Institutions slow to realise ETF potential: Ross

ETFs have turned out to be the best financial innovation in decades.

State Street Global Advisors SPDR chairman Jim Ross in their offices in Sydney. Picture: Britta Campion

When Jim Ross helped create the first US exchange-traded fund in 1993 to better serve investors after the spectacular failure of portfolio insurance during the 1987 crash, he couldn’t have known that his SPDR S&P 500 ETF (SPY) was destined to become the world’s biggest, most liquid equity security, or that ETFs would turn out to be the best financial innovation in decades.

Now SPDR chairman for State Street Global Advisors, Ross says the true potential of ETFs came as technological advances, competitive pressures on commissions and the transition of traditional stockbrokers into financial advisers began to see a rapid uptake in the early 2000s.

“The light-bulb moment was when we started to see the trend toward financial adviser use to build ETF portfolios for their clients,” he says.

“That happened because of competition in the US. Some independent advisers started offering ETFs and some of the more affiliated advisers said ‘we need to be able to compete with this’, so some of those large firms that might not have been fans because their business was still focused on commissions converted.”

That trend led him down under to launch Australia’s first ETFs, the SPDR S&P/ASX 200 Fund (STW) and the SPDR S&P/ASX 50 Fund (SFY) in 2001.

Whereas the original concept behind the SPY was to create a product that would continue to track the S&P 500 during times of crisis, it has boomed in popularity to the point where it now trades twice as much as Apple shares each day. It also paved the way for countless other products.

“At the time, we thought there might be two or three of those in the US, so clearly we did not have a crystal ball,” Ross says.

“But in trying to solve a problem we created a product that was well structured, with good flexibility from an investors’ standpoint, and honestly some of the other things happening in the marketplace helped to ignite the growth of ETFs.

“What we found over time was that what we had created — which we thought was solving a market problem from the late 1980s and early 1990s — was actually a very disruptive innovation.”

It was an innovation that drew criticism from managed funds simply because it hurt their business models, but there’s no doubt ETFs gave investors a lower-cost way to invest in diversified port­folios. After seeing the success of ETFs in the US, Ross turned his focus to other wealth markets and found burgeoning demand for well-diversified, low-cost investment products.

In his view it is still early days for the local market for ETFs. “We continue to see the adoption of ETFs in the SMSF (self-managed super funds) and the financial advice market, and as what I’ve seen happen in the US and Europe, you will see ETFs become universally core portfolio holdings for Australian investors.”

But while Australian ETFs continue to grow about 20 per cent a year, as they have for the past decade, uptake has been significantly slower from institutions compared to the US and Europe. “US institutions make up 30-40 per cent of ETF take up, but here it’s less than 10 per cent and that’s something we continue to work on,” Ross says.

“We are showing them how similar institutions around the globe use ETFs, but it takes time.”

An example is the US insurance sector, where State Street Global Advisors has been promoting ETFs for a decade or so.

Ross recalls introducing the chief investment officer of a US insurance company to the concept of ETF investing six years ago, and they only just bought their first ETF a year ago.

“Insurers obviously have large asset pools, they are cautious about how they invest, and what they needed — because they were looking at fixed-income — was for that market to grow into a solid market for them,” he says.

“Fixed-income ETFs have been one of the faster growth stories globally.

“So we bring that back to Australia and say this is a great wealth market and we see the opportunity for fixed-income ETFs for Australian investors potentially in the institutional side, but also in that wealth market where we continue to focus a lot of our energy.”

While he still hears it said periodically that ETFs are “the next bubble”, Ross says they have come through testing times — like the global financial crisis and the 2018 fourth-quarter sell-off — with flying colours.

“There’ve been so many tests in my 27 years of involvement with them it’s hard to pinpoint one. Passive ETFs were already a very sizeable part of the market during the global financial crisis and they operated as designed during that. They are designed to track an index. The outcome might be 20 per cent down, but if the index is 20 per cent down, they’ve done their job.

“They continued to trade in orderly markets throughout the global financial crisis.”

Indeed he argues that ETFs tend to bring liquidity to the market in times of stress.

“If you look at ETF trading volume, it tends to go up in times of stress as people use them to try to figure out where the markets are.

“In fixed income, we have seen multiple pockets of disruption — quarter-four 2018 was a case in point — and we saw significant volumes of trading in ETFs as people tried to adjust their exposures relatively quickly during volatile markets ...

“As ETFs have grown in the US, investors have found ways to use them to build portfolios for broad strategic asset allocation, or for tactical portfolios. My view on this is that many of the folks using ETFs are probably using them for active strategies — they are just choosing to use an index strategy to implement.

“That works in the US and we’ve seen it come to Australia. The biggest challenge here is in continuing to educate.”