April 2008


Product flow from the ETF sector has reached a torrent. Nick Fitzpatrick talks to investors about their multiple uses and finds one adviser warning of fads. 18_waterfall.jpgONE SMALL SIGN that the heavy marketing of exchange-traded funds (ETFs) in Europe had started to pay off came three years ago when CrossBorder Capital, a London-based firm of investment advisers with 100 major global investors on its books, launched a fund investing only in ETFs. The firm launched the Pulsar Absolute Fund, an equity-based tactical allocation fund that takes long-only positions on indices, which ETFs track, similar to passive index funds.

Then, two years ago, CrossBorder set up a second offering, the Pulsar Macro Fund. This fund is based on equities, credit, fixed income, commodities and currencies and takes long and short positions. But as well as ETFs, it also uses futures.

Both ETFs and futures offer the ability to go long and short, which is increasingly attractive to asset managers, and the two products also step on each other’s territory by offering other tactical and investment advantages with similarities to each other, such as hedging risk.

Consequently ETF providers are battling with futures providers for market share. It isn’t a ferocious battle yet, but ETF providers are upping their game.

Deutsche Bank, which launched db-x trackers, an ETF division, in January last year, recently started telling institutional investors that, in certain circumstances, futures were more risky and less efficient than ETFs, and not necessarily as cheap either.

But what do fund managers make of the two products?

Michael Howell, former chief strategist at Salomon Brothers (London) and more recently ING Barings, is the managing director of CrossBorder Capital, which he set up in 1996.

He explains that the two Pulsar funds are macro-based and invest in country and sector indices rather than individual stocks. Both ETFs and futures facilitate this. Around $100m is invested in the two funds, which have positions in around 25 ETFs. CrossBorder Capital manages around US$300m overall.

“We wanted to take broad sector and country views,” says Howell. “Taking broad views through indices means we don’t have to worry about individual stocks. We don’t need a team of stock analysts and we don’t have to worry about taking a view on, say, Daimler versus Toyota. Instead we take a position on a sector using macro-economic criteria. Taking positions on sectors, such as the US bank sector or the European auto sector, gives us a greater degree of flexibility and more transparency and risk control.”

He adds: “ETFs are an advantage because they are cheap and liquid. Futures are cheaper and more liquid but they don’t have the same breadth of coverage as ETFs. Futures can be too narrow to take broad country and sector views.”

It doesn’t matter so much in the large markets, says Howell. In the US, CrossBorder Capital uses a Russell 2000 future, for example. But in smaller markets like Mexico, South Africa and Brazil, futures are not so active. This is particularly true of industry sectors and more exotic emerging markets.

The view is reflected by Chris Orndorff, managing principal at Payden & Rygel, which uses ETFs and futures in its global equity strategy.

"We use stock index futures, ETFs, and baskets of stocks – essentially creating our own ETFs – to make active country and sector decisions in our global equity portfolios.  ETFs are certainly available for both
South Africa and Mexico and they are liquid."

Breadth of coverage
So although ETFs may not be as cheap or, possibly, as liquid, as futures, at least one attraction is their breadth of coverage. Even if a listed ETF cannot be found, then one can be created in the over-the-counter market, says Howell, who also highlights that for fund managers, ETFs also facilitate product development under Ucits III rules.

He goes on to point out that the relative liquidity constraint of ETFs was eased recently.

“Futures may be more liquid, but since last summer, when the sub-prime crisis began, the market has enjoyed greater liquidity in ETFs. This may have been because institutions and hedge funds have been using ETFs to hedge their risk, which has added to ETF liquidity.”

Howell says there has only been one time when CrossBorder Capital stopped trading an ETF due to liquidity. This was in the Europe Media ETF.

Watson Wyatt, a global investment consultancy, noted in a report about ETFs for pension funds that ETFs
offer “more consistently available liquidity” over derivatives, such as futures and swaps.

Liquidity can also be a problem on the short side. “It can be tricky to go short with ETFs in the smaller markets because of the need to find borrowed stock,” says Howell. “But because we rebalance every month following macro signals from central banks, when we give our prime broker notice to short an ETF, they are normally able to do it easily within a day.” CrossBorder Capital uses Goldman Sachs and NewEdge as its prime brokers. It previously removed another prime broker that was not able to supply adequate liquidity on the short side.

Among other drawbacks, Howell notes that ETFs have to be fully paid for, whereas futures can trade on margin. However, it may be possible to create a contract for difference, which is a margined position comparable to futures, he says.

Orndorff, at Payden & Rygel, says: “The only drawback we see at times is the large management fees imbedded in some ETFs. ETFs are not commodities. In those instances, we just create our own ETF using a basket of stocks.”

Watson Wyatt notes that ETF costs include items that pension funds may not need, such as branding
and liquidity.

Whatever the advantage or otherwise of ETFs or futures, institutional interest is high. To give an indication, Morgan Stanley noted that as at June 2007, total ETF assets were $669bn and average daily trading across all exchanges was $58bn. Morgan Stanley estimated that global ETF asset under managements will be $2 trillion in 2011, and although the vast amount of ETFs remain in equity funds, ETF sponsors have more than 500 new funds filed with regulators awaiting approval for launch.

Product proliferation is seen by Watson Wyatt as a disadvantage because it might make it increasingly difficult for poorly advised investors to separate “the truly useful from the fad”.

Along with product proliferation the number of providers has also risen. Deutsche Bank’s ETF platform, db x-trackers, said last month that it had raised more than e10bn of assets in “record time” since launching in January 2007. Deutsche Bank is now the third largest ETF provider in Europe by assets under management with a market share of more than 10%.

Deutsche Bank said assets under management in ETFs in Europe were e89.17bn at the end of 2007. There are currently 81 db x-tracker ETFs, with 185 listings in Germany, UK, France, Italy and Switzerland.

Manooj Mistry, head of db x-trackers structuring, says that since launch the business has seen ETFs applied to a broad spectrum of uses.

“We have seen large pension schemes and insurance companies using ETFs to equitise cash. They have also used them to get access to new markets or asset classes where they might not have the experience to invest directly.”

He adds: “Funds of funds have  been another area. They use ETFs as an asset allocation tool. If they favour an active manager but can’t find one that they like, they may put their money into an ETF instead.”

Core-satellite porftolios
Mistry also says that private banks that run discretionary businesses use ETFs in core-satellite portfolios. “They put ETFs at the core to get diversification, then the rest is actively managed. Private banks that are being squeezed by clients over fees find this helps them to keep their running costs down.”

Institutions, he says, also use money market ETFs if they get a poor rate of interest on their cash balances with custodians. “They may put their cash into a money market ETF which provides the overnight interest rate less 15bps. With a custodian they might only get Libor minus 100-200 bps.”

Deutsche Bank’s warning to institutions that they may be taking too much risk with futures came from Nizam Hamid, who penned a global market research report. He found that on a six-month horizon, ETFs on the DJ Euro Stoxx 50 Index offer better performance than the future contract.

He also said that research proved that a swap-based ETF on indices where there is no direct future available offers more stable returns than baskets of futures that replicate the index exposure.

He added that baskets of futures have higher tracking errors than ETFs.

Deutsche has come pounding into the market, but iShares, the ETF division of Barclays Global Investors, remains as probably the most recognised provider in Europe. It recently launched two emerging market ETFs on the London Stock Exchange. It also expects assets in fixed income ETFs to grow by over 200% to surpass $200bn over the next three years, as capital market banks look to start trading the products more widely.

CrossBorder Capital uses iShares for the majority of its ETF business.

However, Howell says: “We are also looking at PowerShares, which is offering hybrid ETFs. Whereas iShare’s might give you exposure to a recognised headline index, PowerShares will, for example, pick out just the highest yielding stocks.”

The torrent continues. © funds europe 2008

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