Complex variety spices up a maturing market
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John Davies of S&P Indices talks to Gary Jackson about the prospects for exchange traded funds.
Q. What broad trends are you seeing in the exchange traded fund (ETF) market?
A. There has been a lot of flows into fixed income products. The European uncertainty has driven a lot of flows into fixed income - with huge flows going into US fixed income.
Last year and this year to date, you have seen a lot of assets move into German products, especially equities. In the main, US equity-based products have had a very positive year so far for flows. With European equity products, unsurprisingly, flows have been suppressed. Similarly, commodity-based products have had an up-and-down year, but we still think commodity products will be attractive to investors in the long term.
Q. What about on the regulatory front?
A. The past 18 months have featured a regulatory focus on the structure of the products themselves, whether they be physical or synthetic. A number of providers have taken decisions on the back of that to switch their product types from synthetic to physical.
We are agnostic because we provide the underlying index - the product structure is down to the issuer. But I would say that if you want to provide exposure to certain asset classes, you
have no choice but to use synthetics. If you want real exposure to the commodity futures markets, for example, then you are going to have to use synthetic products.
Q. Do investors show any preference towards physical or synthetic ETFs?
A. The main issue is education. One could argue that historically there wasn’t an issue on using synthetic over physical because it was mainly professional investors involved. The focus in Europe now is to have more transparency on the product structure.
If you look at the asset flows for 2011 and where the top four providers ended up, BlackRock gained new assets and in the main all their products are physical while Lyxor and Deutsche Bank, which are predominantly synthetic, had fairly large outflows for the year.
Whether that is a direct correlation between investors making a choice between physical and synthetic, we do not really know. (Q&A continues below)
Q. A recent Skandia survey suggested that a majority of financial advisers have little understanding of ETF structure. Does this match up with your understanding?
A. Historically I would not have argued with that analysis. But in the last year you have had BlackRock and State Street ramp up their programmes to reach out to IFAs by putting on roadshows to educate them on how the products work.
We also work with the issuers by providing them with research and back-up material for products they have based on our indices. For smaller institutions and retail investors they should be an ideal vehicle to use - as long as they understand what they are buying.
Q. The FSA has expressed concern about the complexity of ETFs.
A. You can have very simple ETFs or you can have very complex ETFs - it is no different from any other investment vehicle. The key thing is to make sure they are transparent so people can understand what they are getting involved with.
Volatility is a perfect example. There are several products in the market based on the S&P VIX index and that is a complicated strategy to understand. But if you look at Source, who have issued some of these ETFs in partnership with Nomura and JP Morgan, they predominantly market these to large institutional investors and again there is a lot of work going into explaining how these products work.
Q. Could we talk some more about volatility ETFs?
A. When the first volatility ETFs came out, they were just plain beta exposures to the index itself and they were not that successful.
By the very nature of replicating the index you have to roll the futures contracts every month and that incurs costs, which bite into the capital investment.
What the second generation of products has done is build into the index ways of efficiently managing the roll to mitigate against the contango effect and it is those products that have seen fairly large inflows this year.
Q. Do you expect ETFs to be beneficiaries of RDR?
A. In theory they should be because they are the lowest cost investment fund that a retail investor can buy. We’ve seen fee pressures on ETFs over the last couple of years where the TERs [total expense ratio] on some of these products have come down.
However, selling into the retail space is a challenge for any investment product. The challenge is making sure the level of transparency, communication and education is there. Education and transparency are critical to the success of ETFs because the cost savings are there already in the product.
Q. Do you see greater use of ETFs in core-satellite strategies post-RDR?
A. There is room for ETFs within a traditional core-satellite where you have active managers as well or you can use them for your portfolio in its entirety. About three years ago there was a small European pension fund that decided to use ETFs for their entire allocation because it was just much cheaper for them to do that. They still do that, as far as I am aware.
Q. What innovations in ETF development do you see coming?
A. People have been talking about active ETFs for a long time. But the challenge for active ETFs is you have to make sure your trading activity is fully transparent in the underlying index. Will active ETFs be the next huge wave? I think the jury’s out, to be perfectly honest.
In terms of other innovations, because of the global economic uncertainty there’s been a switch back to looking at dividend products. State Street launched a US high dividend yield product with us at the end of last year and I think that’s now just short of $600m.
At the same time, because of the volatility in the markets over the last couple of years, we’ve been working with groups to bring out low-volatility versions of standard exposures. PowerShares launched an ETF in the US last year based on the S&P 500 Low Volatility version. That product raised about $1.6 billion in a year and we have a number of partners who are interested in doing similar things in Europe.
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JOHN DAVIES is the head of exchange traded products, Europe at S&P Indices.
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