Advisers' ETF due diligence called into question

Advisers need to better understand how exchange traded funds work and carry out the same due diligence on them as they do on mutual funds, the intermediary head of BlackRock's ETF provider iShares has argued.

Speaking at an event at the London Stock Exchange last week, Pollyanna Harper said some advisers might be “scared by the amount of due diligence to do on ETFs”

She said: “The reality is ETFs are absolutely no different to any other investment that you are doing due diligence on to build in to your portfolios and whether you are outsourcing.

“You just simply need to understand them, they are not complicated and are very similar to index trackers, they just trade slightly differently.”

Harper says around 90 per cent of advisers might not know “what's under the bonnet” of a product, citing funds like GARS, which are very complicated to analyse, especially around securities lending.

There are currently 6500 ETFs and $3.4trn assets within 289 providers in 54 countries on 65 exchanges, according to ETFGI. Overall, since 2005, passive funds have seen nearly fivefold growth and now make up around 23 per cent of the assets under management in the UK, according to the Investment Association.

ETFGI partner and co-founder Deborah Fuhr added: “Three years ago there used to be $15bn of net new assets in ETFs, we saw that growing up to $68bn. Now globally we've had 34 months of positive net new assets going into ETFs. No other new products have had that level of net new assets.”

There are 4147 institutions using ETFs globally, Fuhr adds.

She says: “It is hard to count how many retail people use, but ETFs are the only investment product I know where you find all this types of people and institution having access to the same toolbox at the same low cost with a very small minimum investment size.”

A recent survey by Platforum shows while 62 per cent financial advisers had recommended a tracker fund to clients, only 19 per cent had recommended an ETF. In particular, assets in ETFs on adviser platforms stands at 1.3 per cent of the total platform assets under administration, which is far lower than the percentage of assets in tracker funds.

Costs and smart beta

These comments come as later last week, the FCA has published its long-awaited interim report on the asset management industry finding active management fails to justify high fees for lacklustre returns.

In its report, the regulator found an investor in a typical low cost passive fund would earn £9,455 or almost 25 per cent more on a £20,000 investment than an investor in a typical active fund. The FCA argues this number could rise to £14,439 talking into account transaction costs.

Speaking on the Stock Exchange panel, Fuhr says: “ETFs tell you what they are doing and how from the beginning and often many investors didn't realise that mutual funds do the same thing that ETFs do. But in terms of security lending most mutual funds do it but they never talk about it. It's important to know what an ETF does, whether it is using derivatives or else and from a regulatory point of view, it is under the Ucits regulation like other funds.

“Outside the internal costs of a fund you have transaction costs so that is the measure of how often an active fund or an ETF is traded. In general ETFs don't trade a lot because they are tracking an index so you tend to have less trading.”

But Fuhr warns advisers need to look at transaction costs especially on new products such as smart beta, which aim to deliver a better risk and return trade-off than other passive funds by using alternative weighting based on measures such as volatility, asset weight or dividends.

More than 3 per cent of assets under management are now held in this type of strategy, according to the IA.

Fuhr says: “If you buy an active manager that is trading a lot they are going to have more transaction costs inside their actively managed fund and that is something you need to be careful when looking at smart beta, for example. There's a product that says this is an equal-weighted portfolio and rebalances every month so there's going to be more transaction costs.”

Morningstar research shows in 2015 FTSE All-Share smart beta ETFs charged an average total expense ratio, which includes trading fees, of 0.42 per cent compared to ETFs charging an average TER of 0.33 per cent.

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