June 2013

EDHEC RESEARCH: New index trackers

PowerlinesDespite a broad range of exchange-traded funds, investors still want more product development. As a result, says Felix Goltz at Edhec-Risk Institute, specialised investments, such as infrastructure ETFs, are in demand. Investors demand more product development when it comes to exchange-traded funds (ETFs) to better address their specific needs, research by Edhec-Risk Institute shows. The Edhec European ETF Survey 2012, which was supported by Amundi ETF as part of the core-satellite and ETF investment research chair at Edhec-Risk Institute, examined investors’ usage and perceptions of ETFs in the region. There are three main areas of the survey where investors see a need for further product development. Most interest is seen in the emerging market equities segment, where 49% of respondents want further product development. Existing products in this segment have seen important inflows with approximately a five-fold increase of inflows between 2011 and 2012. There is interest from investors for further product development in high yielding fixed income assets, such as emerging market bonds, corporate bonds and high yield bonds. While all segments of the exchange-traded product (ETP) fixed income sector have grown in terms of assets in 2012, particularly pronounced increases have been within high yield fixed income sub-sectors such as high yield corporate bonds, which has seen an $11 billion (€8.5 billion) increase, and emerging market debt, which has seen a $5 billion increase. There is interest by investors for development of ETFs based on new forms of indices, with 37% of investors interested in further product development. Interest has increased despite a number of ETF launches, which track new forms of indices – also known as smart beta. In 2011, the institute reported that the ETF market was maturing as usage was not growing at previous rates and had stabilised across most asset classes. This year, however, it can be seen that while this trend has continued for certain asset classes, product development within others has driven significant increases in ETF usage. Corporate bonds, real estate and infrastructure have been particularly in demand. The increased usage of infrastructure ETFs seems likely because of an increase in the range of ETF products available to infrastructure investors. This may be because of the recent emergence of more specialised infrastructure ETF products. For instance, investors are now able to gain infrastructure exposure to individual geographic regions through ETFs, whereas previously ETFs could only provide global infrastructure exposure. The increase in the use of corporate bond ETFs may be linked to increasing interest of investors in passive products for their bond investments. Meanwhile, the availability of alternative bond index weighting schemes has also increased. The broader availability of bond ETFs may allow investors to choose an ETF more suited to their risk preferences. It would seem that continuing innovation of the offering within the industry is a facilitator of increased usage of ETFs within certain asset classes. SATISFACTION
Satisfaction with ETFs has remained high across most asset classes. There have been increases in satisfaction for government bond, corporate bond and infrastructure ETFs. This may also be linked to the fact that there has been an increase in product variety over recent years for these asset classes resulting in a product offering that is more likely to satisfy investor requirements.
Of all asset classes, satisfaction with equity ETFs has been the highest and the most consistent over the past six surveys. Aside from the fact that product variety is greatest for equity ETFs, another reason for the consistently high satisfaction rates may be because they have the longest history, hence investors are familiar with their advantages and their drawbacks. This could also be related to the highly liquid nature of the underlying equity asset class compared with other types of ETFs. Satisfaction rates for ETFs based on the most liquid ETF asset classes are far more consistent compared with those based on illiquid asset classes. For instance, hedge fund ETFs and real estate ETFs have exhibited variation in satisfaction rates between 30% and 65%, respectively, compared with 50% and 95%, respectively, over the past six surveys. In contrast, equity and government bond ETF satisfaction rates have been consistently in the region of 90% and 80%, respectively. This may be because two key attractions of ETFs are their liquidity and efficient pricing, both of which are determined by the liquidity of the underlying assets. Investors are also taking action to mitigate the risk associated with trading their ETFs. There is a clear upward trend over the past four years and the average number of ETF trading counterparties per respondent has steadily increased from 2.9 to 4.1 between 2009 and 2012. CHANGING PERCEPTIONS
An interesting and consistent trend in this year’s survey was increased interest in actively managed ETFs, where an increase was shown in levels of interest across relevant questions. In 2012, 17% of respondents were of the opinion that ETFs should become actively managed, which is an increase from just 11% in 2011. Similarly, other results show an increase in the percentage of respondents who prefer “active” or “active and passive” ETFs. The raised interest of actively managed ETFs may be related to the increased levels of disclosure and transparency which are being imposed on actively managed ETFs by the new 2012 European Securities and Markets Authority guidelines aimed at increasing investor protection. Specifically, the guidelines require actively managed ETFs to clearly inform investors that they are actively managed and to disclose how they will meet their stated investment policies including, where applicable, the intention to outperform an index. However, there is a possible blurring of the distinction between what is considered an active or passive product, which is at least partially responsible for this increased interest. In particular, this may be because of the emergence of strategy indices and smart beta ETFs based on alternative and increasingly sophisticated index construction methods (with regard to both stock weighting and selection), compared with traditional cap-weighted indices. This results in indices with different compositions and risk profiles to cap weighted indices, hence investing in them may not be considered passive in the sense of buying and holding market representation.
However, they are still passive in that they follow systematic and transparent rules as opposed to a discretion-based and opaque active management process. ETFs that track strategy indices can be seen as passive in the sense of absence of discretion or as active in the sense of moving away from a buy-and-hold strategy (cap-weighting). That many respondents were referring to ETFs on strategy indices when they indicated interest in actively managed ETFs was confirmed when the institute contacted those who expressed an interest in actively managed ETFs to investigate the cause of the increased interest. The respondents were asked if an actively managed ETF was one that involved discretion within the investment process. In the majority of cases, respondents were not interested in ETFs involving discretionary decisionmaking by a manager, but instead stated they were expressing an interest in ETFs based on alternatively weighted indices that should follow a systematic approach to their construction. There are differing interpretations among respondents as to what constitutes an active versus a passive ETF, and what appears to be an increased interest in actively managed ETFs is an interest in alternative indexation methods, which are arguably more active than cap-weighting. ETF users predominantly wish to stay with ETFs which track some form of index as opposed to involving discretionary decisions of an active manager. As at the end of September last year, according to figures from BlackRock, there were 3,297 ETFs worldwide managing $1,644 billion. The assets under management within the 1,311 funds constituting the European ETF industry stood at $308.1 billion. Felix Goltz is head of applied research at the Edhec-Risk Institute ©2013 funds europe

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