By Julie Hammond, CFA
Global assets in exchange-traded funds (ETFs) reached an astonishing $4.5 trillion at the end of 2017.
That's a remarkable ascent given the relatively brief lifespan of the ETF, and it connotes a startling disruption of the investment management industry. After all, the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) only just celebrated its 25th anniversary and the first modern "ETFs," the Toronto 35 Index Participation units (TIPs), first went on sale in 1990.
But the real ETF-inspired disruption is in active indexing, Joanne M. Hill explained in her presentation at the 71st CFA Institute Annual Conference in Hong Kong.
Hill, who is chief advisor for research and strategy at CBOE Vest, chair of the CFA Institute Research Foundation, and author of A Comprehensive Guide to Exchange-Traded Funds, discussed the trends that have propelled the rise of active indexing through ETFs, where ETFs fit in the evolution of investment strategies, and how active ETFs are disrupting traditional investment management.
"This is not at all about passive indexing," she said. "This is about ETFs as a packaging framework for defining and managing investment strategies." As she sees it, the increased use of ETFs is a direct result of the success that quantitative and systematic strategies have achieved over the last few decades, new technology, and the shift to more rules-based and top-down active investment strategies.
ETFs have transformed the way active investors gain exposure to asset classes, strategies, themes, and investment styles. "Today, the focus is more on the total portfolio, risk factor-based investing, and protecting portfolios on the downside," Hill said. "Even the cap-weighted indices are being used actively."
The ETF food chain is now composed of nearly every type of investor - from human financial advisers to robo advisers, and from asset owners, hedge funds, insurance companies, and investment managers to retail investors. Applications vary depending on investment time horizons as investors apply ETFs tactically to manage short-term views, cash flows, and liquidity, or in more forward-looking ways, say to implement core or enhanced index exposure, multi-asset strategies, and asset allocation, as an alternative to hedge funds, etc.
One of the most popular ETF applications is in factor investing both for exposure and management of risks. In its recent study of US ETFs, "Valuable Versatility in a Newly Volatile Market," Greenwich Associates found that "growing numbers of institutions are using Smart Beta ETFs to guard portfolios against volatility," while investors in general continue to deploy ETFs as versatile, liquid, low-cost tactical tools.
ETFs are being put to ever broader uses, the Greenwich survey finds. Investors are using them as building blocks in top-down strategies and as a source of value at the asset allocation level. Fixed-income ETFs were one of the biggest areas of planned growth in investments among survey participants, who hope to take advantage of the liquidity feature in international credit and domestic high-grade bonds. In addition, investors are increasingly monitoring ETF funds flows to gauge market sentiment and direction.
Fast Growth in Asia ETFs/ETPs Continues
Japan is by far the largest and fastest growing ETF/ETP market in Asia, with approximately $300 billion in assets as of March 2018, according to Hill. The Bank of Japan owns 50% of the Japanese Exchange-Traded Products (ETPs), but as Kathy M. Matsui, co-chair of Goldman Sachs Japan, predicts, the BOJ is unlikely to sell its positions anytime soon.
In addition, Hill said that the Hong Kong SAR market, through its tracker fund, offers a base for global investors in the Asia region and includes China A-Shares. Around 230 China A-Shares will be added to the MSCI indices in June and September 2018, which may positively affect the shares. Investors have a wide range of China ETFs/ETPs to choose from, most of which are indexed to the CSI 300 and broader equities, with about $67 billion in assets all told.
Costs and Risks of ETFs
Disruption also brings potential costs and risks for ETF investors, and the due diligence process requires more quantitative skills and technology as well as a fundamental focus. Hill warned that some investors may pay too much attention to the recent performance of ETFs without considering the underlying fundamentals and risks.
In addition, investors depend on market microstructures to accurately connect securities and pricing, and therefore have the added risk of ETFs growing too large relative to their underlying securities. Indeed, in "Inefficiencies in the Pricing of Exchange-Traded Funds," Antti Petajisto presented new evidence of market pricing inefficiencies in ETFs and introduced a new approach to ETF pricing to control deviation from their net asset values (NAVs).
More Global Expansion Expected
No doubt ETFs will stay at the forefront of investment innovation, growing ever more customized and sophisticated. Hill pointed to "The Death of Active Management Has Been Greatly Exaggerated, by Ben Johnson, CFA, observing that "investors are getting more active with passive and passive is getting more active."
"Investors will continue to expand their use of ETFs for global equity and income diversification," she said. She expects continued growth in European and Asian ETPs, with increasing factor and thematic ETF offerings as more traditional active managers enter and expand their ETF presence. The segments most ripe for change and new product offerings include fixed income, commodities, and alternatives.
"Products have been global from the start, and the US still represents 70% of the total ETF assets," Hill noted. "But growth is now coming from outside the US, with non-US ETFs representing almost 50% of the fund flows in 2018 thus far."
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