Tallying last year's figures for the ETF and ETP industries in the U.S., the latest analysis from London-based industry research firm
The number of ETFs and ETPs that have over $1 billion in assets increased during 2014 to 251, adds EFTGI, which is headed by co-founder Deborah Fuhr. Additionally, the group of ETF and ETP providers grew to 71 at the end of 2014 from 58 at the end of 2013.
Fuhr, a veteran ETF industry observer, says such growth is vindication for a product once dismissed by some investment professionals. In a discussion with Money Management Executive, Fuhr outlines factors that have led to the market's enthusiastic acceptance of ETFs.
What are the reasons why ETFs have become so popular with investors?
Clearly, investors have discovered they want to have active funds that deliver alpha and use risk budgets. They discovered that a significant majority of active funds don't deliver alpha over the long run. They've looked at the impact of higher fees on performance. They've looked at the performance of hedge funds as a category, and see it's even below the performance of the S&P 500, yet they are charging 2 and 20. So the things they like about ETFs is that they allow them to select active funds, or themselves be active in their use of individual stocks or bonds, and then use ETFs to implement exposures to other asset classes and other segments of the market. So the ability to use ETFs in a flexible fashion - you can use them to go short, to equitize cash, they can be a satellite, you can even lend them out - depending on the sophistication and type of client, they can be used in many ways. And they allow you to invest in very small sizes, and are less expensive than many investment tools that you might use.
Are those the only reasons for ETF popularity among investors?
Increasingly we're seeing they are less expensive than using futures, because the cost of banks using their own capital and balance sheet has gone up, the cost of rolling futures has gone up. And the fee of using ETFs annually on the core building blocks has come down. What we're seeing is that many investors, because it is easy to get news, feel they need to react to what's happening and tactically adjust their holdings. In November, we saw the U.S. market, measured by the S&P and Dow performance, was up 3%, so the majority of net new money went into equities. The U.S. market and developed markets were up by two, and emerging markets were down by one. So you can look at the flows, and it is a good indicator of investor sentiment, and it's timelier than mutual fund flows, which tend to be given six to eight months after the end of the month. Also in the U.S. many investor have moved to multi-asset class investing, and so ETFs just make it easy to implement those exposures and deliver different outcomes, whether you want managed, low risk moderate dynamic, target date, or global asset allocation. You're also seeing investors wanting way to access markets and asset classes that were traditionally hard to access. So for a long time, people have liked investing in physical gold through exchange traded products, because as an individual it is hard to own gold bars the same way a central bank does. The same applies with China, India and other emerging markets where it's impossible to invest without applying for quota and meeting certain criteria.
You've been involved in the industry for some time. Is it gratifying to see ETFs gain widespread acceptance?
Having covered them since 1997, I can say many people didn't expect them to be successful. Many refused to look at them, because they said, "Unless you pay me something to sell these products, I'm not going to use them." Many also said, "I'm active, so I can't use them." What we see today is that active managers see ETFs like futures and use them, that many pension funds and sovereign wealth funds, endowments, pensions and hedge funds, and financial advisors are also using ETFs. So they are a very democratic product that allows all types of investors access to the same toolbox, at the same annual cost, with a minimum investment size of one share. Having worked in various firms, from investment banks to asset managers, that is a very unusual proposition. Because usually large institutions have a big toolbox and pay small fees, whereas retail will have a small toolbox and pay much higher fees. So ETFs being a very democratic product and doing what they said they were going to do, to me has always been an appealing proposition. So I think today, seeing all of these traditional active managers saying they also want to have ETFs really shows the power of the wrapper and structure in aiding distribution. It helps to illustrate that it has been a good idea, and there has been growing acceptance around the world. ETFs are now available in 49 countries around the world, in 61 exchanges. It's pretty exciting.
You've mentioned how ETFs have gained on hedge funds.
The fees for hedge funds are 2 and 20, while the average fee for ETFs is about 31 basis points. That's a big difference there. Hedge funds have existed for about 65 years while the first ETF product was launched in Canada in the 1990s. The most recent data provided by Hedge Fund Research is the level of assets in hedge funds at the end of Q3, and at that point, the ETF industry globally was only $200 billion smaller than the hedge fund industry. And the performance of the average hedge fund has been less than the S&P 500.
How will hedge funds respond?
It's the same challenge that active mutual funds face. If you're not delivering alpha, and you're charging higher fees, you have to use your risk budget and deliver that alpha. This is why in Europe we've seen a number of consumer-oriented lobbying groups and the Danish Fund Association complain about the fact that many mutual funds are actually closet indexers. They're talking about measuring the active share within funds, they're talking about the fees and better transparency about total cost. What's going to happen is that you're going to have to use your risk budget and deliver alpha, and if you're not, people are not going to buy you. If you buy something and you're willing to pay higher fees, the expectations are higher - for instance, buying a Volkswagen is different than buying a Maserati. But what you expect in terms of performance or a return characteristic is going to be different too.
To run with that analogy it seems ETFs are Hondas. They get you great mileage and steady performance for a cheap price, compared to a Maserati, which you buy for a different reason.
There's something to that. When people go to cocktail parties, they don't say, "I bought an S&P 500 tracker," but they might go to a cocktail party at Christmastime and say, "I found this great fund, and the manager is such-and-such," and it's very much about personality. So I do think there is the prestige factor. I would say though that many people, in this day and age, are happy to talk about the fact that they care about performance and they care about fees. They are learning that being with something that's not flashy actually in the long run delivers better returns.
When you say that ETFs are a democratic product, are they then taking some of the closed-door mystique out of investing?
They are helping investors understand the market. Investor education is a big aspect of ETFs - understanding the different benchmarks, understanding the risk characteristics. They are aiding investors. If you look at some of the ads that run in the U.S.: "Do you know how much you pay your broker?" or "Do you know what your broker is doing?" ETFs do give you that transparency. Here is what the cost is. Here is what the performance is. This is how we are doing this, and this is what our goal is.
Do you think there is a segment of the industry that wishes ETFs did not exist?
Probably. Historically, it was clear that many active managers didn't want them to exist. There is still a camp of people who are envious and therefore wish they weren't there, because they have to work harder to prove they can deliver that alpha. If you're not, [ETFs] kind of put you to shame.
ETFs have crossed the $2 trillion milestone in the U.S. market. How soon then until they cross $3 trillion?
We actually saw in the past two years alone globally assets increase by a trillion dollars. We've seen typically every five years the assets doubling. But a lot of it is going to depend on, does the SEC approve non-transparent active ETFs, and do firms that want to get into that space convert existing funds into ETFs? If that happens, then ETF assets will grow very quickly.
So much of the future is going to depend on the regulatory changes, and how do new entrants bring products to market. That could also bring significant changes. We have seen in Europe that when Credit Suisse entered the ETF industry, at the beginning they converted an index fund into an ETF. Going from zero to $500 million overnight is a way to grow the industry really quickly. Part of the difficulty in forecasting is that there are a lot of variables out there today.
We're not sure how the regulators will respond, and we're not sure how these firms - there are over 30 that have filed non-transparent active funds - plan to enter the ETF industry. But clearly, more competitors bringing up more strategies means the industry will grow very quickly, especially if we get 30 new entrants and the SEC approves them.
Is there a possibility that regulators might want to slow or stagger the growth of the ETF market?
Anyone entering the ETF industry has to apply for exemptive relief, so they do really control what comes to market. I'm not sure it's so much about controlling growth and proliferation, but rather determining if the products trade close to net asset value. That's why the SEC didn't approve the Precidian BlackRock non-transparent, but did approve the Eaton Vance proposal.
Where do you see product innovation happening? Could there be any cross-over from Europe?
We've seen smart beta grow more quickly in Europe than in the U.S. Many of the largest firms in the ETF ecosystem are part of the global market, so they are looking to tap into the good ideas in one region and bring them to others.
