Exchange traded funds (ETFs) are currently enjoying a significant boom in the US. After the initial domination of the area by institutional investors, retail investors have now discovered the advantages of this product. In the US currently, 171 products with $243bn (e201bn) in assets under management are listed by eight providers.
In Europe the development has been far slower in the past five years. Institutions still dominate the majority of assets of e30bn, which are concentrated in 130 products, listed on 12 exchanges. Germany is one of the largest single markets for ETFs in Europe with approximately E10bn in ETF-invested assets.
Compared to total institutional assets of German institutions of about e1trn, the ETF-penetration appears to be low. Are there signs of changes ahead?
The most obvious use of ETFs are short-term strategies due to their liquidity and tradeability. ETFs are index trackers that are traded at the exchange throughout the day and provide all necessary data, such as continuous net asset value(NAV) and real-time portfolio composition.
At Mercer Investment Consulting in Frankfurt, Erik Crawford talks about some institutional clients that already use ETFs: “Some of our clients use ETFs to run short-term opportunistic or tactical strategies alongside with external mandates.”
Typical short term strategies are sector or opportunistic regional strategies. This approach is supported by a wide range of ETFs available in Europe featuring European small caps, growth stocks, value stocks (dividend strategies), sectors or alternative asset classes. Even commodity ETFs are available.
Before ETFs appeared on the scene only index futures could be used for diversified short term opportunities. They are less comfortable for investors, as they need to include these instruments in their derivatives exposure. In the past, futures have been less expensive than ETFs, but now this changed as well. Comparing ETFs on blue chips with the respective index future shows only minor differences in costs when rollover costs and spreads are considered. ETFs also have the advantage that the strategies can be run on more exotic markets where no index future exists.
The use of ETFs for longer-term long-only investments seems to be rather unusual at a first glance. They are still quite new for many institutions, although the products hit the markets on the continent some five years ago. But there is a reason why this will change in the near future: ETFs appear as an ideal solution for current needs of institutional investors, such as smaller insurance companies, the new pension funds, pension trusts, foundations and treasury accounts of banks. Nearly all investors are currently restructuring their portfolio after having lived for years with expensive tailor-made Spezialfonds, with dirty fees and without best execution. The Spezialfonds have had extremely low management fees that pushed the providers towards cross-financing these gaps through opaque additional fees, such as for brokerage. Investors are now looking for transparent investments which can also be passively managed.
“We use ETFs alongside with other funds and direct investments to build a diversified allocation in equities,” says Martin Großmann who is responsible for the Chemie Pensionsfonds and the HVB Pensionsfonds. Although he does not trade heavily in the products, he benefits from their liquidity: “ETFs are very transparent and liquid instruments. They reduce the complexity of our own risk management through their simple structure and diversified character. Additionally the high liquidity of ETFs compared to baskets of underlyings or other passive funds support the legal requirements set down by the regulator. Last, but not least, their cost efficiency is not challenged by any other kind of fund instrument.”
One development that could help the spread of the institutional long-term use of ETFs is the growing orientation towards core satellite portfolios. The success of the core-satellite approach is based on the savings that can be made on management fees and the growing awareness that many active managers do not beat their relevant benchmarks 70-80% of the time. Depending on the time horizon, this can even go over 90%, particularly in liquid markets.
ETFs can add value in such a portfolio if sizes are comparably small like with many German institutions like foundations or even pension trusts. A variety of different bond ETFs even allows running a core bond component with ETFs.
But ETFs can also play a role in a satellite portfolio. Usually the satellites are meant to produce high alpha while the satellite portfolio is diversified over a selection of managers to reduce risk. Some ETFs are tracking more or less uncorrelated markets – like China, Iceland, Turkey or eastern Europe for regional purposes which can be used similarly, or for portfolio completion.
“Some of our clients use European-domiciled ETFs, for example as a good proxy for niche markets. ETFs can track niche markets efficiently as long as there is enough liquidity in the underlyings, “says Crawford of Mercer.
German institutions can use the products in such a role as long as they comply with their investment constraints. Pension funds, pension trusts and insurances regulated under the Anlageverordnung are required to invest about 80% their assets within the EMU because they are not allowed to run any derivative strategies, such as currency hedging. The new pension funds can invest up to 30% in currencies outside the EMU for then main part of their assets.
Combined with their role in a core-satellite portfolio, ETFs provide a low cost solution for small and mid-sizes institutions which represent the majority of the fragmented market of German institutions with 250 pension trusts, a number of new pension funds, 350 insurance companies, religious institutions and approximately 13,000 foundations.
A second reason why ETFs could become more popular in addition to core-satellite is the growing influence of regulatory issues on German institutional portfolios. There is an ongoing shift of assets from Spezialfonds into multi-owner vehicles, which can be mutual funds for institutions or ETFs. This is happening because, investors do not have to fully consolidate them in their balance sheet as is case with fully owned Spezialfonds, according to IAS rule 27 and its amendment SIC12.
The accounting issue is valid for many institutions like pension trusts that belong to corporates, for banks and most of the insurances. All the other players will face changes in the mid term in the domestic accounting standards HGB that will be derived from IFRS standards.
One open question is why institutions do not buy passive mutual funds instead of using ETFs for long-only investments? This might have historic reasons: The move to more passively managed assets came within the last three years according to research by Greenwich and Mercer Oliver Wyman. ETFs which were first listed in Europe in April 2000 at the top of the tech-hype have stepped into the gap that was left open by the dominating institutional providers which have all claimed to be active managers – maybe due to reasons of profitability. For the established passive players like Barclays Global Investors or State Street, many German institutions were too small to reach the necessary economies of scale for the passive mandate business.
Ishares and Indexchange, though, have been very active in marketing ETFs to institutions in the meantime and have filled the gap in market of a German Vanguard.
Jan Altman is co-founder and executive board member with Funds-at-Work, the Frankfurt-based advisory firm