ETFs: investors’ flexible friends

Exchange-traded funds have proliferated in Europe, offering institutional investors enormous investment choice and liquidity at a low cost. We find out how and why these products are attracting the interest of a diverse range of investors and look at the future potential of the industry. Dawn Cowie reports

ETF's flexibility is part of their attraction for investors

Ten years after the introduction of exchange-traded funds (ETFs) in Europe and few would have predicted that 85–90% of the users of these passively managed, index-tracking funds would be institutional, not retail investors. Or, even more surprisingly, that hedge funds would have been the fastest-growing group of global users over this period. The compound annual growth rate for this group of active investors was 42.4% over the 11 years to the end of 2008, according to a recent research report by asset manager BlackRock. This compares with 31.1% for other institutions.

One reason ETFs have become increasingly attractive to all institutional investors has been the extraordinary expansion of the range of products across sectors, countries and asset classes. At the end of January 2010, the European ETF industry had 896 ETFs with 2,468 listings. The flexibility that this offers to investors, combined with the low cost and liquidity of ETFs, means that they are now a serious alternative to futures, swaps and index funds as tools for tactical and strategic investing.

However, ETF issuers still have work to do educating investors before the market realises its full potential. “In many cases, institutions would rather use index funds or futures in implementing a specific strategy or idea, but a number of funds are discovering that ETFs can sometimes provide a more flexible and efficient solution,” says Jay Bennett, a consultant at Greenwich Associates in New York.

A recent Greenwich Associates survey of US institutional investors found that the most common use of ETFs was for tactical adjustments to their portfolios – for example, to temporarily take an overweight or underweight position relative to their target portfolio. This was a strong trend towards the end of 2008 when market volatility was at record highs and investors wanted to shift their money into a more stable asset class while having the flexibility to react quickly to intra-day market movements.

“A lot of investors bought commodities via ETFs when the crisis was at its peak as a way to invest outside of equities and fixed income,” says a spokesperson for Easy ETF in London. “The advantage over index funds was that the money could flow in and out during the same day if needed as opposed to being penalised on a net asset value basis for falls in the underlying during the day.”

When an investor wants to make a large adjustment to a portfolio in a short space of time, an added benefit of using ETFs over index funds is the ability to go direct to an issuer that will create new units of that ETF. This is a substantial advantage over placing a large order via an exchange and facing a distortion in the trading price.

A rival to derivatives

Futures and swaps, which have been used to gain tactical market exposures, have also come under pressure from the expanding ETF market. The Greenwich Associates survey found that the second most common use of ETFs by US institutions was for cash equitisation, which is the management of inflows and outflows of funds. If an active manager gets an inflow of money from a client, he can use an ETF to get short-term market exposure, rather than having the money sit idle in cash for several weeks acting as a drag on fund performance.

Futures have traditionally been used for these purposes because they are the cheapest way to get access to an index. On price, futures do still have the edge, according to industry experts, but there are only 70 to 80 truly liquid futures contacts compared with a choice of more than 2,000 ETFs. “The Eurostoxx 50 is a very liquid futures contract but, if you look at Turkey, the country ETFs are much more liquid than the futures market,” says the Easy ETF spokesperson.

With ETFs, investors do not need to think about collateral management and the financing needed to meet margin calls as they do with futures, says the spokesperson. Another advantage of ETFs for investors that are not active players in the futures market is the ability to avoid having to manage the roll risk or basis risk as you roll from one forward contract to the next on expiry, he says.

Sector swaps that are popular with hedge funds have also lost ground to sector ETFs during the financial crisis due to concerns about counterparty risk. Sector ETFs are fully collateralised and also have the benefit that you can trade into an ETF with one counterparty and out with another. Industry experts say active investors will continue to trade futures and swaps where they can find the appropriate product but the additional documentation and risk management involved in trading derivatives may deter other institutions.

“Traditional long-only money managers are becoming more sophisticated but they may not be set up to trade futures or swaps,” says Matt Johnson, head of European equity derivatives flow sales at Bank of America Merrill Lynch in London. “ETFs enable them to hedge positions and get exposure without the operational burden of other alternatives.”

Another major driver of the European ETF market has been the growth of asset allocation strategies by institutions seeking a broad range of market exposures. “Managers who run balanced funds or multi-asset-class funds are probably the most natural ETF clients,” says Dan Draper, London-based head of ETFs at Credit Suisse. “They are top-down asset allocators and use ETFs not only for cash management and portfolio rebalancing but also more broadly in the core part of their portfolio and for longer time horizons.”

Deborah Fuhr, global head of ETF research and implementation strategy at BlackRock in London agrees. “Institutional investors have really embraced ETFs as low-cost beta building blocks, which is especially true for the growing number of firms developing multi-asset-class strategies,” she says.

Some managers construct for their clients a fund of funds purely based on ETFs as a low-cost way to create a diversified portfolio. Much of the distribution of these multi-asset-class funds is through third parties to retail investors. “As people increasingly have to take care of their own pension requirements, the multi-asset-class investment approach is getting more popular and using low-cost products such as ETFs in these strategies is becoming more attractive,” says Draper.

The popularity of diversified funds of ETFs has also grown during the financial crisis as many institutional investors and pension funds have become disillusioned with active management after paying 1.5% fees for products that have been underperforming the benchmark. Long-term holders of ETFs can also earn securities lending revenue that can offset some of the annual cost.

However, index providers are fighting back. “The US index fund market has moved aggressively with their pricing to stop the flow of business to ETFs and the same thing is happening in Europe. Asset managers have been either developing their own ETFs or getting competitive with their index funds,” says the Easy ETF spokesperson. Index fund fees have come down from 1% to between 30 and 60 basis points, he says.

Active strategies

More active investors are also including ETFs in core-satellite investment strategies. One form of this is where managers construct their core holdings using ETFs to deliver benchmark returns, while leaving room for tactical moves on the fringes of the portfolio that will generate alpha or a return in excess of the benchmark. Core holdings have increasingly comprised emerging markets or commodity ETFs, areas that may be outside the core expertise of European institutional investors. In March, ETFs were launched in Saudi Arabia and Abu Dhabi, and the potential market for ETFs offering exposure to other hard-to-access markets such as China and India is huge.

“Emerging markets products generally constitute about one-third of total ETF volumes. Many institutional fund managers in Europe do not have the speciality research or the ability to trade in local emerging markets so they use ETFs as access vehicles to broaden their portfolios,” says Draper. This goes back to the theory that if you get your asset allocation correct, 90% or more of your returns will come from that, not individual securities selection.

Core-satellite strategies can also work in the opposite direction, giving active investors a lot of flexibility. Fund managers bet on their expertise as stock pickers to select a core portfolio that will beat the benchmark and then use ETFs as satellite investments to generate additional alpha by taking short-term directional views on a sector, country or asset class. ETFs can also be sold short to protect the core portfolio against market losses.

The shorting of ETFs is quite mature in the US, driven by hedge funds activity. In Europe, shorting of ETFs it is just starting to take off, driven by Source, a consortium of investment banks with strong prime brokerage businesses serving the hedge fund industry. Source is creating sector ETFs to lend to clients in the same way as they would with a sector swap. This trend could be an important way to boost the liquidity of the ETF market. However, it will take time to educate traditional investors about the benefits. “When you are shorting or using ETFs as collateral, they must be recognised by credit committees and risk management within institutions. It is a growing market in Europe but the educational process is still ongoing,” says the Easy ETF spokesperson.

Inverse ETFs, which allow investors to buy the negative performance of the index, are also used by active institutional managers such as hedge funds and day traders, but are not held for more than a day or two because the falls in the index compound each day and the trader would ultimately lose his entire investment. Some of the most actively traded inverse ETFs are provided by Exact from Handelsbank in Stockholm.

Over the past decade, the European market has evolved in a distinct way from the US market in terms of its much lower retail take-up. Another difference is the growth in Europe of synthetic ETFs, which provide the performance of an index via a swap as an alternative to fully replicated ETFs, where the client owns the stocks that make up the index.

One clear difference between synthetic and fully replicated ETFs relates to the stamp duty that investors must pay when they physically buy UK stocks. This affects only fully replicated ETFs and therefore increases the cost as well as the tracking error relative to a synthetic ETF that is tracking the same index. Synthetic ETFs may also have the edge in emerging markets, where it is difficult to hold the physical shares.

“ETFs can be the right vehicle for exposure to emerging markets if they’re listed in the right place and transparent enough in terms of what is in them and how they are traded,” says Jorge Soltero, head of Delta One trading at Bank of America Merrill Lynch. “Some indexes in the emerging markets space are… better replicated synthetically using swaps.”

On the other hand, investors are exposed to greater counterparty risk with synthetic ETFs, a sensitive issue since the financial crisis. There is also uncertainty about whether risk departments at fund management firms will accept synthetic ETFs as genuine exposure to an index.

Although both models have their place, competition is merely adding to investor uncertainty about using the products, rather than encouraging take-up. “The market is very fragmented and it is only getting more so with new entrants in the issuer space. There are 19 Eurostoxx 50 ETFs without taking into account multiple listings, and no ‘go-to’ provider or instrument has emerged,” says Soltero.

Another area of innovation is the emergence of active ETFs, where the ETF tracks an actively managed benchmark such as the indexes created by InvescoPowerShares in the US. There are currently fewer than 25 products globally that are active to some degree, says Fuhr. “As demand for ETF-type products grows and the industry hits $1 trillion, I think it is important to remember that an ETF today is essentially an open-ended index fund, with transparency on the underlying asset and an indicative net asset value and in-kind creation and redemption that is listed on-exchange,” she says. “As products move away from a fund structure and those key features, they should be given another name so that people really understand the products.”

So, although this experimentation creates flexibility for users, it could be risky to overwhelm the market with new ideas while European institutional investors are still getting comfortable with the basic products and before most retail investors have even entered the market.