It's all as easy as A, B ...and CROCI

Monday's (27 Oct) survey from the Confederation of British Industry (CBI) that reveals the fastest sales growth in more than three years for the UK's retailers is easy to understand in many ways. Oil and therefore petrol prices are on the slide, inflation is subdued at 1.2% and unemployment stands at a six-year low, all factors which suggest shoppers have more spending power. Yet at the same time, the YouGov and CEBR consumer confidence index for October showed its biggest monthly fall for four years, wage growth is subdued and retailers such as Next have blamed an unusually warm autumn for weaker-than-expected trading.

This contrasting picture is assessed in fascinating detail by the Bank of England's Chief Economist, Andrew Haldane, in a speech, which can be found word-for-word at http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech764.pdf . It's well worth a read, as it outlines the concept of a “twin peaks” economy in then UK, where the recovery is described as “jobs-rich but pay-poor”. Haldane argues this is due to the mix of jobs created, as he cites how employment growth has been strongest among the highest and lowest-skilled with the mid-skilled actually seeing a drop in job opportunities and finding themselves trading down to keep earnings.

Haldane cites several research papers which analyse this “hollowing out” of the mid-skilled, which the economist notes is “usually attributed to technological displacement...for example, because of the automation and digitisation of certain tasks.”

Lloyds Bank's announcement on Tuesday (28 Oct) of 9,000 job cuts and 150 branch closures as part of its digital programme is one further example of what economist Joseph Schumpeter may well have seen as “creative destruction” and the replacement of one economic order by another. Such periods can unleash new sources of growth and lead to investment opportunities for clients, a thought which has not passed by ETF Securities. The Exchange-Traded Funds (ETF) specialist has this week (27 Oct) launched a new instrument, traded on the London Stock Exchange and eligible for Individual Savings Accounts (ISAs) and Self-Invested Personal Pensions (SIPPs), which provides exposure to the global robotics and automation sector. The sterling-priced version of the ROBO-STOX Global Robotics and Automation GO UCITS ETF comes with the ticker ROBG. The ETF is designed to track an index with 82 individual constituents, 40% of which are pure robotics plays and 60% of which have some exposure, and will be looking to build on the autumn 2013 launch of the New York listed equivalent.

UK launch follows US automation and robotics ETF release a year ago

Source: Thomson Reuters Datastream

The chart above shows how that product is performing and the ETF Securities launch is just one of a series of new initiatives from ETF providers which continue to provide investors with a growing range of portfolio tools and options.

The basics

Exchange-Traded Funds (ETFs) offer flexible and transparent exposure to a variety of different asset classes and markets. They mirror, or track, the performance of an index, basket of stocks or certain asset class and are known as 'passive' funds, as there is no fund manager to select the holdings relative to any benchmark – the ETF follows the benchmark, as best it can. Two techniques can be used to deliver the performance of the underlying assets.

Physical, or direct, replication, whereby the ETF actually owns the underlying basket of stocks or securities, or at least to a degree as makes no difference.

Synthetic, or indirect, replication where the ETF use derivatives contracts offered by brokers and investment banks to generate the performance offered by the index or stocks it is tracking. The ETF Securities ROBG product uses this methodology, for example.

Each approach has its pros and cons. Detractors of synthetic products argue they exposed clients to counterparty risk in the event the firm on the other side of the transaction gets into financial difficulties. Supporters argue synthetics offer a cost-effective means of accessing areas where it could otherwise be difficult to put capital to work, such as commodities or emerging markets, and that the collateral used to back them is outlined in detail on ETF providers' websites. These assets would be sold in the unlikely event of any problems, to ensure the ETF holder gets their money back.

The ten most actively traded ETFs by turnover in London in 2014

Source: London Stock Exchange. Covers period 1 Jan to 30 Sept 2014.

Next generation

Most equity ETFs are currently market-cap weighted and proportionally feature stocks according to their importance in a given index. Each 1% price movement at those firms with the highest market values therefore moves the underlying benchmark and thus the ETF by more than an equivalent rise or fall at the smallest companies.

This can mean an investor can find themselves unwittingly exposed to a small handful of stocks. To combat this, ETF providers are developing tools which are weighted in a different way. Alternatives include equal-weighted, dividend-weighted, earnings-weighted, revenue-weighted and volatility-weighted. These ETFs give rise to the term “smart beta”, instruments which enable investors to tilt portfolios toward firms with certain characteristics, give their holdings a certain strategic bias or neutralise the undue influence of certain stocks.

Source ETP has just launched its second sector ETF in London, the Source EURO STOXX Optimised Banks UCITS ETF, with its ticker S7XP. Coming hot on the heels of the European Central Bank's Asset Quality Review (AQR) the release is timely, at least for those clients who believe the stress tests give Eurozone banks a clean bill of health. The ETF, which used synthetic replication, is designed to reduce exposure to the EURO STOXX banking index's smaller, less liquid constituents to create a more investable sector benchmark.

Meanwhile, Wisdom Tree Europe has just unveiled four dividend-weighted ETFs, its first UCITS products in London. They are as listed in the table below and the focus on income in a low-interest-rate, low-bond-yield world may catch investors' attention:

Wisdom Tree Europe's four dividend-weighted ETFs in London

Source: Wisdom Tree Europe, London Stock Exchange

Not to be left out, db X-trackers just last week (20 Oct) brought four “smart beta” ETFs to London, although it prefers the term “strategic beta.” The focus here on quality, value, momentum and also volatility (in the form of a low beta portfolio) gives experienced clients the chance to tilt their portfolios in a certain direction and refine their overall strategy. The instruments use physical, or direct, replication and provide access to stocks around the globe.

db X-trackers is also bringing “smart beta” to London

Source: db X-trackers, London Stock Exchange

Low cost options

The costs associated with running “smart beta” ETFs can be higher, so expense ratios may stand above those for traditional, market-cap weighted tools. The idea is “smart beta” products offer a superior risk-reward profile although ETF providers remain conscious of the importance of running costs to clients.

As noted in this column before Fidelity and Vanguard in particular have been at the front of a drive to lower the cost of passive investing. Four new tools from the latter released in early October come with annual ongoing fees and charges of between 0.1% and 0.12%. Db X-trackers is again active here, with a cut in its db X-trackers Nikkei 225 UCITS ETF (DR) all-in, annual fee to just 0.09% and its range of so-called Core ETFs cost between 0.07% and 0.19% a year.

It seems logical to expect that “smart beta” will see costs start to fall over time too, although new product developments mean investors can also look toward open-ended investment companies (OEICs) to both reduce costs and keep innovating.

Deutsche Asset & Wealth Management (Deutsche AWM) has expanded its Cash Return on Capital Invested (CROCI) suite of investments with the addition of the large-cap focussed DB Platinum CROCI UK fund. This collective uses Deutsche AWM's established CROCI valuation methodology to invest in a concentrated portfolio of 30 companies, selected from the FTSE 100, that have the most attractive economic valuations according to the CROCI team’s methodology.

This is a fund rather than an ETF and as such it is not a “smart beta” product. Instead, Deutsche AWM sees the fund as a means of capturing “alpha” - or outperformance of a benchmark – on a systematic basis. The CROCI analysts focus on valuation and seek to establish the real value of companies so the fund never overpays for the real cashflow provided by a company's operating assets. After detailed work which take apart a company's accounts and then put them back together, minus any accounting sleight of hand and one-off items that distort the stated numbers, before selecting stocks based on proprietary value metrics.

Deutsche AWM CROCI funds are building a good performance track record

Source: Thomson Reuters Datastream

Deutsche AWM has been running money using CROCI for a decade and its portfolios here already control more than €10 billion. The performance of the DB Platinum CROCI Global Dividends and DB Platinum CROCI Sectors funds stands up to close scrutiny and some investors may warm to the rigorous stock selection process, especially if they do have the time or inclination to do their own research.

Russ Mould, AJ Bell Investment Director.