These types of funds are low cost but they are not (yet?) as popular in the UK as in the US
Thursday 08 Oct 2020 Author: Hannah Smith

The passive funds market in the US is huge, with exchange-traded funds (ETFs) widely used by a range of investors, both novice and sophisticated.

Globally, the ETF market is worth more than $7 trillion, according to ETFGI, of which around $4.6 trillion is in US-listed funds, while $1.08 trillion is in Europe-listed funds.

The UK is behind the curve when it comes to the everyday appeal of these products – why is that, and what can the funds industry do to change things?

WHY POPULAR IN THE US?

There are a few reasons why ETFs are so popular in the US. An important one is that they offer investors a tax advantage, which gives them an edge compared to active US mutual funds.

‘The tax efficiency associated with ETFs is much stronger than the traditional US mutual fund alternative that most investors have used in the past,’ explains Steven Dunn, US-based head of ETFs at Aberdeen Standard Investments. ‘So, for high net worth investors with investments outside of a retirement account, that’s a big deal.’

THE RISE OF ROBOS

Another reason for their popularity is the way the advice market has changed in the US, which set the stage for the rise of ETFs.

Describing this ‘tremendous transition’, Dunn explains that the way people were able to consume financial advice broadened and the advice model became more dynamic.

This resulted in more online investment offerings coming to the market from low-cost providers, triggering price competition.

Advisers who had traditionally used actively managed mutual funds moved towards lower-cost ETFs so they could maintain their advice fees while giving consumers cheaper funds.

‘Once advisers had the ability to build a lower-cost portfolio that is transparent and tax-efficient, that contributed to the take-off in ETFs in the US,’ adds Dunn.

While robo-advisers with risk-graded ETF portfolios are also now gaining ground in the UK, they are not yet on the same scale as some of the very established players in the US.

PRODUCT PIPELINE

Product development has also happened differently in the two markets. Dunn notes there used to be a perception that the UK and Europe were five years behind the US in terms of ETF development, but now the same types of funds you can buy in the US are available globally. ‘What may lag behind a little is some of the infrastructure behind it,’ he adds.

Kenneth Lamont, passive funds research analyst for Europe at Morningstar, says large providers selling ETF products into Europe will often launch in the UK first. This is partly to do with regulation and the structure of the market compared to the more fragmented European market. So, in that sense, the UK is ahead of the curve on the product side compared to Europe.

SYNTHETIC SUSPICION

But what type of ETFs are actually selling in each market? In the UK, there has been a lot of innovation with products in the smart beta area, or those offering factor or thematic exposures.

While the big, core building blocks of portfolios such as FTSE 100 or S&P 500 ETFs still account for the bulk of assets, there is product evolution going on, especially in the fixed income market, notes Dunn, and thematic funds have become more interesting to investors.

On the downside, one feature of the UK funds landscape has been investors’ dislike of certain types of products, Lamont argues, notably synthetic ETFs. These use derivatives to replicate the performance of an index without actually holding the physical securities in that index.

‘Another issue for the UK audience is that there’s been a lot of suspicion with ETFs because in the past there were a lot of synthetic providers…and the use of derivative required a certain level of due diligence from a retail investor. People would rather buy a safe and simple product. In the US, you don’t actually have any synthetics, or at least very few, so that’s another big difference,’ Lamont says.

ESG CHANGES THE GAME

The ESG revolution could be the thing that sees the UK and Europe catch up to the US on ETFs. Europe is the largest market for sustainable passive funds, according to Morningstar, accounting for more than three quarters of global assets, while the US represents 20%.

America has been a slow adopter of ESG, while at home we have wholeheartedly embraced the shift to a more responsible type of investing. ETF providers are rushing to roll out products which tap into this huge and growing trend, which is being largely driven by young investors who are tech-savvy, values-focused and open to using ETFs.

‘We’re seeing record levels (of inflows), record launches, and for once Europe is leading the charge on this so, yes, I think that will favour ETFs, there’s a lot of product out there,’ says Lamont.

But the US is waking up to the importance of ESG, with investors caring more about where their dollars go and product providers starting to respond.

‘The US has been very slow to embrace the ESG aspects, and maybe that had to do with the legacy product, maybe they weren’t as good, maybe the performance wasn’t there. But you have seen the pendulum swing in the US as investors become much more aware of where and how they’re investing,’ says Dunn. ‘ETFs play really nicely into that space because of their transparency, that will certainly provide a leg up to these products.’

If fund providers use the opportunity of growing investor interest in ESG to educate consumers on ETFs and market them better, perhaps they will soon become as mainstream here as they are across the Atlantic.

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