An expected doubling of the Australian exchange-traded funds market by 2020 will create unprecedented investment choice but could leave those who underestimate the risks of new-style ETFs flying blind into the next market storm.
Exchange-traded funds (ETFs) have become a $US4 trillion phenomenon as more investors worldwide switch from active managed funds that aim to outperform, to cheaper index funds that replicate a market return.
After lagging for years, Australia’s ETF market is catching up, off a low base. The combined capitalisation of ASX-quoted ETFs was almost $40 billion in July this year, up 33 per cent in 12 months, ASX data shows. Our market is racing towards 200 ETFs.
“The ASX ETF market will be worth $100 billion within three years,” says VanEck Australia managing director, Arian Neiron. “That’s based on monthly inflows doubling to about $1 billion, plus the overall market return each year.”
ETF Securities founder, Graham Tuckwell, says: “Australia is many years behind European and US ETF markets. Our ETF market has potential to be 10 times larger than it is now.”
Tuckwell, a pioneer of the global ETF market, says the split between active and index funds should reverse. “It makes no sense having 80 per of global equity assets in active funds and 20 per cent in index funds. It should be the other way around: a large base of low-cost ETFs and a much smaller group of active managed funds that outperform over long periods.”
Like most issuers, ETF firms are perma-bulls on their product. For years they have preached the virtues of ETFs over active funds; namely, that index funds deliver better returns than the majority of active funds in the long run (after fees) and are more transparent.
Their message has taken longer than expected to resonate. The local market is worth less than 2 per cent of Australia’s $2.6-trillion superannuation pool. Even at $100 billion, the entire ETF market would be worth less than the value of the Commonwealth Bank.
But three factors suggest the ETF market is on the verge of explosive growth. The Financial Services Royal Commission has sparked daily headlines about fee gauging and poor ethics. Although not related to ETFs, this publicity could encourage more people to favour low-fee products, seek independent advice or manage their own investments.
The second factor is the rise of exchange-traded managed funds on ASX. Platinum Asset Management, Magellan Financial Group and other prominent asset managers have this year launched active ETFs, which are essentially listed managed funds bought and sold like shares.
There are already 21 active ETFs and more on the way as asset managers use ASX as a channel to reach the fragmented self-managed superannuation funds (SMSF) market.
SMSFs are another factor. Fund trustees comprise a third of all ETF investors and the number of SMSFs that use ETFs has almost tripled since 2010, according to the latest BetaShares/Investment Trends’ Australian ETF report. The rise of robo-investing platforms that use ETFs in portfolio construction and maintenance is also driving growth.
If ETFs become a core tool in the $712-billion SMSF sector, the Australian ETF market will become larger than even the most bullish forecasts.
BetaShares CEO, Alex Vynokur, expects strong growth in fixed-interest ETFs, ethical and sustainable index funds, and thematic ETFs in sectors that are underrepresented on ASX. BetaShares is expected to launch an ETF over Asian tech stocks later this year.
Vynokur also expects continued growth in traditional, low-cost ETFs that provide market-weighted exposure to key sharemarket indices. BetaShares, better known for innovative rules-based ETFs, has taken on global issuers this year with the launch of an ETF over ASX 200 stocks.
“The core, market-capitalisation weighted ETFs will still get the bulk of fund inflows,” says Vynokur. “But around that we’ll see continued ETF innovation as issuers find ways to give Australian investors exposure to asset classes, strategies or themes that are hard to access locally.”
This escalation in the volume and value of ETFs is attracting regulatory scrutiny. A recent Australian Securities and Investments Commission (ASIC) review said our ETF market is “generally functioning well” and delivering on its promises.
ASIC identified potential red flags around liquidity, market-marking, bid-ask spreads, indicative net asset values and tracking errors (an ETF’s return compared to its underlying index). The ETF market is mostly handling these issues well, although some smaller funds are less effective and disclosure standards vary.
But the ETF market is being tested in relatively benign market conditions when momentum strategies, such as index investing, are in favour and liquidity is OK. It is less clear how the new breed of ETFs would perform in a market crash when buyers are scarce.
The size of the global ETF market has prompted fears that index funds could spark the next GFC if investors sell en-masse and liquidity stalls – a claim that was not supported during the global equities sell-off in February when ETFs mostly performed as expected, according to US broking giant, Charles Schwab.
Still, if Australia follows international trends, many more issuers will enter this market with funds over increasingly esoteric, unproven indices.
There is talk of cryptocurrency ETFs being issued here by year’s end. Investors who engage in mindless ETF strategies, believing diversification will save them, could face horrendous losses if markets tumble.
“More exotic ETFs with less transparency or governance of their index construction have not been tested in conditions of higher market volatility,” says Patrick Garrett, CEO of fast-growing robo-adviser, Six Park.
“It’s when volatility spikes that we may see a real division between well-constructed ETFs with tested market liquidity versus flavour-of-the-day ETF themes that are attractive on the surface but have fundamental flaws with liquidity or index construction.”
Even some traditional ETFs that provide exposure to market-weighted indices, such as the ASX 200, have rising risk. Most ETF assets here and overseas are in such funds and there is a raging fees war to attract investors who chose mostly on price.
Fidelity Investments this month became the first issuer to launch no-fee ETFs overseas, which some rival managers described as a publicity stunt. But the trend towards lower fees is well established and has further to run. The new BetaShares Australia 200 ETF, for example, charges 7 basis points annually, a fee that was unthinkable a few years ago.
As fees falls, some ETF issuers are moving from using well-known index providers, such as Standard & Poor’s and MSCI, to cut costs. BetaShares, for example, tracks the Solactive Australia 200 Index. It is unclear whether newer index providers have the same level of index governance as the world’s largest providers and what that means for ETF investors.
Six Park’s Garrett is concerned about the trend of market-weighed ETFs using lesser-known indices. “The best ETFs tend to be based on indices that are created and governed by reputable providers with a track record in the market. “
So-called smart-beta ETFs, a source of strong recent growth in the ETF market, also present challenges. By combining elements of passive and active management, they aim to deliver enhanced returns, or lower risk. They could, for example, use a custom-built, rules-based index to identify higher-yielding shares.
Online investment adviser, StockSpot, identified shortcomings with smart-beta ETFs in its latest Australian ETF Report. “While rules-based ETFs are becoming more popular, their ability to outperform market-cap weighted ETFs on a risk-adjusted basis is questionable,” it said.
StockSpot said backtesting studies that issuers use to market smart-beta ETFs can “give false confidence”. It likened backtesting, which examines an index’s historical performance over many years, to “shuffling a deck of cards … until a favourable shuffle emerges”. The risk is issuers choose the best possible backtesting timeframes to promote their ETF.
Also, StockSpot says, smart-beta ETFs often outperform the market because they have higher risk and are may be launched to capitalise on hot trends. For example, smart-beta dividend ETFs were launched as demand for high-yielding products peaked in 2014-15 and some have underperformed. “Unfortunately, underperformance tends to end soon after smart-beta ETFs are launched,” said StockSpot.
Six Park’s Garrett says: “With rules-based ETF indices, the quality of the rules needs to be assessed as they determine the quality and returns of the ETF. Some of the poorest performing ETFs looked great on paper, but have been based more on marketing and flawed premises and less on the basics of low cost, transparency and simplicity.”
Thematic ETFs that provide exposure to global sectors also tap into hot investment trends. Several issuers have launched funds over technology indices or in ethical investing in the past 18 months. Some have performed strongly but the global ETF market has a history of launching niche funds that cash in on investment fads and are too small to be sustained.
Active ETFs (listed managed funds) also have challenges. Although grouped under exchange-traded products (ETPs) on ASX, they are worlds apart from most ETFs that take a passive index approach. Traditional ETFs disclose their holdings daily, but active ETFs need only do after each quarter, making them less transparent.
Moreover, active ETFs mostly rely on internal market makers to provide on-market liquidity, by creating or redeeming units in their fund to meet supply and demand. Traditional ETFs typically use a few external market makers to provide liquidity and ensure a tight bid-ask spread around the fund’s net asset value, so the ETF trades at a fair price.
VanEck’s Arian Neiron is wary of active ETFs. “We support the role of active funds management but have so far steered away from active ETFs,” he says. “A lot of well-known fund managers overseas have raised money and launched active ETFs that have not been successful.
“Active ETFs in Au On balance, the Australian ETF market has so far managed these and other risks well. Never-ending criticism of the market, often from active managers who have a vested interests, is not yet supported by data or local market trends.
Nobody doubts that ETFs are filling gaps for Australian investors or becoming a useful portfolio building block. Or that low-cost ETFs can deliver better risk-adjusted returns in parts of portfolios and complement well-chosen active funds that have a critical role.
But with tens of billions of dollars expected to flow into Australian ETFs in the next few years, and many new products on the way, investors need to do their homework: understand the issuer, market makers, index construction, fees, tracking error and other performance indicators.
Smaller ETFs that invest in illiquid securities or have unproven strategies could be stranded in the next market storm, drowning investors with catastrophic losses.
Australia have not yet been tested in conditions of high volatility, so we don’t know how well their internal market-making capabilities function.” Neiron expects more active ETF managers to appoint external market makers to provide liquidity, transparency and greater price discovery.