First Trust and RiverFront are taking a new and noteworthy approach towards ETFs, or exchange traded funds, one both firms say will help improve tax-efficiency and mitigate foreign currency risk, two issues at the forefront of investor’s minds.
Nasdaq recently sat down with First Trust and RiverFront to discuss the new ETFs, and what benefits investors will see from the new approach. A Q&A follows below with Ryan Issakainen from First Trust and Michael Jones from RiverFront on the announcement:
1. What ETFs are First Trust and RiverFront launching and why?
Ryan Issakainen: First Trust is launching three actively managed international ETFs: First Trust RiverFront Dynamic Asia Pacific ETF (RFAP), First Trust RiverFront Dynamic Developed International ETF (RFDI), and First Trust RiverFront Dynamic Europe ETF (RFEU). These will be our first ETFs subadvised by RiverFront Investment Group, which will actively manage the equity portfolios, as well as dynamically hedge currency exposure.
Financial advisors have come to recognize how big of an impact fluctuations in currency exchange rates can have on investor returns. One of the features of these ETFs that we expect financial advisors will like most is that exposure to foreign currency risk is actively managed, unlike many other international equity ETFs that are either 100% currency-hedged or completely unhedged. From a tax-efficiency standpoint, we believe this is a better approach because investors won’t need to buy or sell ETF shares—which include both currency hedges and underlying stocks—to increase or decrease the size of their currency hedge. Instead, RiverFront will dynamically adjust the amount of currency hedging within each ETF to whatever level they believe is appropriate.
Michael Jones: The potential tax efficiencies from this structure are important when you do a foreign currency hedge. You can't escape taxes on the hedge and the IRS requires that the ETF distribute some of the gains as long term capital gains and some as short term. Most currency hedged ETFs combine a passive stock index and currency hedging strategy. The ETF has to hold all of the stocks in the index, which can limit the ability to offset gains on the currency through tax losses on the stock portfolio. With these new First Trust/RiverFront ETFs, we are not forced to adhere to an index because the funds are actively managed.
2. What is the strategy behind the new ETFs?
Michael Jones: Think of it as a layered process. We start with a top down assessment of relative valuations between the major international asset classes. We use our proprietary Price Matters® process to evaluate the relative attractiveness of developed international and emerging markets. This helps drive our macro allocation between the major asset classes. We then evaluate each country’s relative attractiveness through a quantitative and qualitative assessment of the levels and shifts in macroeconomic variables relative to valuation. Once we have established our top down regional and country selection strategy, we employ a bottom-up company and sector analysis to better inform our top down macro views. The last part of the process is determining the hedging strategy. Which currency do we want exposure to, which do we want to hedge out exposure to? As with every step in the process, we employ a combination of quantitative and qualitative analysis to make these decisions.
Ryan Issakainen: One of the reasons that we believe these ETFs will be such great building blocks for financial advisors to use in constructing client portfolios is how robust the process is that Michael just described.
3. Why these ETFs at this particular time?
Ryan Issakainen: We don't tend to launch ETFs with a narrow window of time in mind. Rather, when we introduce a new ETF, our goal is for it to remain in perpetuity. Often, the timing of new launches is more influenced by the regulatory process than anything else. That said, we believe that there is a good window of opportunity for investors to buy international equities at reasonable prices today. Of course, longer term we believe that an allocation to international equity ETFs can provide important benefits to investors’ overall portfolios.
Michael Jones: We believe the typical US investor seeking international exposure would prefer a broad, flexible allocation. Rather than locking in a specific stock strategy (market cap weighted or low volatility or export weighted) or hedging approach, we think investors prefer a disciplined strategy that can adapt to changing market environments. It's really important to understand the strategy is not confined to just currency decision – the country allocation and security selection is also a very dynamic part of the investment process. Currency volatility was high in 2015 and presented significant investment opportunities, but as we moved into 2016, country and sector selection have been more important drivers of investment returns.
In recent months, we've made the transition from being more focused on the European Union exporters to increased investment in European small caps and Norway. As the euro remains range bound, we're adding new asset class and country exposure to provide more exposure to the nascent European domestic recovery and responding to stabilizing oil prices with more energy exposure thanks to Norway (a major oil exporter). These changes in our stock selection strategy are as significant, or more so, than our currency exposure.
4. How do these ETFs differ from other products? What makes them unique?
Michael Jones: If they [financial advisors] want to replicate our active stock selection and currency hedging strategies, they have to flip between ETFs with differing stocks and currency methodologies. If they do, their clients may have to pay taxes after every transaction -- with our ETFs most of the underlying transactions for country, sector and currency occur in the ETFs and benefit from any tax advantages of the ETF structure.
5. What is your investment approach in managing these ETFs?
Michael Jones: We believe strongly in a quantitative process informed by qualitative judgment. Every investment decision has quantitative tools driving our investment decisions, but with international markets, there's so much experimental monetary policy happening, you can't be a black box. There needs to be a last qualitative input into the decision, an informed judgment as to whether the model outputs need to be adjusted for the extraordinary circumstances of the current environment.
6. Who is the intended primary investor? Retail? Institutional?
Ryan Issakainen: The improvements in tax-efficiency we expect to be provided by these ETFs will probably be more beneficial to retail investors than institutions, but we believe that other aspects of the strategy will be compelling to both retail and institutional investors.
7. How would you characterize the demand for such products?
Michael Jones: We've heard two things -- there's a desire for a new portfolio solutions that offer a more dynamic approach to security selection and currency hedging in the international markets The number of decisions required to succeed in these markets can be overwhelming, and most existing products push these decisions onto the shoulders of the financial advisor. These products will help support the advisor in his or her portfolio construction efforts by taking on some of those dynamic decisions, and delivering these portfolio solutions in a package that makes better use of the ETF structure.
We have also heard that some advisors are also seeking support in setting asset allocation, but need dynamic allocation solutions with lower turnover and tax implications than is currently available in ETF portfolio solutions. These three new ETFs are the first in a series of ETF product offerings that we hope to bring to market in the coming weeks. We intend to combine these ETFs into a series of portfolio solutions that seek to meet this need for dynamic ETF portfolio solutions with a more tax aware implementation.
8. How should the individual investor approach these ETFs?
Michael Jones: Financial advisors who want to get exposure internationally have many options, and many decisions to make. Do you want to invest in an Asia Pacific ETF or a Europe ETF? A Germany ETF or a U.K. ETF? Do you want U.K. currency risk, or Euro currency risk? The benefit of these new ETFs is that all these decisions are built-in, and potentially implemented more tax-efficiently.
9. What’s next for First Trust and RiverFront?
Ryan Issakainen: Our intention is to continue to expand our lineup of international ETFs subadvised by Riverfront, in order to allow investors to combine them into a comprehensive portfolio solution.