Poised for growth in the strategic beta ETF space

Ashley Redmond: I'm Ashley Redmond from Morningstar.ca and I am here with Karl Cheong, Head of ETF Products for First Trust.

Karl thanks a lot for joining me.

Karl Cheong: Thanks for having me Ashley.

Redmond: So you are about to enter your one year anniversary in Canada. So that's great, congratulations.

Cheong: Thank you.

Redmond: But before we get into that you are quite established globally. So why don't you tell me about your global operations?

Cheong: Absolutely. So First Trust is a Chicago-based firm with over US$90 billion in AUM across 267 different investment products. And that spans various asset classes and geographies. In the ETF space however -- we only entered the ETF space in 2007. From there we've become the eighth largest U.S. ETF provider and twelfth largest globally. What's been impressive though is in 2013 we were the fastest growing ETF provider in the U.S. growing our assets about 78% to US$24 billion.

So more recently however, we have expanded our global operations as you just mentioned. We launched three ETFs into Europe. In addition we launched our five TSX-listed ETFs here in Canada. Namely we recently launched our Canada's first European ETF as well as an actively managed Senior Loan ETF.

Redmond: So relative to the big players in Canada you're still fairly small. So what's going to differentiate you here in Canada?

Cheong: It goes back to what has made us successful as a business in the U.S. The first thing is that First Trust was a leader in fundamental investing and index weighting. So what that means is that we created a methodology that's rules-based called AlphaDEX. AlphaDEX essentially takes the best of active management. So selecting and weighting in stocks by investment merit. And we essentially marry it with the ETF structure, which is low fees, transparency, liquidity and all the benefits you get from the ETF structure.

Essentially what that does is combine the best of both elements without the active portfolio managers. We don't want the PM in this case, because when you introduce the PM you add emotion to the equation. We launched our first 16 ETFs in the U.S. in 2007, based on this methodology, and from there 15 out of 16 have beaten their benchmark, by an average excess return of 400 basis points net of fees.

So from that we think that's very powerful strategy we can bring to Canadians. Secondly, we truly believe that you need to the first to market or add something over and above the existing offerings in the marketplace.

I don't think the Canadian ETF industry needs another broad Canadian large-cap ETF in that space. So First Trust has done a really good job actually of identifying niches and attempting to address niches that our larger competitors won't. A good example of that was our First Trust Senior Loan ETF which is actively managed [rather than] being a benchmark. Then lastly we have broad distribution capabilities in the U.S. We currently have about 150 salespeople and that's something we're going to try to build out here in Canada to replicate some of that experience.

Redmond: Let's talk about the AlphaDEX Methodology. So in Canada four of your ETFs use the AlphaDEX methodology and it's a fundamental kind of indexing like you mentioned. So what makes it so distinct from smart beta or as we now call it at Morningstar strategic beta.

Cheong: That's a good question. Even stepping back on the smart beta -- strategic beta Morningstar has labelled it. Smart beta has never received as much interest as it has today. And we don't believe this is going to be a fad and the numbers certainly don't lie. First based on Morningstar statistics US$65 billion of net flows went into smart beta ETFs which represents about a third of the inflows. Then based on another Morningstar report I saw is that there is about US$271 billion of assets tied to smart beta indices which represents about (17%) of the overall ETF pie.

Now secondly, we've seen that the smart money the institutional investors plan to increase their allocation by over half into the smart beta category which is more than any other market -- more than any other category, including market cap.

Now going back to First Trust. So we have been one of the leaders, as I mentioned, in terms of fundamental weighting; now compare that to what other smart beta indices have actually done. When you take a look, one of the first ones has been the RAFI Methodology, or Research Affiliates. What they're doing essentially is they are taking total sales, total dividends, total book value, and then reweighting the complete index.

What we're essentially doing is taking qualitative factors that successful portfolio managers have used. They want to know how much they are going to pay for that book value, how much they are going to pay for their sales. So we are looking at predictive qualities, not just reweighting. The best example I can use is that a portfolio manager would never buy a stock just because it's really, really big. They are actually looking at fundamental factors, and that's what we're essentially doing through our methodology.

We think that all the interest however, through competition in the smart beta space is fantastic, because it's really constructive for the industry because what it's forcing investors to do is look under the hood at the unique exposures that they're taking. And the closer you look at First Trust's methodology the better we look.

Redmond: So in the U.S. First Trust fees are fairly high relative to its peers. In Canada it's fairly competitive. So as you've seen in the last week and half iShares has slashed its fees. So are you planning on engaging in that ETF price war here in Canada?

Cheong: Well First Trust in the U.S. and now in Canada has developed a business model that can sit very comfortably beside Vanguard and iShares and so to answer your question, no, we will never compete for low-fee beta. That is essentially not the model we are going to find. If you were to essentially compete only on price, than low fees will be the only determinant in terms of a successful product and you would see a one-to-one correlation between price and size, but that's not always the case. We think through our differentiated offerings and through our enhanced index strategy that has generated alpha over time. We're going to be competitively priced in the marketplace and we are very comfortable on our approach to pricing and where we sit in the industry at this point.

Redmond: Well it sounds like there is lot of exciting things happening at First Trust right now. So what are you planning for the rest of 2014?

Cheong: It's going to be an exciting year for First Trust. We plan on launching or aggressively expanding our lineup to 10 to 15 ETFs over the next year just to establish more our base, so Canadian investors will know we are here for the longer term.

Secondly, we're going to spend very efficiently on sales and marketing, not only on existing products, but for our future product launches and then lastly we're going to spend a lot of money on developing our headcount and broadening our distribution capabilities like we just discussed. So we are going to be working hard over the next year on these issues.

Redmond: Thanks so much Karl.

Cheong: Thanks Ashley.

Redmond: For more information on ETFs go to the ETFs page at Morningstar.ca.