In my earlier article, ETFs – Twenty Years of Innovation, I touched on the first twenty years of the Australian exchange traded product (ETP) market. It’s now time to explore what the next two decades could bring. The story began with two Australian equity exchange traded funds (ETFs) launched by State Street Global Advisors. Fast-forward to the present day, and investors have access to a vast range of ETFs across a range of exposures. These include equities in developed and emerging markets, fixed income, real estate, alternatives (including currencies), and cash.
Globally, ETFs have increasingly moved into niche segments, such as restaurants, leisure, and the final frontier (space-related investing). There are also ETFs tracking the spending power of specific groups ranging from millennials to billionaires.
While the development of the ETF market has been immense, the next twenty years promise to be equally revolutionary. In response to regulatory changes and technological advancements, providers are bringing more sectors to the market and breaking new boundaries in product development. Specifically, we expect that some of the potential regulatory changes should lead to broader adoption of indexing over active management. We may also see a shift away from traditional security selection towards a whole-portfolio, outcome-oriented approach where indexing and ETFs take centre-stage.
ETFs at the Core of Portfolio Construction
With ETFs gaining a more prominent position in investors’ portfolios, there are several considerations to consider when including ETFs. One of the most important is how closely the underlying index is exposed to and tracks the ETF’s target market. Also, as part of the core, having confidence on how the ETF will perform (i.e., in line with the stated benchmark) is a key benefit. Once this is achieved, costs (fees and trading) and liquidity are the following key considerations.
In tandem with the rising use of ETFs as core holdings, there are a number of trends currently underway in the more developed ETF markets of the US and Europe. These are likely to take hold in Australia too. We already see developments in fixed income, the seismic shift to ESG investing, and model portfolios driving the next leg of ETF growth.
1. Fixed income grows and evolves
While most ETF flows in the Australian market still find their way to equity ETFs, we see a more significant proportion of investments in Europe and the US being allocated to fixed income products.
The next stage of this market evolution is bringing environmental, social, and governance (ESG) factors to fixed-income-focused ETFs. This is particularly so in Europe, which is leading the ESG charge. Notably, the recently introduced Sustainable Finance Disclosure Regulation (SFDR) is playing a pivotal role in underpinning European client demand for ESG-focused bond-based products. However, there are no instant solutions, as integrating developed-market sovereign debt with ESG remains a challenge. That said, it is an area that will gain greater focus over the coming years.
2. ESG becomes mainstream
While it is still a developing theme in the fixed income market, ESG has become more mainstream in the equity space. In Australia, State Street launched the SPDR® S&P®/ASX 200 ESG Fund (E200), which means local investors now have seven ESG-orientated ETFs to choose from – to date, these funds have attracted over $820 million.2 The potential for this trend can be seen elsewhere. As mentioned, this is particularly so in Europe, where ESG has come starkly into focus over the past few years, driven by structural shifts in the regulatory landscape. As such, the trend should only gain greater traction in Australia, as investors look to include ESG in their core allocations.
3. Multi-asset class models
As opposed to the US and Europe, where institutional investors are the leading adopters of ETFs, Australia’s advisors and individual investors are equally important for the local market's growth. Regulatory pressures are increasingly leading advisors towards ETF model portfolios. While still in its early stages, we believe that this development has the potential to be one of the biggest drivers of ETF growth over the next twenty years. Ultimately, clients now expect more from their advisors, who themselves have limited time and resources. This is where ETF model portfolios come into play.
1 Morningstar Direct, as at 8 July 2021.
2 ASX, State Street Global Advisors, as at 30 June 2021.
The returns on a portfolio of securities which exclude companies that do not meet the portfolio's specified ESG criteria may trail the returns on a portfolio of securities which include such companies. A portfolio's ESG criteria may result in the portfolio investing in industry sectors or securities which underperform the market as a whole.