Over the years I’d like to think that I’ve become something of an expert about a widely diagnosed disorder called The Next Big Thing Syndrome. As a journalist, I’m naturally drawn to all that is shiny and new (itself another ailment of behavioural finance) and clearly there’s nothing better than writing about a trend that has momentum behind it. If we add in the inevitable Disruption tag, then we have the makings of a classic Big Story.
It goes something like this:
- The old order have been busily ripping everyone off for a long time and thoroughly deserves their come-uppance
- The new thing comes along, usually helped by either regulation or technology, or both
- A few hardy pioneers jump on the New Thing and proclaim that the revolution is coming and Old Order RIP
- The economics of disruption do eventually force something approaching a tipping point
- But the citadels of the old order aren’t ever stormed very quickly because the old order has inertia on its side
- The young Turks of the New Order discover to their horror that there are lots and lots of behavioural and market quirks that buttress the old order
- The Next Big Thing takes inordinately longer than we all expected to take charge, forcing the disruptors to pivot and think smart with new strategies
- Usually some exogenous factor intervenes – maybe a nasty recession – which eventually forces the Old Order to concede and the New Order is established.
- A whole new bunch of young Turks get ready to storm the citadel and remove the New Old Order
The glamourous world of ETFs I think fit perfectly into this pattern. I have not one iota of doubt that within the next two decades we’ll see a profound change in investing behaviour. Investing in passive funds will be the default in Europe, and especially the UK. It’s just that the journey to get there will take much, much longer than we all think.
In concrete terms, we’re still a very long way from the US situation where net fund sales for ETFs now exceed on a monthly basis sales those for active funds. My guess is that we won’t see any tipping point in Europe for at least another 3 to 5 years, if not longer. I’d dearly like the transformation to happen sooner but if we’re honest the tailwinds supporting ETFs just aren’t strong enough currently – while the headwinds are strong and impossible to avoid.
The ETF industry for instance has great hopes for the rise of roboadvisers – lower cost, more automated portfolio solutions driven by tech and ETFs. I wish these scrappy upstarts were poised to inflict carnage on the existing wealth management industry but if we’re honest, we’d have to admit that there’s a lot of work to do and a Everest sized mountain to climb. Trust in respected investment brands takes decades to achieve and my gut instinct is that most investors will continue to toy with these products using investment sums of between £1,000 and £20,000 i.e subs scale product size. By contrast they’ll keep the larger lump sums for existing brands they trust. Over time this will change but my worry is that for many of the propositions, the entire business case rests on scaling up aggressively within a few years. Given the well-known high customer acquisition costs, I sense that we’ll see a few high profile failures in the next few years. Which will be an enormous pity, especially as these robo advisers are the chief evangelists for the low-cost passive revolution. I hope to be proved wrong!
ETF enthusiasts like me also love to excitedly talk about the huge opportunities available in the retail space, especially as more and more of us have to take active control of our financial planning futures. This will indeed be a huge driver of long term growth and I have no doubt that over the next ten to twenty years we’ll see a profound shift in favour of ETFs and low cost passive unit trusts. But this’ll be a slow, incremental game, dependent on access to key D2C consumer platforms and also very dependent on pricking the idea that stock picking is fun and productive – it’s only fun when you occasionally get it right, otherwise its largely an exercise in wealth destruction.
So, retail is important, yes but the main ETF issuers will need to be inordinately patient. Which brings us to the one most obvious opportunity – advised retail clients. I’ve given up counting the number of ETF issuers I’ve encountered over the last few years who have been enormously enthusiastic about reaching out to IFAs and wealth advisers. Sadly, in such encounters I usually end up sounding like a sour puss.
“Ah yes, I see the plan, pity about the people”, is my usual refrain.
The rampant enthusiasm of issuers usually runs into the sordid reality of incumbency. IFAs and many wealth advisors are hooked on two fundamental business models linked by the notion of out sourcing. Over the last few decades they’ve been progressively scared senseless by the compliance burden of actually advising on which investments their clients should make. Precisely because asset allocation and fund selection is so crucial, they’ve come to realise that it’s also very difficult – and fraught with professional risk.
This explains why the vast majority have decided to sub contract the fund selection bit to one of two business models. The first is the discretionary fund manager or DFM. The second is a wrap platform model portfolio structure – which is in effect a simplified form of DFM.
On paper, the opportunities for ETFs within these DFM and model portfolios is huge. In practice, it isn’t – the internal dynamics of incumbent advantage get in the way.
Let’s start with DFMs. Back in 2014, the excellent Rachel Revesz wrote an insightful article for www.etf.com which looked at the DFM space and ETFs – and counselled caution. You can see the article here : http://www.etf.com/sections/blog/10282-the-passive-dfm-conundrum?nopaging=1
I would suggest looking down the list of top 20 DFMs in 2016 and 2017, that very little has changed – ETF penetration though increased is still very low. The steady rise of Seven IM has been a real boost for the ETF industry but most of the key players such as Brewin Dolphin, Rathbones and Quilter Cheviot I suspect remain largely impervious to the benefits of ETF based DFM portfolios.
Very simply ETFs represent a challenge to their business and professional model. Their value proposition is built on the twin pillars of active asset allocation and superior fund selection. Walk in into an average IFA client and say we kept costs to the absolute minimum by picking from a shortlist of just 10 Vanguard and iShares ETFs/funds, and you’ll be met by a look of horror – “Christ, how can I sell that to my clients – they’ll just think they can do it themselves! I want some investment management magic from you guys not the investment version of Lidl”.
There’s also an embedded culture of active fund selection – spotting the next Neil Woodford or Nick Train is far more interesting than identifying some jargon heavy ETF with an impenetrable name and tracking strategy. Of course, I exaggerate for effect – there are DFMs making extensive use of ETFs but I’d suggest that it’ll only ever be as an adjunct to their main core mission of choosing great active solutions.
Over in the model portfolio space the challenge is even harder. Your wrap platform may boast the cheapest ETF model portfolio but the natural reaction of most IFAs (not all, I freely admit) is to pick portfolios where the readymade narrative about fund selection is provided by an active manager. Cheap is good, but exciting is even better. And all this assumes that you can even get ETFs on to said wrap platform!
In sum, I’d suggest that the full-frontal assault on advised clients is an exercise fraught with peril. Issuers could spend millions on educating the market and barely see the dial move at all.
Again, in very simple terms you’ve got a disruptive Next Big Thing that is a threat to the professional’s business model. And as Turkey’s don’t tend to vote for Christmas, the afore mentioned professionals will find fault with everything the Young Turks propose: “Ah, what about all those synthetic funds…what about stock lending…isn’t the index badly constructed…who controls risk”?.
So, in my humble opinion, for the Next Big Thing (ETFs) to break through into this advisory space requires a new strategy: Focus on the Weak Links of the old order.
One example to start the debate – fixed income. Investment professionals need default bond options – a large portion of their customer base requires an income. With interest rates likely to remain low, investors and their advisers will be engaged in an increasingly fevered pursuit of yield, across sectors and internationally.
This fevered pursuit will soon ram into an obvious reality – that in many specific niches and sub markets, active fund management doesn’t add value, much of the time. Precisely because these fixed income markets are so deep and so liquid, adding value from an active perspective is largely a fool’s errand. But what a good DFM can do is assemble the right building blocks that when put together produce the desired income yield – a bit of corporate income here, add on some govies there (maybe ETFs) and then layer with some more exotic, alternative stuff (investment trusts) to get the yield above 4%.
Giving these asset allocators the building blocks for a desired investment outcome via ETFs makes absolute sense. It also prompts a much more interesting debate which takes the following concepts as ‘given’:
- Both active and passive funds have a purpose
- This purpose and differentiation in outcome varies over time between active and passive
- Different asset classes react to passive and active in different ways during different stages of the market cycle
What hopefully emerges is a more nuanced message: that ETFs make sense, some of the time, in some markets – and not in others. It also involves ditching the broader message of passive is massive (and brilliant) for a professional audience – the idea of ultra low cost might work with D2C retail clients but it doesn’t resonate with many professionals. Cheap usually means poor quality and dangerous. Better to use the language of building blocks and market efficiency/inefficiency to build a case for ETFs.