Overview
Mid-Year Outlook: A global rewiring (full report)
- Research-powered, active solutions are gaining share within the ETF marketplace.
- New investors are being attracted by an expanding range of more sophisticated products.
- Recent market volatility has highlighted the risks associated with ‘buying the market’ and further turbulence could accelerate the adoption of research-powered ETFs over their passive counterparts.
The expansion and maturing of the ETF market over the past five years has been significant, both in terms of growth in assets under management and the increased sophistication of available solutions. The most notable recent development has been the huge increase in the adoption of active ETFs.
A survey commissioned by Fidelity International late last year showed that 37 per cent of institutional investors and distributors across Europe and Asia expected to increase their active ETF allocations over the subsequent 18 months. That figure is likely to have increased through this year’s market volatility. Having a more agile and active approach that benefits from controlled risk management and discerning investment selection is particularly important when addressing the risks posed by heightened levels of market concentration and increased global fragmentation.
The multi-year shift towards passive investing has itself been partly responsible for the elevated concentration risks that investors are now bearing. This is because capitalisation-weighted index trackers inherently provide the lion’s share of flows to segments of the market that have historically performed more strongly, while allocating less to securities that have been out of favour, the result being exacerbated market imbalances and pockets of high valuations. All of this occurs irrespective of any forward-looking view or regard for the current macroeconomic environment.
It’s perhaps unsurprising that solutions which derive value from bottom-up research are now having a moment as heightened volatility increases the dispersion of market returns. Volatility is a symptom of transformation and a sign that that the investment backdrop is evolving, which potentially means a shift in performance leadership. Investors are therefore naturally seeking more sophisticated investment strategies to manage this increased turbulence.
One of the headline findings of the survey was that investors choose active ETFs both to reduce costs and generate alpha, reflecting one of the main areas of innovation for these vehicles: the enhanced integration of research insights into investment strategies.
Rather than simple ‘active’ ETF strategies that apply investment selection processes using backward-looking financial disclosures, well-resourced investment managers are now delivering solutions that are genuinely powered by bottom-up insights from their banks of expert research analysts. The integration of this kind of value-adding intellectual property has the potential to deliver far superior solutions; after all, an investment strategy is only as good as the expertise that underpins it. Recent industry flows suggest that investors agree.
Of course, the integration of fundamental research is nothing new in the world of investment - active mutual funds remain a staple among institutional investors. The difference is that these ETFs seek to provide this alongside some of the typical benefits of passive solutions, such as a high level of transparency and competitive fee rates. To accomplish this, they use innovative portfolio construction and optimisation technologies to deliver research-powered strategies efficiently and at scale.
Responding to the evolving backdrop
For these reasons, the still relatively small European ETF market is likely to develop along the same path as its larger and more established US counterpart over the coming years (irrespective of the difference in ETFs’ tax treatment between these two jurisdictions). This would mean a growing share for research-powered ETFs as their benefits become more apparent to investors.
This does not mean that every active ETF will be successful - to succeed, managers need to deliver solutions that are indispensable. They will have to deliver the flexibility, transparency, liquidity, diversification, and cost-effective market access typically provided by passive ETFs, alongside a genuine capacity to generate alpha, as active mutual funds are designed to do. If they can achieve this, the result will be compelling offerings across asset classes and geographies that investors can ill afford to ignore.
For our part, we have plans to significantly increase the number of ETFs within Fidelity’s range over the next 12 to 18 months. This will allow us to deliver solutions with different goals - across markets or with different risk and return objectives within markets, for example varying tracking error targets or sustainability approaches. Fidelity has been an early leader in this rapidly growing segment of the market. But anyone who wants to hold onto that status will have to invest strongly in the years ahead. The market is growing fast and competition likewise.
