5 ETF Themes From 2015

[This article originally appeared in our December issue of ETF Report.]

Financial Service Titans Jump Into The ETF Pool

This year has seen a significant number of new issuers and brands dive into the ETF pool. In particular, there have been a lot of long-standing expectations flying around the ETF industry, and many of them are intertwined with each other.

For example, market watchers expected that major active managers wouldn’t enter the ETF market until nontransparent actively managed funds became a reality.

Well, we’re still waiting for those nontransparent funds, but the likes of DoubleLine, John Hancock and Goldman Sachs have nonetheless started to establish footholds in the ETF space.

Although Jeffrey Gundlach’s DoubleLine found its way into the space via a partnership with State Street that involves transparent active bond funds, the majority of those entries into the marketplace are closely tied to another huge theme in the ETF industry—smart beta, and in particular, multifactor funds.

John Hancock, Goldman and J.P. Morgan have all launched families of multifactor smart-beta ETFs, although it should be noted that J.P. Morgan launched its first fund late in 2014, with more following in 2015. The trend is important because it underlines the “quasi-active” nature of smart beta. These firms were never going to launch plain-vanilla index ETFs—they needed the potential to add alpha to their clients’ investments.

The most intriguing of these grand entrances, however, has been the launch of John Hancock’s lineup. Not only does it include the first factor-based sector funds, it also offers what many have considered a holy grail of investment: ETFs designed and managed by Dimensional Fund Advisors. The well-known passive (but not indexed) firm, which includes two Nobel laureates on its boards of directors, constructed the indexes for the ETFs using its well-known approach that emphasizes the size, value and profitability factors.

“Even if active outperforms—or I should say, when active outperforms, because it will happen—$2.5 trillion isn’t going out of passive back into active. Once investors start to subscribe to this religion, it’s unlikely they’re going to break from it. Once you start paying 50 basis points for an exposure, or 35 bps for an exposure, it’s going to be really hard to go back to 100, 120 bps for the core of your portfolio,” said John Hancock CEO Andrew Arnott in a recent ETF.com interview.

But the titans aren’t the only ones that made their debut in the ETF arena. Smaller firms like Pacer Financial, Lattice Strategies and Hong Kong-based CSOP Asset Management have also launched their first funds. In all, more than 20 new brands have appeared on the scene in 2015 alone.

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Currency-Hedged ETFs Become Further Entrenched

Currency-hedged ETFs have been around since at least 2010, but one could easily argue that 2015 was their “expansion” year. More than 210 ETFs launched in the first three quarters of the year, and of those, roughly 40 were currency-hedged equity funds. That’s … a lot.

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You could say it all started with the WisdomTree Japan Hedged Equity ETF (DXJ | B-67). The dividend-weighted fund added a currency hedge back in 2010, and then in 2012, it added a screen that pushed out many of the domestically focused companies in favor of export-focused firms. In 2013, Japan’s market started to do pretty well on the back of the yen’s deliberate devaluation, and DXJ outperformed competing Japan funds handily, which many attributed to the fund’s currency hedge at a time when the yen was plunging.

The fund has since ballooned to $16 billion in assets under management (AUM) and was surpassed in March by its sister fund, the WisdomTree Europe Hedged Equity ETF (HEDJ | B-49), which gathered speed with the deliberate weakening of the euro. That fund’s assets stand at $19 billion now.

The growing success of DXJ and HEDJ drew the attention of other issuers. There are more than 70 currency-hedged equity funds currently trading on U.S. exchanges, including those from the likes of iShares, Deutsche Bank and State Street Global Advisors, in addition to other firms. Still, DXJ and HEDJ remain by far the largest such products.

But subsequent currency-hedged funds haven’t become assets blockbusters like DXJ and HEDJ. Fewer than 10 of the ETFs launched so far have more than $1 billion in AUM. Rather, they have a more utilitarian purpose.

Just as a currency-hedged product can add to returns when the targeted currency is weakening against the dollar, it can detract from returns should that currency strengthen against the dollar. With currency-hedged versions of many international ETFs, investors can toggle between the two as foreign exchange conditions dictate.

Yet according to IndexIQ’s CEO Adam Patti, most investors mistime hedging. So his firm has rolled out “halfway hedged” ETFs—international funds that only hedge away 50% of the currency effect in their portfolios and chart a middle-ground compromise between fully hedged or unhedged ETFs, taking the need for market timing off the table.

And WisdomTree is looking to make a potentially deeper mark on the space. The firm has filed for ETFs that will have a “dynamic” currency hedge that will use quantitative indicators to adjust the degree of hedging on a portfolio between 0 to 100%.

Investors Take Wild Ride On China A-Shares

While the ability of U.S. investors to gain direct exposure to China began in 2013, this year marked the first time that China A-shares really became a part of the investment world’s stream of consciousness, in two ways.

First, the roller-coaster ride of China’s stock markets rumbled through financial markets, adding a new dynamic influence to U.S. financial markets and beyond.

Secondly, the decision on whether to add China A-shares—the local securities of Chinese companies trading on the Shanghai and Shenzhen exchanges—to emerging market indexes is an open debate between index providers as well as ETF issuers.

From the beginning of the year until midsummer, China A-shares, as measured by the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-53), rose nearly 50% before giving up all those gains and falling more than 60%. They have since recovered and stabilized, and are down 3% for the year, underperforming U.S. stocks as measured by the SPDR S&P 500 (SPY | A-99). That underperformance has led to more outflows in assets from China A-share funds this year than all of 2014’s consistent inflows.

For early China A-shares investors, this year has been a wake-up call for extreme volatility, to say the least. This has been a dramatic change from 2014’s returns of more than 50%. “Buckle up if you want exposure to China’s mainland stocks” is the lesson most investors have learned.

Those market gyrations, as well as the Chinese government’s unprecedented intervention into its markets when stocks were falling hard and fast through the summer, have clearly highlighted the debate of whether emerging market indexes should include China A-shares.

Right now, only FTSE has said it will begin including China A-shares in its emerging market indexes, which Vanguard uses for its emerging market ETF, the Vanguard FTSE Emerging Markets (VOO | C-88).

Vanguard says it makes sense to invest in China because it has the second-largest stock market in the world by market cap and the world’s second-largest gross domestic product, accounting for 20% of global trade and 7% of global consumption.

“Vanguard has been very clear about the risks of the fund on our website and prospectus,” John Woerth, a Vanguard spokesman, told Reuters recently. “We will continue to educate investors about market volatility and the additional risks that accompany investing in any emerging market.”

Other index providers are taking a go-slow approach.

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Commodities Continue To Weigh On Markets

An absolute bloodbath—that’s the best way to describe the performance in commodity markets during the past year. From oil to metals to agriculture, no area of the commodity space has been immune to the relentless price declines.

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In August, the S&P GSCI Spot Index touched its lowest point since the depths of the financial crisis in 2009, while the Bloomberg Commodity Index fell to its lowest level since 2002.

With performance this bad, some analysts are questioning whether it even makes sense to own commodities anymore, while others urge investors to stay the course.

The case for owning commodities as an investment has largely been about two things: diversification, and inflation hedging. The academic research that ignited a wave of interest in commodities during the last decade suggested that an allocation to the space could enhance returns and reduce the volatility of a portfolio.

This research said that commodities had a low or negative correlation with other asset classes such as stocks and bonds, and that, long term, it made sense to hold them in a portfolio.

Do a few years of lousy performance throw cold water on these findings? Not necessarily.

That commodities have been declining as stock and bond markets rally supports the idea that they are not correlated with other asset classes. And in a low-inflation environment, it shouldn’t be a surprise that commodities are struggling. The figure shown uses the PowerShares DB Commodity Tracking ETF (DBC | C-61) as the proxy for commodities against the SPDR S&P 500 (SPY | A-99).

Commodities not performing well doesn’t mean investors shouldn’t consider them as part of a well-diversified portfolio. Prices being low now make them more attractive from a long-term perspective.

But don’t expect a quick turnaround in prices until the fundamentals shift.

For commodities, the downturn of the last few years has been about surging supply and weakening demand. Both sides of the equation must move in a more bullish direction before prices can sustainably rebound.

In some markets, there is evidence that this is happening. Oil demand this year is on pace to grow at the fastest rate in five years, according to the International Energy Agency.

At the same time, data indicate that U.S. oil production is tumbling from multidecade highs set earlier in the year.

Low prices are doing their part to encourage demand and discourage supply in the oil market. While these trends haven’t been as evident in other commodity markets where production and consumption react more slowly to changes in prices, eventually, equilibrium will be reached across the board (especially if emerging markets escape their current growth funk and inflation accelerates from its current low levels).

The Emerging Market Malaise

Emerging markets had been the promised land of outsized growth and performance for years, particularly after the 2008 financial crisis rattled developed economies to the core. But this year, the investor darling completely fell out of grace.

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In 2015, it seemed investors couldn’t get out of emerging markets fast enough.

The two biggest broad emerging market ETFs, the iShares MSCI Emerging Markets ETF (EEM | B-100) and the Vanguard FTSE Emerging Markets ETF (VWO | C-88), bled a combined $9 billion in net assets in less than 10 months as performance suffered. Investor sentiment toward the region plummeted as the months wore on.

“The head winds that have begun to emerge have shown there may be some cracks in the growth model of emerging markets,” said Dave Mazza, head of Research, SPDR ETFs and SSgA Funds at State Street Global Advisors.

“Perhaps the head wind garnering the most attention is the potential for the end of the commodities supercycle, which may in fact have already occurred,” he added.

This year, commodity markets hit multiyear lows amid abundant supplies of everything from grains to oilseeds to metals, and lagging aggregate demand on a global scale. The S&P GSCI Index hit its lowest level since the financial crisis more than six years ago. The Bloomberg Commodity Index did even worse, dropping to lows not seen since 2002.

As commodities reeled, the U.S. dollar remained strong relative to other currencies—a difficult combination for emerging markets that rely heavily on commodity production and exports. And then there was China …

China’s mainland stock market soared in 2014, with funds like the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | D-53) rallying more than 50% in 12 months. But this year, everyone was focused on a slowdown in Chinese growth, and concerns over the possibility of a hard landing for China only grew as the year progressed thanks to the government’s heavy hand on the markets.

August saw the yuan finally devalued against the dollar after years of an implicit peg—a move that further eroded investor sentiment toward the second-largest economy in the world.

From a valuation perspective, emerging markets are attractive relative to broad-based developed markets, including the U.S. and Japan. But the reality is that growth is now a different story.

On a forecasted basis, earnings estimates for emerging market companies have come down. Yet the return on equity (ROE) on EM companies is now lower than the ROE on broad-based developed markets, including the U.S. and Japan, according to Mazza.

“The growth story in emerging markets is no longer as clear-cut as it once was,” noted Mazza.