Recent years have seen exponential growth in the market for exchange-traded funds (ETFs), driven by investor demand and an increasingly sophisticated range of product options.
The sector has clearly come a long way since the first ETF launched in 1993. That was a fairly basic product linking investor returns to the performance of the largest companies on the US stock market.
Simple though it was, it offered clear benefits for investors, particularly in relation to cost, transparency and liquidity.
Since then, increasing numbers of investors have sought to take advantage of such benefits and the market has grown significantly. In the past five years alone, funds flowing into ETF products have doubled, rising from $5trn at the end of May 2018 to $10trn two years later. BlackRock forecasts that this will rise to as much as $12trn next year, with the possibility of reaching $27trn by the end of 2027.
As the market has matured, so has the range of ETF investment options and products. There are now ETFs linked to all of the world’s major equity stock-market indices, as well as to smaller, niche or country-specific ones. In addition, there are ETFs that effectively track returns of other asset classes, again across multi-jurisdictions – whether fixed income, commodity prices or real estate. Multi-asset ETFs are also available.
ETF: factor-based options
Passive ETF investments these days are not linked to indices based solely on market weighting. Many adopt a far more sophisticated approach, allowing institutional investors to focus on and blend specific investment strategies and styles. This factor-based approach means that ETFs can, for example, be used to minimise volatility in a portfolio or to specifically target value, quality or momentum stocks.
Factor-based investing is nothing new – many active fund managers have for years focused on certain investment styles to try to boost returns or reduce volatility. But factor-based ETFs offer a more transparent and cost-effective way to achieve this – by harnessing data and technology to identify specific factors driving portfolio returns, and then investing in companies that exhibit these.
In this approach, also known as ‘smart beta’, institutional investors can invest in ETFs that are weighted to a single ‘factor’ or opt for a multifactor ETF. Multifactor ETFs aim to provide diversified exposure to a variety of the factors below:
• Quality: targets financially healthy companies with a strong balance sheet.
• Momentum: targets stocks that have an upward price trend.
• Value: targets stocks that are discounted relative to key fundamentals.
• Size: targets smaller companies able to be nimble in particular market conditions.
• Minimum volatility: balanced portfolios of stocks that display lower overall risk to the broad market.
Thematic ETF options
Another big driver of growth has been the increase in thematic ETF options. These allow investors to target specific ‘mega-trends’, many of which reflect the changing world in which we live. These might include the technology revolution, changing global demographics, increased urbanisation or climate change.
Investing in a thematic ETF gives investors exposure to sectors at the forefront of such changes and to companies that appear well-placed to thrive as a consequence.
For example, those interested in how technology is changing industries and driving future profitability might be interested in an ETF solely focused on companies operating in the cybersecurity sector or one geared towards stocks in the robotics and artificial intelligence (AI) industries.
There is also a vast range of ETFs focused on companies tackling climate change. Some take a broad approach, covering the entire spectrum of companies focused on the transition to a low-carbon economy.
But these ETFs can also be highly sector-specific, zeroing in on self-drive electric vehicles and associated technology, or emerging technology in the agriculture and food sectors.
Sustainable investment options
Sector-specific investing isn’t the only way ETFs can help institutional investors adopt a more sustainable investment approach.
Many ETFs, whether linked to a major index or adopting a factorial or thematic approach, are increasingly using sustainable overlays. These effectively give more weight to companies with more positive environmental, social or governance (ESG) scores.
This means that many of these products – even those that aren’t overtly investing in ‘climate’ themes – will screen out companies that have a poor environmental track record or are slow to adapt their business practices towards net-zero goals.
Companies with more positive policies on a whole range of issues – reducing carbon emissions, efficient use of water, cutting down on waste and pollution or protecting biodiversity, for example – score higher.
Scoring will also take into account a company’s policy on social and governance issues, such as transparent supply chains, anti-slavery policies, promoting gender and racial equality, particularly at the boardroom level, and fairer pay policies.
Increasingly, institutional investors themselves are having to publish public information detailing the carbon emissions of their own assets under management. Investing in ETFs that take ESG factors into account can help improve their accountability and transparency on such issues.
Despite this increasingly sophisticated approach, ETFs have not lost sight of the key benefit they offer to investors. They continue to offer liquidity and transparency while being a highly cost-effective way to invest in markets across the globe.
For institutional investors looking to construct well-diversified, high-quality portfolios that reflect investors’ ESG concerns – while remaining sensitive to cost margins in a competitive marketplace – they are an essential tool.
