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Impact investing


ETFs' low-cost index exposure

Exchange traded funds (ETFs), have come a long way since the investment vehicles first appeared on the scene in 1993. Use of ETFs by institutions has snowballed and their popularity is set to keep growing.
“We have seen an increasing customer-base in Europe,” says Bruce Lavine, head of iShares Europe. There is significant usage by asset management firms, hedge funds, internally managed pension funds and a growing number of private bank clients, he says.
“The smart money has been very much exposed to ETFs,” he says. “People have got their feet wet with them, and as they become familiar, they have deepened their use of them.”
According to figures from Morgan Stanley and Thomson Financial, the number of institutional investors holding one or more US-listed ETF or HOLDR (a similar instrument) has grown by 6% during the year to June 2004. Over the past four years, the number of users has grown by 215% from 448 institutions to 1,413.
ETFs are baskets of securities which can be traded in exactly the same way as a single security. They are often based on market indices such as the FTSE 100 or the S&P 500.
One of the reasons that the use of ETFs has increased so much is the wide range of indices that the products are now available on. There are no futures available on a lot of these benchmarks, so where investors want exposure to them, ETFs are a good alternative.
“A lot of people, given that investment has become global, think that it doesn’t make sense to stock pick,” says Deborah Fuhr, executive director and exchange traded funds strategist at Morgan Stanley in London. ETFs provide a low-cost way of getting index exposure, she says.
In investment teams where there are a limited number of people available to stock pick, geographical areas such as Japan can be handed over to ETFs instead. This can make sense, particularly as buying individual stocks at a distance can be time consuming, and the time difference often makes it hard to get the information you need to make good decisions, says Fuhr.
At the end of September, BGI launched the first ETFs in the UK which give access to China and Japan – the iShares FTSE/Xinhua China 25 and the iShares MSCI Japan.
In Switzerland, the Novartis pension fund uses ETFs for tactical reasons within its beta portolio, says André Ludin, head of portfolio management. The pension fund portfolio is a combination of three elements – a safety-portfolio, which contains high-quality fixed income, mortgage and real estate, an alpha portfolio which contains long-term investments in equities, and a beta portfolio, which uses ETFs.

But the British Steel Pension Fund in the UK does not use ETFs at all in its investment management. “We use the underlying assets, so we don’t need ETFs,” says Stuart Colley, the fund’s investment manager. “I can imagine that for rapid asset allocation moves they would be useful, but we have a relatively stable asset allocation… ETFs give you the ability to get in and out quickly, which is not particularly useful for us.”
Similarly, Paul Charles, pensions strategy and policy manager for Diageo, says this fund sees no need for ETFs. “We tend to take a long-term view when we set up our strategy… it is very much viewed as something that doesn’t need to react in the short term,” he says.
However, ETFs can be very useful for pension funds, says Fuhr. The very fact that ETFs are so much more widely used than was the case five or six years ago makes them more useable in some ways. She points out that particularly if investors want to short a certain sector or market, this heavy overall use of ETFs is an advantage,
as it creates more opportunities to borrow.
Morgan Stanley expects both the number of users of ETFs to increase in the future, and the size of investment. It bases this forecast on an exemptive relief which is being granted to a number of ETF managers in the US by the SEC.
In the US, section 12 (d)(1) of the Investment Company Act of 1940 prohibits an investment company from three things. It may not acquire more than 3% of the total outstanding voting securities of another investment company; it cannot invest more than 5% of its total assets in a single investment company and it cannot invest more than 10% of total assets in two or more investment companies.
But over the past 14 months, a number of US ETF managers have been allowed by the SEC to invest in their ETFs above these levels.
As well as this, the implementation of UCITS III in Europe will mean more users and larger investment sizes. At the moment, a UCITS fund is typically only allowed to invest up to 5% of assets under management in other funds, including ETFs that are UCITS compliant.
But under UCITS III, subject to a few conditions, up to 100% of a UCITS fund’s net assets can be invested in other funds.
“With the change in regulations, mutual funds will use ETFs,” Fuhr predicts. The benefit of that additional use will in turn feed through to pension funds, making it easier for them to short or create a hedge using ETFs, she says.
“A number of pension funds do use ETFs as an alternative for futures. We’re seeing people using ETFs in overlays. Often they’re prevented by mandates from using derivatives.”
Chris O’Brien, vice president marketing and sales for Standard & Poor’s Asia and Europe region, says S&P is often approached by people in the pensions industry who want to use ETFs. “We have more and more requests coming in not only from
the pension funds about how these products work, but also from the consultants,” he says.
“People are now putting the opportunity of ETFs in the mandates that are given to managers,” says O’Brien. “They are very pertinent and useful for pension funds.’
Smaller pension funds which might not have the critical mass to manage their own funds could find ETFs useful, he says. Larger pension funds, meanwhile, might be using ETFs not as a core holding, but as a short-term way of rounding out their exposure, he says.
“As the ETFs market has grown, so have the products, also in terms of asset class,” says O’Brien. Whereas the first ETFs were limited to
blue chip stock market indices, today’s range of available ETFs include emerging markets, style indices, sector indices, multiple asset classes including gold, bonds and real estate.
The growing awareness of ETFs and what they can be used for has led to the realisation within investment institutions that they can used them in all varieties. “Originally, they were just used to equitise cash, but now they are used for longing, shorting and implementing inexpensive portfolios,” says O’Brien.

The listing of ETFs in different financial centres has also helped spread their usage. Although Bruce Lavine says iShares is happy to sell its New York-listed ETFs to European institutional investors, it also has iShares which are listed in London, and more recently Switzerland and the Netherlands. Smaller investors and institutions may find it more convenient to deal with iShares that trade in the European time zone, are settled as European securities and, perhaps most importantly, have European tax consequences.
“Also if it’s a UCITS fund, there are limitations on holding unregistered funds… there are good reasons to manufacture locally,” he says.
Though still rising, the growth in ETF products has flattened out somewhat in the past two years. Morgan Stanley data show the number of ETFs rising rapidly between 1999 and 2002, from 33 to 280. Since then, though, the number has only climbed to 304. However, the growth in assets held in ETFs has continued with steady strength.
Fuhr says that, for a while, there were many firms launching competing sector products. In they end there proved to be too many. But now,
by and large, there is a good range
of products for investors to use. So
the explosion in new product launches is over now, but there are still new ETF products in the pipeline,
she says.
O’Brien adds: “Product issuers are now only issuing new ETFs where they can provide unique added value, rather than just doubling up.”

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