Seven most innovative ETF launches this year

The development of the passive industry over the past year has fallen into three areas: price, asset class and smart beta. The whole industry has been subject to increasing price pressure. Straightforward index-tracking mutual funds and ETFs have seen a scramble to the bottom on fees. Vanguard, for example, launched four ETFs based on FTSE indices at the start of October with ongoing charges ranging from 0.1 per cent to 0.18 per cent.

However, the real innovation has been in the expansion of smart beta and quasi-active strategies. Deborah Fuhr, the managing director at exchange traded fund research firm ETFGI, says: "This is about weighting stocks to deliver better returns than market capitalisation-weighted indices. These products screen stocks based on value, dividends or volatility. We have also seen an increasing number of products combining a number of factors. We also have 'active' ETFs and, increasingly, currency-hedged ETFs."

Although smart beta is not genuinely 'new': It is already well-established in the US. Powershares launched smart beta ETFs based on fundamental measures of company size such as book value, cash flow, sales and dividends in 2011 and the SPDR S&P Dividend Aristocrats series has proved popular. However, it has gained momentum in the UK this year and become a mainstream choice.

iShares, for example, has launched four ETFs based on world stock market indices this year, constructed according to certain stock characteristics - value, size, quality and momentum factors - on the basis that these have provided better returns than that of the index over time. 'Value', for example, seeks out those companies trading at a valuation discount to the wider market. Momentum picks those stocks that are seeing a strong run of performance.

Investors can also get access to an increasing range of assets within an ETF structure. For example, Source and emerging markets asset manager Ashmore launched two active ETFs focusing on emerging market bonds this year. Ms Fuhr says that the development of fixed income ETFs continues to be a major focus for the industry. This year also saw the launch of the first exchange traded fund tracking Egypt's EGX30 index of the 30 most actively traded companies listed on the Egyptian Stock Exchange, suggesting the industry is finding ways to break into new, less liquid markets.

The other major shift in the passive industry has been the conversion of existing ETFs from synthetic to physical replication. Partly this is a reflection of consumer preference. Flows have increasingly been channelled to physically replicated indices as investors have grown concerned over issues such as collateral and counterparty risk in synthetically replicated indices.

John Husselbee, head of multi-asset at Liontrust Asset Management, says that the innovation is generally welcome, bringing a new competitiveness to both the active and passive industry: the active industry has to stay on its toes and keep costs lower, while the passive industry needs to experiment to work out where there is demand, ultimately creating a stronger and leaner offering.

However, the expansion of the universe is not universally applauded. Some believe that the object of passive investment is to provide a straightforward, cheap means to access stock markets and some of the new products, with their higher costs and greater complexity, go against this. James Calder, head of research at City Asset Management, says: "I am sceptical about a lot of innovation in the passive industry. Passive funds are there to do a job, to replicate an index. These new products are often more like quantitative active funds and charge more money. These funds will work, until they don't."

His biggest objection is on cost: "Investors need to look at what they are paying. These products can be high charging and if investors are paying a high fee for a quasi-active approach, why not simply buy an active fund?"

Equally, not all innovation has worked, and a number of funds have closed over the course of this year. iShares has closed a number of specialist ETF funds this year, for example. We asked experts from Morningstar and Hargreaves Lansdown to pick out the genuinely strong innovation in the passive industry this year for investors to consider:

Most innovative ETF picks

Lyxor JPX-Nikkei 400 UCITS ETF (JPXG) and Source JPX-Nikkei 400 UCITS ETF (S400)

These two ETFs offer a means to track the JPX-Nikkei 400 index. The new index was launched last summer to showcase Japan's most profitable, shareholder-friendly companies. The companies selected for the index meet global investment standards, such as efficient use of capital and investor-focused management perspectives. The ETFs offer an alternative means to take Japanese exposure, excluding some of the larger and weakest companies.

Adam Laird, passive portfolio manager at Hargreaves Lansdown, says: "The index removes companies with patchy earnings or profit records and ensures that companies meet certain corporate governance standards, which have blighted Japanese companies at times. These ETFs give investors a way to invest in better Japanese companies."

Lyxor UCITS ETF Russell 1000 Value (RUSV)

'Smart beta' funds have drawn criticism for their complexity and expenses, but the Russell 1000 Value index is well-established and widely used. It isolates 'value' stocks from among large US companies that trade at a valuation discount to the wider market.

Mr Laird says: "In the US, using passive investments for value investing is commonplace and many tracker funds exist that only choose value stocks within the market. Though it has its ups and downs, value investing has traditionally been a profitable strategy. Lyxor's launch was one of only a few ETFs on the London Stock Exchange to explicitly track value stocks."

Boost Gilts 10Y 3x Short Daily ETP (3GIS)

Active managers have historically struggled to add value in gilt markets. Markets are efficient and managers need to second-guess the direct of interest rates to beat the market. Passives are therefore considered a strong alternative. This Boost ETF shorts the market offering a leveraged means to benefit from interest rate rises.

Mr Laird says: "There is a lot of speculation currently about interest rates - when they will rise and by how much. When interest rates rise, bond yields generally rise, which accompanies a fall in bond prices. Shorting gilts is a way to benefit from future interest rate rises and this ETF is leveraged to magnify returns. Investors should be wary though - this product will make losses if rates stay static or are cut further. Leveraged products are designed to be held for a very short length of time and should only be considered by experienced, sophisticated investors."

iShares $ Corporate Bond Interest Rate Hedged ETF (LQDH)

On a similar theme, interest rate-hedged ETFs offer a means to take fixed income exposure, while protecting against interest rate rises.

Caroline Gutman, fund analyst, passive fund research, Morningstar Europe, says: "With QE winding down and inflation rates expected to increase, interest rate-hedged ETFs may be a suitable for investors who want fixed-income exposure protected against interest rate hikes. iShares is the first to offer an interest rate-hedged ETF in Europe."

China A-shares ETFs - including the db x-trackers Harvest CSI300 Index UCITS ETF (RQFI), the CSOP Source FTSE China A50 UCITS ETF (CHNP), the ETFS-E Fund MSCI China A GO ETF (CASE) and Lyxor Fortune SG ETF MSCI China A (CNAA).

In October, Chinese regulators allowed foreign investors to access previously off-limit stocks traded in Mainland China (A-shares) in a bid to attract foreign investment. Access to A-shares is initially limited to Hong Kong brokers, who can only access 568 A-share companies with a maximum investment of $210m per day, but that is expected to increase, and A-shares could eventually grow to a 10 per cent weighting in the MSCI Emerging Markets index.

Ms Gutman says: "There has traditionally been a large spread between A-shares and Hong Kong-listed H-shares, with A-shares often considered undervalued. These ETFs may be suitable for long-term investors with a strong stomach and who foresee increased access to A-shares and eventually a narrowing of the spread with H-shares."

UBS ETF – MSCI USA 100 per cent Hedged to GBP (UC74) - products also available hedged to EUR and CHF

Currency hedging in ETFs is a relatively new phenomenon, but one likely to catch on at a time when monetary policy in the UK and US, is diverging from that in the eurozone and Japan, creating greater currency volatility. These offer a means for investors to reduce, or enhance the currency exposure on their portfolios.

Ms Gutman says: "Over half of the currency-hedged ETFs available were introduced in the last year. The US dollar is currently at its highest level in four years. Investors who want exposure to the US but want to protect against a potential depreciation may want to consider a currency-hedged US equity ETF. S&P 500 currency-hedged ETFs have been available for more than a year, but UBS ETFs is the first to offer a currency-hedged MSCI USA ETF in Europe. The MSCI USA index has a slightly larger exposure to mid- and small-cap equities than the S&P 500 index."

ETFS US Energy Infrastructure MLP GO UCITS ETF (MLPX)

This is labelled 'Strategic Beta' and provided dividend-screened infrastructure exposure. It tracks the Solactive US Energy Infrastructure MLP Index at a time when accessing UK infrastructure assets is increasingly expensive, with infrastructure investment trusts, for example, trading at chunky premiums to net asset value.

While there are a number of ETFs tracking infrastructure indices in the US, this is the first European listed one. This ETF could be used tactically and could appeal to investors who want secondary exposure to the US energy industry through companies engaged in energy logistics such as pipelines, storage facilities and other assets used in transporting, storing, gathering, and processing natural gas, natural gas liquids, crude oil or refined products.

10 biggest Exchange Traded Product launches of 2014 year to date

Source: BlackRock

Top five smart beta ETF by 2014 net inflows

Source: Deutsche Bank