Finding the right flavour ETF amid expanding ETP menu

Glenn Freeman  |  13/10/2016Text size  Decrease  Increase  |  

Glenn Freeman: I'm Glenn Freeman for Morningstar, and I'm joined today by Alex Prineas, Morningstar's Associate Director of Manager Research.

Alex, thanks for joining us.

Alex Prineas: Thanks, Glenn.

Freeman: First up, Alex, do you see this growth of flows into ETFs continuing for some time or is it starting to flatten out now?

Prineas: We think the growth in ETF assets is structural. It's a long-running trend, not a fad. We have seen ETF assets growing at about 50 per cent per annum for a number of years in a row.

Now, nothing is going to grow at that rate indefinitely. In fact, we have seen ETF asset growth slow down a little bit in the last 12 months or so.

The market was up about 21 per cent in the year to the end of August. But what you've got to keep in mind is the backdrop of pretty lack-lustre flows to more traditional unlisted managed funds.

So, 21 per cent growth against that lackluster backdrop is actually pretty incredible. And if you did see strong equity markets again, not that I'm sort of predicting what type of equity market environment, but if you saw a strong equity market environment, you could easily envisage ETF asset growth recovering to that 50 per cent level again.

Freeman: We've seen variations like exchange-traded managed funds. Are these genuinely different to exchange-traded funds or are they just the same thing just by a slightly different name?

Prineas: They are genuinely different. You can't just assume that all exchange-traded funds or exchange-traded products are the same or even similar.

For example, the most successful of these newer exchange-traded products is Magellan's active global equity strategy. We think Magellan has the research capability to outperform the index over the long run, but inevitably with any active strategy there are going to be periods where you do underperform as well. So, that's completely different from a passive approach, where you're likely to get the index returns day in and day out.

There's also the question of portfolio disclosure. So, with a traditional passive ETF, you have a very good idea from one day to the next and whenever you make your investment exactly what the portfolio is.

Whereas with these active exchange-traded products you don't necessarily know on the day that you buy what is in the portfolio. In the case of Magellan's product, you know that you're getting exposure to a portfolio of global equities that is favoured by Magellan's research. You just don't know exactly what those global equities are until a couple of months later.

So, that contributes to slightly wider bid/ask spreads. Or another way of thinking of bid/ask spreads is transaction costs on when you buy and sell an active ETP and those bid/ask spreads – I guess the lower level of transparency around the portfolio means that those bid/ask spreads are a little bit wider than passive ETFs and they could go even wider in periods of intense market volatility. This hasn't really been tested in a period of GFC-style volatility in Australia.

So, you know with these products that your investment is held in a custodial arrangement. So, you know that you have a claim on the underlying assets. So, there is no concern from that angle relative to traditional managed funds or passive products. It's more of a concern around transaction costs.

So, we think that these newer active style of ETPs are more suited to long-term investors who can simply wait out periods of volatility. Whereas if you're absolutely forced to trade on a particularly day when spreads maybe high, then that's an extra cost that you need to factor into your investment strategy.

Freeman: And are there also other types of ETFs being created now?

Prineas: Yeah, the market is growing rapidly, both in the number and the type of ETFs or ETPs that are available. So, in the early years, back in the early 2000s, you just had the basic building blocks of Australian equity ETFs from SPDR and Australian-listed property ETF from SPDR.

Then later on you had global equity ETFs. Quite a number of them launched by – probably iShares led the way in global equity ETFs. We've also seen fixed interest ETFs, both Australian and international and also, global properties. So, you've had these kind of basic building blocks of a portfolio being built out.

What we've also seen is ETF or ETP development go well beyond those basic building blocks with a number of more esoteric or specialized products. So, you can now buy, for example, equity products that have leverage or that have inverse exposure to the equity market or that use derivatives to generate extra income or manage risk in some way. So BetaShares has probably been leading the way in terms of products that offer those types of exposures.

There's also another group called Market Vectors that does a lot of, what we call, strategic beta or…factor indices that give you exposure to different vectors or factors of the equity market, so things like value, growth, dividends, equal-weighted ETFs and so on and there has also been other new ETP or ETF providers like ANZ ETFS have joined in launching products in the Australian market. So, the offerings have expanded rapidly.

On the whole, we think that's good for investors that enables them to tailor their exposure more precisely and enables them to manage risk in a more precise way. However, as I pointed out earlier, investors can't just assume that all these products are the same. There is a great variety of products each with pros and cons and of course, different costs associated with them. So, the key there is to dig deeper and look specifically at what the ETF does.

Freeman: Alex, thanks very much for your time today.

Prineas: Thanks, Glenn.

Freeman: I'm Glenn Freeman for Morningstar. Thanks for watching.

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