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Alex Vynokur on how ETFs disrupted investing

Alex Vynokur is Chief Executive Officer of BetaShares Capital, an Australian provider of Exchange-Traded Funds (ETFs).

 

GH: What was the ETF market in Australia like when you first started?

AV: We launched our first product in December 2010. We spent a lot of time explaining what an ETF actually is. Many Australian advisers, and certainly most self-directed investors, thought we were talking about electronic funds transfer. A lot of heavy lifting had to be done early. We also had to build trust in a new business and trust is something that takes a lifetime to build.

GH: What was the size of the existing ETF market at the time?

AV: I’d say about $10 billion, and now it’s over $50 billion, so it’s come a long way.

GH: You decided from the start that you had to spend a lot of money and resources on education.

AV: Our view is that making investors more informed makes them more confident. Whether that’s trust or knowledge, education is critical. You must be a key participant in the market. Once the market exists and is thriving, it is easier for new participants to come in and launch niche products and benefit from the growth of the industry. But if you want to be an industry leader, you need to lead on education.

GH: Can you remember the business plan when you started, and what you forecast at the three- or five-year milestone?

AV: The three-year milestone was definitely not met, but we have been surpassing milestones since. More importantly, more than half of all financial advisers in Australia have adopted ETFs as part of their investment process versus well under 10% when we started. We're also seeing self-directed investors, SMSFs in particular, gain familiarity with ETFs. The message of both indexing and ETFs is translating into strong flows.

GH: We were slow out of the blocks with ETFs. Even now, while something like 35% of the US funds market is in index investing, it's about 15% in Australia. Is there something about Australian financial advisers and their use of active managers that has contributed to that?

AV: Yes. Historically, ETFs didn't have a level playing field here. ETFs never paid commissions to advisers and pre-FoFA, the adviser business model relied on receiving commissions via platforms. Only active managers were recommended. Since FoFA and the stronger interpretation by the Royal Commission, we now have a level playing field.

But I’m not an indexing zealot that believes the whole world should move to indexing. And what constitutes an index is being redefined to include smart beta, variants on factor-based indexes and thematic indexes. In fact, thematic is becoming a substitute for individual stock picking.

I believe the funds management industry is going through the most fundamental period of disruption that we've seen in 100 years.

GH: Including a lot of fund managers closing.

AV: Yes, similar to music, media, print. Those industries have gone through tough times. Spotify brought havoc to an industry that was cosy and comfortable for a long time and the funds management industry is going through its own Spotify moment. Some fund managers will emerge stronger but a lot are hurting.

GH: You as an individual and BetaShares generally have supported both active and passive investing. When you meet with a financial adviser, how do you reconcile supporting both?

AV: Yes, I believe in the coexistence of active and passive. I also believe that when 75% of active managers consistently underperform the benchmark over 1, 3, 5 or 10 years that, where a recommendation is on merit and in the best interests of the client, ETFs will do well and their growth will continue for at least for the next decade or two.

Funds management is bifurcating. The days of actively-managed funds which are actually index huggers are numbered. They face extinction. Market returns or beta will be priced at index fund fees. Those delivering outperformance or alpha have a strong incentive to deliver that alpha and not hug the index.

There's been a lot of beta dressed up as alpha historically, and ETFs are clarifying the conversations. Clients are allocating a significant portion of their portfolio to a core for beta and indexing. Those advisers or clients who are searching for alpha must make allocations to higher conviction, active strategies. These days, there's nowhere to hide and managers need to justify their fees.

GH: In the last year or so, a major competitor of ETFs, the Listed Investment Company (LIC) structure, has experienced some problems. The majority of LICs, especially in equities, are trading at a discount to NTA, with some quality managers at 10 or 15% discounts. Plus there’s criticism that they still pay commissions as a way to circumvent FoFA. In that environment, has the experience with active ETFs been as successful as you hoped? The fund balances don't seem high enough to me.

AV: I think it's going pretty well. But on LICs, while active will thrive alongside passive but in a different equilibrium, I do believe that delivering strategies using an open-ended ETF is a more honest way rather than locking up money in a closed-ended vehicle. Investors cannot redeem LICs at fair value. Asset management is a business of trust with the client, first and foremost. All managers’ future prosperity must align with the wellbeing of the clients. The client should be able to take their money at fair value. While this is a generalisation, the interest of the fund manager in securing permanent capital is often at odds with the interest of the investor.

The renaissance of LICs over the last few years was not just about the managers seeking permanent capital. It was also parts of the adviser community struggling to wean themselves off commissions. That conversation will play itself out over the coming months.

But I do accept with a LIC there is a legitimate use to hold assets which are not themselves liquid.  ETFs are fantastic at delivering true to label returns for asset classes which are themselves liquid. If the asset is inherently illiquid, such as physical infrastructure, you cannot place a toll road in an ETF because we benchmark against having 100% of our assets redeemed on any given day.

But I take a critical view of regulatory arbitrage and bypassing the spirit of the regulation with strategies which are perfectly manageable in an open-ended vehicle

GH: Do investors understand active strategies within ETFs, not only the indexed versions?

AV: We have a world of changing consumer preferences. The old days of downloading a 50-page PDF, printing an application form, scanning it and sending it back to the fund manager - that user experience is outdated. The experience of owning an ETF, active or passive, is far superior, and investors would much rather have all their investments housed alongside their direct shares. That's a big part of the growth of active ETFs and the user experience will continue evolving.

I see a day where the distinction between listed and unlisted funds is lost and it will be all about the user experience. Transparent pricing, ability to buy and sell at any time, availability across platforms, index supplemented by quality active offerings.

GH: How do you choose a new ETF? BetaShares now has more than 50, and at the time of launch, I’ve wondered about demand for some of them.

AV: We start with the needs of clients, and they vary significantly. Australia has a large retirement savings pool with investors both young and old. Risk appetites vary tremendously. Also, a portion of the market takes advice from financial planners and full service brokers, while a significant portion is completely self directed. Our product range includes core building blocks for portfolios across many asset classes. And at the same time, you'll see products which are more satellite or tactical, such as global thematics, cyber security, agricultural, healthcare. The Australian exchange is highly concentrated in financials and materials and we need funds for greater diversification.

GH: And fixed interest availability has undergone massive change in the last couple of years.

AV: Yes, cost-effective access through ETFs has become good. Traditionally, investors shied away from fixed income in the Australian market because it's was more complicated to understand and hard to access. And in the past, most superannuation investors were young accumulators. You could get away with a heavy equities portfolio because you had the time horizon to ride out the storm.

Today, the superannuation cohort is approaching or at retirement and issues such as sequencing risk and volatility affect how people sleep at night. The term deposit is good at preserving capital but there is not the negative correlation of different types of bonds versus equities.

GH: And in specific equity segments. I remember talking at conferences when NDQ (the NASDAQ100 ETF) was launched as a way to invest in Facebook, Google, Microsoft, Apple, etc on the ASX. It was launched a few years ago at $10 and it’s now $19, right?

AV: We believe the story of technology is long term and an allocation to the NASDAQ100 is sensible. But we also know investors cannot always rely on the sunny days of equity returns. If you had said three years ago that the top funds for flows would be fixed income, you would have been laughed out of the room.

GH: Of the 50+ ETFs you have, can you identify one that's done a lot better than you expected and that you're particularly proud of, but also one that you're disappointed with?

AV: Let me reflect on that (long pause). The cash ETF (ASX:AAA) has seen a level of adoption that has surpassed what we thought might be possible. A lot of people say they just leave cash in AAA. It's very humbling. We were aware of the opportunity on platforms because they were well known for not being generous on cash balances.

GH: Yes, and there's been more said about that in the media recently where platforms pay poor rates or nothing on cash.

AV: One that's surprised on the downside for us is the RAFI (fundamental indexing) product based on smart beta methodology. It’s done okay, close to $300 million in assets, so not a poor performer, but we expected a greater level of adoption.

GH: We see ETFs close in Australia sometimes, although none by BetaShares. Do you have a critical mass target or something that says a fund is not worth doing any more?

AV: We always think about our range and we have good economies of scale with $8 billion under management. We take a long-term view rather than looking for quick wins. I don’t see closing products as negative but more a sign of a maturing industry. Traditional managed funds open and close regularly, it’s accepted as the norm. We don’t feel a need to close any of our funds. There have been instances, such as with our gold ETF, where there was little interest for years and nobody wanted to talk about gold. Then suddenly, over the last six months, there’s more activity than we’ve seen before.

GH: Can we turn to the recent ASIC announcement on pausing the issue of new actively-managed ETFs. To quote:

“ASIC has requested that exchange market operators do not admit any managed funds that do not disclose their portfolio holdings daily and have internal market makers while it undertakes a review during the remainder of this calendar year.”

What is the issue here?

AV: Traditional ETFs which follow an index disclose their portfolio every day to allow market makers to buy or sell units on the exchange. But active ETF managers are concerned about protection of the intellectual property in their portfolios and want delayed transparency. This concept has been accepted globally. In some parts of the world, a model sometimes referred to as the ‘Canadian model’ allows the investment manager to disclose the components of the portfolio to market makers provided they sign a confidentiality agreement. They are then able to make a market in the same way as a traditional index ETF.

The ‘Australian model’ is where only one market maker undertakes the role and it is the same entity as the investment manager and the responsible entity. In other instances, such as with BetaShares which is not the investment manager, we partner with active managers and market makers so there is some separation. Our view is that the ‘Canadian model’ has merit. The existing model here is workable but can be improved with disclosure to multiple market makers.

GH: What is ASIC’s concern? How might an investor be disadvantaged when the investment manager and market maker are the same?

AV: ASIC will look at potential conflicts, for example, the market maker may have an incentive to set spreads or otherwise transact for its own benefit rather than the investment fund. With our active funds, we are not the investment manager and use an agent broker to conduct market making. We have no incentive other than ensuring investors are treated fairly. This is a matter of seeing if the framework can be improved. It’s a complex issue but we like a model where active ETFs and passive ETFs have market making done the same way.

GH: Last question. Australian ETFs are now over $50 billion. Where will they be in five years?

AV: Close to $150 billion, maybe in seven years as opposed to five.

 

Graham Hand is Managing Editor of Cuffelinks. Alex Vynokur is Chief Executive Officer of BetaShares Capital, a sponsor of Cuffelinks. This material has been prepared as general information only, without reference to your objectives, financial situation or needs.

 

For more articles and papers from BetaShares, please click here.

 

6 Comments
Gary M
August 23, 2019

Agree, any fund manager who needs me to fill in a long application form and provide certified copies of documents loses my money. Who can be bothered?

SMSF Trustee
August 23, 2019

Um, Gary, to access a listed vehicle you have to fill out forms and prove your identity under anti-money laundering laws. You just do it with the broker you transact with rather than the investment manager.
Fund managers are just obeying the law when they ask you to prove you're not a terrorist financier but a decent guy, as I'm sure you are.
Of all the reasons not to use a managed fund, this is the most ridiculous of all!

Gary M
August 24, 2019

Um, SMSF Trustee, it's not like that at all. Most if not all SMSFs and investors already have a broking account, so to buy LICs and ETFs involves no extra paperwork. Some direct applications processes to fund managers still require certified copies of trust deeds (JP anywhere in the house?), identification of trustees and wet signatures. It's a painful process of many pages to fill in and source documents. And to access the manager on a platform involves ongoing platform costs, not a small one-off brokerage of an ASX trade.

So as the articles says, the convenience of doing all this online with no more paperwork and extra ongoing fees is one reason ETFs are doing so well. Not 'the most ridiculous of all' unless you have nothing else to do than fill in forms and look around for a certifier.

SMSF Trustee
August 24, 2019

Your comment was about paperwork, not other costs, so I addressed that. ETF's are not as innovative in that way as some might like to think. That's all I'm saying here.

SMSF Trustee
August 24, 2019

It isn't the advent of ETF's that's taken away the repetitive paperwork requirement, it's platforms. You have to do the paperwork somewhere along the line, or the provider of the investment has breached anti-money laundering laws among other things, but with platforms you do it once then have access to lots of funds.

ETF's have just taken a different route (listing and you being identified by your broking agent) than the platforms took years ago.

Let's not overstate the extent to which these things have innovated.

I have moved my SMSF into several new funds over the last year or so and not had to do any additional paperwork.

Dean
August 22, 2019


Unlisted managed funds do NOT pay commissions to advisers. That stopped years ago.
Unlisted managed funds are NOT all actively managed. There are plenty that are indexed.
ETF's are NOT all indexed. There are plenty that are actively managed.

 

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