Opportunities abound for ETF and index innovation

Jul 25th, 2013 | By | Category: ETF and Index News

By David Stevenson

If the sheer quantity of new product launches is any measure of the virility of a business sector, then the exchange-traded funds (ETFs) and indexing sector looks to be in fine form! Barely a day goes by without a new ETF or index making its debut in Europe or America, whilst growth in Asia will surely be at an exponential rate over the next few years.

ETF and index innovation needs to be smarter by David Stevenson

ETF and index innovation needs to be smarter, suggests David Stevenson.

The pace of innovation has, of course, slowed down a tad. Most broad asset classes are pretty much saturated by now, with few new takers for, say, a Euro Stoxx 50 Index tracker, especially as there’s already more than 20 ETFs for this narrow opportunity and it’s hard to think that any new structure could add that much value.

In my view, over the last few years, many innovative new fund launches have focused on fixed income. ETF giant iShares pretty much dominated this space until recently and its competitors have been playing catch up ever since (SSgA SPDR has launched some great funds in the emerging markets debt space). There’s also a fair bit of what one might generously call ‘in-filling’, where a newish provider decides that they need their own version of a major index just to make the range look ‘complete’.

Given the breadth and depth of recent launches, it’s hard to work out what might come next. Is there really anything new that’s worth turning into an ETF? I’d say a defiant yes and suggest that there are four broad categories where new ideas are needed:

1) Granular sector plays.

I apologise for the horribly nerdy language but the idea here is simple. Most broad equity market indices such as the MSCI World series (or the Stoxx Europe Total Market Index in Europe for that matter) feature a fairly exhaustive list of individual sectors. This is all fine and dandy, but many investors want more targeted detail or granularity within their sector or theme exposure. At the moment, many of the specific, granular sector opportunities are either ignored or swept up in ever-so-slightly hooky heading of ‘thematic’ ETFs. I’m sure that most thematic indices start off with good intentions but in reality the end result is a slightly modish, even arbitrary collection of unconnected businesses rolled together into one fund. The world has already seen far too many clean energy and water trackers with bizarre inclusions as constituents to want any more.

No, a better approach is a very specific sub-sector where you understand exactly what you are getting plus a generous dollop of marketing intelligence to understand what the investor is buying. Two examples should suffice. Even after their rally, I’d still buy a UK housing sector tracker. I’d want a clear and focused vehicle which gave me exposure to exactly what I wanted in terms of catching the likely recovery in our housing sector (i.e. home builders, home improvement retailers, building materials and fixtures suppliers, perhaps home furnishing companies). Similarly, I like US banks (a play on the US housing recovery) and US oil equipment services (energy infrastructure will require a huge amount of new capital expenditure). iShares in the US does an admirable job of providing targeted access to these ideas via its iShares US Regional Banks ETF (IAT) and iShares US Oil Equipment & Services ETF (IEZ) products on the NYSE Arca. Back in the UK, a focus on say picks-and-shovels industrials would be very welcome.

2) Sensitivity Trackers

Sensitivity trackers are another take on the first theme but essentially amount to indices where the companies are very sensitive to a key ‘macro’ driver. One small but perfectly formed example should suffice. I’m growing more and more enthusiastic about investing in the UK domestic economy – in my view we’ll be surprised by the upside. That play at the moment involves me as an investor taking a bet on the FTSE 250, which has a stronger domestic focus than the more well-known FTSE 100. (There are a range of FTSE 250 ETFs, including now short and leveraged versions). The challenge, though, is that once you scan down the list of companies in that particular index you notice a rather long tail of internationally diversified outfits with little correlation to the UK economy. There’s nothing intrinsically wrong with those mid-cap internationals but it’s not the linear exposure to the UK economy I would choose. So, why not develop a UK domestic index with that direct exposure. A few colleagues over at new outfit called GBIndices are developing this exact approach but no-one else really seems to be racing to provide that sensitivity via an index and then a fund. Ditto for China, where at least The Economist magazine has upped the ante via its Sinodependency Index. Likewise, index giants MSCI, Stoxx and Russell have all recently introduced ‘economic exposure’ indices based around a similar concept. The key idea here is to be inventive with the term ‘beta’. Instead of beta to main market moves, why not develop beta measures that are sensitive to macro forces (trade flows, for instance) and then turn them into sensitivity indices.

3) Multi asset class macro

Investors crave asset-class intelligence. Many find the huge range of asset-class choices mightily confusing, and many react by simply defaulting to tried and trusted ideas. Investors are also scared stiffless by risk and frankly have no intellectual tools for dealing with risk analysis and measurement – except that they readily grasp the idea that they might lose a bundle if ‘all hell breaks out’! Good investment advisers should fill this gap but we all know a dirty secret, which is that many professional money managers in the wealth space act like a herd. Into this breach should step indices and trackers where the painful task of asset-allocation analysis and selection is done for you by experts who understand about how macro factors drive risk tolerances. At the moment this approach starts with simple target risk structures – already proving successful for Vanguard via its LifeStrategy range – and then moves on to more sophisticated approaches such as Deutsche Asset & Wealth Management’s db X-tracker SCM Multi Asset UCITS ETF (XS7M).

But there’s much more that could be done especially around alternative assets – skills in dealing with these sectors are thin on the ground even at the big private banks, so anyone who could navigate their way around specific commodity sub-classes or hedge fund strategies could prove a hit. The same for a fundamentals or value-driven multi asset-class approach, where specialists work out which markets and screening methodologies to focus on as part of a diversified portfolio

4) Fundamentals weighted

Last, but by no means least, let’s stick with that theme of fundamentally or value-driven methodologies – a strand of the highly exciting and innovative ‘smart beta’ concept. My colleague Simon Smith’s article last month on the new Barron’s 400 ETF (BFOR) reminds us that interest in fundamental-driven indices is alive and kicking. The success of Andrew Lapthorne’s SG Global Quality Income Index and its linked Lyxor ETF also shows us that there’s a large number of value and income-focused investors looking for new ideas that are a bit punchier than just a simple fund overlay for the MSCI World. These latter approaches are worthwhile but the differences between the value index fund and the benchmark aren’t that great – many investors I talk to want punchier indices where there’s more concentration via a smaller number of stocks and simpler value-driven screens incorporated into the index. Crucially, this approach should be extended to international markets and into bonds, where Research Affiliates via its RAFI suite is doing a fine job at the moment.

The views and opinions expressed herein are the views and opinions of the author, David Stevenson, and do not necessarily reflect those of ETF Strategy.

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