Needing to be convinced
For European pension funds, Exchange Traded Funds, or ETFs appear to be at the ‘conference’ stage – generating some talk in the market, but as of yet translating little into a serious investment proposition.
Many schemes are aware that ETFs are open-end investment funds that trade on a securities exchange.
Few seem to have drilled deeper yet to see how they may be used to index core holdings or pursue more sector rotation strategies.
Debbie Fuhr, vice president at Morgan Stanley in London elaborates on the applications of ETFs that she believes can appeal to institutional investors. The first potential use, she explains, is for equitising cash flows.
She cites the example of a scheme managing an MSCI euro fund, which receives a small amount of cash – in the order of e20,000.
“Rather than sitting on bits and pieces of cash which could cause cash drag and misperformance, with an ETF you can buy a single security, as opposed to sitting on cash or just picking one or two names. The challenge is that with small amounts of money if you buy or overweight one or two names then if it’s not an active product you are running, what you find is that you suffer mistracking.
“Additionally, if you are running funds internally you often don’t have time every day to pick one or two names to equitise cash. ETFs are a tool to use. Many funds will use futures for this very purpose, so ETFs are an alternative to using futures or carrying out a programme trade.”
Similarly, Fuhr explains that for cash management the story is similar.
“It looks at both sides of the equation – money coming in and out because people are redeeming. Here if you hold 3/4/5% of your fund in an ETF, then if someone redeems, rather than having to pick one or two names to sell, you sell off the ETF to raise cash. Investing in an ETF just makes managing the portfolio more efficient.”
Alternatively, she notes that, in the past, European pension funds have used active managers to get exposure to Asia or Latin America, where because of the time difference they didn’t have the necessary stock picking abilities. Here she believes ETFs could also be a useful tool.
Sector rotation is another area where Fuhr flags up the potential of using ETFs. “You don’t have futures on complete families of sectors. There are none in the States and a few in Europe. What’s happening is that as people find more that the performance of a stock is driven primarily by the sector analysis as opposed to the country of domicile, then you look for tools that allow you to implement sector tilts. Capitalgest in Italy recently got approval to launch a fund of funds that exclusively use the Eurostoxx sectors as well as another one for the FTSE global sectors. Their idea is that their expertise is in sector rotation – if you believe, as many people do, that asset allocation is driving performance then investing in the individual stock is not going to get you very far.”
Again with hedging, Fuhr notes that at the same time as shorting the market, a fund may also want to own the same stocks through an ETF: “If you do also own those shares then by doing the same strategy it gives you a form of protection and can lower the amount of loss that you might incur.”
Lastly, Fuhr explains that for some pension funds the use of ETFs could be instrumental in building an international portfolio. “This depends somewhat on the benchmark required, or the in-house capabilities of a pension fund for trading and settling a whole bunch of names.
“As an example, there was a spectacular EAFE ETF trade recently where an investment manager won a mandate to invest $2.25bn in cash. The option then is to pick from 50-100 names, or if you pick a very small subset of that because that is all your back office can handle then your tracking error is huge. However, using an ETF allows you very easily with a single security to go and get very broad exposure. People will do this as part of a transition, so it might make it easier now, but also when you transition the portfolio to another manager.”
While Fuhr offers her view on the potential advantages to be gained in using ETFs, she is also conscious that this will not be an overnight investment story for European institutions.
“The number of people looking at ETFs and asking to know about them has increased significantly. It’s unusual to typically take a lot of calls from a client asking to meet up and talk about ETFs. But, over the last six months the frequency of that has increased a lot. I think what is going on is that we are getting more mentions about ETFs in the press and people at least have to know what these things are. It’s not always that they are keen to start using them straight away, it’s just that they need to know.
“Having said that, I do find that a number of pension funds are looking more seriously, particularly now as there are whole MCSI families of sectors and the FTSE global sectors, and so on.”
The other challenge with ETFs, she explains is the educational battle. “The first issue is to understand that the liquidity on an exchange is not representative of how liquid ETFs are. The second is the question of who can use and get approval to use ETFs. Many asset managers, for example, in the UK, have had to go back to their investors to get their approval to include ETFs in their portfolio. This makes the process quite slow.”
For the most part, Fuhr believes the trend in Europe will mirror the US somewhat in that fund’s will start to give their investment managers discretion to invest in ETFs.
“I believe this will happen, although there are markets such as Holland where pension plans manage much of their own assets and where I have seen plans using ETFs and are planning also on using them for sectors.”
On the ground amongst pension funds, Fuhr’s approximation of the story so far for ETF use certainly rings true – few schemes have any detailed knowledge of ETFs, fewer still have considered investing in them.
Geof Pearson, pensions manager at the approximately e4.5bn pension fund for UK retailer J Sainsbury, is one scheme manager who has looked at the concept of ETFs following the invitation to attend a conference in the US a couple of years ago. “At the time it seemed a really useful thing for us because, for example, UK pension funds have typically got a high equity content in their own country, so you get effects such as large holdings in Vodaphone, BP, or Glaxxo.
“At the time the TMT and automobile sectors were hitting big and the idea was that you could get an ETF for a particular index, for example. In effect you could buy ETFs for these sectors.”
Pearson explains that he then went away and looked at whether the ETF route was a viable way of making sure the fund had a better exposure to the world markets on a sector basis.
“Obviously we are now very grateful that we didn’t invest in this particular way! If we had gone down this path though, the bits that we would have filled in would have been those where the UK was a bit light.”
Generally, Pearson believes that ETFs is not a subject that has set the UK pension market alight. “I remember that when I got back from the conference it was a subject where very few pension schemes seemed to know what I was talking about.
“In this industry it is normally quite good to impress people with your knowledge, but in this area there is not much knowledge.”
“In the States, of course, it is a much bigger industry. It’s probably two years or more since I went to the conference, but I remember that there were quite a lot of technical issues being discussed. It was certainly being sold as an indexing conference with lots of funds invited that held great big chunks in passive funds. The message was that this might be a way of enhancing performance in a cost efficient way. We had a good look at it and we decided that an alternative way of achieving our goal would be to dilute our UK equity holdings into overseas equities.”
Herve Noel, deputy director at the Brussels-based, e1.2bn Tractebel pension fund, says the fund doesn’t use ETFs, explaining: “We already have index funds and passive management and we have good expense ratios on these funds.
“The way I view ETFs is that they are much more designed for individual investors. I think there is also a question of reliability and how they track the index, etc. I have to say that although we haven’t really looked at this very closely.”
So despite their uses within institutional portfolios, the reaction of pension practitioners generally has been muted and uncertain. This should not be taken as thumbs-down for the concept of ETFs, but an indicator to promoting them of the efforts they need to make to convince investors of their worth.