ETFs market expands despite market volatility

The Australian exchange traded product (ETP) industry experienced solid growth in 2018 despite the share market drop as investors took advantage of more attractive valuations and instant diversification benefits to build their portfolios with low-cost exchange traded funds (ETFs). Flows to international ETFs were almost double those for Australian equity products.

Looking forward we expect continued strong growth in 2019, with a greater variety of ETPs set to list on the ASX and with smart beta ETFs gaining greater market share. We also expect to see continued strong flows into international equity ETPs with the Australian share market expected to underperform in 2019 with the local economic growth likely to lag the US.

Despite high levels of market volatility, the Australian ETP market experienced its second highest year of net inflows on record in 2018, similar to the US listed ETP market, growing 13.2% to $40.4 billion over the 12 months to 31 December 2018.

In December, the industry had net inflows of $418.1 million taking the 2018 total to $6.4 billion. The US listed ETP market experienced $US315.4 billion of net inflows, also its second largest year ever.

Over the year, international equity ETPs were the most popular in Australia with $3.2 billion in net inflows, compared to $1.7 billion for Australian equities. This reflects the trend for Australian investors to diversify portfolios into offshore assets using ETFs. Following the rise of US technology stocks, investors have chased growth and opportunities offshore that are not available locally.

Another appeal of international investing was expectations of a lower Australian dollar, which boosted returns from unhedged international investments over the year.

ETP providers recognised this demand, with the number of international equity ETP products available increasing by 16% to 88 in 2018.

Australian and international fixed income ETPs attracted net flows of $1.1 billion over the year to 31 December as investors boosted allocations to relatively defensive assets given greater market volatility. The number of fixed income ETP products available increased by 20% to 24 in 2018.

With ongoing market volatility expected this year and a possible slowdown in Australian economic growth, we are likely to see healthy flows continue into fixed income ETPs and possibly more products launched.

We expect the industry to keep growing strongly as investors and advisers continue to recognize the benefits of ETPs over unlisted funds. The market correction during the last three months of the year has also opened up great opportunities for investors to buy ETFs at more attractive valuations. This increase in inflows despite price falls suggests the ETF industry is still very much in a growth phase, highlighting the significant appeal of ETFs in enabling investors to achieve strategic asset allocation.

Moreover, the outcome of the Hayne Royal Commission will mean that investors and legislators will be looking for value and performance in investment products. ETFs, especially smart beta ETFs, have the edge in providing this.

Greater diversity on offer

By strategy, smart beta ETFs that track indices that do not use conventional market capitalisation weightings are gaining increasing popularity, accounting for about one quarter of all inflows, at $1.6 billion in 2018, as investors seek investment outcomes above market performance offered by traditional ETFs which track market capitalisation indices.

Smart beta ETFs retain the transparency, liquidity, rules-based approach and ease of trading of market-capitalisation based index ETFs, with the added advantage of being specifically designed for investment purposes, something traditional market-capitalisation benchmarks are not.

We also seeing more active managers enter the market with ‘Active ETFs’. We expect growth in this segment to be muted as investors understand that like their unlisted counterparts, Active ETFs typically charge significantly higher fees and lack transparency compared to index fund ETFs. However this introduces more competition for index-based ETFs which make up almost 90% of the ETP industry, all of which is contributing to downward pressure on management fees.

We expect the value of the ETP market will likely rise above to $50 billion as investors continue to allocate their portfolios away from unlisted managed funds, given the clear benefits of ETPs on fees, transparency, liquidity and price discovery.

Importantly, we have found no evidence that the market volatility experienced in 2018 was either caused or exacerbated by the global ETF industry, as is regularly argued by a number of market participants and commentators. ETPs are being used as legitimate and transparent investment vehicles for investors to implement effective portfolio strategies and their accessibility is attracting new investors daily.

_{All data source: ASX monthly ETP report as at 31 December 2018, VanEck, ETFGI report as at 31 December 2018}

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