Global trends in index tracker and exchange traded funds

Global trends in index tracker and exchange traded funds

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The first low-cost balanced unit trusts in South Africa

In 2009, Nedgroup Investments launched the first true low-cost balanced unit trust portfolio in the South African market, namely the Nedgroup Investments Core Diversified Fund. In early 2010, we added the Nedgroup Investments Core Guarded Fund. These Core portfolios aim to meet the need for simple, low-cost, multi-asset unit trust portfolios that can be easily incorporated into a financial planning process and blended with other actively managed multi-asset unit trust portfolios. The portfolios track custom benchmarks consisting of a range of local and global asset classes and are implemented by our Best of Breed™ partner, Taquanta Asset Managers. The local asset classes follow tailored indices to provide prudent, balanced and low-cost exposure to their respective investment universes, while the global indices are tracked via a number of global exchange traded funds (ETFs). The total expense ratio of the Nedgroup Investments Core portfolios is nearly 1.2% less per year than that of the average active balanced portfolio, providing evidence of the low-cost advantage of these portfolios.[1]

Screening the global ETF landscape

Our investment process includes a regular review of all eligible global ETFs to ensure prudent low-cost global exposure within the Core portfolios. As many of the largest ETF providers do not have a presence in South Africa, we are required to do offshore due diligence visits to these index asset managers. On a recent due diligence trip to the US, I had the opportunity to visit some of the giants in the index asset management industry. Among the firms I visited were two of the three giants in indexation, State Street and Vanguard (iShares being the third). I also visited the small cap specialists, Dimensional Fund Advisors, as well as some of the newer ‘kids on the block’ that specialise in alternative index strategies, namely AQR Capital, Invesco PowerShares, WisdomTree and FlexShares (Northern Trust).

One of the highlights of my trip was the visit to the head offices of Vanguard in Malvern, Pennsylvania, arguably the most respected investment company in the world. Vanguard was founded by John Bogle in 1975 and currently manages around $2.8 trillion. The company has its roots in active management as it originated from the Wellington Management Company, which launched the first US balanced mutual fund in 1928. Vanguard is best known for its index mutual funds and ETFs. It is also the third largest active manager in the world, managing just over $900 billion on an outsourced best of breed basis. The majority of the offshore holdings in the Nedgroup Investments Core Guarded and Core Diversified Funds are now invested in Vanguard Global ETFs. The remainder of the offshore holdings are invested in iShares Global ETFs.

During my trip, I noticed a few trends that are relevant to South Africa’s current and future investment market, especially the use of low cost index products.

The search for low-cost strategies is driving the uptake in index-type products

As more and more studies show that costs have a significant impact on long-term returns, investors are increasingly using low-cost strategies. This has led to a massive uptake in index-type products over the past 10 years, especially in the ETF market (as shown in the chart below).

In the past six years, US index equity mutual funds and ETFs have received $795 billion in cumulative net new cash and reinvested dividends. ETFs took roughly double the flows of index mutual funds. Some of these flows have come at the expense of actively managed mutual funds, which have experienced a net outflow of $575 billion over the same period. The majority of these index mutual fund and ETF assets are managed by three of the largest index fund managers in the world ̶ iShares (Blackrock), State Street and Vanguard. Together they manage 70% of the global ETF assets.

Smaller index fund managers differentiate themselves through ‘smart beta’ products

Over the past few years, these large index fund managers have lowered their fees as they grow, making it difficult for the smaller players to compete. Smaller index fund managers have opted for the ‘smart-beta’ products to differentiate themselves.

The ‘smart-beta’ debate centres on an alternative approach to indexing

In the US, there is currently a big debate about the use of alternative approaches to indexing, also known as ‘smart-beta’. Most of these smart-beta products are rules-based indices that do not use the market capitalisation weightings of traditional indices like the FTSE/JSE All Share Index (ALSI). Instead, they use weightings based on underlying share earnings, dividends and other non-price related measures, for example the FTSE/JSE RAFI 40 Index. Rules-based strategies have been gaining some traction in the US and currently a quarter of ETF institutional investors make use of these products.

Beware not to completely disregard market-cap indices

However, over 90% of institutional investors still use traditional market cap strategies[2] as the core of their portfolios. They have been replacing ‘benchmark-huggers’, that is, active fund managers who don’t take high convictions bets against their benchmarks but charge high asset management fees with smart-beta products. It is important to note that from a diversification perspective, traditional market-capped strategies are less correlated to high conviction actively managed funds than smart-beta strategies. Many investors therefore opt to construct Core-Active™-type portfolios that only consist of high conviction active funds and use traditional market-capped strategies as the core of the portfolio to bring down the overall cost to the investor.

A large driver of the rules-based market is the smaller index providers who cannot compete with the three giants on fees in the market-capped index product space. It is therefore in their interest to develop new strategies and products to gain market share and we are likely to see a lot of product development by these providers.

Pressure on traditional index providers

As competition between index asset managers (iShares, Vanguard and State Street) and index providers (FTSE, MSCI, S&P) increases, index licencing fees have come under pressure. Licencing fees are charged by index providers to all asset managers tracking their indices. To reduce costs further, Vanguard recently moved from using MSCI indices as their fund benchmarks to CRSP and FTSE indices for their local and global portfolios respectively. CRSP indices are provided by the Centre for Research in Security Prices affiliated to the Booth School of Business at the University of Chicago. There is currently a steady move away from traditional indices, especially with the rise of rules-based strategies that use non-market cap indices. Many index managers also develop their own customised indices to cater for specific client needs, such as providing dividend income.

Retirement challenges

Auto-enrolment in the US has helped to ensure that more individuals are using retirement vehicles such as 401k retirement savings plans. However, the US does not have asset class guidelines like South Africa’s Regulation 28 of the Pension Funds Act. Members can therefore decide on their own investment portfolios based on their risk appetite. Studies have found that most members in these schemes are too conservative in their fund selection, with many only investing in cash. Target date retirement funds have become popular ways to address this problem. These funds work in a similar way to the life stage strategies used by South African pension funds in which an individual’s equity exposure is reduced as they near retirement. The Nedgroup Investments Core portfolios are currently available in these life-stage strategies on most Umbrella Retirement fund platforms in South Africa.

The US trend towards index products is underway

A third of the total equity assets in mutual funds and ETFs are in index funds[3]. They are also growing more rapidly than their non-index counterparts. In 2013, index funds grew by 15% compared to 4% in non-index funds. In South Africa, passive and index products make up less than 3% of the total investment industry[4]. Although it is still early days, regulatory pressures and an increasing demand for lower cost investment options is likely to produce similar trends in South Africa over the next 10 years.  

Local investors will likely access index products via unit trusts

In the local market, ETFs do not offer a structural cost advantage and cannot be easily incorporated into financial and retirement plans. Investors are also likely to prefer market cap indices over smart-beta strategies as they are simpler and offer greater diversification when combined with traditional actively managed portfolios. Finally, balanced portfolios are likely to be favoured over single asset class portfolios because of the member level (Regulation 28) compliance requirements for retirement savings.

 

[1] The annual management fee of the Nedgroup Investments Core portfolios is 0.35% per annum (excluding VAT) while the total expense ratio (TER) is currently 0.47% per annum (this includes VAT and the costs of the offshore ETFs).

[2] Source: Cogent Research, The Evolution of Smart Beta ETFs Report, January 2014

[3] Source: Morningstar Fund Research, 2013 Global Flows Report.

[4] Source: Morningstar for Unit Trust and ETF market shares. ABSA Survey for the Institutional and Life industries. The PIC’s index holdings are not included in here.