Traditional institutional index funds are a major barrier to ETF success, at least in the UK pensions market, our panel on ETF industry development hears. Though smart beta could change this. Edited by Nick Fitzpatrick.
Tom Caddick, head of global multi manager, Santander Asset Management
Simeon Downes, investment analyst, SCM Private
Pedro Fernandes, head of European exchange-traded products, NYSE Euronext
Neil Morgan, senior advisor, AllenbridgeEpic Advisers and senior pension trustee, Capita Asset Services
Fannie Wurtz, head of ETF sales, Europe, Amundi
Funds Europe: Are the increased inflows to passive investment funds reaching ETFs, or are they going to the more traditional index mutual funds?
Fannie Wurtz, Amundi: Last year, of the €38 billion of new assets flowing into passive funds in Europe, 45% were into ETFs and the same trend is continuing in 2013. These products address two complementary markets. There is no cannibalisation between them as they both point to growth in index expertise.
ETFs are used mainly by asset managers and they are getting more traction with institutional investors and pension funds.
But index funds traditionally have been used more by the asset owners.
Index funds are concentrated into flagship exposures, but people going to ETFs are doing so more for their flexibility, tactical asset allocation, and innovation.
Neil Morgan, Capita: For the vast majority of UK pension schemes, exposure to passive investment is through institutional pooled index funds provided by the key passive managers. There’s really no great appetite at all in the UK institutional space for ETFs – though it may be different for smart beta ETFs.
Simeon Downes, SCM Private: What I find interesting is that pension funds in the US use ETFs for a whole variety of purposes. Usage is much lower in Europe, perhaps about 15% in the US compared with only 1% in the UK. So why is it so different? This is hard to understand.
Morgan: In the UK, at least it’s just a matter of costs. You can get exposure to a well-known manager’s UK tracker fund for 2bps-5bps. My experience is that ETF total expense ratios (TERs) are more expensive.
Pedro Fernades, NYSE Euronext: A lot depends on how much value a pension scheme places on the liquidity and intraday flexibility.
Morgan: Yes, that may be the case. There is a price for intraday liquidity and maybe US pension funds value that. But this would seem a bit silly from the UK perspective, because pension schemes have got long investment timelines. Even more mature schemes have ten to 15 years before they wind up, so they don’t really need that intra-day liquidity. If you’re paying an extra fee for an ETF, I don’t think schemes actually need ETFs to get passive exposure.
Tom Caddick, Santander AM: I’m not sure about the liquidity argument because ETF liquidity is markedly different in the US to the UK. There is more off-exchange trading in Europe and on-exchange trading in the US, meaning there is more liquidity in the US than in the UK.
Wurtz: Pension funds in Europe are interested in the innovative strategies and solutions offered by ETFs that are often not available through index funds. Indeed, the range of index funds is quite limited to large plain vanilla exposures. As Amundi is also an index fund manager, we believe that each product meets different needs.
ETFs offer institutional investors, such as pension funds, the flexibility either of being used for tactical bets or being held as longer strategic positions because their performance is good. They are also useful when the size of an exposure is too small to have a dedicated mandate or for transition management.
Morgan: Pension schemes certainly use ETFs for transition management, but that’s just a very temporary use. Of course, they use futures contracts as well, which are usually cheaper and can be used to access the more inefficient, esoteric markets and asset classes.
However, ETFs can be used to access the more inefficient, esoteric markets and asset classes. But most consultants will recommend active managers so it’s difficult to argue that ETFs are going to be used more heavily in the near future, because pension schemes are quite happy to use active managers and institutional pooled funds for traditional market-cap exposure.
Downes: Isn’t it more about choice than one or the other? You can pick what the best tool is. If you can access the S&P 500 for 2bps, great, don’t buy an ETF. But if you can access US high yield bond indices most efficiently and cost-effectively via an ETF, then surely a pension fund would see the advantage of an ETF?
Morgan: Pension schemes do need to make a comparison. They have to decide how they are going to approach their objectives, with either active or passive mangement. Then they need to look at what yield they need; then they’ve got to look at using either pooled funds or, if they are big enough, segregated mandates – and ETFs too, in theory. But if most ETFs are more expensive in general, then consultants will probably tend not to look at them.
Fernandes: When we look back at 2007 and 2008, we had days when indices were dropping between 4% and 6% in Europe. At this time, it’s highly valuable to have ETFs within a portfolio, because investors can exit in real time. Now that volatility levels are lower and investors feel more confident, they may not feel the need to use ETFs, thus the value of intraday liquidity tends to be lower.
Morgan: There are one or two pension schemes I know of that have incorporated ETFs as liquid intraday vehicles in case some major event happens; but, in general, pension schemes have got other ways of hedging against tail risk.
Fernandes: When we speak about costs and compare index funds and ETFs in Europe, yes, indeed the average fee of institutional index funds is lower than the ETF fee. However, in the US, markets are more mature, highly competitive, and their costs have been coming down year on year.
Downes: iShares and UBS are cutting prices, so that trend is happening in Europe, too.
Fernandes: Yes, but we are no where near the same levels that we are seeing in the US.
Wurtz: What about the issue of portfolio contruction? Pension funds, asset managers and private banks can all use ETFs as a complementary tool to traditional passive and active strategies. How they allocate depends on their liabilities and investment horizons.
Caddick: Yes, it’s not a binary decision between ETF versus traditional passive. I don’t care which product we use as long as it is the right one for a particular market and strategy at any one point in time.
But the US is cheaper than Europe and this is the reason there is not a big difference between usage of the two fund types there. Passive funds have probably got close to a floor in terms of costs, and ETFs are coming down.
ETFs are getting cheaper largely due to demand, but there have been other factors, and liquidity is one. Why is off-exchange activity so much higher in Europe? If there were more on-exchange activity spreads would tighten. I agree there is a movement on price now, but we’ve a long way to go.
Downes: The US is essentially one exchange; in Europe we have lots of different regional exchanges. This is part of the problem.
There have been advances. iShares has made it possible to buy their best value and most liquid ETFs across all exchanges, but that’s only one development.
Fernandes: The post-trading level is where you find most of the frictions and fragmentation. In the US there is one entity where ETFs are cleared and settled via the DTCC [the Depository Trust and Clearing Corporation]; in Europe, there are multiple CCPs [central counterparties].
Morgan: A number of UK pension schemes invest in ETFs, but do not realise it, because diversified growth funds use ETFs and these are very popular with defined benefit and defined contribution schemes. They use ETFs for exposure to gold, for example. And also the trend towards fiduciary management in the UK requires a full or partial delegation to a manager and can make use of ETF vehicles.
I know of a few larger schemes that are looking at ETFs as a vehicle to get certain exposure. They are large scheme with the in-house ability to compare and contrast between institutional pooled passive funds and ETFs.
There hasn’t been much enthusiasm from the consultant community. Quite rightly, this is based on the fact that costs are higher and for some of the more esoteric markets, active management may be the best approach.
Funds Europe: Would you agree that active managers are best employed in inefficient markets, such as emerging markets, or less researched sectors like small caps, while a passive approach is more suitable for efficient markets?
Caddick: It’s easy to come at it from that angle, and I wouldn’t violently disagree, but it also makes sense to consider how consistently successful active managers are in some of those markets. I am an advocate of active management and we are always willing to pay for actives where justified, but in some of those markets it is difficult to find true consistent outperformance.
Even if you look at some of the more efficient markets, some of the sector rotation decisions and some of the stock drivers that can come in to play still means that there’s plenty of alpha to be had.
But there is also a case for using passive investment for easy tactical access and as a core part of your portfolio in some of those inefficient markets.
Downes: In terms of small cap exposure, it’s very hard to get the exposure that you want. Choice is restricted because liquidity isn’t there, so you pay the active manager to be aware of that.
In terms of the larger, more efficient markets, if you do not want cap-weighted exposure then maybe active is better in certain cases, maybe not; but if you look at it from a factor-based model perspective and find you have a passive option, potentially that has many more advantages over active management, including costs.
Wurtz: Clients want to avoid too much concentration and seek diversification, and this can be achieved by mixing active and ETF investments to build a well balanced portfolio.
One can also implement active asset allocation by using passive investment vehicles.
Downes: As a passive investor you can choose exposure to a particular market if you think it’s undervalued. The point of clients investing in ETFs is that we will make the call as to what we think is undervalued and overvalued.
Fernandes: To add value, it is vital that fund managers have local expertise to manage active emerging market funds.
Morgan: Most people would agree that developed markets are really efficient. It is difficult to get alpha from active management in developed markets. By alpha I mean the sort of extra return you get from skill, and by active equity management I mean a discretionary stock picker. It’s difficult to find discretionary stock pickers who are consistently good over any particular time period.
But in the emerging markets you are probably more able to find managers who tend to outperform, so in these slightly more inefficient markets, which aren’t looked at as much, then perhaps an active approach can be better.
Caddick: Investors run the risk of getting caught up in broad statistics that tell them active management doesn’t provide consistent outperformance. I refuse to give up on the belief that active management is dead as the evidence tells us that alpha can be generated, just not en masse. But of course this is consistent with the definition of alpha.
Active investing for us will come through in a number of different levels. We are typically looking to deliver controlled beta with flexible and diversified alpha. As a long-only investor, beta is going to make up the majority of our returns over time, but we can try to eke out alpha within that.
Fernandes: ETFs are helping to clarify what is active alpha generation and what is not. There are still a lot of active funds where the fund manager focuses on the benchmark, but operates as an active asset manager.
Morgan: Over the past five years or so it has become a little more evident that there is some skill in active management in developed markets – at least where you have a focused and concentrated portfolio.
Some of the studies that have been carried out on the benefits of active management have included the closet indexers and the benchmark huggers, who we all know are going to under perform after costs because they’re not doing anything different from the index.
There is some evidence that focused funds could be included as part of a growth portfolio for pension schemes.
Funds Europe: How should an institution choose an ETF product? Which are the main considerations, taking into account factors such as liquidity, size and tracking error?
Downes: You look at the structure of it. Is it synthetic or physically replicated? If it is physical, is the provider engaging in stock lending? That’s a question you should always ask: What percentage of stock is being lent out? In terms of liquidity, size does matter, but you have to accept that a new ETF is not going to raise a billion dollars instantly.
Morgan: A pension scheme has to start by looking at its objectives and what it wants to achieve, and then decide which vehicle it wants, whether ETF or not. I think it’s very rare a pension scheme in isolation would buy into an ETF, but certainly, diversified growth funds are doing that.
Then the diversified growth fund manager would look at all the usual issues, like fees, the annual management charges, TERs, product complexity, turnover and transaction
costs – and, of course, the replication methodology.
In short, you need to look at the whole market place. It deserves as much attention as that which consultants traditionally have given to picking an active equity manager. There are so many products out there, especially in the ETF space, and if you are comparing them, there are so many things to compare and contrast before you can come to a definitive answer about what’s best for the scheme or the fund.
Wurtz: For ETFs specifically, it’s all about tracking the index properly. You need to look at the tracking error to know you are not 1% above the index one day and 1% below it the next.
It’s also about cost – the TER – because you want to buy the cheapest ETF available tracking any given index .
Finally, it’s also a question of the liquidity of the underlying index, especially in the fixed income world where you can find differently constructed indices representing the same asset class. Varying index methodologies will imply different levels of liquidity for the corresponding ETFs. This is also true in the world of smart beta indices where methodologies can differ significantly.
Downes: The sensible thing to do is look at the spread. If the spread is tight, that’s probably okay, because the chances are there are enough market makers there. You can have spreads that are 5 basis points, versus 1.5% on the same-size bundle.
Fernandes: Although it is important when you launch a product to ensure that the underlying market has some liquidity, I would not put a threshold on that.
Essentially, an ETF reflects the liquidity of the underlying assets, and putting a threshold where you won’t trade if liquidity is below a certain point may not be the right thing to do. The underlying asset faces the same liquidity problem. An ETF provides a more efficient way to access the underlying liquidity.
Funds Europe: Liquidity is one of the attractions of ETFs, but is daily liquidity really of great importance to long-term investors?
Fernandes: It depends on your strategy on whether it’s short-term or long-term. It should be noted that even with a long-term strategy you can always value in the fact that if there’s stress in the market then you can get out intra-day.
Caddick: It might be said there is a nonsense to this concept of a long-term investor being concerned about intra-day moves, but the reality is that even a long-term investor has to plan both their entry into and, more importantly, their exit from a position.
Morgan: Pension schemes don’t need intra-day liquidity. A pension scheme can trade institutional pooled funds within 24 hours and 48 hours if it needs to. There may be some schemes that have a very small amount of ETFs and use them for the intra-day liquidity, but this will be for a specific type of temporary event, like transition management. However, diversified growth funds and fiduciary managers may take advantage of the intra-day liquidity, too, to invest tactically and opportunistically.
Caddick: Yes, for that reason alone – liquidity and mark-to- market valuation – we would use ETFs at the margins. We’d use them more wholesale for other reasons.
Wurtz: Liquidity may not be the most important feature for long-term investors who may find ETFs interesting for other reasons, such as overall cost and the quality of replication as illustrated by tracking error.
But while some long-term institutional investors may chose to trade ETFs at end-of-day NAV [net asset value], others may wish to trade more actively during market opening hours and benefit from the flexibilty provided by an ETF.
Funds Europe: What is smart beta and where is the dividing line between beta and alpha?
Morgan: A crucial point about smart beta – which can be considered as an alternative way of weighting stocks – is the criteria by which those stock weights are determined. Smart beta indices are rules-based Ultimately, pension schemes will be comparing the performance of the smart beta portfolio with a traditional market-cap index. Smart beta is not going to replace market cap as a benchmark.
Alpha is just a skill-based extra return you supposedly get from a fund manager who picks stocks on a discretionary basis. There’s not much evidence that that’s successful, but focused portfolios may be an exception, as I mentioned previously; however, there is evidence that virtually all smart beta portfolios outperform market cap-weighted indices. You can try any smart beta strategy; it works. Most of them work very simply because they tilt towards certain factors, like value, which has outperformed over the longer term.
Trustees and their advisers have to decide how much market cap exposure they want, and whether they want any discretionary stock picking active management, which is quite expensive.
If they want some outperformance, they should really be looking at smart beta, because you can get exposure to these value or small-cap tilts very much more cheaply than with traditional active equity.
The ideal composition going forward, in terms of the growth part of a pension scheme portfolio, would be a mix of diversified growth funds, traditional market cap-weighted index funds, and also some smart beta exposure or a mixture of different smart beta portfolios where one is more value-tilted, like fundamental indexation, and one is more small-cap focused. Most trustees and advisers recognise that the returns from smart beta have been better than those from market cap indices over the last 40 years, whether due to risk premiums, or behavioural aspects.
I don’t see that as going away any time soon. Smart beta is a more effective way, probably, to get outperformance relative to traditional market-cap benchmarks rather than going for a traditional active equity manager, where results are going to be much less predictable.
Fernandes: When I think about smart beta, I think about it as transforming active management strategies to systematic and rule based conventions. The indices are bringing more and more of the alpha that the active managers used to deliver, and in a very industrialised way.
Morgan: Yes. The implementation, the transparent construction methodology, is all very mechanistic. All they’re doing is harvesting these very well known stock anomalies or risk premiums that have been round for a long time.
Wurtz: For the moment, the offer is only just starting. It’s of intellectual interest, but flows into the smart beta ETF space so far remain modest. However,we are convinced that this type of innovation will be an axis of product development.
The important factor to bear in mind when looking at smart beta strategies is that it may be difficult to find a basis for comparaison. Unlike cap-weighted indices, where the methodology is simple and identical for all the index providers, you can have different indices. For example, in minimum volatility, where performance will vary according to the provider’s methodology.
Morgan: Some active management outperformance at present is what we know now as smart beta, just that it charges more money for what should be a fairly straightforward process.
There have always been style biases in active portfolios – such as value and growth, small cap and large cap – so, to a large extent, we’ve had smart beta already. But smart beta offers cleaner exposure and different ways of getting exposure. For example, a small cap portfolio tracks a small cap index, but an equal weighted index also has a small factor tilt, though that’s perhaps a less clean way of accessing the small cap factor.
Caddick: Again, we are in danger of writing off active management with some fairly sweeping statements, wrapped up with smart beta hyperbole.
It strikes me that this is a natural, and probably fairly healthy evolution within the market. Some active managers have been using a very mechanistic approach. There were times when that worked and times when it didn’t. It seems a perfectly natural evolution to start taking those active approaches that are more mechanistic and industrialise them. It presents a healthy challenge to true active management.
Again, investors need to make the decision about what the right approach to a target exposure is. If the evidence is that a particular strategy is desirable and that strategy is mechanistic and can be delivered through a low cost smart beta approach then it is logical to potentially select this approach. But smart beta is not the panacea to consistent outperformance, just a healthy challenge to traditional active management and potentially outdated cap-weighted indices.
Morgan: One of the issues here is that market cap is just a very inefficient benchmark because they are driven by price and there is a lot of concentration in indices. You only have to look at the tech sector in the S&P 500 back in the 1980s. It is a momentum-driven weighting strategy.
One of the issues the industry has to address is just how wedded to market cap are we going to be in future? Given the weight of money that’s already invested in market cap, obviously we will be very much wedded to it; but I think there are smarter approaches around, and we need to recognise that market cap weighting is not the most efficient way of putting together a so-called passive portfolio.
There is perhaps more traction in the ETF market in the smart beta space because, as pension schemes come to look at smart beta, there’s a little bit of a herding effect. But the key players in the traditional pooled index fund space are now developing smart beta portfolios and products.
Funds Europe: Finally, what is the outlook for growth and the success of ETFs in the European market?
Wurtz: In continental Europe, we see increasing usage by institutional clients, especially in the less mature markets in the south. Institutions in northern Europe already use them extensively and the market is a bit more mature. There is definitely room for growth of distribution channels with regulatory changes such as RDR [retail distribution review] in the UK and elsewhere, which will encourage retail investors to look at ETFs. Innovation will be a key growth driver as new products, such as hedged ETFs or fixed income ETFs classified by rating, are created to meet institutional clients needs.
Downes: The ETF market in Europe is growing, but to give a sense of perspective, the first ETF in the US is 20-years-old. The first mutual fund-type structure goes back to the 18th century in Amsterdam. The first unit trust in the UK was in the 1930s.
They’ve had a lot of time to develop. The ETF market is not mature yet. It’s got a long, long, long way to go.
Morgan: ETFs will be a slow-burn in terms of UK pension schemes entering the market. Fees and TERs need to come down to a much lower level than where they currently are to compete with institutional pooled funds. But I think in the smart beta space pension schemes will certainly be looking at ETFs, so the ETF market could gain some traction in that area.
Caddick: The European ETF market is looking in pretty good shape now and for the future. Having said that, to become truly mainstream, we’ve got to see some pricing action, downward pressure on price, and improved efficiency within that. More on-exchange activity, tight spreads and low prices will mean we can start seeing these become a permanent staple.
Fernandes: Clearly, in Europe, we have some distance to go in terms of catching up with the US retail market. Whether we can reach those levels of usage remains to be seen. RDR changes will help encourage investors in the UK to look at ETFs, as retail intermediaries are beginning to see increased flows from retail investors. In addition we are starting to see changes across Europe with the Netherlands also implementing changes in January 2014. On the institutional side, there are still products out there that are more competitive than ETFs, but I think ETFs will close the gap and we’ll see pension funds and other institutions investing more in ETFs than they are doing today.
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