Last year assets under management held in exchange traded products in Asia-Pacific grew at an astonishing rate of 8.3 per cent, three times that of the global average. Are these DIY vehicles a threat to the region's private bankers?

Last year assets under management held in exchange traded products in Asia-Pacific grew at an astonishing rate of 8.3 per cent, three times that of the global average, according to the BlackRock Investment Institute in its year-end ETP Landscape Report.

Despite the yo-yoing equity markets in the latter part of the year, the global ETP industry ended the year up 2.9 per cent in AuM, at $1.525 trillion. Net inflows totalled $151.9 billion in 2011, highlighting “the popularity of this asset class in a tumultuous year for global markets,” BlackRock said.

Much of the growth was due to the US economy and driven by US-listed products, but Asia was the real star of the show. Asia-Pacific ETP AuM grew nearly 9 per cent, product offerings surged a whopping 38.5 per cent, with 123 new products launched and only three de-listed, said BlackRock.

An ETP can be defined as a derivatively-priced security benchmarked to an index or stock which trades on a stock exchange, and is the umbrella term for vehicles including closed-end funds, exchange traded funds and exchange traded notes.

An asset or a liability?

Investment managers are divided on whether ETPs will ultimately help or hinder the private banking industry, which rakes in its highest fees from hands-on active discretionary management. It is not surprising that they are getting twitchy. In the first 11 months of last year the global ETP industry captured $142 billion in net new assets, compared with net redemptions of $29 billion from the mutual fund industry for the same period, according to BlackRock.

“ETFs are eroding wealth management margins and it is not going to change,” said David Pinkerton, chief investment officer of Zurich-based, Abu Dhabi-owned Falcon Private Bank. “Increasingly individuals are using these instruments to construct portfolios, replicating the markets. And as investors become more cautious as the economic environment worsens, some are prioritizing low-risk products over a money manager making the highest alpha."

He added that last year the difficult economic environment meant many active managers could not significantly distinguish themselves with alpha, weakening their value-add proposition for investors.

Didier Duret, chief investment officer at ABN Amro Private Bank, agreed that demand for ETFs in on the rise. “Interest for ETFs will grow exponentially,” he predicts. “And yes, they will grab market share from private banks, but if they can be integrated into a portfolio, they can be a useful diversification strategy.”

As transparent, low-cost and low-risk products, ETPs are easily accessible. As “DIY” investments, are considered by many a serious threat to the world of private banking. Investment managers make their highest fees from discretionary portfolio management where the private client takes very few of the decisions.

An ETP revolution

Of course, critics of the industry say that the fees charged for private banking are overly expensive and opaque, and the ETP is a welcome vehicle to help move towards a balance in the industry, if not a revolution. Alan Miller, the founder of SCM Private, a boutique wealth manager that invests clients money purely in exchange traded funds, is a stalwart critic of the traditional retail fund industry. He puts the annual fees charged by UK multi-asset funds industry at around 3 per cent overall, if you add up all the fees and expense ratios. This compares with around 1.25 per cent for an ETF cost, including the 75 basis point fee which goes to him. He initially charged a 5 per cent performance fee, which he decided to scrap last year.

Miller said: “Many high net worth individuals are seeking a new approach to wealth management focused on superior performance, fairer charges and greater transparency.”

This is particularly applicable to Asia, said Pinkerton, where the high proportion of entrepreneurs is cultivating a 'day trading' culture. He added: "ETFs are also attractive because of the diversity of directional betting that can be executed at a low cost manner through them." He predicts ETPs will grow most rapidly in Asia. 

Critiscism

The growth in popularity of ETPs has prompted some vocal critics of the industry. Terry Smith, one of the most outspoken figures in the UK’s investment scene, this week reaffirmed his belief in the perils of exchange-traded funds.

The founder of Fundsmith believes that synthetic, swaps-based products contain the kind of counterparty risk hazards that had come to light in the credit crunch.

Smith has also hit out at leveraged “long” and "short" ETFs. (Synthetic ETFs take their name from how they do not hold an underlying basket of physical securities, but replicate returns from an index via swaps and other financial instruments.)

“I am sure as I can ever be that they [many ETFs] are being mis-sold. There are clearly risks involved in ETFs of the sort people have experienced in the financial services industry in the last three to four years,” Smith said at a London briefing this week.

Smith added that ETFs are touted as easy to trade on exchanges, but that high trading turnover will blunt returns by increasing trading costs. “So why buy an ETF rather than an index fund? You can deal daily in most index funds. The only people who want to deal more frequently than daily are hedge funds, high frequency traders, algorithmic traders and idiots.”

Room for private banks

Pinkerton agrees that although they may be seen as a threat, there are still a lot of unknowns about ETFs which may put off investors.

"ETFs can be counterproductive to a market due to their ease of entry and exit encourage more speculative trading and positioning than longer term investment. ETFs literally enable anyone to trade like a hedge fund manager, but as we have seen in last year’s markets even the so-called best managers can suffer inferior results. The point is just because ETFs are low cost mechanisms to enter and exit a trade idea, does not mean that they all should be used as trading positions," he said.

He added that the markets that have the deepest liquidity as measured by the average daily volumes are the markets that will continue to gain market share as places to execute all financial instruments including ETFs.

"Lots of ETFs are not true to their marketed promise, and there is a handful of active equity managers who still do add value, especially in the emerging markets where there are still many unknowns. Private banks still have an edge in portfolio construction especially if they are client centric in nature and have an open architecture environment.”