News Summary Analysis

June 11, 2014

ESMA: Investors Must Do More Due Diligence On Smart Beta

Investors must do more due diligence on smart beta indices compared to market capitalisation weighted strategies, the European financial markets regulator has warned.

The European Securities and Markets Authority (ESMA) published its final guidelines on exchange traded funds (ETFs) and collateral on March 24, which started two years ago amid the Libor-rigging scandal, when traders manipulated the interbank borrowing rate for their own benefit.

Clement Boidard, policy offer at ESMA, speaking in March at the EDHEC-Risk conference in London, said that now is a good opportunity to look beyond what the regulator has already legislated. Investors should pay particular attention to risk disclosure on smart beta indices.

"Everyone can understand what an index based on stock capitalisation is, but when it comes to, say, low volatility, you may end up in a very concentrated portfolio and investors might not be really aware of the risks they are taking," he said. "We think more should be done in this context to disclose the methodology and the key types of risks on these indices."

John St Hill, principal portfolio manager at the Pension Protection Fund, said that a lot of indices are opaque, but even market cap weighted indices come with their risks. "Understand what you buy," he said. "Even cap weighted indices have bets in them."

Top 5 Investment Myths

There are some very common market myths that investors should be aware of when it comes to building their portfolio. Here are the top five:

  • This year will be a stock pickers market
    Gina Miller, founder of the True and Fair Campaign, explains that fund managers often use this line to win clients into their actively managed investment products.
    "Of course every year, by definition, some stocks will outperform others and those that pick the right ones will do well," she said. "However, basic statistical evidence shows that every year at least half of active fund managers will be unsuccessful in this elusive treasure hunt."
  • Total expense ratio equals total cost
    This is sadly not the case. The total expense ratio (TER) normally covers just the management fee and a select few other explicit costs. But what about administration expenses, audit and performance fees, dealing commission, stamp duty and foreign exchange dealing costs?
  • Safe haven assets won't lose you money
    Ben Seager-Scott, senior research analyst at wealth manager Bestinvest, said he is frustrated by the perception that assets like gold and government bonds won't lose value. Investors often pour into these so-called safe haven assets when things are going wrong elsewhere, but it is not always the right move. Gold, for example, shocked investors when it plummeted from around $1800 per ounce in 2012 to nearer $1200 in summer 2013.
  • Emerging markets will give you good returns
    Shaun Port, chief investment officer at discretionary wealth manager Nutmeg, warned that the BRIC countries – Brazil, Russia, India and China – have only one thing in common, which is high risk. He said many mistakenly assume that high economic growth will translate into high equity market returns.
  • The ETF is just as liquid as its underlying
    A common myth is that an ETF, which tracks an index of bonds or equities, is just as liquid – or illiquid – as the underlying holdings it invests in. But this is not necessarily the case. In fact, in fixed income markets, the ETF can be even more liquid than the underlying.

Passives Set To Become Core Investments By 2020

ETFs are set to boom and passives will become core investments by 2020, according to a new report from PricewaterhouseCoopers.

Professional services consultancy and think tank PwC found that traditional active management will continue to grow in the future but at a slower pace than passive strategies, which do not involve a fund manager making tactical decisions and are generally cheaper.

The research read: "Traditional active management will continue to be the core of the industry as the rising tide of assets lifts all strategies and styles of management. But traditional active management will grow at a less rapid pace than passive and alternative strategies, and the overall proportion of actively managed traditional assets under management will shrink."

In October ratings agency Fitch also said these passive vehicles are on the increase, as fund groups would need to lower costs in a world of fierce competition. Moody's also released a report saying the outlook for European ETFs is "favourable".

As of January this year there was $2,321 (€1,381) trillion worth of assets invested across 5,025 exchange traded products, according to BlackRock. This has grown from $1,651 trillion in 4,411 ETPs as of January 2012.

Rob Mellor, PwC Asset Management 2020 leader, said: "The successful asset managers of 2020 will have already started to shape their responses to some or all of these game changers."




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