Exchange-traded funds (ETFs) in Europe became even more popular during 2014. That was shown by the assets under management, which were set to hit all-time highs toward the end of the year. The net flows into ETFs were also at record levels.
This raises the question of whether ETFs can continue their success in 2015 and the years beyond. To find out more about the future growth strategies of ETF promoters, Detlef Glow—Lipper's Head of EMEA Research—spoke with Ian "Hector" McNeil, Co-CEO at Wisdom Tree Europe Ltd, during the Lipper Expert Forum in London on November 11, 2014.
What are the major challenges that ETFs face with regards to the growth of the overall ETF segment right now?
The growth of the ETF market could be stellar compared to the other asset management sectors. If you consider Europe is $450bn and approximately 3% of the total Mutual Fund market AUM compared to the US where ETFs are at $2tn and 12% respectively (ETFGI press release 7/07/14). What is even more telling is that the growth rate velocity is significantly steeper than any other segment as well.
Europe stalled somewhat 2010 to 2012 due to the internal bickering in the industry over the risk issues around physical and synthetic products. That debate has largely been settled with physical being the preference for the vanilla ETF product. Synthetic still has a role in providing access to exposures that physical can't such as short and leveraged and commodity exposures. During the industry fight new ETF investors took flight, but now the understanding levels are significantly higher they have returned in droves.
Going forward the industry will see the following areas of development leading to exponential growth to catch up and rival the US ETF market. Areas such as:
- ETF model portfolio providers who will offer IFAs ways to implement ETFs for their clients
- A liquid borrow market of the ETF itself to help increase liquidity and investors who want to short. Plus provide extra income to holders of ETFs to help reduce carry costs
- A deep and liquid options market for ETFs. Offering simple ways to hedge or deliver yield
- Increased availability of 'smart beta' ETFs to allow ETFs to become more competitive against active mutual funds
- Increased journalist awareness of the benefits of ETFs over other instrument types
There is a lot of noise around the so-called smart beta or factor investing ETFs at the moment. Are these products the next big thing in the ETF industry?
WisdomTree (WT) has been one of the main advocates of alternative beta more commonly known as 'smart beta'. WT made a decision around 2005 that there was a better way to index than market capitalisation. The following quote "Earnings basis for weighting stock portfolios," in an Interview with Robert Jones, Goldman Sachs Asset Management, Pension & Investments, 6/8/1990 helps describe the central flaws to market cap indices:
"Stocks are not always fairly valued, at any given time there'll be some stocks that sell below fair value and some that sell above fair value. The problem is finding which is which...
The ones that are overvalued have more capitalization than they would have if they sold at fair value and the ones that are undervalued have less capitalization. Therefore any cap-weighting scheme like an index fund will, almost by definition, mathematically over-weight the overvalued stocks and underweight the undervalued stocks.
If you assume prices eventually will tend toward fair value, that would make an [market cap weighted] index fund a suboptimal portfolio. Our idea is to weight using another measure that is a better representation of the economic importance of the company."
WT in Europe currently focuses on dividend weighted indices. Many of these indices have track records going back 7 to 8 years and that live track record has on the whole delivered better risk adjusted returns. Performance against market capitalization is often better and also the relative yield is higher.
Smart beta also allows ETFs to challenge the active management world in in terms of performance at a lower cost. This offers cost effective better risk adjusted returns over time.
From your point of view, what will be the growth drivers (markets/client segments/products/etc.) for the ETF/ETP segment in the next few years and how do you ensure that WisdomTree Europe ETFs/Boost ETPs will participate from these trends?
The main driver for growth will be a broader adoption of ETFs by the broader investor community. The spectrum of this will include self-directed retail up to institutional and hedge fund managers. ETFs will be used for a wider and wider variety of solutions some but not all are included in the chart below:
ETFs will continue to take market share from the mutual fund world, but will start to compete with many other asset management product including listed and unlisted derivatives. As the choice broadens from beta to smart beta to active there will be very few areas where choice is not
How will the ETF/ETP landscape (products, promoter, trading, availability of products, etc.) change over the next five to ten years?
So far, Europe has not seen the emergence of many independent and specialist players, whereas in the US there are over 40 such providers. US providers have also started moving into Europe, for example First Trust recently established a European business and WisdomTree bought a majority stake in Boost, with the objective of launching its platform into Europe.
There have been some independent European success stories, such as ETF Securities and Source, which should provide encouragement to US firms and European start-ups. ETF Securities has experienced unbelievable success in the commodity space and Source has had some success in the same sector space and other niche investment strategies. Source's roots, however, are not truly independent; whilst managed independently it was originally owned and set up by a panel of investment banks. It is likely that new, more specialist players will emerge and fill the void left by these retrenching investment banks. This will be especially the case for innovative ETF investment strategies rather than straight 'beta'.
The main battleground for innovation is, and will remain for some time, what is loosely referred to as 'Smart Beta'. This is an imprecise 'catch all' term for index methodologies other than market capitalisation, united by a philosophy that market cap weighting tends to overweight stocks that are already overvalued and underweight future value. 'Smart Beta' is where providers will focus their innovation, and where savvy investors will focus their trading and investment strategies. Particular success has been evident for methodologies that weight by dividend, by earnings, by minimum variances and through equal weightings. 'Smart Beta' will allow the ETF industry to push the investment case for lower cost actively managed funds, especially where those strategies are proven by positive track records, for instance WisdomTree, with its seven years' experience in this area.
2014 and beyond will see the European ETP market continue to grow rapidly, change in structure and see increasing innovation. While safe to say the US is still leading the way, Europe is learning and catching up fast!