The development of alternative products allows investors to tap asset classes that are otherwise hard to access. But do these new breeds undermine the appeal of ETFs? Helen Fowler reports
It is the hallmark of many businesses that as they mature, so-called ‘alternative’ ideas become absorbed into the mainstream. Whether the same will hold true of the ETF market, where innovative products are frequently appearing, remains to be seen.
The $1trn ETF industry used to be made up entirely of plain vanilla products that tracked established indices. While these products still dominate, accounting for the vast majority of ETF assets, increasing numbers of providers are launching more esoteric versions that test the definition of an ETF to its limits.
In the last year more ‘alternative’ funds have come to market. These range from active funds run by investment managers to products based on hedge funds, real estate and private equity. Inverse and leveraged products have also grown in popularity. Market leader BlackRock is among those managers seeking permission in the US to sell active ETFs.
To put this in perspective, ‘alternative’ ETFs remain a tiny part of the overall industry. At the end of June, alternatives had just $1.7bn in assets, accounting for a miniscule 0.2% of the overall pie, according to BlackRock.
Yet ‘alternative’ ETFs have grabbed the popular imagination. “They (alternatives) get a lot of air time,” said Manooj Mistry, head of db x-trackers UK. “But the bulk of assets are still going into equities.”
A leap too far?
While some people see the development of newer products as a natural evolution in a fast-growing industry, others, including the Bank of England (BoE) are worried. “It is important that the industry does not overreach when innovating in the ETF arena,” the BoE concluded in a recent report.
“The growth of ETFs has been rapid and their use is broadening out across and within asset classes,” continued the BoE. “One risk is that the benefits of ETFs become outweighed by complexity, opacity and contingent risks.”
Others share the BoE’s scepticism. “The challenge is that clients may not understand what’s going on inside the ETF,” said Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock. She added that without proper understanding of what they are buying, investors can be disappointed and surprised at the returns they receive.
Part of the difficulty lies in the way ‘alternative’ products are changing the definition of an ETF. “In the US, the term ETF is increasingly being used to cover a broad set of products with dissimilar characteristics – many are not even structured as funds,” according to BlackRock.
The emergence of new types of ETFs risks confusing people. Fuhr said: “It’s making it a challenge for people to understand all the products in terms of structure, as well as what the underlying holdings are, as many are using securities, physical commodities, swaps or front and forward month futures, for example.”
Much of the criticism levelled at so-called ‘alternative’ ETFs centres on a few particular underlying assets, most notably real estate, private equity and hedge funds. Actively managed products as well as leveraged and inverse ETFs are also coming under scrutiny.
“There is a lot of concern around leveraged and inverse,” said Fuhr. Leveraged funds claim to offer investors the chance to double up their bets, whether positive or negative, on certain markets. Investors use leveraged products when they are so confident about a market’s direction they want to double, or even triple, their return. Inverse ETFs are adopted when investors want to take negative positions in asset classes, either to remove unwanted exposure or to express a negative view.
“Like all innovations in fund products there are some that are helpful and some that are not so helpful,” said Chris Sutton, senior investment consultant at Towers Watson. In Sutton’s view, leveraged and inverse products fall into the latter category.
“They are a bit unhelpful in the sense that providers are taking the badge of an ETF, which stands for transparency and simplicity, and applying it to products that are neither of these things,” said Sutton. “That exposes investors to some risk. You have to be wary.”
Although leveraged ETFs represent only 3% of the market in terms of assets, according to the BoE, turnover on the funds may account for as much as a fifth of daily ETF turnover. This reflects how investors use leveraged ETFs as shorter-term trading tools, more so than other types of fund.
There are concerns that leveraged ETFs may amplify dislocations between fund values and the underlying index. “It is very important that this should be watched going forward,” said the BoE. “There would be the potential for a basically good market to be undermined over time if it becomes dependent on leverage.”
Towers Watson’s Sutton is especially dubious about the merits of products tracking absolute return and private equity. Sutton said: “With the funds trying to replicate private equity or hedge funds, you have to ask yourself, if the underlying assets are illiquid, and investors are having trouble getting exposure to them, what is it about the ETF that succeeded and made these obstacles disappear, and is it real?”
Numerous providers besides BlackRock are either applying for actively managed products or making moves in that direction. In July, WCM Investment Management and ETF provider AdvisorShares in the US launched the first actively-managed international ETF. In January Marshall Wace, one of Europe’s largest hedge funds, launched an ETF tracking its investment strategies.
In the US there are more than 20 ETFs that employ an element of active management. But BlackRock’s Fuhr said it was unlikely a truly active manager running a concentrated portfolio of a small number of securities would want to manage an ETF and disclose daily their underlying positions.
Undermining ETF benefits?
As the industry embraces more complex products, detractors argue ETFs are in danger of losing the transparency, simplicity and low-cost benefits that have won them such popularity. More complex products, such as leveraged and inverse funds, not only potentially add risks, they also add extra costs, while the full extent of charges is not always immediately clear. For example, Marshall Wace is charging 0.25% a year on its hedge fund ETF and the underlying structure charges a further 1.5%, plus 20% of profits.
Supporters of newer products point out that they are not breaking any rules in introducing newer assets in ETF form. “If you look at the definition of an ETF it doesn’t say it has to be based on something simple or complicated,” said Mistry at db x-trackers.
“I see it as an access tool, giving access to a benchmark index,” he added. “That index could be made up of equities, bonds, commodities, or almost anything. It’s unfair to say ETFs are becoming more complicated. Liquidity and transparency are all in the structure, just as in a standard ETF.”
Last year, db x-trackers became the first to offer investors an ETF tracking hedge fund returns. The index is based on the performance of 40 or so hedge fund managers on Deutsche’s managed accounts platform. In less than 18 months since its launch last March it has attracted $1.3bn, highlighting a significant amount of investor demand for new types of product.
ETFs based on more complicated underlying investments can be a good way for investors to make their first allocation to a new asset class, according to Towers Watson’s Sutton. He said: “Because of the degree of confidence people now have with the ETF wrapper, if you’re an investor going into a new asset class for the first time, choosing an ETF product might be a suitable way to dip your toe in the water.”
Sutton continued: “Obviously you can’t rely on the fact it’s an ETF, but if you’re putting 1% of your funds into it, an indexation product like an ETF isn’t a bad way to start.”
Institutional investors want an expanding ETF product set, said Mistry: “When we’ve come up with innovations they’ve been based on feedback from clients. People asked us if we could deliver a hedge fund ETF. The products being made available through ETFs are reacting to a change in how institutional investors are running their portfolios.”
Increasing numbers of portfolio managers are shifting the focus of their work, said Mistry. More of them are choosing to put more effort into asset allocation and less into the traditional role of picking individual stocks, dovetailing with the development of ETFs. “Rather than using their skills to stock pick, say, they make the investment decision to invest in Brazil or hedge funds,” said Mistry. “The product set in ETFs allows them to do that.”
Mistry defends the higher fees charged on alternative products. “Typically you do see higher fees on alternatives,” he said. “These markets are less accessible and harder to hedge. The fees reflect the cost of access, and, from experience, clients are happy to pay it.”
One of the biggest arguments in favour of ETFs offering access to hedge funds, real estate or private equity is that they open up these markets to smaller investors. “It’s opened up greater possibilities, to more of the medium and smaller-sized investors,” said Mistry.
Aware that new products attract higher fees and offer a unique selling point, providers are intent on innovating, despite criticism levelled at them. “We are always looking at new areas,” said Mistry. “Maybe the pace won’t be as fast as the previous three years but you will still see products launched to fill a niche. We are looking for opportunities to provide tradable and efficient products on alternative assets.”
Any industry is bound to evolve and grow, and the ETF business is no exception to that rule. Although the overall alternatives universe remains small, the success of individual products such as db x-trackers’ hedge fund ETF suggests investor demand for them is strong. “You can’t expect the product set to stand still,” said Sutton at Towers Watson. “And do I really want to see another version of the same index?”
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