ETF Trends
ETF Trends

As investors seek out new ways to access the international markets in a growing universe of investment options, look to a smart beta exchange traded fund strategy that could potentially enhance returns and diminish risks.

On the recent webcast (available on-demand*), ETFs vs Mutual Funds: What’s the Difference?, Steven Vannelli, CEO and CIO of Gavekal Capital, pointed out that ETF asset growth has surged in recent years whiles the mutual fund industry has seen asset growth slow. Over the last decade, assets in ETFs expanded 690%, whereas mutual funds saw assets grow 88%.

The slowing asset growth in mutual funds may be partly attributed to large outflows out of actively managed funds, which shrunk by almost $800 billion over the last decade.

Many investors have grown weary of active funds’ high costs and extended underperformance, opting for cheap index-based options instead. Consequently, Vannelli projects that at the present growth rate, ETF assets could exceed mutual fund assets within a decade.

When investing in various markets, notably international markets, the ETF wrapper may be a better investment tool to access the moves. In comparing the Morningstar World Stock ETF Average with the Morningstar World Stock Mutual Fund Category Average, Vannelli found that international stock ETFs exhibited a higher total return or generated a greater alpha with a higher Sharpe ratio. Essentially, the world stock ETFs exhibited a more attractive risk-adjusted return.

Part of the outperformance found in ETFs may be attributed to the investment vehicle’s low management fees, which eat away at total performance over time.

“The average ETF expense ratio is 64% less than the average mutual fund,” Vannelli said. “Average distributed gains for ETFs were four to 10 basis points versus 1.48% to 2.94% of NAV. Assuming a tax rate of 30%, these distributions add 50 to 100 basis points to total cost.”

The Morningstar World Stock ETF Average expense ratio is 0.46%, compared to the Morningstar World Stock Mutual Fund Category Average of 1.28%. Moreover, ETFs showed lower capital gain distributions due to their more efficient structure, which also help limit costs.

“ETFs may have been superior to mutual funds across all capacity metrics… and had an identical correlation to mutual funds,” Vannelli said.

Many investors, though, still rely on what they know, which include mutual funds that may not efficiently provide market exposure. In a survey of financial advisors on the webcast, 62% of those surveyed indicated that they still utilize mutual funds for their global allocations, and 51% said they plan on increasing their global exposure.

Given ETF’s more efficient exposure to international markets, investors may continue to slowly move toward the ETF wrapper as their go-to investment tool to access global exposure.

For example, the Gavekal Knowledge Leaders Developed World ETF (NYSEArca: KLDW) tracks international developed markets and is the first exchange traded fund based on the so-called Knowledge Effect. Since its inception on July 7, 2015, KLDW has outperformed the benchmark MSCI World Index by over 1%.

The index-based Knowledge Leaders ETFs select companies based on the innovation process and other criteria, including characteristics like intangible property as a percentage of assets, intangible investments as percentage of sales, gross margins, financial leverage, net debt as percentage of capital, operating cash flow margin, free cash flow margin and return on invested capital.

Due to its quality control, KLDW also exhibits a greater Sharpe ratio than the Morningstar category average, or a greater risk-adjusted return as the smart beta ETF provides improved diversification benefits, lower drawdowns and enhanced upside potential.

“KLDW outperformed the ETF and mutual fund Morningstar World Stock category average on every performance/risk/capacity metric,” Vannelli added.

Given its more customized indexing methodology, KLDW is similar to other smart beta ETFs in regards to their above-average fees – the ETF comes with a 0.75% expense ratio, but it is still cheaper than the broader international mutual fund category. Potential investors, though, may be relieved to know that the ETF has distributed no capital gains since inception.

* Email Cassandra Egan at cegan@etftrends.com for the link to the on-demand webcast.