Fidelity: The ETF Evolution (April 2019)

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Fidelity’s approach to finding volatility harmony between ‘smart’ income and quality ETF strategies

Factor investing and smart beta have entered the mainstream over the past decade, with a number of exchange traded fund (ETF) strategies today seeking to identify factors or individual themes that could help investors produce better diversification and risk-adjusted returns than traditional market cap-weighted indices. In 2018 alone, over $77bn was invested into smart beta funds, up 12.4% on the previous year. It is little surprise given this growth – and the fact historical performance is standing up to sector critics – that traditional active giants such as Fidelity are now also turning some of their attention to this area. Nick King is the man tasked with leading the group’s foray into smart beta ETFs. Over the past three years, King has successfully helped Fidelity build a range of specialist ETF strategies that draws on the group’s active expertise and heritage. The result is a series of focused and differentiated ETF products. King reveals that each ETF follows an investment strategy developed by the group’s in-house research team that leverages fundamental active insights to inform the factor definitions and applies portfolio construction principles to mitigate the unintended biases. Interestingly, the growth in the ETF space is not just a UK phenomenon for Fidelity. In Australia, King is leading the foray towards the evolutionary ‘active’ ETF universe, which allows Fidelity to combine the features of an ETF with a mutual fund, proving the breadth and reach of the group’s ambitions in this area.

The ETF Evolution

Welcome

CONTENTS

Interview: NICK KING, HEAD OF ETFs, FIDELITY

Income vs Quality ETFs

Fidelity Quality Income Range

In order for the ETF market to continue to grow at this kind of rate, we need to find new client types and new uses for the structure”

Nick King, Head of ETFs, Fidelity

Nick King, Head of ETFs at Fidelity, reveals how the group is planning to expand its ETF range in the coming years and why innovation is key to the sector’s success

‘With greater dispersion in markets expected, ‘smart’ ETF strategies will be most valued going forward’

Fidelity hired Nick King, who joined the group as Head of ETFs from market leader BlackRock iShares, to establish a new ETF capability for them in 2016. Since then, the team based in London and Hong Kong, have leveraged resources from across the firm to help build a new range of differentiated ETF products. “Our clients increasingly use a combination of active, passive and systematic products to build their portfolios. There are cases where paying for alpha makes sense, and others where clients simply need the most straightforward, low-cost way of gaining access to a market,” explains King. “Fidelity believes in offering our clients the flexibility to choose from a range of best in class investment tools whatever solution they’re looking for.” Rapid growth King believes the rapid growth of the ETF market in recent years has been driven by a number of factors, including the growth of index investing generally but also the convenience that the wrapper provides: “Market conditions have been very positive for passive investing. Over the past 10 years, the MSCI AC World Index has returned nearly 12% per annum. When returns from market beta are so high, it is easy for alpha to be overlooked. In addition, the volatility and dispersion of stock returns has been low, making it more difficult for active managers to outperform.” Regulatory changes have provided a further tailwind he adds: “Conduct rules aimed at enhancing consumer protection are driving markets towards a fee based advice model, which in turn highlights costs for clients and ultimately has increased the popularity of lower cost investment strategies.” Yet King notes that building the ETF business at Fidelity has not been easy in the highly regulated and competitive environment the asset manager finds itself in today. “Building an ETF business is challenging and it is a very competitive market. The resources, relationships and brand of Fidelity have been critical for us to make progress. We also realised early on that it was essential that the products we brought to market were differentiated from what is already out there.” “Fidelity has a strong heritage of active investing. By combining our active investment expertise with the systematic aspects of index investing, we are able to provide differentiated solutions aligned to the outcomes our clients are looking for.”

he passive investment sector has enjoyed phenomenal growth over the past decade, and assets under management have continued to rise as investors look for low-cost vehicles that can deliver returns as good as - or in some cases better than - actively managed funds. In particular, the exchange-traded funds sector has also seen rapid growth with assets under management reaching a new high of $5.32trn in February 2019, according

to data provider ETFGI.

Quality income range Fidelity’s first ETF range screens stocks to identify ‘good quality’ companies based on their profitability and cash flows. Among the highest quality companies, Fidelity then selects the highest yielding securities to invest in. “The Quality Income ETFs are based on indices which have been developed by Fidelity’s research team. Fundamental active insights inform the factor definitions used to identify quality companies. Risk management principles lead to index rules that minimise unintended sector, size and country risks.” A number of existing income ETF strategies have large weightings to sectors such as utilities which pay higher dividends, and avoid sectors such as information technology, which have not historically paid such high dividends. A key point of Fidelity’s income ETF range is to ensure that it has a sector allocation which is more representative of the broader market. “In other income ETF strategies, sector positioning becomes the main driver of the returns, rather than the income strategy that is being sought.” King says the range will be built out gradually and will seek to launch strategies that are clearly relevant for its clients, rather than putting out “as many products as possible and seeing what sticks”. Active ETF expansion The group has also made strides within the ‘active’ ETF market, and launched its first active ETF in Australia in October last year. Active ETFs allow Fidelity to combine the features of an ETF with a mutual fund and provide a securitised structure that can be held in a brokerage account. King believes structurally it is one of the most significant developments the ETF market has seen in years. “The structure we are using here is very interesting; it is a hybrid of a traditional mutual fund and an ETF wrapper. It provides intra-day trading on an exchange as well as instant confirmation of execution, just like an ETF. However, like a mutual fund, it has a limited requirement for publication of holdings which allows us to protect the intellectual property within the fund.” Fidelity’s first active ETF is currently only available in the Australian market only, predominantly because the European regulatory environment does not support the structure of active ETFs as yet. Unlike the European market, where full transparency is required, Australian regulators allow for limited transparency of holdings. In addition, Australia has a significant and growing self-managed superannuation client base that is used to holding individual securities within a brokerage account and thus active ETFs are able to fit alongside their existing holdings well. “It is not yet clear to me yet that the market is there in Europe to demand this type of vehicle. But we are pushing ahead with these innovative structures in other areas like Australia, which is very exciting.” ETF outlook King is pragmatic in his outlook for the ETF market as a whole, noting it is fair to say investors should “expect lower beta returns than those seen over the last 10 years”. Innovation within the sector is required if growth is to continue at its current levels, he says. “In order for the market to continue to grow at this kind of rate, we need to find new client types and new uses for the structure. For example, this might come from wider retail usage, but it’s going to require education and also potentially operational enhancements. We also need further innovation, including the development of efficient active ETF structures,” he says.

The ETF Evolution

Income vs Quality ETFs

Fidelity Quality Income Range

CONTENTS

Income vs Quality: Finding volatility harmony between the two

Factor investing has entered the mainstream in recent years - $77.6bn was invested into smart beta exchange traded funds during 2018, up 12.4% on the previous year. Academic research and historical performance have illustrated that exposure to certain factors can help investors to enhance returns or achieve specific investment outcomes. Factors such as size, value, quality, momentum, dividend yield and low volatility have been widely adopted by investors seeking higher returns, lower risk, better diversification or a combination of the three. A number of smart beta indices have been designed to offer a convenient way to get exposure to these factors. But no two factor indices are quite the same. Different ways of screening stocks for exposure to the desired factor can give quite different exposures. Active fund managers targeting the same style can have portfolios that look very different. So too with smart beta indices, which is why it pays to understand exactly how index methodology affects the underlying portfolio. In this article, the Fidelity ETF team discusses the benefits of exposure to the income and quality factors and how portfolio construction can help to mitigate some of the unintended by-products of this exposure. How should investors use ETFs for income? Screening stocks that pay higher dividends is an obvious way to raise the yield of a portfolio when income is a priority. It is perhaps not surprising that the results of the simple backtest below show that a portfolio comprising the top quintile of stocks in the MSCI World Index when ranked using a combination of dividend yield and payout ratio results in a yield more than twice that of the broader market. But in addition to that extra yield, total return also increases markedly - in an average year, the top quintile income portfolio returned nearly 3% more than the benchmark. The downside is that volatility also rises compared to the benchmark. Whilst this simple income screen will identify stocks that have attractive yields on a backwards-looking basis, it will not filter out companies with deteriorating fundamentals or those that are paying unsustainably high dividends. A way to improve our simple income portfolio would be to include only those stocks that have strong balance sheets with the ability to keep paying dividends into the future. A quality screen is a good way to achieve this.

Income plus quality In theory, using a quality screen in tandem with an income screen should help reduce the volatility of the income factor by avoiding those companies with weak fundamentals that look attractive on a yield basis but will be unable to sustain dividends in the future, while still giving exposure to the high-quality, high-yielding stocks. And this is exactly what our quality-income backtest shows. Compared to the income screen on its own, the top quintile portfolio of a combination of the quality with income factors causes a significant drop in average annual volatility and a substantial improvement in Sharpe ratio. And the good news for income investors is that, although not as high as the income factor on its own, dividend yield is nearly twice that of the benchmark.

The income factor increases yield and returns but also volatility

Backtest from 31/12/1994-30/09/2018 using MSCI World universe. Income score defined as an equal weighting of dividend yield and payout ratio. Quintile 1 represents the stocks with the highest income score. Stocks in quintile portfolios were market capitalisation weighted and rebalanced semi-annually. Source: Fidelity, December 2018.

Adding some quality The quality factor identifies companies with strong balance sheets that achieve stable and sustained profitability. Intuitively it makes sense that such companies would outperform over time, and this intuition is confirmed by an extensive body of academic research. The results of the backtest in the table below show that the top quintile of the quality screen returned over 3% per year more than the MSCI World over the sample period with lower volatility, resulting in significantly improved risk-adjusted returns.

The top quintile of the quality screen returned over 3% per year more than the MSCI World Index

Backtest from 31/12/1994-30/09/2018 using MSCI World universe. Quality score defined as an equal weight of return on invested capital, free cash flow margin and free cash flow stability (for banks, an equal weight of return on equity and debt to assets was used). Stocks in quintile portfolios were market capitalisation weighted and rebalanced semi-annually. Source: Fidelity, December 2018.

Avoiding the biases of factor investing Most factors tend to favour stocks from certain sectors at the expense of stocks in others. For example, the technology sector is often underrepresented in income indices because many companies in the sector have historically chosen to invest a high proportion of their earnings back into the business,rather than paying out as dividends. At first glance this may not seem important - after all, if you want income and you are still getting exposure to the highest yielding stocks in the market, does it really matter if there are no technology stocks? The answer is: it depends. Strategies that do not consider dividend yield in the context of the sector that a stock belongs to can end up with significant sector bets that investors might not even be aware of. The impact on total portfolio return can be both positive or negative - a tech-sell off might be avoided, but a sudden increase in healthcare regulation might hit the portfolio harder than others. Investors need to be sure of what they are getting and decide what is right for their desired outcomes.

Combining a quality screen can lower the volatility without compromising the excess returns

Backtest from 31/12/1994-30/09/2018 using MSCI World universe. Quality-income score defined as an equal weight of the quality and income scores used in the single factor backtests above. Stocks in quintile portfolios were market capitalised weighted and rebalanced semi-annually. Source: Fidelity, December 2018.

Using a combination of quality and income screens provides the additional yield income investors seek with a much higher risk-adjusted return than an income screen on its own

When does quality-income perform well? The quality-income combination offers significant outperformance over time. And by their nature, these factors tend to favour more mature, stable companies. The charts below and on page 12 show how this outperformance and defensive tilt can provide a strategy that beats the market in the long run and offers protection in falling markets.

Adding constraints We have seen how simple quality-income strategies can lead to significant sector and country bets, relative to the broader market. However, there are a number of ways to control sector and country weights to ensure they are more representative of the market. In the unconstrained quality-income quintile portfolios, stocks are simply ranked by their combined factor score and the highest ranking 20% by market capitalisation are selected to form the 1st quintile portfolio and so on. However, by considering stocks relative to others in their sector and country, the final portfolio has country and sector exposures that are as close to the starting universe as possible. Here’s an example of how this can be implemented. Imagine a grid with sectors on one axis and all the countries in the selection universe listed on the other. Squares on the grid are sector/country intersections, such as French industrials or UK financials. The highest ranking quality-income stocks are then selected within these intersections and weighted so that each intersection has a similar weight to the starting universe. This method of portfolio construction will result in some dilution of factor exposure - the portfolio will not contain the stocks with the highest quality-income score, but the stocks with the highest scores that still allows sector and country weight neutralisation. The positive effects of neutrality can be seen using attribution analysis. Attribution analysis gives a breakdown of the contribution of both stock selection and sector allocation to the excess returns generated by a portfolio - whether it was superior stock picking or simply an overweight to the technology sector that helped your portfolio beat the market. When sector and country weights are neutralised, a greater proportion of excess returns come from stock selection rather than relative sector allocations. This means that a greater emphasis is placed on picking high quality, income paying stocks in the constrained portfolio.

How sector weights deviate from the market in an unconstrained quality-income portfolio

Backtest from 31/12/1994-30/09/2018 using 1st quintile quality-income screen above. Average country weights for 10 largest countries shown, backtest from 31/12/1994-30/09/2018 using 1st quintile quality-income screen above. Source: Fidelity, January 2019.

The 1st quintile quality-income portfolio significantly underweights Japan and overweights the UK

Selection effect versus allocation effect in quality-income

Backtest between 30/12/94-29/06/2018 using 1st quintile quality-income screen above. Constrained portfolio market cap weighted within each sector/country intersection, unconstrained portfolio market capitalisation weighted. Source: Fidelity, December 2018.

Quality-income outperforms the market overall

Quality-income country/sector neutral market capitalisation weighted portfolio. Source: Fidelity, January 2019.

Quality-income gives downside protection in bear markets

This is summarised by the table below. The 1st quintile quality-income portfolio outperformed the benchmark in 70% of months when the MSCI World had a negative return. Conversely, in the months when the benchmark gained in value, the factor portfolio broadly matched the performance. The ability to capture almost all of the upside when the market rises while outperforming when the market falls is what drives the excess returns of the quality-income factor combination.

1st quintile quality-income factor portfolio vs. MSCI World

The Fidelity Global Quality Income Index The backtests above use a simple design to illustrate the potential for excess risk-adjusted returns of the income and quality factors and the advantages of combining them to focus on those companies most attractive for income investors. The Fidelity Global Quality Income Index uses these two factors but features a more refined portfolio construction process to enhance the benefits and reduce the unintended exposures. Results have been just as good - between 1 January 1999 and 31 October 2018, the index outperformed the MSCI World by 2.6 % per annum with lower volatility (15.4% compared with 16.7%) The starting universe for the Fidelity Global Quality Income index is the largest 2,000 stocks from developed countries that meet basic liquidity and size requirements. Stocks that do not pay dividends are also removed at this stage. The remaining stocks then pass through a quality screen which filters out the lowest scoring half of the universe based cash flow margin, return on invested capital and free cash flow stability. These metrics are used to ensure only companies exhibiting sustained profitability and strong balance sheets make the final selection. The resulting pool of around 1,000 stocks then pass through an income screen. Stocks are ranked by a size-adjusted yield score and the top 250 are selected across each sector and country basket using a similar process to that described above. The yield score is adjusted by size to ensure the index does not exhibit a significant small cap bias and can be constructed from liquid, investable companies. This portfolio construction method ensures that only the highest yielding, quality stocks are included in the final portfolio and, crucially, that sector and country weights are similar to the starting universe. This approach is consistent throughout Fidelity’s Quality Income index range which also includes the European, US and Emerging Markets strategies.

Interview: NICK KING, HEAD OF ETFs, FIDELITY

The ETF Evolution

Fidelity Quality Income Range

CONTENTS

actor investing has entered the mainstream in recent years - $77.6bn was invested into smart beta exchange traded funds during 2018, up 12.4% on the previous year. Academic research and historical performance have illustrated that exposure to certain factors can help investors to enhance returns or achieve specific investment outcomes.

Factors such as size, value, quality, momentum, dividend yield and low volatility have been widely adopted by investors seeking higher returns, lower risk, better diversification or a combination of the three. A number of smart beta indices have been designed to offer a convenient way to get exposure to these factors. But no two factor indices are quite the same. Different ways of screening stocks for exposure to the desired factor can give quite different exposures. Active fund managers targeting the same style can have portfolios that look very different. So too with smart beta indices, which is why it pays to understand exactly how index methodology affects the underlying portfolio. In this article, the Fidelity ETF team discusses the benefits of exposure to the income and quality factors and how portfolio construction can help to mitigate some of the unintended by-products of this exposure. How should investors use ETFs for income? Screening stocks that pay higher dividends is an obvious way to raise the yield of a portfolio when income is a priority. It is perhaps not surprising that the results of the simple backtest below show that a portfolio comprising the top quintile of stocks in the MSCI World Index when ranked using a combination of dividend yield and payout ratio results in a yield more than twice that of the broader market. But in addition to that extra yield, total return also increases markedly - in an average year, the top quintile income portfolio returned nearly 3% more than the benchmark. The downside is that volatility also rises compared to the benchmark. Whilst this simple income screen will identify stocks that have attractive yields on a backwards-looking basis, it will not filter out companies with deteriorating fundamentals or those that are paying unsustainably high dividends. A way to improve our simple income portfolio would be to include only those stocks that have strong balance sheets with the ability to keep paying dividends into the future. A quality screen is a good way to achieve this.

3&4

Quality income country/sector neutral (market capitalisation weighted within each sector/country intersection). Source: Fidelity, January 2019. 30/12/94-29/06/2018.

Past performance is not a reliable indicator of future returns. The ETF tracks an equity index and as a result the value of the fund may go down as well as up. Performance data is based on the net asset value (NAV) of the ETF which may not be the same as the market price of the ETF. Individual shareholders may realise returns that are different to the NAV performance. This fund invests in overseas markets and so the value of investments can be affected by changes in currency exchange rates. The Fidelity Emerging Markets Quality Income UCITS ETF invests in small and emerging markets which can be more volatile than other more developed markets.

The Fidelity Quality Income strategy aims to provide exposure to high-quality dividend-paying companies whilst avoiding unintended biases towards particular sectors or countries. By combining the group’s active investment expertise with the systematic aspects of passive investing, Fidelity is able to provide a truly differentiated solution aligned to a client outcome, in this case, income.

The Fidelity Quality Income ETF range

Fidelity only offers information on products and services and does not provide investment advice based on individual circumstances, other than when specifically stipulated by an appropriately authorised firm, in a formal communication with the client. Fidelity International refers to the group of companies which form the global investment management organisation that provides information on products and services in designated jurisdictions outside of North America. This communication is not directed at, and must not be acted upon by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Unless otherwise stated all products and services are provided by Fidelity International, and all views expressed are those of Fidelity International. Fidelity, Fidelity International, the Fidelity International logo and F symbol are registered trademarks of FIL Limited. FIL Limited assets and resources as at 31/03/2019 - data is unaudited. The Key Investor Information Document (KIID) is available in English and can be obtained from our website at www.fidelityinternational.com. The Prospectus may also be obtained from Fidelity. Fidelity UCITS ICAV is registered in Ireland pursuant to the Irish Collective Asset-management Vehicles Act 2015 and is authorised by the Central Bank of Ireland as a UCITS. The Index which the sub-fund of the Fidelity UCITS ICAV is tracking comprises the equity securities of the relevant companies. For more information on the Index, please refer to the publicly available index methodology at www.fidelity-etfs.com/documents.Third party trademark, copyright and other intellectual property rights are and remain the property of their respective owners. Issued by FIL Pensions Management. Authorised and regulated by the Financial Conduct Authority. ETFSSO-01-010419

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Source: Fidelity, Bloomberg as at 28/02/2019. Index yield is calculated as the weighted average dividend yield of each individual constituent. Dividend yield is calculated as sum of dividend per share amounts that have gone ex-dividend over the prior 12 months, divided by the current stock price.

*From 1 February 2019 a fee waiver of 5bps will be applied to the Fidelity Quality Income ETF for a period of 12 months. The headline OCF of this ETF will not change, however the Fund management company will collect a reduced fee for a period of one year.

Interview: NICK KING, HEAD OF ETFs, FIDELITY

Income vs Quality ETFs

The ETF Evolution

CONTENTS