Can ETFs stay ahead of the pack if value is about more than price?

The push for greater value has been a defining theme of the global investment industry strengthened the past few years. On one hand, a decade of low yields has strengthened investors’ determination to reduce costs. On the other hand major regulatory initiatives, such as Markets in Financial Instruments Directive II (MiFID II) and Packaged Retail and Insurance Investment Products Regulation (PRIIPs) have increased transparency requirements around the charges of investment products and services.

This value agenda has been an important tailwind behind the ETF industry’s remarkable growth. ETFs’ total expense ratios are typically lower than for comparable mutual funds, and they continue to fall. So it’s no surprise that many ETF providers welcomed the UK FCA’s recent Asset Management Market Study (AMMS). Looking at the UK investment market as a whole, the AMMS found significant evidence of a lack of competition.

Even so, we think it would be a mistake for ETF promoters – in the UK and elsewhere – to underestimate the implications of this landmark study. The AMMS presents a number of challenges to the ETF industry. Nor will it be the last word in the debate over value. ETF providers need to ensure they understand the evolving shape of regulatory thinking, and that they are ready to respond.

The UK regulator’s overall aim was to ensure that the asset management market works well, and that investment products provide consumers with value for money. The AMMS identified a number of significant failings in the UK’s asset management market, especially in relation to retail investors – both advised and non-advised.

In particular, the AMMS found that asset managers generally give insufficient consideration to whether they deliver value for money, and that investors are often overcharged. Commercial pressures were seen as insufficient to ensure price competition at the point of sale, with fund governance bodies failing to exert sufficient pressure on post-sale costs.

At first glance, ETF providers may feel these findings are of little relevance to them. After all, ETFs have a strong track record of reducing costs and increasing retail accessibility, and EY research indicates that they already offer good value for investors. Furthermore, according to a research carried out by EY in 2018, providers believe there is further scope for an overall reduction in management fees over the next 3 years. And in any case, the majority of European ETF investors are institutions – a group that the FCA found served better by the asset management market.

That’s an understandable view. But a closer look at the AMMS shows that several of its findings are highly relevant to the ETF industry. For example, the study found that:

• Investors see costs as important, but often do not understand them well. FCA research suggests that 45% of retail investors consider charges to be an influential factor in their choice of fund, but that an alarmingly high 22% are ‘not sure’ whether they are paying fund charges.
• Investors rely heavily on best- buy tables, despite their limitations. Morningstar ratings, which provide quantitative, risk-adjusted comparison of past performance net of costs, are particularly influential. These ratings are agnostic between active or passive funds, which can result in inaccurate comparisons when selecting index-based investments.

The existence of these gaps in investor understanding should be a concern for ETF providers hoping to attract retail inflows. That’s especially true given the irrelevance of past performance in determining the suitability of passive investment products.

If ETF providers should take note of the AMMS’s findings, it is very important they understand the remedies outlined in the FCA’s subsequent policy statement. In particular, a plan to strengthen the existing duty to assess investor value – the so-called value-for-money assessment– will require providers to:

• Assess value over the life of an investment, not just at the point of sale.
• Consider value for end consumers, including those represented by institutions.
• Incorporate all investor costs within the fund, such as indexing and hedging costs that could be interpreted as inclusion of tracking error for ETFs; transaction costs external to the fund, such as brokerage charges that are hard to obtain will also need to be disclosed.
• Look beyond costs and consider suitability when assessing the value of investor outcomes.

Given the ETF industry’s track record of cost reduction, providers may be tempted to assume that they already comply with this proposal. But the new requirements will force providers to revisit factors, such as the value eroded by trading costs, the relative merits of index construction, and the degree to which stock lending income is used to offset fund costs. 

The new remedies also create significant practical hurdles. In particular, promoters must conduct value assessments of every fund in their range from September 2019 onward. The FCA has not defined what constitutes “value,” but promoters will need to:

• Consider a non-exhaustive list of factors, including performance versus expectations, the split of costs and benefits between agent and investor, and the value of services purchased on behalf of investors
• Conclude that each fund offers good value or take corrective action if it does not
• Explain the assessment annually in a publicly available report

ETF providers may already work hard to educate clients about the performance and suitability of their funds, but this effort will now need to take place within a formal framework. The scale of the challenge is illustrated by the growth of smart beta and multi-factor ETFs. How will promoters demonstrate the value of these products?

Our conversations with leading ETF promoters on this topic suggest that the ETF industry is firmly in favor of any measures aimed at enhancing investor value.

Even so, it seems that most ETF providers have not yet developed a formal framework that will allow them to conduct value assessments and demonstrate compliance with the AMMS’ proposals. EY research indicates that only a small proportion of ETF providers have a value- for- money framework in place, suggesting that many firms have a long way to go in this area.

We see potential risks to the industry from failing to respond appropriately to the AMMS and its proposed remedies. Conversely, we think the AMMS gives ETF providers a valuable opportunity to enhance their contribution to the value agenda. In the process, they could strengthen their competitive position within the asset management market.

Seizing this opportunity will not only require promoters to take a robust approach to meeting the FCA’s requirements. It will also require firms to demonstrate leadership on investor value – and in related areas, such as transparency. In our view, these are some of the most important areas of action for promoters to consider:

Five steps to demonstrating leadership on investor value:

1. Obtain more data on market flows to help facilitate analysis of market activities
2. Improve transparency over the securities lending and collateral activities of ETFs beyond the requirements of the guidelines issued in 2014 by the European Securities and Markets Authority (ESMA) on Undertakings for the Collective Investment of Transferable Securities (UCITs) ETFs
3. Improve investor experiences, especially via provider websites, to support the retail growth agenda
4. Provide more education for investors and intermediaries
5. Demonstrate why smart beta and other innovative products offer value for investors compared with other investments
   
   

Demonstrating investor value is not only crucial for ETF providers with an existing or planned presence in the UK market. In time, the FCA’s decision to take an assertive stance on investor value could influence, or be copied by, other regulators.

That is particularly true in Europe, which already sets high standards for costs, charges and suitability via MiFID II. Irrespective of the future relationship between the UK and the EU, we would expect the FCA to continue to set very high standards for investor protection. The recent ESMA paper on applying UCITS standards also shows that European authorities will continue their focus on costs and disclosure.

In the longer term, the wider adoption of value assessments could have far-reaching global implications for the global ETF industry, especially, in major retail markets, such as the US, Canada or Australia.

The debate on investment value is evolving rapidly. The strengths of ETFs as a low-cost investment vehicle must not be allowed to give promoters a false sense of security. Value is about much more than management fees.

The UK is currently driving the agenda by requiring providers to demonstrate that they deliver value. Promoters in the UK need to understand the full implications of the new requirements and ensure they’re ready to demonstrate that they have performed the value assessments.

Looking ahead, firms should consider how the FCA’s actions and the wider value agenda could impact operating models around the world. The largest firms in the industry should consider developing global frameworks that follow best practices in demonstrating value for money.

Ultimately, this may require the ETF industry to adapt its cultural focus on low management fees into a more holistic approach toward investor value. The industry has consistently been ahead of the curve on costs, but will need to demonstrate fresh leadership if it is to fulfil its long-term retail ambitions.