Cerulli Global Edge: Australia’s ETF sector grows to maturity

Cerulli Global Edge, June 2013

Within a short space of time, Australia’s exchange-traded fund market has grown to a position of maturity – in product, if not in assets. By March 2013 there were 85 exchange traded products listed on the Australian Securities Exchange, with a record market capitalization of A$7.12 billion – small fry compared to, say, the country’s A$1.5 trillion superannuation industry, or the US$2.08 billion ETP market worldwide, but with enormous capacity for growth.

According to BetaShares, an Australian ETF provider, the ETP market cap of Australia has grown by a compound annual growth rate of 29% per year since 2004, with the vast majority of that growth since 2009. Australia’s original ETF, State Street’s SPDR S&P/ASX 200 Fund, is still by far the biggest: its A$2.165 billion market cap represents one third of the entire market, and more than three times the next biggest, a physical gold ETF. But the most striking feature of the industry’s evolution in the last five years is the broadening of product into every major asset class and world market.

For many years, State Street had the market to itself, as other issuers didn’t see much possibility of traction in Australia. This was chiefly because the most common model for buying product was through financial advisors who were remunerated on a commission structure. Since ETFs did not pay trail fees, advisors had no incentive to recommend them, and frequently did not.

The turning point was the shift towards a fee for service model for Australian financial planners around 2008, which is now enshrined in legislation. Suddenly, planners had no reason to favour one product over another on the grounds of a commission structure. They looked afresh at ETFs and saw their considerable advantages: cheap and liquid methods of delivering diversification – building blocks for a portfolio.

Since then, a host of new entrants have moved in, each with particular angles: iShares set out to deliver world equity ETFs, some for global or regional indices, some for single countries; Vanguard, already a leader in passive mutual funds in Australia, set about rolling out its own product set in ETF form; ETFS specialised in commodity products, most notably gold but also other precious metals; and Russell launched the first products with a degree of subjective judgement in them, such as holding stocks with a high dividend yield or a value methodology. The last to enter meaningfully, Betashares, started out with currency and cash ETFs.

For years Australia had no fixed income ETFs, as the regulator and stock exchange could not agree on their structure and liquidity, but once that was resolved, a host of products covering everything from government to corporate securities, locally and globally, swiftly appeared. Today, it’s hard to see obvious gaps. State Street made the most recent launch, the SPDR S&P World ex-Australia Fund, in March, but that looks similar to existing products. Natural gas and crude oil products are among the most recent new ideas.

So where’s the money going? Well, the search for yield – a global phenomenon – is well reflected in Australian ETFs. According to Betashares, out of $100 million of new inflows into ETFs in Australia in March, $50 million were into equity income and yield strategies. Investors are also using them as a cash investment: Betashares’ Australian high Interest Cash ETF saw the most value creation in March, followed by a dividend product.

What we don’t yet see in Australia are the ETFs with a twist that flourished several years ago in Europe and the UK: inverse ETFs, leveraged ETFs, or synthetics. ETFs began to grow in Australia at exactly the same time that concerns were growing about synthetic and complex structures in the UK and elsewhere, and perhaps for this reason, there has always been resistance to a synthetic model if it can be avoided; some managers started out with a synthetic product and then changed the structure to have physical underlyings after it appeared it wouldn’t otherwise sell. Naturally it’s not always possible to have full physical backing – one can’t in a crude oil fund, without acquiring an oil tanker – but nevertheless synthetic products are notable for their absence.

Instead, a sort of middle ground has appeared in which ETFs follow benchmarks which involve a subjective judgement. The Russell yield product was the first, but another recent example was a product tracking an index devised by UBS, made up of the stocks in Australia the broker has a ‘buy’ recommendation on. Others follow a particular style, such as Russell’s Australian Value ETF. We are likely to see more products like this in the years ahead, rather than leveraged or inverted products.

Australia still represents only a relatively small part of the Asia Pacific ETP landscape, which according to Blackrock stood at US$146.4 billion in March, between 558 products. Japanese equity products alone, for example, account for $54.12 billion, and China equity $46 billion. One product alone – the ChinaAMC CSI 300 Index ETF – had more inflows in the first quarter ($2.62 billion) than Australia’s largest single ETF has garnered in well over a decade, while the Nikkei 225 ETF has almost twice as much under management in one product as the entire Australian industry put together.

But the sheer scale of Australia’s asset management industry suggests the headroom should be considerable for growth, for several reasons. One is that ETFs fit self-managed super funds very well – and these funds are now the largest single part of Australia’s superannuation industry, accounting for A$474.4 billion under management by the end of 2012, composed of just under half a million individual funds. These funds, predicated on the spirit of going it alone, are natural users of ETF to build up a core position in various asset classes – domestic equities, global equities, fixed interest of various forms, real estate, commodities, and cash – with any active bets used around the edges to express a particular conviction.

Another reason is because of growing Australian dissatisfaction with high-fee mutual funds that do little more than track a benchmark, or even come in below it. Increasingly, Australians seem to want to use passive methods for the bulk of their exposure, then either a truly active fund, or perhaps individual stock selection, to gain alpha.

A third is because in Australia, the fee advantages of ETFs are unarguable. Even quite complex fixed income ETFs typically come in with a fee of less than 0.4%, while it is still fairly commonplace to see 2% funds in equity mutual funds, perhaps with a performance fee thrown in. The MySuper legislation, now in effect in Australia, has increased awareness of fees considerably, and consumers have a closer eye on these numbers than perhaps they used to in more predictable times in the stock market.

New entrants will likely continue to appear – UBS is an example, while another group, Chimaera Capital, launched an Australian mining fund – but first mover advantage is likely to be considerable for the first clutch of ETF providers, and in particular State Street’s Australian equity market product. No doubt there will also be new ways of slicing and dicing the market so as to create new product. But really, from here on in the momentum has to be in new flows into existing products, so that they can push up to represent a far larger proportion of the Asia Pacific market than they do today.