3 Kinds Of ETF Innovation

The meteoric growth in the use of exchange-traded funds (ETFs) in the past decade has led to ETF providers scrambling to provide ever more innovative and arguably complex instruments to lure new assets.

The industry has come a long way from the plain vanilla ETFs tracking major equity indices such as the FTSE 100, developing in both the type of index being tracked and how that tracking is replicated.

The range of innovations with the ETF field may broadly be divided into one of three categories.

Unusual Exposures

First there are those ETFs that create unusual indices to track. For instance, there is an ETF which tracks an index that solely consists of robotics companies, the Robo-Stox Global Robotics and Automation GO UCITS ETF. These sort of ETFs are innovative in terms of the underlying companies being tracked and fill a niche for the investors who may wish solely to have access to such companies.

Smart Beta ETFs

Then there are ETFs which track well-known or established indices, but reconstruct the index in order to provide different access to it, for example skewing an index to focus on so-called value or momentum companies. These are collectively seen as smart beta ETFs and have enjoyed significant growth in recent years.

Adam Laird, head of passive investments at Hargreaves Lansdown said the WisdomTree Emerging Markets SmallCap Dividend UCITS ETF is an example of this type of innovation. The recently launched ETF weights stocks so that the companies paying the highest dividend are the largest constituents in the ETF.

The UCITs version of the ETF was only launched last year, but the U.S. version has been available since 2007. The weighting to income stocks has allowed the ETF to outperform its reference index by 7 percentage points in that time, according to data from FE Analytics. However, the weak performance from emerging market equities means the return on the ETF was only 40 percent.

Short & Leverage

Finally, there are ETFs that are innovative in that they provide leveraged access to existing indices. These allow particularly bullish investors to take extreme positive or negative bets on certain markets, for example commodity spot prices.

Laird gives the example of another newly-launched product, the Boost Gilts 10Y 3x Short Daily ETP.

The exchange traded product allows investors to benefit if gilts sell off, with the return leveraged three times through the use of derivatives.

However, Laird said he does not consider such products to be suitable for the vast majority of investors because “triple leveraged short products are very costly to hold and highly volatile”. He said people should not invest in such ETFs unless “they truly understand” the investment.

The danger in leveraged ETFs is illustrated by the performance of the Boost ETF, which has lost 26.8 percent since its launch in August 2014; although the 10 year gilt yield has fallen by 20 percent in the same time period.

Laird said new innovative ETFs tend to vary between physical or synthetic replication, but there are more physical ETFs around for investors to choose from. The WisdomTree ETF physically replicates its index, but the Boost ETF, through its extensive use of derivatives, only synthetically replicates. Investors will need to understand the structure of each ETF, as well as its cost and the complexity of the underlying securities being tracked, before committing their cash to this increasingly innovative industry.

Case Study: Anna Sofat, Addidi Wealth

Anna Sofat, founder and managing director of financial advice firm Addidi Wealth, said she uses ETFs for both core portfolio holdings but also more niche investments. She said she has used ETFs for areas such as exposure to the property sector and for commodities exposure, including at one time buying an ETF to get exposure to grain.

She added that she welcomed innovation within ETFs because the industry is able to react to new opportunities more quickly than the fund management industry. Therefore, she sees a role for innovative ETFs in “filling a need” for certain clients.

However, she warned that advisers “have to be mindful of innovation”, particularly as the ease with which ETFs can be launched means they tend to be the first available products allowing access to any new investment fad.

Sofat said: “It is the advisers’ job not to just jump on to the back of the latest trend – you still need to have a robust investment strategy. On balance I like innovation, but it has to be backed by good strong fundamentals.”

Sofat also warned that investors should avoid innovative ETFs until they reach £25 million in assets due to the possibility that smaller niche ETFs could face closure if demand remains lacking, while larger ETFs also provide better liquidity and generally lower costs.

Innovative ETFs do tend to be more expensive than more vanilla products and can even stretch towards the realms of active management fees, according to Sofat. She said higher costs should not necessarily put off investors but advised: “you have to look at what you are getting for that money”.