Wealth managers increasingly incorporating ETFs into clients’ portfolios

18 July 2014   Category: News, Asia, Global, Hong Kong   By Derek Au

Since launching over two decades ago, the global ETF market has grown into a US$2.5 trillion business backed by more than 5,000 products. Behind the explosive growth of ETFs, wealth managers have played a key role by increasingly adding these low-cost products to investors’ portfolios.

According to a survey by the US-based Financial Planning Association (FPA), the principal organisation for Certified Financial Planner (CFP) professionals, financial advisers’ use and recommendation of ETFs continues to grow, outpacing all other investment vehicles. The survey revealed that 79% of financial advisers currently use or recommend ETFs when working on an investor’s portfolio, up from just 40% in 2006. Although 57% of advisers believe a combination of active and passive management provides the best overall investment performance, the proportion that are likely to have increased their use of passively managed funds over the past year is 30%, higher than 18% in the case of actively managed funds, the research showed. 

“The study seems to point to a shift toward investments with greater transparency and liquidity,” says director of the FPA Research and Practice Institute, Valerie Porter. “Perhaps advisers are responding to consumers’ demands for lower cost investments that allow them to be more nimble in their investment approach.”

Versus mutual funds

Among wealth managers, Hong Kong-based investment firm EXS Capital, which manages $260 million, is perhaps an extreme example of the industry’s enthusiasm for ETFs; in 2009, it migrated all of its investors’ assets to ETFs.

Managing director, Jessica Cutrera, tells AAM’s sister publication ETFI Asia that ETFs provide investors with benefits such as low cost, high liquidity and accessibility to more markets and asset classes, as well as more predictable performance. “In our experience, particularly on a five-to-ten-year basis, the vast majority of active managers underperform the market, particularly in developed economies. So in our view, using an active manager for US large cap stocks – we don’t believe an active manager adds value in that space. So we look for low-cost, tax-efficient ETFs to allow us to access the segment in the market we want.”

Ms. Cutrera adds that the all-ETF strategy has proved effective, as it helps wealth managers save costs compared to active funds, which incur average expense ratios of about 125 to 150 basis points. 

In fixed income, where current yields are at historic lows, this point is particularly pertinent. “You could use a bond manager, but right now in fixed income, yields are very, very low. So I can buy some of iShares’ bond ETFs for less than 20 basis points. An active manager probably charges me at least 100 basis points,” she says. 

Another wealth manager, UK-based London & Capital, with AUM of $4.1 billion, covers both ETFs and actively managed equity and fixed income vehicles. It concurs though that the relatively high management fees for active funds deter investors. 

Chief executive officer, Philippe Legrand, says: “ETFs are stock exchange traded, and thus transaction costs are minimal; whereas for mutual funds, typical upfront charges range between 1% and 5%. These upfront charges will seriously affect clients’ performance; this is particularly true under a low interest rate environment. It does not make sense for investors to pay that kind of upfront charge for a bond fund yielding about only 3% to 5% nowadays.” He adds that more investors would turn to ETFs if they were aware that, on average, actively managed mutual funds underperform their respective benchmarks. 

Mr. Legrand says that his firm has in-house, actively managed discretionary equity and fixed income bespoke portfolios for long-term investors, while ETFs are generally used for shorter horizon investing requirements. “For satellite investments – short- to medium-term, thematic and exotic plays – we would use ETFs, if available, to gain exposures in these spaces, as these are pretty much beta plays.” He adds that the firm will choose between ETFs and mutual funds based on their cost-effectiveness and risk/reward metrics from clients’ perspectives. 

The wealth management industry in Hong Kong acknowledges that the use of ETFs has been growing among institutions, advisers and retail investors worldwide. Linda Luk, a member of the member services committee at the Institute of Financial Planners of Hong Kong (IFPHK), anticipates that the regional ETF market still has plenty of room for growth, as investors and advisers become more familiar with the use of different types of products. 

“A key driver for ETFs is their relatively low cost compared to similar funds. Currently, many of the funds available for sale across Asia offer trailers or additional commissions for the adviser selling such investment vehicles. As investors become more educated, and advisory services become more fee-transparent, we will continue to see significant growth of ETFs across Asia,” says Ms. Luk. 

She adds that another major benefit of using ETFs, compared to mutual funds, is the effectiveness of benchmark diversification. “An ETF might contain hundreds or thousands of securities – more than many actively managed funds, and far more than a typical portfolio of individual securities. However, this can vary by ETF, so it is important for an investor to go beyond the headline name of the ETF in order to truly understand the market coverage and number of holdings in the fund.” She also points out that ETFs give investors greater trading flexibility, as they offer intraday pricing which facilitates shorter-term tactical decision-making within a portfolio. 

Ray Chan, vice president, head of ETF business development, Asia ex-Japan at State Street Global Advisers (SSgA), the manager behind the SPDR stable of ETFs, tells ETFI Asia that the uptake of ETFs by high-net-worth individuals (HNWIs) is a trend of note. 

“We are starting to see a trend evolving among wealth managers – especially at the HNWI level, and mainly through private banks – in that the use and uptake of ETFs has been on a continuously increasing uptrend over the last few years. I think especially after the financial crisis, there has been a lot of emphasis on searching for investment vehicles that are easy to understand, simple and transparent. So these are some of the key attributes ETFs clearly present to a lot of wealth managers,” says Mr. Chan.

He adds that Asian wealth managers have put a lot of focus on the use of more traditional broad-index ETFs, as uptake of ETF products in the region is still at a nascent stage. However, Mr. Chan says that the penetration of sector ETFs has been increasing as well. “More recently, we have been seeing a lot more activities. Wealth managers are trying to gain more traction using different sector ETFs to fulfil their asset allocation purposes, because more and more wealth managers are starting to realise the benefits and the convenience of using ETFs for those strategic and tactical asset allocation adjustments.”

Need for education

While wealth managers are stepping up the use of ETFs in order to build their clients’ portfolios, there are indications that this trend is still in its infancy. According to a survey by research firm S&P Capital IQ, half of the 150 respondents said that they used ETFs for between 0% and 20% of their clients’ assets, while just 12% used ETFs for 60% or more of their clients’ portfolio. The consultant believes wealth managers’ need more education on ETF trading and structures before they will make greater use of these products. 

Unsurprisingly, indices providers and ETF issuers have been actively promoting education on ETFs. John Davies, vice president of global exchange-traded products at S&P Dow Jones Indices, says: ”Wealth managers carry out various due diligence procedures as part of their normal business practices. We work proactively with product issuers and wealth managers to provide as much education and awareness of how the underlying indices are part of the process. There is an ongoing shared responsibility between ourselves and product issuers in this continuous process.”

Mr. Chan points out that SSgA has also been actively involved in education on ETFs for wealth managers. “We have direct dialogues with different end users or investors of ETFs in different market segments, such as institutional wealth managers, and we constantly come up with ideas of trying to help them understand the benefits of ETFs.” He says that SSgA has held numerous educational sessions and events for clients to try to build up awareness of ETFs. 

Conflict of interest

However, even for wealth managers that have become familiar with ETFs, they may still choose to promote actively managed mutual funds to clients, due to the prevalence of the existing commission-based adviser model. 

However, Ms. Cutrera says that the gradual shift towards annual fees has helped to remedy what appears to be a conflict of interest scenario. She cites the example of the US, where in the past decade or so wealth managers have begun charging clients a portion of assets as annual fees, rather than taking commissions on individual transactions. 

In addition to the US, regulatory changes in the UK and Australia have also restricted the ways that fund issuers can offer commissions. Mr. Chan says he hopes that Asian regulators will follow suit in this regard. 

“In the UK and Australia in the last few years, we have been seeing a ban on commissions received by advisers from the mutual fund providers. So with those kinds of activities, you automatically and immediately align the interests of distributors and the end clients for the intermediaries to look for the best and most cost efficient solutions,” says Mr. Chan.

There are signs that more countries are looking to scrap the commission-based adviser model. Mr. Davies believes this could lead to an uptake in wealth management and retail use of ETFs. He adds that these products have helped to democratise investing, and “have become an important instrument in the investment tool kit for wealth managers, and will become increasingly so.” 

“ETFs represent around 10% of global fund assets. However, it took around 17 years for the first $1 trillion to be invested in global ETFs; it only took three years for the second trillion dollars to be invested; and now within 18 months we are half way to the third trillion. As investors look more and more for cost effective portfolio management and outcome-oriented investment solutions, index-based investing will assume a more important role and ETF assets will grow as a result,” Mr. Davies concludes.