Some 25 years after their US introduction, exchange traded funds (ETFs) continue to proliferate globally, with attributes including low fees, high liquidity, ease of use, full transparency and bona fide tax efficiency. Today, ETF products cover a growing range of investment strategies, from equity and fixed income to commodities, smart beta and real estate, as well as emerging segments, including both passive and active approaches.
Having first gained traction in the US and later across Europe, ETFs have expanded into emerging areas, including Latin America. A key catalyst is Brazil, where steady economic growth and a slew of regulatory reforms have helped pique investor interest. As capital once again flows into Brazil and neighbouring regions, a growing number of foreign investors are turning to highly liquid, low-cost ETFs as a way of boosting local allocations, while the relative safety and flexibility of ETFs have attracted participants within Latin America itself, particularly those seeking greater international exposures.
According to Greenwich Associates, a market intelligence and advisory services firm for the financial services industry, 2017 saw a nearly two-fold jump in ETF adoption throughout the region, with strategies such as fixed income, real estate and commodities among the list of exchange traded gainers. Looking ahead, domestic pension plans and other asset managers in Brazil are expected to boost ETF adoption as a way of gaining access to the US and other key markets that may be otherwise off limits due to cross-border restrictions.
ETFs on the fast track
Since the start of the decade, global ETFs have achieved an organic annualised growth rate of 19%, more than four times that of standard open-ended mutual funds. Going forward, a number of structural trends are likely to drive future ETF adoption. First, many managers have begun to shift their focus away from securities selection and more towards portfolio design/asset allocation in order to achieve maximum value. Next, changes within the fixed income market have helped further ETF growth. Because banks no longer consider bonds an efficient use of capital when cross-trading, bond market liquidity has been impacted, resulting in wider bid/offer spreads – upwards of 50–60 basis points (bps) across the high yield sector, for example. Compare this to iShares’ iBoxx $ High Yield Corporate Bond ETF, currently averaging around 1bps. Not surprisingly, managers are gravitating towards such products to reap the cost savings.
Investors are also increasingly using ETFs as financial instruments, often in place of derivatives such as forwards and swaps, particularly for corporate bond and emerging market strategies. Long-term market structure shifts are accelerating the trend. As banks’ balance sheet costs increased due to new capital and liquidity requirements, transacting hedged derivatives has become pricier (by as much as 30–40bps, in some instances). By contrast, an equivalent ETF derivative substitute can be had for a fraction of the cost (4bps, on average). While derivatives are still preferable for levered or short positions, ETFs have become the go-to option for long managers.
Additionally, the ongoing move from commission to fee based advisory services – driven in part by demands for greater transparency around investment products – bodes well for ETFs, particularly as managers seek lower-cost strategies that can support fee-based economics. At present, only about 3–4% of funds remain transactional, mainly to reach otherwise inaccessible portions of the global market.
Uptick in Latam
Latam investors are turning to ETFs to achieve asset-class diversity across different geographies using a relatively safe, liquid instrument. Regional pension funds were among the first to look abroad for investment opportunities: it was the early 2000s and qualities like “lowcost” and “no counterparty risk” had yet to become the industry buzzwords of the post-crisis era. Following 2008, investors who had incurred significant losses resulting from opaque credit exposures were suddenly clamouring for liquidity, asset class diversification and, above all, full transparency – attributes intrinsic to the ETF structure.
Ultimately, Latam managers began to see ETFs as versatile, investor-friendly products for accessing global indexes, thereby providing clients with the all-important element of diversification. The success of these early ETF forays would subsequently compel other local asset managers and insurance firms to take the plunge.
Today, institutional ETF allocations continue to rise throughout the region, reaching 13% of all invested assets during 2017, according to Greenwich Associates – a nearly two-fold increase year-over-year. Mexico maintains front-runner status, with ETFs averaging roughly 40% of the country’s total share volume (compared with 25% in the US). Though utilisation in Brazil remains well behind, a similar quest for diversification, the result of an ongoing shift in local economic conditions, has begun to emerge in that country, and, accordingly, observers see ETF assets under management (AUM) in Brazil (currently estimated at around USD 2.5 billion) steadily rising over the near term.
Key to this evolution has been a slow but steady awareness that looking outside the region is no longer an option but a requirement. Not even a decade ago, the percentage of nondomestic allocations in the region was almost zero – today, that has improved to around 10%, which is lower than where it should be, but a step in the right direction. Another argument in favour of ETF investing is preferable tax treatment. In Mexico, local investors using ETFs with foreign exposures pay a 10% withholding tax, compared with an average 30% tax on gains when trading individual foreign securities.
Buy, buy Brazil
Brazil began offering ETFs in 2004, and currently includes 15 listed exchange traded products, most of them equities-based (a first ever fixed income ETF debuted in September 2018). Despite its relatively small size, the market has averaged some USD 50 million in daily volume, thanks in part to products ranging from repos and stock loans to futures and options, as well as the ability for investors to use ETFs as trade collateral. The majority of ETF owners are institutional clients, accounting for some 62% of exchange traded allocations according to stock exchange B3, with foreign investors representing just 7% of regional activity.
Like many in the region, Brazilian investors have historically favoured domestic securities, in particular high interest bearing fixed-income products. Given the severe turbulence of the last few years – including a sustained drop in commodities pricing and subsequent equities selloff – many are now taking a second look at international asset classes, and not just for their tax incentives. At present, regulations prohibit foreign funds from being distributed within Brazil; additionally, many regional banks and other financial companies lack the infrastructure to directly invest in foreign exchanges. Hence, listed Brazilian ETFs that trade in the local currency yet offer full international exposure remain the easiest – and least costly – route for globe-trotting investors. Accordingly, more regional managers are expected to offer ETFs in an effort to meet this growth in demand.
When sizing up prospective ETFs, it is crucial that investors seek the most qualified providers possible, while also considering such criteria as fund liquidity, AUM, number/type of offerings as well as years of service in the field. For their part, providing adequate information can help managers ensure that investors choose a basket of securities that properly reflects their long-term objectives. Accordingly, going forward, education remains a priority for both passive and active fund managers, not only around foreign allocations, but also fixed-income strategies that have traditionally dominated Brazilian portfolios. As part of this effort, custodians and administrators continue to work with managers to provide support for institutional clients seeking increased ETF exposure.
For Brazil and other regional markets that have almost exclusively focused on local opportunities, the ability to gain global access through ETFs is a potentially game-changing development. Given the pronounced volatility that has roiled the regional markets over the last few years, it is perhaps no surprise that investors are finally looking to diversify their portfolios using different currencies, sectors and asset classes. And, as many are discovering, ETFs are often the most efficient way to make that happen.
Nicolas Gomez is Head of Latin America and Iberia iShares at BlackRock. Jeffrey Baccash is Global Head of ETF Solutions and Andrea Cattaneo is Head of Securities Services, Brazil at BNP Paribas.
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