Deborah Fuhr, managing partner at ETFGI, is one of the world’s leading experts on the exchange-traded fund (ETF) industry. She has been researching ETFs for twenty years, and as one delegate at the CoreShares ETF Exchange remarked last week, there doesn’t seem to be anything she doesn’t know.

At the conference, Fuhr recalled how when she started covering the ETF industry in 1997 there were just 21 products listed on world exchanges, with assets of $8 billion. Today there are nearly 7 000 exchange-traded products listed in 56 countries, holding investments worth over $4 trillion.

This growth is not only remarkable in real terms, but also in relative terms.

“Compare this to the hedge fund industry,” Fuhr said. “The first ETF product was launched in 1990 in Canada, making the industry 27 years old. The hedge fund industry is 67 years old, but in June 2015 the assets in the ETF industry overtook those in hedge funds, and at the end of the first quarter of this year it was more than $800 billion larger.”

Seeing alpha differently

She said that the uptake in the use of ETFs is still growing as more and more investors are adopting a ‘barbell’ approach to their portfolios.

“Where they can find alpha, whether through individual securities, active funds or hedge funds, they do that,” Fuhr noted. “But increasingly they are finding that it’s difficult to identify active or even hedge funds that consistently deliver alpha. So they are looking to use active strategies on one side and embrace ETFs and indexing on the other side, with the goal of generating alpha through asset allocation.”

As Fuhr pointed out, studies have shown that around 90% of long-term returns are due to asset allocation. As ETFs are a simple way to gain broad exposure to specific asset classes, investors and financial advisors are increasingly using them for this purpose.

“We are seeing significant growth in ETFs because people are seeing alpha differently,” she noted. “For instance your global equity exposure might be through an MSCI world index tracker, but you can then use other ETFs to overweight specific regions like Japan or the US. This allows you to tactically generate alpha, and increasingly we are seeing people doing this.”

In these instances, ETFs are often used to express views about where people do or don’t want to be invested, based on what is happening politically and economically. This allows for more specific risk management.

The same applies to balanced portfolios across multiple asset classes. ETFs offer an efficient and cost-effective way to gain or increase specific exposures to fixed income, property and commodities.

ETFs have also become very popular as a way to invest in emerging markets where research is either hard to find or difficult to understand.

“It’s very difficult to use research produced in China written in Chinese, for example,” Fuhr noted. “Many investors use ETFs to gain exposure to Asian markets, and I think that will continue to happen.”

New uses

Smart beta also continues to gain popularity. Over the last 15 years the compound annual growth rate of smart beta ETFs has been 31.9% compared to a 19.0% compound annual growth rate for ‘vanilla’ market cap products.

These funds allow investors to introduce factor tilts, such as value or momentum, into a portfolio, or address specific needs like providing an income through high-dividend products. They are also, increasingly, providing access to themes such as sustainable and responsible investing.

The nature of ETFs is also opening up interesting new uses.

“ETFs have always been a unique offering,” Fuhr said. “They are the only product I know of that is democratic in that everyone has access to the same toolbox at the same annual cost, with very small minimum investments.”

This is what has led to the birth of ‘active ETFs’. These are essentially actively-managed funds listed on an exchange within an ETF wrapper.

In some countries there are tax benefits to doing this, but the more interesting reason for their development is that they break down barriers to access. As they can be bought and traded like any share, there is no need for these funds to be listed on platforms and investors can buy into the fund at the cost of a single security.

A concern for some fund managers, however, is that many regulators require ETFs to disclose their holdings daily. This means everyone is aware of what the managers are doing, which can make it challenging to buy into and sell out of positions.

It’s difficult to see how this could be overcome, and this may limit the appeal of these products, but it does show how innovation is taking the industry far beyond the traditional use of ETFs as just vanilla broad market index trackers.

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