Growing ETF complexity raises due-diligence burden: Morningstar

The rise of exchange-traded funds is leading to more complex underlyings and more issuers entering the ETF market. But this also means investors must do more due diligence, says Morningstar.

Not only is the market for strategic-beta exchange-traded products (ETPs) growing fast in Asia, but the complexity of their underlying benchmarks is also increasing, according to recent research by Morningstar. This has implications for investors in that it will require them to do more due diligence on these products.

“This [growing complexity] is part of the natural evolution of the market and one that has already played out in the slicing and dicing of traditional market-cap-weighted exposures along the lines of region, country and sector,” said the report.

Strategic-beta ETPs are passively managed investment products that make active bets against broad market-capitalisation indices. 

As these strategies become increasingly nuanced, increasingly infusing elements of active management into an index, Morningstar said “investors’ collective due-diligence burden will continue to increase”.

“Investors will have to do their homework in understanding the different products and indices,” said Jackie Choy, Hong Kong-based director of ETF research at Morningstar. They will need to study and understand the nuances, he told AsianInvestor, because there is more to selecting these smart-beta ETFs than plain-vanilla ETFs, which is why they are used almost exclusively by institutions.

Morningstar said strategic-beta ETPs tended to have lower expense ratios than their comparable actively managed peers, though not as low as plain-vanilla passive funds.

Impact on fees

Morningstar has not seen strong evidence that the increased complexity has had any effect in terms of increasing expense ratios for these products, noted Choy. However, he added, competition in this landscape is likely to put pressure on fees.

Citing the US market, which is far larger and more advanced than Asia, the Morningstar report said that 71 of the 608 strategic-beta ETPs in circulation saw their net expense ratio decrease from 2014 to the 2015 fiscal year. The median decline in fees among this group was 0.03%. Meanwhile, 63 strategic-beta ETPs saw their fees inch higher, by a median level of 0.01%. The remaining 474 products remained unchanged. 

The trend for more sophisticated passive products is likely to continue and ultimately accelerate, as newer ETPs tracking new and unproven benchmarks appear and more new entrants make their way into the market, said Choy.

On a global basis, low-volatility and minimum-variance indices have been very popular, but in Asia Pacific the growing interest in such factors has been limited by a relative short supply of products, according to Morningstar.

In the absence of locally available products, investors will use ETPs from the US or Europe, Choy said. “Especially if they are thinking about strategic-beta ETFs, they are likely to invest in US ETFs.” 

New entrants

The shift to ETPs has been so dramatic that fund groups that have always been avowedly active in their approach are now launching such products. While this is playing out most obviously in the US market, where groups such as Goldman Sachs and Franklin Templeton are now entering the ETF market, Morningstar expects a similar picture to emerge in Asia.

Morningstar’s research of the global funds industry as a whole shows that Asia is the region seeing the strongest growth in passive equity AUM (click on graph, left). 

The global shift from active to passive funds is showing no signs of slowing. Actively managed US funds suffered a net outflow in 2015, while their passive counterparts attracted some $400 billion in net flows. There has never been a larger gap between US active and passive flows.

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