#NotAllETFs: LGIM on why investors need to think more deeply about their index exposure

by | Sep 16, 2019

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Commodity ETFs exist, but ETFs are not a commoditised product. Due diligence on ETFs, even for seemingly straightforward exposures, can make a significant difference to an investor’s returns.


 

ETFs are passive. Index investing means the FTSE 100 or S&P 500. For many, picking an ETF can simply mean choosing the option with the lowest headline fees.

These are myths, stubbornly persistent ones. The rapid growth of the ETF industry makes it more important than ever to challenge and correct them.

 

The investment environment has changed

The value of assets held within ETFs globally reached $5.5 trillion at the end of June this year, according to research firm ETFGI. Just 10 years ago, that figure was $1 trillion. The growth rate does not appear to have peaked; the industry began 2019 with assets under management of $4.7 trillion. The market rally has undoubtedly helped, but the point remains that an increasingly vast sum of money is allocated to ETFs.

There are certainly a great many advantages for investors in this greater adoption of ETFs, but it is worth being aware that the sheer weight of these assets has the capacity to influence market behaviour. This is increasingly evident when you look at what happens around index rebalancing dates for popular indices.

Index additions and deletions are generally announced before they are enacted, allowing some opportunistic traders to act in advance of the implementation date of the changes. The theory is that when a security joins a heavily owned index, price-insensitive investors like some tracker funds will have to buy it and so could push up its price if market timing is not considered. Those who can get into a security, between the confirmation of its promotion and the day such investors submit their bids, often have the opportunity to profit.

 

When we investigated this arbitrage opportunity, we discovered that – over the course of 14 rebalances from February 2015 to May 2018 in a major global equity index – investors potentially lost up to 6.5 basis points of performance because prices moved between the index announcement and reconstitution. Those basis points may not sound like much, but they are equivalent to a year or more’s worth of fees for some index strategies.

An active approach to index design

There is nothing that requires investors to accept these inefficiencies, however. That is why, when we designed our core ETF range, we built in mechanisms to avoid these crowded trading periods through alternative rebalancing dates for our own indices.

Similarly, we understand that responsible investing is becoming increasingly important to our clients. For our core ETFs, then, we integrated Legal & General Investment Management’s Future World Protection List, which we believe helps ensure companies in the ETF portfolios meet minimum standards for best business practices in order to mitigate risks that may affect long-term investment performance. This approach should shield investors from the negative future outlook associated with controversial weapons manufacturers, pure coal companies, and consistent violators of the UN Global Compact.

 

Put simply, we believe that index investing should not mean passive management. An experienced index management team should be able to capture opportunities and, as importantly, manage the risks associated with the increased usage of market-cap weighted benchmarks and the potentially adverse impact of unsustainable business practices over the long term.

Fees certainly matter but the importance of value preservation through building better indices should not be overlooked either.

Remaining responsive to change

We hope our core ETFs demonstrate our commitment to intelligent index design, but it is perhaps our thematic range that most clearly epitomises our approach. Our clients have summarised this approach as ‘active research and systematic implementation’.

 

Powerful, long-term forces – from artificial intelligence to healthcare breakthroughs – are shaping markets and the economy. Innovation lies at the heart of many of these forces, with technology changing our behaviour not only by helping people and businesses perform existing tasks more efficiently but by creating new solutions to longstanding challenges. The question is how to harness the potential of these forces within a portfolio.

For us, the answer begins with active research. We first want to gain confidence that a theme addresses a wide opportunity set, has a high potential growth rate, and will endure through time. Several indicators help us do this. We focus on themes that: are disrupting and challenging traditional sectors and industries; have the potential to structurally change the economy; are still in the early stages of transforming our world and so may have immense growth potential; are currently experiencing increased adoption by delivering efficiencies or meeting evolving needs; and are enjoying high consensus growth forecasts.

The second step is active research into defining the thematic universe of stocks, which we conduct by working with independent experts who undertake bottom-up analysis. Through this process, we can identify companies across different sectors that are genuine leaders in that theme.

 

Trying to future proof an index

This work is essential because thematic investing, as we understand it, cannot depend on traditional industry classifications. The robotics and automation theme is a good example: some investors may use industrials or even the technology sector as proxies, but they offer at best only partial exposure to the theme and, at worst, exposure to the companies that are going to be disrupted by the theme.

While traditional industry classification approaches work well for mature markets and sectors, they may not be able to accurately identify companies related to individual themes that are in their nascent stages of development. Indeed, we believe themes are the sectors of the future.

As investors come to recognise that themes and sectors are not equivalent, we expect them to demand better designed indices in the future.

 

The final stage is systematic implementation. Combining this active research with a transparent and rules-based strategy implemented through an index of liquid securities helps to ensure that an investor’s exposure to a theme is not subject to behavioural biases or unintended risks. Starting with an equal-weighting methodology can furthermore embed diversification in the thematic index and guard against stock-specific risks.

Taken together, we believe this commitment to intelligent index design – underpinned by active research and systematic implementation – sets a benchmark for the ETF industry. Not all ETFs are the same, and we are confident that investors will soon begin to favour propositions that can stand out from the pack.

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