SMSFundamentals: Passive And ESG Investment On The Rise

SMSFundamentals | Mar 12 2019

Exchange traded fund manager BetaShares observes a shift in investor preference towards passive investment strategies and a growing demand for ESG-based alternatives.

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Passive And ESG Investment On The Rise

-Trend towards passive rather than active investment choices
-Passive ETFs increasingly popular
-ESG awareness permeating ETF demand

By Greg Peel

Leading Australian exchange traded fund manager (ETF) BetaShares has expanded on its monthly Australian ETF review and introduced a quarterly global ETF review.

The inaugural review finds a global ETF industry boasting US$4.8trn in assets under management at end-2018, reflecting a global per annum growth rate of 20% since 2005.

The strength of the ETF industry can be largely explained by a growing preference for “passive” investment strategies, BetaShares notes, which still dominate the global ETF space. In the US, the broader unlisted funds market (known as “mutual funds”) has also seen a tilt towards passive investment.

An investor can choose to be either “active” or “passive” in their approach to investment, or perhaps a combination of both. “Active” investors will make their own portfolio choices and be constantly looking to tweak allocations in a chase for the best returns. “Passive” investors can either give their money to someone else to worry about, or make “passive” investments.

ETFs provide a wide range of passive investment alternatives, from a simple index ETF, such as the ASX200, to sector-specific, high yield or other focal point. The point is passive portfolios simply replicate an index or other benchmark and basically what you see is what you get. If the ASX200 falls, so does an index ETF, and the fund manager is not to blame.

“Active” ETFs will see a manager chopping and changing within the ETF portfolio in an attempt to outperform a given benchmark, not always with success.

In the wider US fund management industry, 2018 saw US$431bn of net inflows into passive investments (mutual fund and ETF) and -US$418bn of net outflows from active investments, which is the highest level of annual outflows on record.

ETFs are a user-friendly means of passive investment, being exchange-listed with a mandated and consistent bid/ask spread (meaning you can always get out as well as in). While growth in ETFs in Australia has been exponential in recent years, penetration of the wider “mutual” fund industry is only 1.5% compared to 16% in the US.

The Volatility Myth

There has been concern, in the US in particular, that the growing concentration of ETF investment within a market can lead to increased volatility in times of market weakness, akin to the “portfolio insurance” issue of 1987 (Google it), as ETF fund managers struggle to cope with a rush of sell orders in a falling market. BetaShares believe these accusations to be unfounded.

BetaShares provides the graph below to make its point.

The ETF manager highlights the November-December period when the US stock market went into a tail spin and fingers were again pointed at ETFs. Yet as the graph clearly shows, ETFs saw net inflows over the period rather than outflows as one might expect. Hence the “myth” is disproved.

BetaShares does not make reference to the January-February period.

ESG and Smart Beta

Two of the key trends observed by BetaShares over 2018 were the rise of ESG and ethically-orientated products and “smart beta” strategies.

“Ethical” funds have been around for a long time and are more notable for what they don’t invest in rather than what they do. Companies with ties to alcohol, tobacco, guns, gambling, sweatshop labour and so forth are examples of what an ethical fund would not invest in.

ESG funds go the other way, investing in companies that rank highly in terms of their approach to environmental impact (E), social responsibility (S) and corporate governance (G). Recent history suggests that companies which have strong ESG track records tend to outperform the market over time.

Growing interest in ESG investment may be driven by a social conscience or by noted outperformance, and if interest continues to grow then by default such outperformance should be guaranteed.

In the US in 2018, investment in ESG-based ETFs grew by 26% in terms of asset under management value, and 57% in terms of inflows.

Flows into “smart beta” strategies experienced an annual growth rate of 60% in the US in the decade to 2018.

“Beta” is a measure of a stock’s tendency to move in line with the market rather than do its own thing. If a stock market is up in a session then high beta stocks will be up as well, being market drivers. Low beta stocks may or may not rise as they are not overly tethered to macro forces, while negative beta stocks (defensives) may be down on the day.

The standard “measure” of a market is a market capitalisation-weighted stock index such as the ASX200, which is assigned a beta of 1.0. The beta of individual stocks is then determined by comparison in a range of below zero to above 1.0, but just like market cap, it is a moveable feast.

“Smart beta” fund managers assign weightings to portfolio selections by some means other than standard market cap. Applying a smart beta approach to the Australian market might, for example, come up with an index equivalent that is not weighted 25% to four big banks and 30% to the wider financials sector as well as 18% to mining, but rather might seek greater diversification to dilute market risk.

As the popularisation and sophistication of the ETF industry and of investors around the world continue to grow, we predict the uptake of funds with differing methodologies to continue to be adopted”, said BetaShares CEO Alex Vynokur in a press release.

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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