Can FCA policies on ESG advice generate new interest in ETFs?

Matt Brennan, AJ Bell

The scrapping of commission payments to financial advisers was set to strengthen consumer appetite for ETFs in the UK, writes Philippa Aylmer.

Yet while we have seen exponential growth in the use of indexing strategies, the adoption of ETFs by IFAs and wealth managers is still lagging behind.
 
After the introduction of RDR, “ETF enthusiasts assumed there would be a huge wave of advisers switching to ETFs” says Ben Seager-Scott, Head of Multi Asset Funds, Tilney Group, “but this was too ambitious.” Seager-Scott is seeing ETF use growing but he says the barriers are manifold. “Some are operational and some are more to do with behaviours and legacy positioning.”

ESG becomes central to regulation

But new FCA rules could prompt an increase in adoption of ETFs. Following on from the EU Commission’s introduction of Sustainable Finance Disclosure Regulation (SFDR), the FCA is in the process of setting out proposals requiring financial advisers to disclose sustainable investment options to clients. 

The fact that many sustainable investment products are only available as ETFs means that “whether they like it or not advisers are going to have to look at ETFs when considering a passive sustainable option,” says Matt Brennan, Head of Investment at AJ Bell. “If you don’t embrace ETFs, you are closing yourself off to new ways of investing whether that is by theme or sector.”

Andrew Limberis, Investment Manager at Omba Investments which runs three UCITS funds of ETFs on a number of platforms such as AJ Bell and Transact, also believes that ESG will create new ways of thinking about investing. “It will be how ETFs will evolve with equity ETFs leading the way, and fixed income following suit.

“We are likely to see some change to existing pure market cap weighted indices,” says Limberis. Launches of ESG products by BlackRock, UBS and Xtrackers are predominantly in ETF format, with fewer index fund launches for example. “Essentially, there will be far more ETFs that aren’t traditional market cap weighted in nature. One of the key areas will be in thematics where the focus is on purity of the theme and investment thesis: a modern take on passive investing,” he adds.

ETF adoption, ESG or otherwise is not quite so simple

Yet Seager-Scott thinks that in practice introducing ESG ETFs will not be quite so straightforward. “The proliferation of ESG indices helps raise awareness, but advisers can struggle with the deeper and more meaningful E, S and G elements. 

“If you want to do less harm in your portfolio, ETFs are good. But in terms of more proactive good, active managers still have the edge. For things like stewardship, voting and engagement, ETF providers are more constrained: they are less likely to be active stewards of capital in the way that active managers can.”

There are cultural and behavioural barriers to ETFs too says Seager-Scott. “To some extent, managers are used to the active style of managing portfolios. They have good relationships with fund managers and want to stick with what they know.”

Seager-Scott also points out that open-ended active funds in retail funds have attractive profit characteristics. Limberis agrees. “Many of the financial services firms have their own products. Their margins are something that they would lose if they moved fully into passive.”

Not only that, inevitably, there is more communication between active fund managers and advisers than between ETF funds adding that “when you use ETFs, you can end up in-sourcing decisions which means advisers take on more responsibility for managing the portfolio,” adds Seager-Scott.

Brennan believes it is more a case of inertia or an education gap - not understanding what an ETF is and how it works. “As soon as we put them in a model portfolio, advisers are happy to use them. We have rarely had an adviser say they did not want to use our models because they use ETFs. However, if there is an easier alternative which is index funds, advisers will be more likely to use them rather than learning about ETFs.”

Sector composition is another major barrier for wealth manager use of passive vehicles says Oliver King, Research Analyst at WH Ireland. “Unlike their US counterparts, which are rich with high-growth industries like technology, the major indices are more heavily weighted towards mature sectors like financials, energy and industrials. Given that the environment has been so unfavourable for these types of companies in recent years, many have favoured more actively managed funds which deliberately avoid these areas of the market.”

Wealth managers also generally look to add value through both asset allocation and security selection. “While the former can be easily achieved when holding index-tracking funds, the latter can be much more difficult. This gives money managers a natural draw towards active vehicles, which allow them to give clients a differentiated market exposure and (hopefully) add additional alpha,” adds King. Last week, WH Ireland announced that David Ross, co-founder of Carphone Warehouse, has taken a 9.9% stake in the company.

Operational hurdles 

There are also some fundamental issues on the operations side. For example, platform charging structures are not as straightforward or as cost effective for ETFs. “ETFs are listed and a lot of systems have flat fees for listed investments. If you have to pay a flat fee every time you trade, for a smaller portfolio it can rack the costs up,” explains Seager-Scott.

The other limiting factor for ETF use is fractional trading – holding fractions of shares rather than whole shares. If platform technology does not facilitate fractional trading, there is the chance that trades will fail when rebalancing a portfolio. The ETF industry has started to rectify this however: for example, iShares’ have a policy that all new ETFs have a price GBP5 per unit which makes fractional trades less likely to fail. 

There are also other issues with platforms. Some require large lead orders or funds have to pay to go on platforms or some have to pay a broker to trade ETFs for them. 

“Platforms are the gateway,” states Seager-Scott. “If ETFs are not available on a platform, then someone on the platform can’t use them. An ETF not being on a particular platform might mean that wealth managers and IFAs won’t use it as they are looking for commonality. It is easy to underestimate that impact.”

Brennan also believes that MiFID rules can sometimes push investors towards index funds rather than ETFs as the transaction fees in ETFs are more visible. “From an investment point of view, ETFs are the best option but if the operational issues are too big, index funds look more convenient.”

There is undoubtedly still a long way to go before we see mass adoption of ETFs. Nevertheless, the beating drum of ESG might bring ETF education up the priority lists, hopes Brennan. “And if nothing else, this legislation will force advisers to at least consider ESG as part of their advice process.” 
 

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