ETFs are a positive force for disruption

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Despite volatile financial markets in the last 12 months, the global exchange traded fund (ETF) industry has continued to expand rapidly. There are nearly 6,000 ETF and exchange traded products (ETP) globally, representing total assets of US$2.8 trillion. While small in the context of total global assets under management, the consistently strong growth of ETFs means all market participants should be taking this product seriously.

Growth driven by low cost, diversification and easy access

The ETF industry’s growth over the last two decades represents one of the financial sector’s greatest success stories. Institutional and retail investors alike are looking for products that are low cost that offer easy access to a diversified investment product range. EY’s recent Global ETF Survey found ETF issuers globally expect their businesses to grow by around 18% per annum for the next three to five years, with higher growth predictions for Australia, within the range of 20% to 25%.

To date, ETF assets equate to less than 12% of the US mutual fund market, 4% of the European market and, despite strong growth of an average of 30% over the last decade, less than 2% across most of Asia-Pacific. The Australian proportion is similarly small, but it is increasing and, with the development of innovative cost-effective products, the local market will grow significantly. While relatively slow to take off, the Australian ETF market has effectively doubled in size over the last two years to now be about $21 billion. In part, this has been driven by change in regulations relating to adviser remuneration and a greater understanding of the role ETFs can play in building more diversified, liquid, transparent and lower cost portfolios. Adviser and broader investor education remains critical to the ETF growth story.

There is also a favourable macro view for investment philosophies that emphasise diversification and cost minimisation as drivers of long-term performance. Tailored portfolios will result in the ETPs taking more market share from traditional active and passive mutual funds.

Retail versus institutional demand

Globally, institutional investors drive the bulk of ETF inflows, but they still remain comparatively underinvested in ETFs in Australia where the vast majority of ETF investors are retail. ETFs offer these retail investors access to products which were traditionally only available to institutions.

Institutional investors on the other hand are commonly using ETFs for core exposures, precision exposures, hedging and access to new markets. They are increasingly seen as a substitute for fully-funded futures, as the cost of holding long positions on key indices increases with every quarterly ‘futures roll’. Defined benefit (DB) pension funds are significant users of ETFs and insurers are beginning to use ETFs for long-term investment, although they have been slower adopters.

Active managers listing funds

Active managers with no history of issuing ETFs or ETPs are responding to developments such as smart beta, launching ETPs or partnering with existing providers. The Australian ETF market illustrates the potential that can be unleashed when innovation and regulation complement each other. Prevented from marketing non-passive products as ETFs, local managers have begun to list exchange traded managed funds (ETMFs).

EY’s Global ETF Survey asked promoters of ETFs how they planned to differentiate themselves in the market. Over 20% of respondents identified ‘innovation’ as the key differentiator, a significant increase from 15% in the 2014 EY study. Innovation was also identified as a key to success in distribution, where nearly 25% of ETF providers see the new phenomenon of online retail investor accounts as being fundamental to their success – a massive increase from 6% and 4% in the 2013 and 2014 EY studies respectively.

Innovation has always been integral to the ETF story and new products are critical for the growth of the industry. Product development is arguably now moving forward faster than at any time in the industry’s history. This current explosion of innovative effort reflects a combination of factors. On the supply side, ETF providers view innovation as crucial to building profile, generating net inflows and defending profit margins. Demand is created by persistently low yields, self-management of the decumulation of super balances and an increased desire for cost-effective diversification tools.

The launch of active ETFs over the last 12 months and the development of ETMFs to strike a balance between transparency and confidentiality by quoting a price linked to net asset value illustrate the innovative trend.

Online distribution

Our Global ETF Survey found 90% of respondents viewed digital channels as an area of opportunity and 89% expected robo-advisors to accelerate the growth of the industry. Developing an online presence is a leading priority for technology spending among ETF providers. Of course, a sudden focus on digital distribution is not unique to ETFs.

There is obvious potential cross-over between online or automated advice and the use of ETFs to create model portfolios. Although still in its infancy, online advice enables investors to compare a range of criteria, including total costs and overall investment return. In the US, many of the largest ETF providers offer their own online distribution platforms, however the emerging trend in Australia has primarily been from independent robo-advisors targeting SMSFs.

For ETF providers, investor demand is the most important driver of product development, but market-specific regulation means that most innovation has a strong local flavour. For example, while leveraged and inverse leveraged funds are enjoying significant success in markets such as Japan, Korea and Taiwan, and are soon to be launched in Hong Kong, they have limited demand outside of these markets.

Innovation and creativity always creates controversy and will inevitably come with some risks. Even so, there is a particularly strong sense that the digital dawn could be a ‘eureka’ moment for retail adoption of ETFs. After all, the product and technology share some common themes: low costs, transparency and breadth of choice.

 

Rita Da Silva is Ernst & Young’s ETF Leader for Oceania. The views expressed in this article are the views of the author, not Ernst & Young. The article provides general information, does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information. Liability limited by a scheme approved under Professional Standards Legislation.

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