smart beta which is also the driver of growth in market share, with an annual growth rate in smart beta at nearly 40% compounded over the last five years, compared with a general growth rate for market cap standing at a more sedentary 18.6%.
A recent survey of institutional investors, meanwhile, showed that the percentage of these investors “currently evaluating” smart beta has doubled since 2014, while the number who “have never evaluated” smart beta has dropped to 12% from 40% over the same period.
For those already adopting smart beta, the percentage of the equity portfolio allocated to smart beta has also grown rapidly over the same period, e.g., those who say their smart beta allocation is over 20% has increased to 39% in 2016, from 18% just two years ago.
Impressive statistics indeed; and in the same survey, those investors with smart beta allocations reported they were “satisfied or very satisfied” with the ability of smart beta to deliver on intended outcomes.
Interestingly, among this segment of investors, it has been Europe that has led the way in adopting smart beta strategies, with the percentage rising to 52% in 2016 from 40% in 2014, while in North America, the percentage has risen to just 28%, from 24%, over the same period.
Active, or passive?
One interesting debate that seems to persistently crop up alongside the main smart beta discussion is the question of whether it should be classified as “active” or “passive” investing.
The rise in multi-factor investment strategies has probably given a boost to the view that smart beta, in spite of having its roots in passive investing, is becoming more and more complex, and is therefore becoming something more akin to active investing, with the fund manager’s skills being focused on identifying the factors and combinations of factors that give rise to superior performance.
In the same survey mentioned above, the proportion that viewed smart beta equity investing as “active” rose to 35% in 2016, from 22% just a year earlier.
Smart beta’s uncertain future
Given that smart beta assets under management are said to have ballooned to US$616bn in 2015 from just US$103bn in 2008, some commentators are beginning to question whether smart beta will effectively become a victim of its own success, particularly if the growth trend continues.
One leading commentator on the subject recently said that “many smart beta strategies outperformed the market because their underlying stocks became more expensive, not because of the factors the indices claimed generated strong performance”, adding that, “we foresee the reasonable probability of a smart beta crash, as a consequence of the soaring popularity of factor-tilt strategies”.
Strong words but you can see the logic, that if investors are all following the same factors, then inevitably prices will be pushed up, with a correction being inevitable.
Outlook for retail ETFs, smart beta
The success of smart beta in Europe, meanwhile, in terms of sales and assets under management at least, has come from institutional investors, since ETFs in general – and therefore smart beta in particular – have had very little impact thus far in the retail markets. This has been due to a number of factors, including their perceived complexity, and therefore a general lack of understand of ETFs and smart beta among retail investors.
Then too, there is a well-entrenched competitor in situ, namely, the traditional fund management industry, which is unlikely to give up its dominant position without a fight.
It is interesting to note that in the UK, relatively few advisers are as yet recommending ETFs in a significant way, even though, in order to qualify as a regulated independent financial adviser, they are technically obliged to show that they are considering the whole investment market when advising their clients.
We are, however, seeing a rapid growth in discretionary fund managers adopting ETFs in their model portfolios, alongside a gradually growing uptake among advisers, and these are trends we are expecting to continue.
Meantime, ETF providers must face up to the challenge of making their products more accessible to advisers and investors, by focusing more on the investment merits of their products, rather than on their complexities.
Platform providers,whether in the UK or in the international space, must also up their game, in order to have the functionality to be able to offer ETFs while at the same time being fit for purpose in terms of the regulatory regimes in the markets in which they operate.
Bill Vasilieff is chief executive of Novia Global, a recently-launched offshore platform based in Bath, England, which targets international advisers, wealth managers and intermediaries. Prior to coming to Novia, Vasilieff had been a co-founder of Selestia.