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Special Report

ESG: The metrics jigsaw


Role of funds in portfolios

Before we consider specific uses of Exchange Traded Funds (ETFs) in pension funds, it might be useful to look at the overall pension fund management process.
The investment aspects of this process can be categorised under the following headings:
o Strategic Asset Allocation (SAA)
The SAA typically concentrates on the distribution of assets in a portfolio under broad classification headings, such as equities, bonds, cash and alternatives (including real estate, private equity, hedge funds etc). It is primarily driven by the make up of the pension fund’s liabilities; namely the proportions that relate to current employee, former employees with claims on the pension fund and current pensioners and the managers and sponsor’s attitude to risk. Any investment decisions implemented under this heading are intended for the long-term – they would not be revised unless there were significant changes in either liabilities, funded status or attitude to risk.
o Tactical Asset Allocation (TAA)
The TAA is concerned with short term (months rather than years) departures from the SAA based on the investment managers valuation differences between market segments. Unlike SAA, which concentrates or broad investment categories, TAA is often executed at the level of individual equity sectors or countries.
o Short term cash management
o Risk management
o Trading
o Changes of managers and shifts between Active/Passive and Core/Satellite
In all these areas ETFs can be useful, but there are other methods – direct investment in the underlying securities (segregated funds), unit trusts (OEICs), exchange listed investment trusts (ITs), and derivatives. Table 1 summarises the suitability of ETFs, unit trusts, ITs and derivatives in these areas.
The management of the pension fund (in the UK normally the Trustees) usually employs professional investment managers to look after their assets. When we ask investment managers if they use ETFs, the answer is usually “Sometimes, but not often, as we can execute basket trade in the liquid shares that normally underlie an ETF easily and at low cost”. In our experience, this is the main reason why ETFs are not used as much as perhaps they should in large pension schemes, because they introduce another layer of expenses and intermediaries.

o Strategic Asset Allocation (SAA)
For pension funds, SAA would normally be implemented by the appointment of suitable investment managers for segregated funds (assets of more than E100ms, say) or pooled funds (OEICs) for smaller pension funds. ETFs could be employed in the strategic layer, but they are normally based on large-cap indices to provide the necessary liquidity in the underlying basket of shares. Institutional investors’ equity benchmark would usually be a relatively broad-based index, such as the MSCI and FTSE World indices. Where ETFs are based on the MSCI or FTSE indices, they typically use the most liquid segment of these indices. Unit trusts tracking these broad indices are generally available and would be the most common route in implementing the passively managed SAA. Only the very large pension funds might find it economical to have segregated tracker funds. Investment trusts would not normally feature much at the strategic layer and derivatives traded on the exchanges are normally of too short duration and based on too narrow indices.
As we mentioned earlier, one aspect of SAA is the allocation to bonds. Until recently we could not use ETFs in this area of SAA management. At the end of July 2002 the first ETFs based on fixed-income indices were launched in the US by BGI. With their introduction it is now possible for a pension fund to implement its entire SAA using ETFs. Whilst this may not be the preferred option for large pension funds, for small and retail pension funds this may be an attractive possibility.

o Tactical Asset Allocation (TAA)
For the purposes of TAA, we would consider all vehicles suitable, dependent on the type of investment stratagem. For short duration (less then six months), TAA shifts in major regional equity markets futures are likely to be most cost effective. However, they are not available on as many indices as ETFs and unit trusts and also some funds are not permitted to use derivatives. Even when a pension fund is allowed to use derivatives, there is often a requirement to have a separate manager agreement to cover this.
ETFs are also ideally suited for the implementation of sector- or style-based strategies. This is particularly true in the US, where the range of available ETFs is quite large. In the European context, the range of ETFs for sector-based strategies is quite good, but there is not, at present, enough variation based on style or market cap.
For some more esoteric asset baskets investment trusts may be the only option, but as their price is often at a premium or a discount to their Net Asset Value (NAV) the realised return can be affected by other factors not under the investor’s control.
The fact that ETFs trade within very narrow margins around their NAV is one of their main advantages and makes them most suitable for short term TAA.

o Short term cash management
When irregular cashflows are received, ETFs are very useful in gaining temporary exposure to an index whilst a more considered analysis of available options is being undertaken. Futures are also often used in this area, where they exist, but there are many potential pitfalls, such as unexpected margin calls and the need for specialist documentation.

o Risk management
Managing the risk budget agreed at the periodic strategy reviews is an important part of the overall governance. Existence of ETFs and derivatives makes it possible to implement pro-active risk control. ETFs and futures can be sold short, protecting the fund from anticipated short term falls in the market. The wide range of available ETFs make it possible to fine tune this, limiting the exposure to a particular sector, for example technology. Unlike futures this hedge can be put on without any time period constraints or the need for any special documentation.
Because trading costs in ETFs are low, it is even possible to consider a dynamic hedging using ETFs to effectively replicate on option style protection where this is not available. We should mention that in the US options on selected ETFs are available making it possible to buy puts and calls on sector exposure.

o Trading
The high liquidity and transparency make ETFs suitable instrument for short term trading strategies. However, pension funds are normally not engaged in short term trading as it could jeopardise their tax-exempt status. However, where the trading can be demonstrably shown to be done for purposes of efficient portfolio management, as, for example in the case of dynamic hedging mentioned above, this would normally be allowed without any adverse effects on the taxation.

o Changes of managers and shifts between Active/Passive and Core/Satellite
It has been suggested that ETFs can be used effectively in transition management. In our experience investment managers who specialise in transition management do not use ETFs very often as they can execute the necessary trades in the liquid stocks easily and cheaply by other means. However, where specialist transition manager is not used, ETFs can be used to good effect as a temporary home for the assets, whilst a decision is being made as to which investment managers will be appointed to look after the funds in the long term.
Peter Ludvik is a partner at Watson Wyatt LLP in Reigate, UK

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