Jose Garcia-Zarate Senior Fund Analyst, Morningstar
@MorningstarInc
©2015 Morningstar, Inc. All rights reserved.
Jose Garcia-Zarate
Senior Analyst
Passive Strategies Research - Europe
Exchange-Traded-Funds From Basics to Strategic Beta
Agenda
▶ The Basics
▶ Key Market Statistics
▶ Strategic Beta
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The Basics
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▶ An Exchange-Traded Fund is an open-ended fund that replicates the performance of a specific index or strategy
▶ Defining attribute: ETFs trade on an exchange like common stock
What is an ETF?
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Exchange-Traded Products (ETPs)
An umbrella term referring to a broader set of vehicles.
Exchange-Traded Notes (ETNs)
Senior unsubordinated debt instrument. Not UCITS compliant.
Exchange-Traded Commodities and Currencies
(ETCs)
Track commodities and currencies. Not UCITS compliant.
Exchange-Traded Funds (ETFs)
Track a wide variety of predominantly equity and fixed
income indices. UCITS compliant.
The Creation and Redemption Process
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Replication Methodologies
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g Physical Replication
/Seek to mimic the index by holding the actual securities
/Full or sampled replication
gSynthetic Replication
/Obtain the index exposure through OTC swap contracts
/Hold securities (or have collateral posted) to mitigate counterparty risk
/Exchange the performance of the securities with the performance of the reference index
Key Features and Uses
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gKey Features
/Low costs
/ Intraday liquidity / Trading flexibility
/Access to all asset classes
gHow ETFs are used:
/For buy and hold investing
/For tactical investing
/For cash equitisation
/To gain instant, diversified exposure to a market, strategy or asset
TER is not the only cost to consider when buying an ETF
gHolding Costs
Physical ETFs
/TER (-)
/Rebalancing costs (-)
/Securities lending (+)
Synthetic ETFs
/TER (-)
/Swap spreads (-/+)
g Trading Costs
/Bid-offer spread (-)
/Brokerage commission (-)
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Holding Costs + Trading Costs = TOTAL COST OF OWNERSHIP
How to Measure Tracking Ability
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g Tracking error
/Volatility of a fund’s return differences over a period of time
/A low tracking error indicates the fund has consistently tracked its benchmark
g Tracking difference
/Difference in returns between a fund and its benchmark over a period of time
/Perfect tracking means the ETF’s return lags the index’s by an amount equal to the ETF’s fees
/Positive tracking difference indicates the fund has outperformed its benchmark
Key Market Statistics
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Global ETP Market – AUM Growth
▶ AUM closing in to USD 3trn worldwide
▶ USA accounts for 74% of global AUM; Europe follows with 17% and Asia with 6%
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Source: Morningstar. Data as of end March 2015.
Europe ETP Market – AUM Growth
▶ ETPs represent 6.5% of total investment fund market AUM in Europe
▶ Q1 2015 saw record high net inflows of EUR 31.2bn
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Source: Morningstar. Data as of end March 2015.
Europe ETP Market – Market Share by Asset Class
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Source: Morningstar
Europe ETP Market – Market Share by Replication Method
▶ Morningstar has a neutral view on replication
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Source: Morningstar
Strategic Beta
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Assets are flowing into passive investment vehicles that are increasingly active in their nature and implementation–the line between active and passive is now more blurred than ever before
▶ Strategic Beta—widely referred to as “smart beta”—refers broadly to a growing category of indices and the exchange-traded products and other funds and investment products that track them
▶ The majority of these indices seek to enhance returns or minimise risk relative to a traditional market capitalisation-weighted benchmark
▶ Others seek to address oft-cited drawbacks of standard benchmarks such as the negative effect of contango in long-only commodity futures indexes and the overweighting of the most indebted issuers in market capitalisation-weighted fixed-income benchmarks
▶ These benchmarks and the investable products that track them exploit many of the same sources of return (size, value, quality, momentum, etc.) or mitigate risk in a manner similar to active managers
▶ This category represents a middle ground on the active-to-passive spectrum—deviating from a traditional strictly passive market portfolio, but doing so in a rules-based, transparent, and relatively low-cost manner
Strategic Beta Defined
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▶ Many have defined the space in the negative, including products tracking any benchmark that is not market capitalisation-weighted
▶ Per our definition, while most of the indices that underlie investment products in this category are not market capitalisation-weighted, some are (e.g., those that have style “tilts”)
▶ We do not include sector indices, thematic indices, country indices, and other types of indices that screen constituents on the basis of sector membership, investment theme, or geography in this category
▶ We also exclude benchmarks that underlie those products that are included in our “trading” categories, such as leveraged and inverse funds
Strategic Beta Defined
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Is Strategic Beta Passive, Active, or Both?
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Strategic Beta
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Rules-Based (Passive)
Bet Against Market Portfolio (Active) Market-Cap
Weighted
Actively Managed
Strategic Beta
Taxonomy
Strategic Beta
Risk-Oriented
Minimum Volatility/Variance Low/High Beta Risk-Weighted
Return-Oriented
Dividend Screened/Weighted Value Growth Fundamentals Multi-Factor Size Momentum Buyback/Shareholder Yield Earnings Weighted Quality Expected Returns Revenue Weighted
Other
Non-Traditional Commodity Equal-Weighted Non-Traditional Fixed Income Multi-Asset
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Strategic Beta ETP Market Share – US v Europe
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Source: Morningstar. Data as of end March 2015.
Favoured Strategies - US v Europe
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Source: Morningstar. Data as of end March 2015.
What’s Driving this Trend?
▶ Investors cite multiple reasons for using strategic beta products
/ Managing risk
/ Enhancing returns
/ Tactically adjusting asset allocations
/ Portfolio completion
/ Reducing fees
/ A general disillusionment with active managers
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Morningstar’s Mission
▶ The goal of Morningstar’s research team is to play the role of referee in this space
/ By laying the ground rules
/ Highlighting the winners
/ Calling out the losers
/ All in the interest of helping investors navigate this increasingly complex landscape
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in association with the IFP
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