Round table: The UK ETF market comes of age

iShares FTSE 100 UCITS ETF (ISF) launched on the London Stock Exchange 16 years ago and since then the market in ETFs has boomed, with assets invested in ETFs listed globally breaking through the $3 trillion milestone for the second time ever at the end of the first quarter of 2016 (assets first broke through the $3 trillion barrier in May 2015). ETFs are most commonly used by investors as a low-cost way of targeting a wide range of asset classes and regions, and are becoming more prominent parts of investors' portfolios.

Let's start with a simple question - what is an ETF and what are the key differences between an ETF and a tracker fund - when would you use one over the other? And when is an active fund better?

JP: An ETF is a simple, transparent and easy-to-use vehicle that is traded on a stock exchange and tracks the performance of an index. ETFs and trackers are both designed to track an index, but an ETF has continuous liquidity and you are able to trade it intraday - many investors choose ETFs over trackers because they offer that. Typically, an ETF will also offer more exposure than a tracker - for example, in emerging markets or the bond markets, whereas index funds tend to be more about core exposures.

AL: Tracker funds are simple investments and tend to give straightforward exposures in core areas. ETFs play a part where you need more niche exposure or when you need more flexibility in investing. Active funds have a lot more powers and active fund managers can go into different areas for different reasons, so have the potential to outperform, although in reality not all of them do and most investors blend all three in their portfolios.

ETFs are often flagged as being very low-cost investments. But are there less obvious costs that go beyond the headline fee?

AL: On an annual charge basis, ETFs do tend to be one of the lowest-cost options out there, but don't forget the part that trading costs play. If you are holding the ETF for a short time period then you might find that the bid-offer spread (gap between the buying and selling price) has more of an effect on your total investment over time. You can find spread quotes on most brokers' websites or if you are talking to a broker over the phone they will give you an indication of what it's like for the size you are trading.

JP: Trading costs for the retail or individual investor are continuing to improve and we work very hard with our partners to try to improve the processes behind trading an ETF across the industry. We try to manage the bid-offer spread on our products and have a team who do that with our brokers, as well as a team who do it with our partners - the platforms. With platforms such as Hargreaves Lansdown and Bestinvest we work with their teams to make sure that we deliver the best solution for the client.

What is a smart-beta ETF and when is it useful?

JP: Smart beta is, in our view, just the evolution of investing. As technology advances and data becomes more globally available, we have been able to take aspects that were the realm of active managers and capture them in an index that an ETF can track.

AL: I think where smart-beta is useful is where it starts to take the place of an active manager in a portfolio because that is where a lot of these ETFs are being used. They are being constructed to do something a simple FTSE All-Share index, for example, couldn't do.

When does smart-beta become stupid? Has it become a gimmick and are there too many smart-beta ETFs out there now as a result?

BSS: This is an innovative area and it's such a broad church - it is only natural that all of these new strategies will launch and be tested by the market. I don't think there are too many ETFs, but there will be a pruning process whereby some will get a lot of attention while for others it turns out there is not a demand.

I wouldn't say the market is getting more gimmicky, but we have seen a shift in smart-beta away from strategies such as value and quality, which are broad investment strategies, to more thematic ideas such as share buybacks. There is nothing wrong with thematic investing, but if we start seeing ETF indices for everything beginning with B that will be a problem.

AL: I don't like it when products get overly complex. A lot of these strategies were developed for institutions and professional investors who have complex needs, but which don't apply to an individual's portfolio. Some of these have been criticised, too, because they've been built for marketing reasons on back-tested results, rather than designed on their potential to deliver returns in the future, and I am very wary of that.

Time will tell if this market is a bubble. The best products that do use time-tested strategies and methods probably will come out well overall, but you need to be prepared for a period of underperformance with any investment.

How should investors go about putting together an ETF portfolio?

BS: For a purely passive portfolio you start with asset allocation, so think about broad markets, then take a view on whether you want exposure to equities or bonds, and drill down into sub-allocations, which means looking at things like geographical or sector exposures. Then consider whether you want to add some sort of (smart-beta) tilt, maybe a value or quality ETF or an income requirement.

AL: For core portfolios, I think standard mainstream indices are the simplest and lowest cost way to get access, but smart-beta can provide something extra and do things active managers do in your portfolio, for example producing income, reducing risk or boosting returns.

What are the most common mistakes you see in ETF investing?

BSS: The first common mistake that I come across is looking only at the reported ongoing charge figure, and not thinking about the additional internal and external costs like the bid-offer spread. The other common mistake is not understanding the index and only reading at the top line of what it does. Obviously, the FTSE 100 is pretty simple, but once you get into more complex areas even some of what people think are mainstream indices, like buying a European ETF, can be more complex. For example, is it a Europe or Europe ex UK index? And what about Asia Pacific? You might want an ETF tracking ASEAN (Association of Southeast Asian Nations) and China, but not realise that you are instead tracking a developed Asia index with 60 per cent in Australia, and a little bit of Hong Kong and Singapore.

Are there advantages in using ETFs to invest in bonds?

JP: I think the bond market in ETFs is now coming of age and becoming much more important. The take-up has been slower than in equities, but awareness is growing that people have been looking more at fixed income, particularly at the type of bond they might not be able to easily hold directly such as emerging markets or high yield. We are looking at the end of a 30-year bull market in bonds, so people are becoming more aware of what they're holding and also want to be more nimble in investing, and an ETF provides a lot of that.

Fixed-income portfolio managers are also finding it harder and harder to find the liquidity they need in the bond markets, so use an ETF. This is where the secondary market element of an ETF becomes very important (the fact that ETFs trade on stock markets). There are many days where hundreds of investors are trading our fixed-income ETFs without us having to go to the bond market to create new units of the funds. At any time, we see a lot of buyers and sellers which is where fixed income ETFs, given the spreads you sometimes see on fixed income securities, become really interesting for both retail and institutional clients. Sometimes when there is stress in the high-yield market, some investors see opportunity and want to buy, while others want to sell, and we don't even need to trade the underlying bonds as investors are just buying shares off each other.

So why are bond ETFs often perceived as a riskier and more controversial area?

AL: The controversy is focused on this idea of liquidity. The worry is to do with the fact that ETFs trade much more frequently than the investments within them. If that broke down at some stage it could create an issue for investors in selling their ETFs. This has happened in some places in the US and we haven't experienced it in the UK, but it is a possibility and a danger, so investors need to exercise caution.

If markets look as though they are facing problems, there is a high level of trading and things are looking irrational, it is wise to take a step back and leave it for some time. Just because ETFs can trade every day and throughout the day, as an investor you should not go in intending to trade throughout the day because you might get into problems.

BSS: Liquidity around ETFs is a confusing subject. People often talk about ETFs as being very liquid, but ultimately if that liquidity is one-way, then an ETF can only be as liquid as its underlying assets. What we've been talking about is two-way liquidity: as long as there are buyers and sellers you can trade significant volumes and don't have to touch the underlying assets. But that's different to one-way liquidity. You might say a market isn't very liquid, but I can tell you that if there's a panic and everyone is trying to sell, it's very easy to buy a high-yield bond or ETF and that's where things can get more hairy. It's a very live discussion in the industry between active and passive - are ETFs causing problems or are they a form of price discovery?

Joe, have you seen large selling of high-yield bond ETFs in distress periods - is that a worry?

Yes we have and our high-yield ETFs have been put through some very important stress tests and come out positively - whether in the financial crisis or late last year in December when high-yield markets experienced significant stress. The ETFs will never be less liquid than their underlying, and at the end of the day we do have the ability to give underlying securities to the investors if that is a problem. Whatever price the bonds are trading at you will still be able to trade them. I won't say I couldn't foresee any issues because you never can say that, but there have been a number of events in the past five years which have put the ETF and fixed-income markets under significant stress, and our ETF has performed incredibly well and come out with more fans than it had before.

Some argue that ETFs are responsible for causing market volatility for reasons including the fact they are used for short-term trading. Do you think that is a fair criticism?

BSS: ETFs are a very useful tool, and they've made it easier for institutions to trade and retail investors to get involved. I don't agree with this idea that having more marginal traders is an issue. Hedge funds and investment banks have been doing this for decades. It's nothing new and hedge funds and banks have proved themselves more than capable of ruining markets on their own. I don't think having retail investors being able to access ETFs and institutional investors being able to trade them with less marginal costs is causing the volatility - I think it's sour grapes from hedge funds.

JP: I agree. A lot of work has been done on this by the industry, participants and people who sit outside of it, and there's no evidence that ETF growth has caused correlations to increase or impair price discovery. I think that ETFs offer a second layer of liquidity that, when markets do become stressed, offer a way to buy and sell in those markets. So I completely agree that there is no evidence to suggest that ETFs contribute to volatility.

Looking to the future, what change would you like to see take place in the industry and where do you want to see innovation?

BSS: Fragmentation of the European market is one of the biggest issues that I see. One of the challenges we have in Europe is that you may have an ETF domiciled in one place but traded on lots of different exchanges, and that can push up the cost of trading. In the US, where there are far fewer exchanges, the cost of trading tends to be a bit lower.

Another issue is over-the-counter trading. It's an irony that these are called exchange-traded funds as most of the trading is done off exchange and that's not always reported. It's a lot harder to get full clarity on how these are trading if you're not on the system.

I'd also like to see securities lending and collateralisation policies tightened up - I'm not a fan.

AL: The concerns I have are around the complexity of products and availability of information for individuals. I don't think there is anything wrong with having more of these investments out there, but people need to be able to tell exactly what they're doing and the information needs to be readily available.

I would also say that we are making a lot of progress in costs and in the charges of investments. But there are other areas where costs haven't been as quick to fall, and I'm looking forward to seeing more fees dropping in emerging markets and some of the riskier bond areas.

There are also some areas that remain untouched by ETFs. Mixed-asset investments, which blend bonds and shares, have been very popular in the actively managed fund space, but there are very few options available to the ETF market at the moment. We may see more of these coming in the future, but we're not quite there yet.

JP: I think a huge amount of progress has been made and we continue to focus on what we call market infrastructure, trying to remove the fragmentation that we see and trying to get trades reported on exchange in a similar way to the US.

Where are you seeing opportunities in the year ahead and which ETFs are you using to gain access to those?

BSS: It's a challenging environment and the investment outlook does look challenging. We've had a long period of excess liquidity and a good few bumper years fuelled by things like QE [quantitative easing], so overall I'm cautiously positioned across all of the different equity classes.

Within that I tend to favour the European markets. The European Central Bank has engaged in QE and though that is not necessarily helping to boost the economy directly, it is supporting asset prices. I am trying to use more smart-beta approaches in Europe to try to get some defensive views in there. Europe is full of banks that have struggled recently, so I like iShares Euro Stoxx 50 ex-Financials UCITS ETF (EXFN) to reduce exposure to banks, and we use iShares' quality and value for those to try to get defensive characteristics.

A market we are wary of is the US. It does look expensive and valuations are high, so there we prefer a value play and use Invesco PowerShares FTSE Rafi US 1000 UCITS ETF (PRUS). With income we try to get a blend, so use iShares UK Dividend UCITS ETF (IUKD), which is a more forward-looking measure, and also the SPDR dividend aristocrats range, which has a backward-looking focus on quality, too. I like SPDR S&P US Dividend Aristocrats UCITS ETF (USDV), SPDR S&P Euro Dividend Aristocrats UCITS ETF (EUDI) and SPDR S&P Pan Asia Dividend Aristocrats UCITS ETF (ASDV).