Exchange traded funds (ETF) and private equity strategies sit at two ends of the investment spectrum. ETFs are highly liquid, passive products that track an index or follow a rule-based strategy; while PE funds generate returns for their investors by actively making long-term investments in private markets. Despite their differences, they share one thing in common: rapid asset growth.
Earlier this year, the assets globally invested in ETFs and other exchange traded products surpassed USD5 trillion for the first time, which is more than triple the amount the industry handled at the beginning of the decade1. There has also been strong growth in private equity, where assets under management have doubled over the last ten years to more than USD3 trillion2, with Asia accounting for a quarter of the global total3.
More growth to come?
After a prolonged period of such strong growth, can ETFs and private equity managers continue to attract capital in the coming years? This was the opening question of a panel discussion that was part of the 2018 HSBC Securities Services Leadership Forum, which assembled experts to share insights on the current trends in both active and passive management.
The popularity of ETFs among investors can be attributed to their cost efficiency and the way that they can be used for portfolio completion, said Laura Lui, Partner and Co-Chief Investment Officer at Premia Partners Company. Developed markets like Europe and the US, have already taken advantage of these benefits, she said, and future growth will likely come from new products that go beyond traditional market cap weighting – such as smart beta, factor investing, and inverse or leverage products.
“But in Asia, we are still at the beginning of the growth journey, especially in Hong Kong and China,” said Ms Lui. Investors in the region are buying pure beta products for the first time. In contrast to crowded developed markets, there are still plenty of product gaps in Asia that have yet to be filled by ETF providers, she said.
The prospects for further growth in private equity also remain strong, as investors become more familiar with the asset class in the current low interest rate environment, said Maverick Wong, Managing Director, Head of Private Equity at China Ping An Insurance Overseas (Holdings) Limited. “A lot of fiduciaries are required to deliver a target return to their beneficiaries and in a low interest rate environment a lot of them have to balance the equation by increasing their allocation to an asset class such as private equity that generates higher returns,” he said.
There are fears that with more people investing in PE funds, private markets have become overheated, with investors paying higher multiples for stakes in companies. Mr Wong agreed that valuations have become high and that investor should consider the costs allocating to the asset class while it is so popular. But he also emphasised that the long-term nature of PE investments can help offset cyclical risks.
Investing for the future
Another subject of discussion was how active and passive managers are approaching one of the most important financial trends – namely, the growing importance of environmental, social and governance in investment decisions.
“ESG is very suitable for ETFs, since ETFs is a rule-based form of investing, and ESG requires the application of rules,” said Ding Chen, Chief Investment Officer of CSOP Asset Management. The limiting factor in Asia, she said, is a shortage of indices that satisfactorily track companies in the region that meet ESG criteria.
On the side of active managers, Ping An’s Mr Wong said that private equity funds have been applying ESG criteria to their investments for some time, as it is a good indicator of a company’s long-term sustainability. A business that contaminates the environment for example, will be hit by costs incurred by cleaning up the contamination, and could even be forced to shut down. ESG also has additional benefits he said, improving a company’s brand and higher employee satisfaction.
Finding the right solution
Investors considering ETFs for the first time, might find it hard to differentiate providers – especially when it comes to multiple products that track the same index. Liquidity levels and cost are always an important consideration, said Premia’s Ms Lui., but there is another factor that the potential buyer of an ETF products needs to evaluate – its investment process.
“When a fund diverges from the benchmark, clients want to know why that is the case,” she said. “An active manager may or may not be able to provide a detailed explanation of how its investment process led to this result. But as a passive manager, we are always able to provide a transparent and easily explainable account of how we invest.”
Moving from the product to the company level, ETF providers can be differentiated on their ability to innovate, said CSOP’s Ding Chen. The market grants innovators in the ETF space with a strong first mover advantage where the winner takes all, she said, adding that even the world’s most popular indices are only able to support a handful of ETFs.
“ETF players need to find a niche,” she said. “Cost is essential, but so too is product innovation, which is whether you can provide a new investment solution.”
When considering private equity for the first time, an investor might want to take a gradualist approach. Ping An’s Mr Wong explained the stages that an institution can gain exposure to private equity, beginning with a fund of funds that provides access to a diversified pool of assets in a cost-effective manner. As the business’ ambitions for the asset class grows, it can then start picking individual PE funds. The next step is co-investing with a partner, which requires a small group of dedicated professionals. The final stage would be direct investment, which brings with it the demands of running a full PE team.