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Magazine Issues » July-August 2012

ETFs: Everyone is different

ManequinThey are transparent, low-cost, liquid, and they can totally divide opinion. Fiona Rintoul gauges sentiment about ETFs among users and providers.

For Alan Miller, co-founder of SCM Private, exchange-traded funds (ETFs) are the biggest revolution in investment since mutual funds were set up. Miller, whose private client fund management firm uses ETFs as the basis of all its portfolios, believes they are the “modern way forward”.

Why, then, isn’t everyone using them?

In Europe, where institutional investors dominate ETF flows, assets under management in ETFs stood at $264.9 billion (€213 billion) in May 2012, according to a BlackRock report – a bijou amount compared with the €5.4 trillion of European institutional assets run by asset managers overall. Some see this as an opportunity waiting to happen.

“If you look at the size of the market relative to the size of mutual funds, there’s a lot of space for investors to embrace ETFs,” says Steve Cohen, iShares head of investment strategies in Europe, the Middle East and Africa (Emea).  

Certainly, the number of indices being tracked by ETFs is on the rise. John Davies, senior director at S&P Indices, says that more than 30 ETFs have listed against S&P indices in Europe this year – the highest in any year since ETFs came to Europe.

“There has been massive uptake in Europe this year, and that trend has been replicated globally.”

There are also signs that institutional investors are becoming more aware of ETFs and of what they can do – and more inclined to use them. In the Edhec European ETF survey 2011, 63% of respondents said they planned to increase their allocation to ETFs, with just 1% planning to reduce it.

“ETFs are now well known to institutional investors,” says Valérie Baudson, managing director at Amundi ETF. “Four years ago, you could meet institutional investors who didn’t know much about ETFs. Today, that  is rare. It’s a key advantage of ETFs that they are completely known by most institutional investors.”  

But some see roadblocks to very much wider ETF use. According to Miller, some actuaries and consultants have a dinosaur-like attitude towards ETFs – with perhaps just a soupçon of protectionism thrown in.

“More liquidity, more transparency, lower costs: who wants that to catch on?” he says.

And, indeed, most consultants are less whole-hearted in their endorsement of ETFs than are, say,  Miller or the ETF providers. For Chris Sutton, senior investment consultant at Towers Watson, the primary purpose of ETFs for institutional investors is – and probably always will be – to achieve short-term goals.

“They don’t challenge more traditional, long-term index holdings,” says Sutton. “There remain much better, more cost-effective ways of doing that outside ETFs.”

The kind of short-term goals for which ETFs can be useful to institutional investors include transition management, tactical asset allocation, cash equitisation and toe-in-the-water exposure, whereby investors use ETFs to try out a new asset class that they are considering including in their main portfolio.

“ETFs are a good way of learning about new markets,” says Sutton. “We saw it in the commodities markets four to five years ago. A lot of investors went in through ETFs.”

When it comes to tactical asset allocation, the attraction of ETFs is that they allow investors to gain “exposure without complicating their internal set-up”. Lately, this has proved particularly useful on the fixed-income side, as institutional investors both increase and diversify their fixed-income exposure in response to a challenging economic environment.

“They can invest in a whole range of bond markets without setting up mandates,” says Sutton.

Another use of ETFs that has developed since the credit crunch is to create a tactical, more liquid buffer on top of a strategic portfolio.

“Adding liquidity to a portfolio is valued more highly since 2008,” says Cohen.

For Miller, however, the idea that ETFs should be confined to narrow, short-term uses such as transition management is “ridiculous”.

While conceding that very large pension funds can probably allocate a portion of their portfolio to equities more cheaply by investing directly or using a large index manager, he says that actuaries generally “cannot see through the real costs”.

“We can buy the UK economy through a FTSE 100 ETF.” says Miller. “We can buy that at a spread of two basis point and we don’t pay stamp duty. It’s cheaper than buying shares. Actuaries are not thinking about the total cost of ownership.”

Certainly, providers see institutional investors using ETFs in a plethora of ways, including as cost-efficient beta in core portfolios.

“Small to medium-sized pension funds are looking at ETFs for mandate exposure,” says Davies. “Larger pension funds are using them tactically.”

ETFs can also be used on their own or as part of a blended fund.

“The flexibility of ETFs plays to investors using them in different ways,” says Cohen. “Multi-asset funds are using ETFs in portfolios alongside active funds, and in passive-only multi-asset funds.”

Sometimes what starts out as a transition-management investment turns into a long-term holding. “ETFs lend themselves to transition management, but some institutional investors find the experience so positive, they decide to use ETFs for the longer term,” says Cohen.

On the pension fund side, this is particularly likely to be the case for niche investments.

“Pension funds use ETFs for long-term exposure to investments that are less plain vanilla or are much smaller for them,” says Baudson. “In those cases, they don’t want to go into a mandate.”

This helps explain why some of the greatest demand at the moment is for emerging markets ETFs. In the Edhec survey, almost half of respondents said they would like to see more emerging markets equity ETFs developed. Another popular category is volatility ETFs.

“Since the beginning of the year, the largest inflows have been in emerging markets and volatility,” says Baudson.

The desire to control volatility has also meant that plain vanilla products have been popular.

“In very uncertain economic times, people go back to plain-vanilla products,” says Davies. “We launched a low-volatility version of the S&P 500 last year. Powershares listed an ETF on that index that attracted $1.8 billion.”

These kinds of variegated demand patterns mean that providers believe they must have a wide range of products to succeed. Investment consultants, however, see it differently.

“There are thousands of ETFs but only about 10% or less are useful for investors and economic for managers,” says Sutton.

“It gives pause for thought. There could probably be some consolidation and contraction in the market.”

And while Baudson says that institutional investors usually do due diligence on a whole range, Sutton sees the due diligence process for ETFs as being very much about the individual product.

“Not all ETFs are created equal,” he says. “You do have to drill down into the specifics of these funds. It’s fund X versus fund Y. They could be from the same provider or different providers.”

This difference of opinion probably reflects the varying requirements of different institutional investors; an asset allocator may be more interested in assessing a suite of products than would be a large pension fund.

Whatever approach is taken, issues that have concerned investment consultants and investors in the past include counterparty risk in synthetic ETFs and unreported stock lending in physical ETFs. Standards of reporting have improved, however, with companies releasing guidelines on how much stock they will lend in physical ETFs and collateral levels in synthetic ETFs. As a result, providers argue that ETFs now offer better transparency than other investment vehicles.

“The debate we had over the past year was extremely useful,” says Baudson. “Now the level of transparency in ETFs is fantastic compared to the rest of the industry.”

Miller argues that this level of transparency allows investors to make reasoned judgments when investing in ETFs. “How many pension trustees know how much of their portfolio is on loan?” he asks.

In any case, concerns about stock lending and counterparty risk do not seem to top investors’ list of concerns. “First, they want to know if the fund tracks the index perfectly or not,” says Baudson. “The most important risk is tracking error risk. Next comes liquidity and then cost.”

It remains to be seen whether institutional investors will come to agree with SCM’s Miller that ETFs are the modern way to invest, but it seems likely that ETFs’ share of the nstitutional pie will continue to grow over the next few years.

“The European market has a lot of room for growth in terms of adoption by institutional and retail investors,” says Cohen. “There are a lot of regulatory changes coming that
will change the asset management industry landscape.”

©2012 funds europe