Australian ETF market could top $100 billion in 2020

2019 was a record year for flows into exchange traded products (ETPs) despite high levels of volatility, and the market could surge over $100 billion in size in 2020 as more and more investors realise the benefits of ETFs including ease of investing, transparency, cost effectiveness and liquidity.

Over the 12 months to November 30, 2019, the ETP industry surged ahead, increasing in size by 48% to a record $60.39 billion market capitalisation.

Several factors have fed the record level of inflows.

Many investors turned to Australian fixed income ETPs in 2019 for the first time to wait out equity market volatility and seek income as it dried up from other sources such as savings accounts and term deposits.

In the later months of 2019, renewed confidence in the Australian equity market has seen investors pump money into local shares. Reflecting that, domestic equity ETP flows have overtaken international equity ETP flows.

Investors too have directed money into property and infrastructure ETPs for income in an era of record low interest rates. All of this has fed record net flows into ETPs over the year to November 30 of $11.95 billion, well ahead of 2018 net flows of $6.4 billion and 2017's record of $8.09 billion.

Australian ETPs dominate flows

Australian equity ETPs attracted the greatest net flows in November at $851 million, well ahead of inflows of $519.5 million for international equities. Flows rose after the ASX 200 gained 3.28% over the month after slipping modestly in October.

Over the year to November 30, with the S&P/ASX 200 up around 26%, net flows to Australian equity ETPs totalled $3.7 billion, surpassing flows to international equity ETPs of $3.55 billion. ETFs make up around 90% of total ETP assets under management (AUM).

Investors have also poured a record level of flows of $2.7 billion into Australian fixed income ETPs, which primarily invest in income paying bonds.

Total flows into the fixed income ETPs for the year to November 30 jumped to a record $4.18 billion, including cash ETPs and international fixed income ETPs. That represents around 34% of all ETP flows.

This highlights an important point - ETPs are being used by investors not only to grow their exposure to growth assets such as shares, but also to build out the defensive and income allocations of their portfolios. This is unsurprising given ongoing equity market volatility and fears of a global economic slowdown.

More products on offer

With an expanding diversity of assets being offered by ETPs, and the portfolio diversification they offer, even more funds will likely flow into the ETP market in 2020, which could take it to a market capitalisation of over $100 million.

Investors can now invest in offshore developed and emerging equity and debt markets, domestic and international fixed income, commodity ETPs and those specialising in particular countries or asset classes such as quality shares.

The VanEck Vectors MSCI World ex Australia Quality ETF (QUAL), for example, invests in around 300 quality companies as determined by MSCI based on three easily identifiable financial characteristics that enable companies to better withstand a downturn: high return on equity; stable year-on-year earnings growth; and low financial leverage.

Increasingly too, many ETFs are now available in Australian dollar hedged and unhedged versions, another key development of the market.

With the local currency potentially falling next year to US65c with lower interest rates, unhedged ETFs enable investors to take advantage of any fall in the currency.

The VanEck Vectors MSCI World ex Australia Quality (hedged) ETF (QHAL), the Australian dollar hedged version of QUAL, enables investors to manage their desired currency exposure.

A falling Australian dollar boosts returns for international investors when assets are converted into local currency. So, if the Australian falls 10%, the value of offshore investments would rise 10%. A rising currency does the opposite and erodes returns.

Flows to smart beta still growing

As the industry has grown, the range of ETPs has increased from simple index-tracking ETFs to more complex managed funds, including so-called 'active ETFs', which allow investors to access the capabilities of active investment managers on ASX.

Active ETFs do not track an index and not required to publish their full holdings at any time.

By contrast, ETFs track an underlying index and provide full transparency of their underlying holdings.

Smart beta ETFs combine the best of active and passive investing: having the potential for outperformance while being rules-based, transparent and cost efficient.

Reflecting their appeal, flows to smart beta ETFs were strong in November, striking $468.7 million, just over one quarter of all ETP inflows. Over the year to November 30, flows jumped to $2.68 billion, up 70%.

With that quick growth, smart beta ETFs have almost doubled their market share since 2016 while the market share of active ETPs has more than halved, as investors chase more targeted investment outcomes, improved performance and lower costs through smart beta strategies. Their market share will continue to grow in 2020.

Indeed, the huge growth of the ETF market is evidence of lack confidence investors and advisers have in active management - and fees and underperformance are the major catalysts for the switch by investors to ETFs.

The latest SPIVA Australia Scorecard reveals consistent underperformance for the majority of Australian active funds in most categories over the year to June 30, 2019, and it is the same story over longer periods (5-, 10-, and 15 years).

Many investors are shifting to ETFs because of this underperformance. When combined with excessive base and performance fees, the days of the active managed funds industry are numbered. The ETF industry is taking its place.

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