RESEARCH
Product pricing is not the be all and end all of index product selection
KPMG research: There are several factors that influence investors when selecting index products
Tim
Tim West
Partner and Head of Asset Management Consulting
KPMG, November 2017

Key points

  • Cost is by far the most commonly cited reason to pick a particular index product
  • Other factors including index construction, liquidity, and investor type play a key role in selection
  • Many investors look beyond headline price to look at the Total Cost of Ownership (TCO)
  • ETFs are far and away the most popular index product in the KPMG survey.

BlackRock contributed to the funding of this research. For the avoidance of doubt, the views contained herein are those of KPMG and BlackRock did not have editorial oversight. Click here to find out more about the research.

Capital at risk. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.


Two approaches to product selection

KPMG found two distinct approaches to product selection. Some investors are focused on bottom up product selection on a case by case basis, seeking to pick the best product irrespective of provider.

Other investors would have a panel of approved providers, and would then pick products from providers on that list. This is not to say that investors won’t look elsewhere. As one private banker told KPMG, “If it is available from an existing product provider, we look at that product first. If it doesn’t meet our requirements, we’ll look at a new provider”.


Product selection criteria

Although cost is by far the most commonly cited reason to pick a particular index product, most interviewees KPMG spoke to said understanding index construction is their starting point for making sure a product is the right way to gain a desired exposure. Investors need to understand both index constituents (to whom the index offers exposure) and index methodology (how the index weights those constituents).

Investors need to understand exactly what they are getting with a particular product. For example, if an investor wants exposure to the pharmaceuticals sector, it’s not enough to just buy an ETF with ‘pharma’ in the name. Are the underlying assets big pharma companies? Mostly biotech stocks? Or a mixture of the two?

What are the top three factors which lead to you selecting a particular index vehicle?

Top 3 factors

Source: Index Investing: Views on Index Investing from the UK Wealth Market, KPMG – October 2017.

Index

Investors rightly view cost as an important component of their decision but many recognise that product pricing is not the be all and end all of product selection. Many investors select the right product and only worry about price as the tie breaker if there is more than one comparable product. One adviser told KPMG that getting the right index is so important that “if we want a specific index for investment reasons, that will trump price.” Another said that “we don’t think about cost, except in the sense of only caring about net returns.”

“Cost headline is important but not everything… Getting the right index for the exposure we want is the most important thing.”

More sophisticated investors (across all segments) are more likely to make this finer distinction about net returns over headline cost. A more nuanced view of net returns incorporates factors like tracking error, liquidity and all-in costs over the investment’s holding period.

Desire for low tracking error is universal, and considered both over long time periods and also in different market regimes. Sophisticated investors sometimes unpick structural performance drivers of different ETFs accessing the same market, with some going as far as to create long/short trades to generate returns from these differences.


Liquidity

Liquidity is also a consideration for many investors. Focus depends on investors’ size. Larger investors who trade with providers’ capital markets desks might focus both on primary market liquidity as well as how fund size and secondary market volumes impact liquidity. One private banker at a universal bank noted that if one of their Discretionary Portfolio Managers needed to do a trade, “we could potentially crush the market with a big order.”

Other investors focus on secondary market liquidity, particularly if they use index products tactically (which means they benefit from the ability to quickly enter and exit a position). These investors are willing to pay a premium for this benefit.


Total cost ownership

Many investors look beyond headline price to look at the Total Cost of Ownership (TCO) over a given holding period, accounting for ongoing charges and entry and exit costs.

In short, the general consensus is that index mutual funds (IMFs) can have higher entry and exit costs (through dilution adjustments) whilst ETFs have higher ongoing charges. This means that if you are investing over a holding period greater than 12-18 months, IMFs likely offer better value. Shorter-term investors may prefer using ETFs, particularly because intra-day tradability can support optimal timing of entry and exit.


Physical versus Synthetic

KPMG see widespread preference for (and often insistence on) physical replication to avoid counterparty risk: as one financial adviser said “in a black swan event [synthetic exposure] could bring huge consequences. It’s not worth it for 2 basis points (bps) in savings.”

For commodities, however, replication preferences varies. Some think physical replication is too costly and might even work against the investor in instruments like oil ETFs. Gold is an exception – “we’re buying it for insurance, so no sense in then using a derivative that may not pay off when you most need it.”


Product preferences by investor type

ETFs are far and away the most popular index product in the survey. Every private banker surveyed uses them. 86% of wealth managers uses them. Only two thirds of financial advisers use them. This still seems high given the drawbacks advisers face with the use of ETFs.

Which instruments do you use to access index investments?

Instruments - Index Investments

Source: Index Investing: Views on Index Investing from the UK Wealth Market, KPMG – October 2017.

Financial advisers are the only investor type who make more use of index funds (70% of participants do) than ETFs.

Wealth managers report the most concentrated use of ETFs. A small minority make any use of index funds or derivatives. Given wealth managers KPMG interviewed reported central trade sizes that can go into the hundreds of millions of pounds, they benefit from the greater liquidity and tradability ETFs can offer. Investors who trade in these sizes may also be more focused on managing counterparty risk. Investors looking to minimise counterparty risk might be less comfortable with the use of derivatives and structured products.

Almost half of the private bankers surveyed use derivatives or structured products. This could be due to a sophisticated client base more cognisant of the benefits these products can bring. A factor may also be private bankers’ access to investment banking colleagues’ structuring and sales skills.


Download the full KPMG Index Investing Report

The market for index products has exploded in recent years, but there is little information on how the UK wealth management market use index products and why. KPMG aim to fill this gap by sharing insights gleaned from investors themselves.

Download research report

To find out more about the research report including the methodology and key findings click here

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