ETF themes for 2014

Jan 11th, 2014 | By | Category: Alternatives / Multi-Asset

By David Stevenson –

I’m not sure about you, but I always think that every Christmas festive break seems to pass by even faster than the last one. Personally, I’ve spent most of the last few weeks wishing that someone could come up with an exchange-traded fund (ETF) that lets you make money from volatile weather, in which case I’d have stuck all my money on this fabulous innovation!

ETF themes for 2014 by David Stevenson

David Stevenson, columnist at ETF Strategy.

Excesses of rain, wind and snow seem to be becoming the norm, all of which might prompt some to consider whether clean energy time may have finally come around again or have second thoughts about whether investing in catastrophe bonds might be such a smart idea after all….but that’s for another column and another time!

This week, I’m going to dust off the trusty old crystal ball and gaze into the future for all things ETF related. I’ll stay away from making any big bold investment predictions, largely because I have no better track record in this department than anyone else. I’m much more interested in what kinds of ETFs I think investors might be buying in the coming twelve months.

The first big theme is that we’re likely to see growing global enthusiasm for what are euphemistically called “growth risk assets” i.e. growth stocks around the world, where a capital gain is the primary driver of total returns rather than income. US growth stocks have shot ahead in the last year and the last time I looked the Russell 2000 Growth Index, which tracks US small-cap growth stocks and is investable via the Vanguard Russell 2000 Growth Index ETF (VTWG) and iShares Russell 2000 Growth Index ETF (IWO), was trading at a ludicrous 26 times profits on a paltry dividend yield of not much more than 0.5% pa. This enthusiasm for growth will probably start to go global as US investors begin to realise that their local growth stocks are already “fully valued” (a generous understatement I’d suggest). The first wave might hit Europe – and especially the UK – as investors look to snap up shares in businesses that are operationally highly geared to benefit from improving national economies.

Over time this enthusiasm for growth assets might begin to fan out globally and eventually it might even hit emerging markets and especially China. In particular, I’d expect to see a growing wave of excitement about Chinese A-shares with a plethora of new ETFs launched in the US and Europe in the next six months. Lurking in the background of this will be a fascinating momentum trade, which is to take profits from Japanese equities and reinvest it in Asia generally and small cap/growth assets specifically.

This enthusiasm for capital growth and “growth risk assets” doesn’t mean that investors will entirely ignore income-orientated dividend opportunities. What seems to be happening instead is that we’re witnessing two very traditional herd-like migrations – more cautious bond-focused investors are slowly taking profits and reinvesting some new cash into equities, but they’re sticking to income producing, quality assets. This scramble for yield has now pushed down rates to relatively low levels within traditional asset classes, which has in turn sparked the other great herd-like migration – more risk-friendly investors start to bank their profits from defensive, dividend stocks and look to make more money from growth assets, increasingly certain that global growth will be robust in the next few years.

Back in the world of the more defensive income-orientated investor, we’re likely to see much more innovation as ETF issuers come up with increasingly esoteric ways of dicing and slicing income flows. I was especially struck by the fact that in the US some of the most successful ETF fund launches have been around sophisticated structures such as senior loans and MLPs, both of which are designed to give investors a supposedly “robust” yield of 5% or more. Back here, in the UK, this trend has been mirrored in the world of closed-end funds and investment trusts where we’ve seen a spate of fund raising by infrastructure specialists and loans funds focusing on either asset-backed securities or senior floating-rate loans. My guess is that we’ve not seen the last of these issues and we’re likely to see a reverse trade – ETFs starting in Europe that tap into loans and infrastructure whilst US ETF issuers focus on alternative assets such as non-energy infrastructure and possibly even catastrophe-based reinsurance funds (which supposedly provide a steady insurance premium based income flow). Look under the bonnet and we can see a number of common characteristics – yields above 5%, secured assets, relatively illiquid underlying assets and greater risk.

Many of these new income intensive alternative funds will also be actively managed, which is my next big trend for the new year. My sense is that 2014 will (finally) be the year of the actively managed ETF (or active ETF). We’ve had a few early innovators already hit the markets, but over the next 12 to 18 months that’ll turn into another of those great herd-like migrations, in this case consisting of traditional active mutual fund managers looking to open up new business lines by setting up an active ETF that can be traded like any share and will boast simple-to-understand fee structures. My guess is that we need one of the very large traditional equity fund management groups to make the break and then everyone else will follow, with potentially at least a few hundred active ETFs listed within the next 18 months. The flipside is that as this wave of ETF innovation intensifies, traditional closed-end funds (in the US) and investment trusts (in the UK) will begin to feel the pain.

One area where ETF issuers might be especially active is in commodities. The huge commodities spectrum is likely to see a massive dispersion of returns over the coming year with precious metals probably due yet another kicking – gold below $1000 by April would be my bet – whilst industrial metals start to stage a tentative recovery. Energy might also have a weak year ahead of it as oil prices continue to slide slowly lower. In this situation my guess is that specialist commodity fund managers should be able to prove their mettle, especially if they have an active ETF wrapper around them as they switch between different commodity baskets.

My last big theme is all about slightly esoteric products finally hitting the mainstream, namely smart beta and multi-asset class ETFs. With a fair wind these should start finding their way into a mainstream stockbroker and fund platform near you! Smart beta has its critics, for sure, but my suspicion is that the big mainstream ETF issuers  don’t really care about this debate if only because they’ll be looking to bring out their own copycat smart beta ETFs over the next year, with minimum/low volatility and equal weight indices leading the charge. But for me, the most exciting thing is if multi-asset class ETFs finally become as popular as they should be.

I’ve always thought that using an actively managed ETF to put together asset class building blocks in a dynamic (sometimes even tactical) fashion makes huge sense, especially if you can keep the costs to a minimum. It’s the sort of model that sits behind the Nutmeg business in the UK and a host of peers in the US and it’s smart one.

Yet I also think it’s true to say that very few of the first wave of multi-asset class ETF managers have really struck a chord, largely because they lack the distribution muscle to get their products in front of investors. That’s allowed the big traditional fund management groups to carry on peddling their overpriced fund of funds mutual fund offerings to the mainstream. But change is coming and I think we can look to RDR (the Retail Distribution Review instituted by the FSA here in the UK, now the FCA) as the primary driver here.

Clean platform pricing will kick in from April this year and we can expect a fierce price battle to ensue as the big fund groups start to issue clean share classes at lower cost to the very biggest platforms. This use of scale will put the second tier of fund management groups in a very difficult position as they start to lose business to these big players. With the main mass-market platforms relentlessly pushing cheap, clean share classes from the big asset managers, pressure intensifies for these second tier players to use new channels to market. Active ETFs might thus arrive at an ideal moment especially for fund of funds or multi-manager products.

Why not look to port over an existing range of multi-asset class funds into an active ETF structure and work around the big fund platforms? These second tier fund groups will then put the necessary sales and marketing effort behind multi-asset class ETFs to push the innovation into the mainstream, finally giving ordinary investors a real choice. All it takes then is for the passive fund specialists to push their even cheaper, more strategic offerings and we’ve finally all collectively worked out a way to save the average investor an absolute fortune!

It looks set to be an exciting year.

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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