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More than a decade after they were first launched, exchange traded funds (ETFs) can no longer be called ‘new' investment instruments. But with the range of ETFs on offer continually expanding to cover an increasing number of markets, institutional use of the instruments is still booming.

ETFs are baskets of securities, usually representing an index, which are as easy to trade as a single share.

Most see their primary use in helping investors avoid ‘cash drag' by staying fully invested in the market, but they also have a variety of other tactical and strategic uses, say their advocates.

"ETFs - relative to other types of investment fund product - are quite simple and transparent," says Dan Draper, head of Lyxor ETFs UK & Ireland, which is part of Société Générale Corporate & Investment Banking.

Because of this simplicity, they are coming to be seen as retail products, although this is not where their primary use really is, he says. "If you look at them in the US, they are very much institutional instruments."

The main benefit of ETFs for institutional investors is that they are a good way of outsourcing investment which is beyond the institution's expertise. "A large asset manager may be good in fixed income and global asset management, for example, but there may be some areas where someone else can do it better," Draper says.

Fees for ETFs can be higher than some institutions would pay to have their own passive portfolio managed, depending on the economy of scale they were able to achieve. But Draper says fees for ETFs can be clawed back through securities lending.

"One thing we're seeing is pension funds utilising securities lending," he says. "That's the way pension funds can offset a lot of the cost."

ETFs are useful as tactical trading vehicles, but they also allow outsourcing without having to use derivatives, he says. When pension funds believe they can get alpha from a different investment market, ETFs can easily be used to buy that exposure without the fees, resources and human capital that would be required were they to take another route.

"Finding truly consistent outperformance from a fund manager is really difficult," says Draper.

"Pension funds are using ETFs for a variety of different reasons, and in various different ways," says Greg Ehret, senior managing director of State Street Global Advisors and head of European sales and distribution.

One tactical way that pension funds use the instruments is to get full exposure to a certain asset class quickly, and real estate is a good example, he says. For example, a pension fund may have €100m allocated to property, but initially only be able to have between €15m and €20m of capital called.

"ETFs are a good way of getting exposure," he says. "As the fund gets capital calls, it can just roll the ETFs in." In this way, ETFs are a type of cash equitisation related to a specific asset class, allowing the pension fund to be within they guidelines of their asset allocation more than would otherwise be the case.

"While a real estate investment trust (REIT) ETF may not be quite lined up with real estate, it does have similar characteristics," says Ehret.

The instruments can also help a pension fund rebalance asset allocation after a new cash inflow, says Ehret. "If you have a cash inflow, instead of putting your money to work with a manager that's closed, you can buy the ETF," he says. In this way, a closed fund can be extended.

There are also cases where a pension fund finds itself with cash in hand in the middle of a transition, he says. "They might have cash that needs to go to work; then it's a case of maintaining the exposure," he says. ETFs can be used to fill such a gap.

But while ETF providers say the instruments are excellent investment tools that pension funds can use in a variety of ways, consultants say that UK pension funds seem to make little use of them.

However, in continental Europe the instruments appear to be more widely used by retirement institutions. The HVB Pensionsfonds in Germany, industry-wide pension fund ABP in the Netherlands and the Novartis pension fund in Switzerland have all said they use ETFs to some extent within their investment.

Some pension funds in Europe are not allowed to use derivatives in their investment strategy because of regulations. Where this is the case, ETFs can provide a similar type of ‘basket' exposure, allowing the fund to achieve its objective without breaking rules.

 

ith the trend towards greater diversification, more fund managers are using ETFs. The job of most portfolio managers has become both broader and deeper, according to Deborah Fuhr, managing director of investment strategies at Morgan Stanley, as they cover all the developed and emerging markets as well as looking at sectors and countries.

"We have found that many are admitting that they do not have the time or resources to try to add value in all markets, and are embracing the use of ETFs to gain international market exposure," Fuhr says.

In other cases, the instruments are used to equitise cash or take and overweight or underweight position, she says. More and more, investors are using ETFs as an easy way of getting beta exposure to international emerging market benchmarks, so that they have more time to gain alpha by selecting stocks in markets where they believe they can add value, she says.

In Europe, the UCITS III directive allows UCITS funds to invest significantly more in other UCITS funds and UCITS ETFs than previously, she adds. UCITS III lets a UCITS fund invest all of its net assets in other funds or ETFs, whereas before such a fund was typically only allowed to invest up to 5% in other funds.

Some pension funds use ETFs as overlays in cases where most asset management is outsourced, says Fuhr. An in-house management team can use an ETF to overweight a certain geographical region, for example, without altering the country-specific mandates it has.

Even for investors that are allowed to use futures, there are some advantages in using ETFs for overlays rather than futures, Fuhr says. ETFs can be less expensive, and the tracking risk relative to the benchmark is less with an ETF than with a futures contract. In addition, there is no need to roll it over, as there is with a futures contract.

Index providers have been coming up with many different indices, which will form the basis of new ETFs, says Fuhr.

Barclays Global Investors recently launched the first ETF based on Standard & Poor's Listed Private Equity index.

ETFs can be useful instruments for pension funds and other investors taking a core-satellite approach to their portfolio, according to the EDHEC Risk and Asset Management Research Centre in France. "ETFs offer a natural vehicle for implementing allocation strategies both in the core and the satellite," it reports.

Core-satellite is becoming the norm. EDHEC says 48% of European investors and asset managers are using the core-satellite approach, and a further 9% say they will implement this type of organisation in the near future. With a core-satellite approach, a portfolio has a clear separation between a core portfolio managed passively, and one or more very actively managed satellites, says EDHEC.

In terms of management fees, EDHEC says a core-satellite approach could cost 28bps. In the example, 80% of the capital is allocated to the core portfolio and 20% to the satellite, with the core portfolio attracting 10 bps of fees and the satellite costing 100 bps.

ETFs can be used in tactical asset allocation strategies too, it says, in sector rotation and style rotation strategies, as well as rotation strategies between segments of the bond markets.

"ETFs allow investors to capture the performance related to risk premia of certain asset classes," such as small cap stocks, emerging market stocks, value stocks, commodity indices and high-yield bonds, EDHEC says. The instruments can be used to create "performance-seeking portfolios".

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