The ongoing debate over whether there is a place for exchange-traded funds (ETFs) in institutional pension funds’ investment programmes was given a fresh injection with the recent publication of Beyond the Future: ETFs as Financial Instruments, by BlackRock’s iShares division.
For “certain investors and certain portfolio usages”, ETFs might represent a cheaper route to access equity indices, suggest the authors. Pension funds are among the clients that iShares says are buying into the trend of moving away from futures as the traditional instrument of choice for institutional investors looking for beta and towards ETFs.
“Pension funds are very big passive investors and a number have concluded that ETFs are a better way to access beta than the increasingly expensive futures route,” says Ursula Marchioni, head of equity strategy and ETP research at iShares EMEA.
Futures face the headwind of the increased cost of capital applicable to banks under Basel III and the Volcker Rule. Investors holding long, non-leveraged futures positions will have likely experienced a noticeable increase in the cost of rolling their contracts over recent months.
ETFs, on the other hand, benefit from the tailwind of increasing market share – the industry managed assets estimated at $2.8trn (€2.4trn) as of November 2014. With 5,300 products available they offer a breadth and depth of investment exposure not available in listed futures while becoming cheaper and more liquid, allowing for ever more efficient intra-day pricing and trading.
Pension funds have, of course, been known to use ETFs tactically, to ensure continued exposure while in the throes of transition management, for instance, but Marchioni predicts that strategic use will also increase.
“Approximately 65% of US pension funds already declare they use ETFs for strategic investment, buying and holding for two years or more,” she says, citing Greenwich Associates research (figure 1).
This is driven partly by the increasing savings available compared with other products but also by the additional revenue from lending not only the ETF’s holdings, but the ETF units themselves. “Pension funds can generate extra fees and we see more European pension funds following their US peers into using these investment vehicles,” Marchioni adds.
Tim Huver, ETF product manager at Vanguard Asset Management, is another who believes that strategic use will grow.
“Because of the low costs, pension funds are starting to see possible strategic use advantage in ETFs competing with other products such as funds or derivatives,” he says. “We see this as one of several themes driven by regulation with increased focus on costs.”
“We have seen a lot more interest in ETPs from institutional investors here in Europe, following rapid growth in the US where ETPs are much more on the radar of institutional as well as retail investors,” agrees Bernhard Wenger, head of European distribution at ETF Securities.
“As institutional investors have become more familiar with the product, it opens up conversations with other parties, including pension funds. Many rely on advice from independent consultants and outsourced investment management services that still tend to use traditional investment products.
“However, as the conversation shifts towards convergence of alpha and beta, with new in-vestment themes emerging, and perceptions changing, we believe this is a great opportunity for ETPs.”
Jane Welsh, senior investment consultant at Towers Watson, acknowledges ETFs are a useful addition to the toolkit for short-term exposures. But this comes with an important caveat.
“We have good reasons for being a bit sceptical but we can see the attractions for certain other investors,” she says. “Our clients tend not to take short-term positions other than during a transition process. ETFs will thus remain very much a short-term niche product for long-term investors like pension funds who can usually access the same strategies through pooled funds which have lower total expense ratios and which may be more tax-efficient.”
There are European pension funds making strategic use of ETFs – as testified by some in a forthcoming report from BlackRock and Greenwish Associates (figure 2). Austria’s APK Pensionskasse is among them.
“APK uses ETFs to get exposure at low cost to markets we consider to be very efficient, and therefore less attractive for active managers,” says senior investment manager Poul Thybo. “Although we do not trade very frequently the fact that ETFs trade intra-day is also a nice feature we sometimes use in our asset allocation process.”
But if the stance taken by the likes of Jan Østergaard, investment director at Industriens Pension in Denmark, proves typical, the sell-side might be guilty of premature celebration.
“We do not use ETFs and for the time being do not plan to,” he says. “We have considered doing so, but found, among other things, that tracking error versus our benchmarks was too large and there were some cost issues compared to alternative ways of getting exposure.”
In conclusion, the investment house has long had many mansions. ETFs have moved in and made themselves comfortable. The sell side is convinced they will make their presence ever more keenly felt, but so far the buy side in Europe appears to be keeping its options – and its futures – open.