Financial authorities examine potential conflicts of interest

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Regulatory changes being proposed and adopted by financial authorities across the globe are poised to put exchange traded funds under the spotlight.

Financial authorities are examining how financial advice is being delivered and creating potential conflicts of interest in markets such as the UK and Australia.

The UK’s Financial Services Authority recently proposed adopting a more interventionist approach in an effort to strike a balance between consumer protection and consumer choice. While the regulator is opening a debate rather than formulating rule changes, there is a presumption in favour of low-cost financial products.

The FSA is also completing its retail distribution review (RDR), scheduled to go into effect in January 2013, which will ban commission paid by investment product manufacturers to financial advisers.

“If [regulators in the UK] end commissions on sales of investment products, people see that as favouring ETFs, because ETFs don’t carry commissions,” says Loren Fox, senior analyst at Strategic Insight. “It makes it a more level playing field between ETFs and mutual funds.”

India and Australia banned commissions paid by financial-service providers to distributors in mid-2009.

The idea is to have investors pay for advice, freeing advisers from conflicts of interests.

And in the US, proposals to reform rule 12b-1 by the Securities and Exchange Commission should halt front-load fees on sales of mutual funds.

These regulatory moves coincide with other trends that are driving investors to take a closer look at low-cost index products.

“There is now a more empowered or more educated investor base,” says John Gabriel, an ETF analyst at Morningstar.

“You can’t get away with high commissions any more. It is more about suitability.”

Flows into ETFs are testament to what analysts have observed as a shift in investor preference. In 2010, $169.4bn of new assets went into ETFs and exchange- traded products globally, according to a report on the global ETF industry by BlackRock. The assets of such investments increased by 26.6 per cent to $1,311bn, which was greater than the 9.6 per cent increase in the MSCI Index measured in US dollars.

Mutual funds experienced global outflows of $139.7bn from January to October of 2010, while ETFs took in $140.3bn during the same period, according to Strategic Insight.

As investors seek accountability and suitability from financial advisers, the use of ETFs in asset allocation strategies is also accelerating.

“When you have more fee-based products with a wrap fee, the strategy lends itself more to ETFs,” says Gary Black, chief executive of start-up Black Capital Management, and former CEO of Janus Capital Group.

Positive flows and a changing regulatory landscape have encouraged providers to accelerate the pace of product launches and enter new territories in recent years.

Despite the fragmented nature of the European market and the limited access that retail investors have to institutionally priced investment products in the region, HSBC put a toe into the market in 2009 and has since garnered $7.5bn in assets under
management, says Farley Thomas, head of ETFs at HSBC.

HSBC, claiming 12-13 per cent of the Asian ETF market, decided to bring the experience over to Europe, Mr Thomas says.

“ETFs are easy to access, they are relatively low cost, they are transparent,” Mr Thomas says. “This explains the significant growth of ETF assets under management through the credit crisis. Investors who exited the investment market using mutual funds may have re-entered the market using ETFs, because they are designed for trading rather than for buy and hold.”

HSBC could have a competitive edge in Europe, as banks dominate the distribution of financial products, analysts say.

“We decided to develop the ETF business in Europe from nothing in 2009 and we have been building activity there steadily since then,” Mr Thomas says.

“Our strategy in Europe is to build a range of ETFs that wealth managers, institutional investors and self-directed investors can use for specific asset allocation decisions.

“Over the medium to long term in Europe we aim to have a top-10 position, with perhaps 10 per cent of market share.”

The bank plans to roll out a number of new ETFs in Europe this year, Mr Thomas says.

Vanguard, which is synonymous with indexing and holds the top-three spot in global ETFs with $148.5bn under management at the end of 2010, is being careful about its entry to the European ETF market.

Market barriers mean it has to move slowly, says Tom Rampulla, managing director of Vanguard Investments UK.

“In Europe distribution is controlled by the big banks, so the uptake is going to be tough.” Banks will naturally prioritise distribution of their own products, he says.

However, Vanguard is evaluating ETF launches for this year, Mr Rampulla says.

“I see a lot of similarities between what happened in the US and what is happening in the UK,” he says. “A big drive is the distribution model.”

In the mid-1990s about 10 per cent of adviser compensation in the US came from fees. Today that percentage is in the range of 50-55 per cent.

“Here in the UK, we have a pretty major shift coming at the end of next year. The trends look to be similar,” Mr Rampulla says.

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