The exchange-traded fund (ETF) sector in Australia may currently represent only a small slice of the Australian wealth management market, however, the segment is poised for exponential growth in the coming years.
As self-managed superannuation fund (SMSF) investors continue to drive the growth rate in the sector, research mounts that an increasing amount of financial planners are allocating more client funds into ETFs, partly a consequence of the move to fee-for-service remuneration models.
Meanwhile, fund managers near and far are eagerly eyeing the market with imminent plans to launch their own version of ETF products in Australia.
"People should be looking at this market in Australia as the next place for growth; the question is just whether they're all going to come rushing in or whether they're going to do it strategically," Russell Investments director of ETF product development Amanda Skelly says.
"UBS, PIMCO, Deutsche Bank, every big ETF provider is looking at Australia as an opportunity to launch their product in.
"There's going to be a huge rush and I'll tell you what we're feeling it here at Russell, particularly because State Street brought out another great product, which kind of validates the theme that we were going with our product, but that's just another competitor and we're expecting more."
As a result of increased competition in the sector, the ETF market is likely to be cut into various segments as small and large domestic and global fund managers increasingly vie for a portion of this growing sector.
"The market will be sliced and diced in different ways and into thinner segments," AltaVista Research president Michael Krause notes.
"Purists will complain that this perverts the very idea of index investing, but ETFs serve many purposes, not just as long-range retirement investments, they are really the perfect tool for asset allocation, even if that means finetuning exposure in an existing portfolio on either the long or short side.
"And we haven't even talked about bonds and commodities yet, which are big product categories in the US."
However, it seems this trend Krause highlights could already be evolving in the Australian market.
While the local arm of UBS is currently considering whether it could bring ETFs into the Australian retail market, the firm is looking closely at launching bond ETFs.
"We see an opportunity in this market - there are a number of players but the market hasn't really taken off yet," UBS Global Asset Management (Australia) managing director and head of Australia and New Zealand Ben Heap says.
"We think that we have a capability across the organisation that would allow us to be a significant player here."
In addition to bond ETFs, Heap says the firm is also looking at listed Australian property and infrastructure products to differentiate itself from its peers. Considering the three major global ETF players - State Street Global Advisors (SSGA), Vanguard and iShares - currently have the major broad-based indices already covered, some say they shouldn't be too concerned about new players entering the Australian market.
"For a new competitor to come in and try and track a similar or the same index, they're coming from a position where they're starting with lower liquidity, they could arguably be starting with lower fees to try and compete, but you need some serious scale to be able to do that," Morningstar co-head of fund research Tim Murphy notes.
So while Murphy expects the existing large ETF players to continue expanding their product range, other sizeable fund managers will potentially come to the Australian market just as they have done so offshore.
"Particularly a trend at the moment in the US is in active ETFs, so PIMCO and Legg Mason are two large fund managers not really known for their indexing capabilities but who have been launching active ETFs," he says.
"So we'll probably see those at some point, probably not in the short term in Australia, but then you're also likely to see a number of smaller players try and jump on the bandwagon and create more niche-type products and that's certainly what we've seen in the US."
Murphy adds a range of smaller players will enter the market with an increasingly niche, narrow subset of ETFs.
"The potential negatives will be if some of those smaller players will start launching a bunch of ETFs that are dangerous to investors when used inappropriately," he explains.
"For example, micro-sector based, leveraged, inverse, triple leveraged, triple inversed ETFs, which give ETFs a bad name, which has occurred particularly in the US."
But for now, Vanguard ETF product manager Robyn Laidlaw says product issuers have a fair way to go in offering advisers a full solution of ETFs for portfolio construction. However, Laidlaw notes there is always a place for niche ETF products.
"Now there are very niche products in the US market that do all sorts of interesting things, but it's also important to understand that around a third of assets in the US market sit within the top 10 products," she says.
"So the niche products are there and they're used and there's always a place for them, but it is just a more niche part of the market."
While there will be new issuers and new products coming to the market, she adds it is important to observe how overseas trends in the ETF sector have played out, which potentially translates to how the Australian market will evolve.
"The key thing I think about the US market is in terms of where the assets are - around 85 per cent of those US assets are with the top three ETF managers," she says.
"So it is really about traditional index managers and those who have done this and are known to do this, and there will be room for niche products to come to market and we will see that where the scale of things go we can look to the US for an indication."
Meanwhile, Krause notes that if a secular trend towards index investing follows a similar path to what's occurred in the US, ETFs will take a big share of the market from managed accounts in Australia. "The secular trend will drive growth from the demand side; from the supply side issuers know what works and what doesn't from a business standpoint, having tried just about everything in the US, and can bring those products to market in Australia," he says.
"At a minimum I would expect growth and value versions of the major indices, more fundamentally-weighted indices and international sectors and thematic ETFs to be listed in Australia."
However, with a host of new players expected to enter the ETF market, there is the risk for the sector to become flooded.
Murphy says there is no doubt this will eventually occur in the Australian market.
"It's already happened in the US and that's why you've already started to see rationalisation. It's gone up towards 1000 different ETFs over there, but ultimately there's only so many ways you can slice and dice given markets," he says.
Skelly agrees there is a definite risk of the ETF market becoming saturated with product issuers.
"I think in 12 months' time this is going to be a really interesting space in just how saturated does it get, and a lot of people aren't going to survive because to get into the business you need to be committed and it's an investment," she says.
"If there's a lot of players that come in most are not going to survive. You either need to be a big player with scale, like Vanguard, State Street and iShares, or you need to have a strong capability that others do not have.
"At Russell we feel that's our index technology and we can come up with these niche strategies and we already have that index infrastructure so it was relatively easy for us to come to market.
"But if you're starting here without a lot of scale or without any onshore capabilities, it's going to be a real challenge."
BlackRock iShares director Tom Keenan shares this sentiment. "To be a successful ETF provider, it's all about scale. The margins are not as high as traditional managed fund business models have been in the past and it's very much about getting economies of scale," Keenan says.
"So will all ETF providers in the Australian marketplace be successful? I'd say the answer is definitely no."
Zenith Investment Partners director David Wright also argues that some of the existing ETF offers in the Australian market, as well as some of the new providers, are not all going to be successful in attracting flows.
"Even some of the existing ETFs are so specialised that if they were used in a portfolio it would tend to be only a small proponent, so you need an awful lot of portfolios using those to really generate meaningful funds under management," Wright explains.
"So it could actually be that over time there will be growth in the number of ETFs, but it will go full circle; there will be some rationalisation of those that don't gain any traction or support." For the ETF issuers that provide more niche exposure to investors, Keenan points out this will result in different structures and various levels of counterparty risk.
"So as that industry is growing and matures in terms of its product choice, so too will the need for investors to completely understand exactly what they're investing in and know more about the ETF provider that they're choosing," he says.
"There's a small number of providers in Australia and I'm sure the number of providers will grow; whether there's room or not, that remains to be seen."
Although ETF market capitalisation was only $3.75 billion in August this year, the ETF story is ultimately about the growth rate.
ETFs have been one of the fastest-growing alternative investment types, according to the Investment Trends ETF December 2009 report.
"In late 2006 there were about 9000 Australians using ETFs in total. It took a couple of years for this to double to 19,000 and then another year to double again to 38,000 investors by the end of last year," Investment Trends analyst Recep III Peker says.
"At the end of last year there were another 64,000 investors considering an ETF investment, the highest number among alternative investments. If previous conversion rates are sustained, the ETF market has the potential to grow quite rapidly."
There are many factors currently fuelling the growth in ETFs in Australia, such as the advice industry's migration to fee-for-service.
"A lot of advisers are sort of considering what is my business model, what is my value proposition to clients, and if it's around investment advice, portfolio construction and asset allocation, the ETF can provide an easy-to-use tool in terms of that portfolio construction piece," Laidlaw says.
Looking to overseas trends, Murphy notes the movement away from commissions in the US also sparked considerable take up of ETFs.
"If you rewind 10 years ago, around that time in the US the advice space made a systematic shift from commissions to fee-for-service and that coincided with an explosion in growth of ETFs," he says.
"So given what's happening in the advice space here currently, we're certainly expecting to see a similar trend developed over the next five to 10 years.
"So the move to fee-for-service and the increased focus on costs in the whole investment chain will see greater focus given to ETFs, which will see more money go that way. So that will improve liquidity and therefore result in tighter spreads and consequently better outcomes for ETF investors over time."
The fact ETFs are now available on more investment platforms in Australia has also provided investors with better access to this asset class.
"One of the reasons why I think the sector is going to continue to grow is ETFs are now on more platforms, so it's a lot easier for advisers to access ETFs and they are more comfortable dealing with platforms, so that's certainly helping," Skelly says. Furthermore, the proliferation of broader product ranges, with more fixed income and non-equity-based products coming to the market, will also trigger growth in the ETF space.
"So at the moment we have equity products, whether they be international, Australian or sector based, and if we have a more rounded range of products for advisers I think that will also help with the growth and take up of ETFs more generally," Laidlaw explains.
"Also as investors are looking to simplify, advisers and investors are very focused on costs and how they can reduce cost structures within portfolios. I think that's a scene that we're seeing that will also lend to the growth and further use of ETFs."
Growing awareness of ETFs and education will also be an impetus for further development of the sector, SSGA global structured products group (Asia Pacific ex-Japan) head Susan Darroch adds.
"Education has also driven growth. We've been educating the market since 2001 about ETFs and how to use them," Darroch says.
Meanwhile, Skelly observes Vanguard has played a major part in the education piece for ETFs.
"If you think of some of the earlier players to market, like SSGA when they came out 10 years ago, you didn't see a lot of traction until iShares and Vanguard; Vanguard came out with a lot of education strategies so that helped everyone in the ETF space," she says.
However, Keenan argues education also has real potential to hold back the growth in ETFs, largely due to lingering misconceptions in the marketplace, particularly around their structure and liquidity.
"Certainly that's a major piece of work for the ETF industry to continue to educate the market on so people get much more comfortable with the liquidity that underpins ETFs, because liquidity is one of the core benefits," he says.
"So one of the biggest threats is not so much a product, but the education around how they work and what the benefits are to investors."
However, he adds a lot more education will continue to filter in from various sections of the financial services industry.
"So you'll have ETF providers, research houses and other consultancy firms that are all forming part of that education effort," he says.
"The more products we see listed on the ASX [Australian Securities Exchange], the more legitimacy it gives to the ETF industry and education will increase naturally because of that, so I'm very confident that education barrier will be broken down."
Hence, Morningstar has already started publishing research on 13 of the largest ETFs, which account for 96 per cent of assets currently invested in ETFs in Australia.
"So we're obviously trying to focus on the largest, most liquid, most relevant ETFs to investors currently," Murphy says. "We will expand that over time as new ETFs come to market which are interesting and as the market in Australia evolves, because the ETF market in Australia pretty much lags every other market in the world in terms of its development, so it's still very early days here.
"For advisers we've got the education material supporting the individual ETF recommendations to help them pick the right ETFs for the right types of clients."
Zenith also recently initiated research into ETFs, which was primarily driven by client interest and demand, Wright says.
"We'll adopt the same business model approach to the coverage of ETFs that we do in our broader business and that is taking a best-of-breed focus," he says.
"So we'll only be covering those managers and underlying ETFs in the ETF space that meet our best-of-breed criteria, which will be interesting because we're aware that there are some new and smaller players coming to the ETF market.
"So I think in the first instance it will be coverage of the established managers and mainstream ETFs."
The research houses' involvement and their ratings on ETFs products will also translate to greater awareness and understanding of the asset class, according to Laidlaw.
"It really ties back into the education piece that Vanguard is focusing on, and researchers are another party in the market that's assisting with that," she says.
Skelly agrees. "All of the research houses coming out with research will help generate awareness and get advisers and dealer groups comfortable with ETFs, so that's helped increase adviser acceptance and also will increase the growth of ETFs longer term," she says.
