ETF Report: Acceleration to Mach 3

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By Howard Moore

Assets continue to pour into exchange-traded funds, spurred by a combination of increased institutional buying, regulatory developments and rising interest in fixed-income ETFs. Assets invested in ETFs and other exchange-traded products listed globally reached a record $3.34 trillion at the end of July, according to research consultancy ETFGI, more than double their level just five years earlier (see Figure 1) . U.S.-listed ETFs and ETPs also reached record levels of assets at $2.37 trillion.

“Investor confidence returned during July after the surprising result of June’s Brexit vote,” says Deborah Fuhr, ETFGI’s managing partner. The Standard & Poor’s 500 rose 3.7 percent, developed markets outside the U.S. gained 5.1 percent and emerging markets were up 4.8 percent.

Steve Deroian, head of ETF strategy, John Hancock Investments	David Mazza, managing director and head of ETF and mutual fund research, State Street Global Advisors	Martin Small, head of U.S. iShares, BlackRock
“Smart beta is about tilting the odds slightly more in your favor.”	“The average bid-ask spread in the high-yield market is about 150 basis points, while that of a high-yield ETF is about 3.”	“The equity ETF business was basically down for the first several months of the year, but fixed-income ETFs have seen record flows year to date.”

Making a steamy July even more impressive, the first part of the year had actually seen tepid ETF flows, largely attributable to broad risk-off sentiment across equities. “The equity ETF business was basically down for the first several months of the year, but fixed-income ETFs have seen record flows year-to-date,” says Martin Small, head of U.S. iShares at BlackRock. They are now close to $57 billion globally, with more than $600 billion in fixed-income ETF assets-under-management globally. “It’s inspiring,” he says. “We’ve already surpassed year-to-date our full-year 2015 fixed-income ETF inflows by a considerable margin.”

New interest from institutional investors is one big driver, according to Small. “This year marks the acceleration of institutional ETF adoption from commercial airspeed to Mach 3,” he says. “Institutional investing has been a monster propellant of the ETF market this year.”

Regulatory tightening is also focusing more attention on ETFs. Capital requirements and other costs of complying with Dodd–Frank and Basel III have made banks less willing to maintain large bond inventories, making it more difficult for investors to create a diversified portfolio of individual bonds. Bid–ask spreads have widened as well, making trading more expensive. But because fixed-income ETF volumes have risen, their spreads have narrowed. “The average bid-ask spread in the high-yield market is about 150 basis points, while that of a high-yield ETF is about 3,” notes David Mazza, managing director and head of ETF and mutual fund research at State Street Global Advisors. That makes ETFs more attractive to many fixed-income investors. “Purely from a trading and cost perspective, they’re much more efficient,” he says.

Smart-beta ETFs
There was a time when ETFs were considered retail products; institutions utilized them only tactically, holding them for a day or two for cash equitization. “Now institutions are using them more strategically, they represent larger parts of the portfolio and they’re held for longer periods,” says Mazza.

One reason is the rapid growth of U.S. equity smart-beta ETFs, which saw roughly $13 billion in 2016 new investment through the end of August. As a transparent, passive investing framework, smart beta uses ETFs that are weighted in favor of investment factors, styles and themes rather than traditional market capitalization. “Smart beta is about tilting the odds slightly more in your favor,” says Steve Deroian, head of ETF strategy at John Hancock Investments.

With equity markets experiencing high volatility over the past year, low-volatility and dividend-factor ETFs have seen dramatic asset gains. “It’s notable because defensive smart-beta strategies gathered assets in U.S. equities while broad U.S. equities had outflows for at least the first half of the year,” says Small. This suggests greater adoption of smart beta based on track records of observed performance. “Smart beta is definitely meeting the needs of institutional clients.”

Such is the attraction that smart beta has lately accounted for most new ETF product development. Over the past year, John Hancock has launched a suite of multifactor smart-beta ETFs that combine value, size and profitability. When the portfolio is rebalanced semiannually, some stocks are retained that may not meet all the criteria as long as they exhibit positive momentum. “We’re working to build a better core product,” says Deroian. Each factor, such as size, value, quality and momentum, has a record of outperforming the broad markets over the long term, but combining them helps the fund to diversify, smooth returns and thus ride out periods of underperformance.

“Increasingly, investors are using smart beta as core, a complement to core and, in some cases, as satellite alpha strategies,” says Deroian. For example, smart beta can reproduce active managers’ factor strategies systematically, with potential outperformance over time and at lower cost. John Hancock’s smart-beta ETFs are based on investment principles developed by Dimensional Fund Advisors, with which the firm has worked on actively managed mutual funds for more than ten years. This underscores how smart beta can blur the lines between active and passive — an attractive quality for investors who have traditionally used active managers but more recently have been looking for passive solutions and lower fees.

Risk protection and risk play
Smart beta is not the only area in which ETFs are expanding their repertoire. For example, many institutional investors now use ETFs as hedging vehicles in place of derivatives. Regulatory constraints on derivatives are one reason, but beyond this, market dynamics have made futures pricing more volatile. “There isn’t the surety of cost that you have in an ETF,” says Mazza. And even if ETFs do not provide the opportunity to use leverage, the total cost of ownership may still be less than for other vehicles. “This can be really powerful for investors.”

The other side of the coin is the radical resurgence in risk appetite post-Brexit; in a reversal of the past two years’ trend, some of the largest investor flows have been to emerging-markets ETFs. “Through August of this year, there has been close to $16 billion of net new assets” pouring into these funds, Small notes. This reflects institutional use of ETFs as a means to gain rapid exposure and seize opportunities in attractively valued markets that require ease of entry. No longer do investors have to set up sub-custodial accounts in each market. “The ETF has truly transformed investors’ ability to access the world, and we’re seeing it in inflows,” Small says.

Good done well
Another sector of the ETF market — small, but rapidly growing — is socially responsible investing (SRI) and the investing framework around environmental, social and governance principles (ESG). At one time, SRI strategies simply excluded undesirable categories of stocks such as tobacco or so-called sin stocks. Now they tend to be based on indexes weighted toward companies that follow a desired investment or operational policy. “Being more inclusive means more resilient investment results over time because you don’t end up with big biases in the portfolio,” says Mazza.

SSGA recently launched several ESG ETFs with large institutional investors as seed partners. One, based on the S&P 500 Fossil Fuel Free Index, was created with the support of the Natural Resources Defense Council. Another, developed in conjunction with the United Nations Joint Staff Pension Fund, is based on the MSCI ACWI, reweighted toward companies with a lower carbon exposure than the broad market. A third is based on a diversified index of companies that promote gender diversity.

“These can be considered core exposure because they are based on rebuilt and reweighted broad benchmark indices,” notes Mazza. The low-carbon fund especially underscores ETFs’ evolution into a more dynamic ecosystem in which an investment thesis embraced by a particular institution can be adapted to appeal to intermediaries and the retail market as well. Coupled with the rise of smart-beta funds and the increased use of ETFs to implement risk-related strategies, this suggests that ETFs may come to fulfill more and more of investors’ strategic needs in the years ahead.