Exchange-traded funds (ETFs) have made headlines during the first few months of this year as the UK’s Investment Association (IA) announced the first chairman of its ETF committee and Lyxor launched the cheapest ETF in Europe.
According to chairman Adam Laird (pictured), who is also head of strategy for northern Europe at Lyxor ETF, the incorporation of ETFs into the IA is recognition that the sector now represents a key part of the investing landscape.
“I’m looking forward to using the committee to drive ETF understanding and promote their use,” Laird told Portfolio Adviser upon news of his appointment.
Weeks later Lyxor announced the launch of two ETFs – the Lyxor Core Morningstar UK NT (DR) Ucits and Lyxor Core Morningstar US Equity (DR) Ucits – which carry a total expense ratio of 0.04%. The nearest rival ETFs charge 0.07% for the same products.
Picking a strategy
According to Laird, these prices bring Europe in line with US products, but is choosing an ETF all about cost?
AJ Bell Investments active portfolios head Ryan Hughes – who helps with fund selection for the firm’s passive model portfolio service – says there was a time when the assessment of passive strategies was a relatively simple task: just identify the cheapest tracker on the market and use it.
“This rather unscientific approach looks well off the mark in today’s environment, where there is a wide range of tracking strategies available from many more providers. It makes the assessment of these strategies all the more important,” he says.
So what factors does Hughes look at when picking ETFs?
He says: “There are a number of key considerations when we are assessing passive strategies, combining both quantitative and qualitative assessment to try and identify the very best managers.
“At the simplest level, this includes ensuring we are tracking the most appropriate index, which sounds obvious but there are a number of subtleties in how similar sounding indices are constructed.
“For example, MSCI and FTSE both offer emerging market indices yet classify South Korea differently. The FTSE regards the region to be developed and therefore does not include it in the index. This is an extreme example but illustrates the point that not all indices are the same.
“Another thing we look at is the replication method. We have a preference for strategies backed by physical replication rather than synthetic but it is important to understand how the strategy is implemented.
“It is vitally important to understand and assess the impact of transaction costs. In some cases it may be better to invest in a strategy with a higher ongoing charge but lower transaction costs, rather than simply buying the cheapest headline strategy, as this saving may be wiped out by higher transaction costs.
“Therefore, it is worth looking at strategy on a ‘total cost of ownership’ basis rather than the simple headline cost.
“We also constantly assess the market liquidity, which is key to ensuring we are able to trade ETFs in a cost-effective manner.
This typically points us towards larger providers and strategies as we have to be confident the market will be able to support our trade size when we come to transact.
“While this may sound obvious, there are certainly instances when less liquid ETFs cannot be sold at the price you want or in the size that you need.
“The passive market has evolved significantly and gone are the days of just buying the cheapest strategy. The research, selection and monitoring of passives is now far more rigorous and, as a result, higher-quality products are now being produced, which can only be to the benefit of investors.”
ETF evolution
Peter Sleep, senior investment manager at Seven Investment management (7IM), likens ETFs to singer Barry Manilow. “That is to say, 10 years on, they have been through a lot but they are basically the same as ever.
“Any makeover ETFs have had has only been skin deep but at heart they are the same,” he says.
The basic structure of ETFs, the buying and selling intraday on an exchange continues to function well, despite the worst the markets have thrown at them.
“Just as the cost of Barry Manilow’s CDs fell as online streaming gained popularity, ETFs have become a whole lot cheaper in the past 10 years. Cut-throat competition from new entrants has forced down prices. A decade ago an S&P 500 ETF would have cost you 0.40%; today it is around 0.04%.
“As fees on ETFs have fallen, issuers have scouted around for new ‘value added’ ideas that might prove to be the next hit. This has led to a constellation of smart beta and thematic ETFs.
“The longest-running hits have been the higher-dividend ETFs, but also thematic ETFs such as robotics and cyber-security have shot up the charts.
“We have nearly always had fixed-income ETFs but offerings in areas such as high yield and emerging market bonds have introduced investors to new styles.
“A lot of the indices ETFs have followed are bespoke and ‘liquid’ to enable the issuers to keep their intraday trading promise and also illustrate the limits of ETF investing, ie that they cannot go into illiquid areas of the market.”
“For example, the ETF issuers know they would have a guaranteed hit if they marketed something tracking cobalt or lithium for the electric car enthusiast, but the underlying market is not sufficiently liquid.
“Some issuers have also bought to market products that few investors really understand, such as the infamous Vix ETFs. In their simplest form these products stretched punters to their limits and at their most complex they were beyond nearly everyone, except those calculating the fee.
“The next 10 years will no doubt bring more of the same – greater choice and lower fees. Some of the labels may change but, ultimately, you will continue to be able to buy and sell ETFs intraday, on an exchange.”
Keeping an open mind
As costs come down and the ETF industry evolves we asked Ben Yearsley, a director at Shore Financial Planning, if his use of the products has grown during the past few years and whether or not he expects to increase their use going forward.
Despite the increased popularity and assets in ETFs, he says he still finds it difficult to fit them into client portfolios.
“First, mainstream platforms have been fairly slow in adopting anything that isn’t a traditional fund,” he says. “Second, apart from more specialist areas, such as sector-based or commodity ETFs, what are they giving me that’s not available elsewhere?
“I can get a leveraged FTSE 100 if I want, or short oil, but should I be using these in client portfolios? I suspect the answer is no for the majority of advisers.
“The simple answer is that I am not using ETFs any more than I did in the past. I have an open mind about all investment, yet I haven’t felt the need to push for inclusion of ETFs in client portfolios.
“I still equate ETFs with trading and not investing. Although I prefer active investing there are some markets where passives are more appropriate. But do I need to invest via an ETF over a passive fund? I don’t think so. Passive funds have improved in the past decade and now have more openness, transparency and, crucially, far better pricing.
“Should advisers be trying to play market volatility, trading in other words, or should they invest for the long term? My view is that you should invest for the long term and not attempt to time markets. From that perspective I won’t be increasing my use of ETFs owing to market volatility.
“ETFs do have an advantage over [any mutual fund] in this environment due to live pricing but if you are investing for the long term, again, it shouldn’t matter. Indeed, live pricing creates its own problems – when do you trade for clients, for example?
“There is no reason to suggest ETFs will be any better or worse than [mutual] funds in a volatile environment but it will be incumbent on advisers to use them sensibly.”
