John Donohoe, CEO of Carne Global, explains to Emma Cusworth how alpha/beta purification and increased competition will support continued ETF market growth
The merits of separating alpha and beta have long been a hot discussion topic in the investment world. In the wake of the crisis, and the resulting dissatisfaction with many alpha managers, the purification of alpha and beta will likely take on new vigour.
The ETF industry’s expansion increasingly presents investors with pure beta products to form the core of portfolios, making it well positioned to benefit, according to John Donohoe, CEO of fund management advisers Carne Global Financial Services.
Yet much work still needs to be done to increase awareness about the benefits of both alpha/beta purification and the different characteristics of ETFs to ensure demand continues to grow.
Meanwhile, as increasing numbers of ETF manufacturers launch products, competition will push down operating costs, allowing further growth of the industry.
“Within Europe, the debate about optimal portfolio construction continues to rage,” Donohoe says. “Pure beta is still a relatively new proposition and educating investors and their consultants is an on-going task.”
Alpha under fire
In recent years, consultants and other investment advisers have increasingly scrutinised alpha providers, warning against the dangers of paying alpha-level fees for beta performance. The resulting trend is a move towards large, cheap beta elements in the core of portfolios, supplemented by smaller, higher-volatility alpha satellites.
“Pensions consultants, for example, have moved towards a stance of querying the value added by alpha managers: whether they are just closet index providers, the best value for money, their expenses and so on,” Donohoe says. “Many schemes have gone down the road of having a large beta exposure and then a smaller, enhanced alpha element, but the question of the ideal proportions remains.”
Donohoe suggests one of the better theories for achieving investment objectives as cheaply as possible is to have 80% to 90% in beta and then use the balance for much higher volatility and expected returns.
This enhanced alpha element will naturally involve higher fees. Yet Donohoe argues: “The overall combined fee is much lower so the same risk/return profile could cost 50 basis points less.”
The debate, which has long been a topic for pension funds and their consultants, has also filtered down to insurance companies and more recently the high net worth and wealth management markets.
As cheap, pure beta products, ETFs stand to gain significantly from this shift. In order to see those gains, however, considerable effort is still needed to ensure investors not only see the benefits of pure beta, but also understand the characteristics of the ever-expanding range of funds on offer.
“Not all ETFs are equal,” Donohoe warns. “Trust in both providers and their products is essential. It is important investors know what the providers are doing and also understand the underlying indices and their constituents. Investors need to know how the index is derived, how the ETF itself is structured, its liquidity, counterparty risk and, in the case of synthetic ETFs, the underlying collateral.”
He argues investor education needs to happen on both the broad beta and product levels, although this will be tougher to achieve for ETF issuers than for alpha providers.
The trouble is they suffer from an inherent disadvantage versus their alpha competitors. “ETF providers won’t necessarily find allies in the big distributors,” according to Donohoe. “Whereas higher fee-earning alpha providers can share some of their fees with the distributors, ETF providers don’t. They have to fight their own battles in terms of educating potential buyers to their benefits,” he explains.
To some degree, things are already beginning to change, helping ETFs become more established.
The rise of new products
A new generation of actively managed products based on ETFs, such as funds of ETFs and other hedge fund type strategies, is emerging. “These are not passive products in themselves, but they use beta elements for portfolio construction and tactical or thematic exposure,” Donohoe says.
This shift will support ETF asset growth in the future. Donohoe says: “The investor base will continue broadening out as providers such as wealth managers find more ways to use ETFs to build products. More big banks are also launching broad ETF suites, which they sell through their already established multi-jurisdictional distribution networks.”
Increasing competition could have another advantageous effect, helping support future ETF growth by driving down operating costs.
The expense of listing, maintenance and other exchange-related expenditures will be a major factor in determining how much more competition the ETF market can sustain, Donohoe believes.
“This is still a relatively new industry in Europe and many of the initial products were traditionally listed on the London Stock Exchange, which has relatively high costs. Other exchanges are now getting more competitive and are reducing these barriers, bringing down the operational costs of running ETFs,” he explains.
“As the industry gets bigger, costs should be driven down further, improving the economics for providers.” He adds that costs are already starting to fall, although the market still needs to reach a critical mass to make ETFs work, as they involve a lot of administration costs which are not present for mutual funds.
“Ultimately, what makes sense wins. These products make sense and are very appealing for a large segment of investors.” Donohoe says the market will continue to grow quickly, reaching as much as €2trn in the next three to five years, which will allow more players in and further decrease costs. He adds: “Meanwhile, providers have to continue the educational push both in terms of the arguments for pure beta and to improve product-level understanding.”
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