More than meets the eye
The usual selling point for ETFs is that they are cheap, but that has rarely held for institutional investors. Anthony Harrington finds less obvious, but arguably more compelling, advantages
At a cursory glance, it might seem that exchange traded funds (ETFs) have little to offer institutional investors. For some time the view was that they represented yet another passive stab at market beta with an additional layer of cost.
Simon Vanstone, head of institutional at Vanguard, which launched a range of ETFs over the last year to complement its pooled funds, says that there is a real difference between US and European pension funds – with the former being much more enthusiastic ETF users. Continental European funds are more involved than UK funds, but even here it is non-pension fund institutions that dominate the market.
“One of the off-putting features about ETFs is that institutional users are accustomed to negotiating prices on pooled funds,” he says. “With ETFs, the price is the price. I see some exposure from UK pension fund portfolios to ETFs, but the weight of asset demand in this class is from other institutional investors.”
But survey after survey over the past year showing more and more pension funds and asset managers either already using ETFs or planning to do so, might indicate a turn in the tide.
Phil Page, client director at Cardano notes several reasons why an institutional manager might prefer ETFs over mutual funds for a portion of the portfolio, largely having to do with the enhanced liquidity, convenience, granularity and focus offered by ETFs. Real-time pricing is another key factor.
“If you take the traditional index-tracking pooled fund, you find that the price of the units in the fund are struck at most once a day, and more usually, once a week,” he says. “Plus you have to give a day or two’s notice ahead of trading, which means that if the market is moving rapidly, you are effectively buying blind, with no idea what the price will be when the trade is finally done.”
Related to these advantages, perhaps, Page points to the impact of changing pension fund governance structures on ETF use. “The fact that we are seeing a slow increase in the use of ETFs by pension funds has a great deal to do with the slow but steady pace at which funds are moving to discretionary mandates,” he says.
Trustees who want to keep a tight control of the overall investment decision-making tend to prefer advisory-only relationships. They will tend to have, say, 40% of the fund in equities via passive trackers and though they will understand all of the potential advantages of ETFs, the products don’t really interest them. With a core approach and zero interest in market timing the fact that mutual funds have a cheaper total expense ratio than ETFs will be key.
But Page claims that the higher returns that pension funds see being achieved in discretionary mandates is whittling away at the ‘core-allocation’, advisory-only approach. Cardano has been able to show returns in its discretionary mandates that are around 3-4% per annum better than those achieved in its advisory mandates, via passive trackers.
“In an advisory relationship trading tends to be pretty static and decision-making is all around the core asset allocation,” he says. “With a discretionary relationship you are looking for the best opportunities over the next year or so in the market, and ETFs definitely have a role in allowing you to access those opportunities.”
Mark Johnson, head of UK sales at iShares, BlackRock’s ETF outfit, makes some of the more familiar arguments about the convenience of ETFs for providing a quick tilt or balancing out the different risks in a portfolio, for equitising cash or implementing interim beta strategies when transitioning between different managers. But he also adds that ETFs offer some clear advantages when a pension scheme needs to liquidate some of its holdings.
“Most times, in a traditional portfolio, when the fund needs cash you would look to sell down the most liquid parts of the portfolio, which would be the equity allocation,” he says.
“So you end up slicing horizontally, which tilts the portfolio as time goes on. If you held 10-20% of the portfolio in ETFs instead, you could sell them down pro rata to retain the shape of the portfolio.”
Johnson makes the point that while ETF charges might be higher, that is a premium for the extra liquidity and dynamic pricing they offer compared with passive trackers. Offsetting that cost, to some extent, is the fact that the spread rates are correspondingly tighter.
“Spreads in US high yield companies in a mutual would be 60-70 basis points, but would be in the single digits in an ETF,” he observes. “We can model the cross-over point for particular clients where it makes more sense to hold either an institutional pooled fund or an ETF. But the point is that there is a lot more to the ETF decision than meets the eye and the conversations get pretty complex very quickly.”
For a large, sophisticated pension scheme an ETF is now just another tool in the institutional tool kit sitting alongside futures, total return swaps or CDSs. But the environment is changing for many of these alternative instruments. Johnson argues that, in a world moving towards central clearing for derivatives, institutions are becoming slightly more wary of the time that can be taken up by documenting deals.
“If a pension fund wants to enter into principal documentation with a counterparty for a swap agreement, it can take the better part of a year to negotiate this,” he says. “ETFs, by contrast, can be accessed immediately.”
Swaps can be attractive because they are unfunded and trade on margin, giving a degree of leverage. But that doesn’t mean that ETFs, which demand 100% cash funding, don’t have a growing role alongside these derivatives.
“If you are running an LDI portfolio, you are going to want to have some levered bond exposure to match the duration of your cash flows, plus a combination of Gilts, linkers and swaps in order to extend out the duration of your portfolio,” Johnson notes. “But a credit ETF could diversify the portfolio and add yield to the mix. That can work perfectly well in concert with levered instruments.”
Once a fund moves in this direction, the sheer flexibility of ETFs and their ability to be crafted to reflect any requirement can prove very attractive. One major fund moving to ETFs is the Arizona State Retirement Plan, which worked with iShares to develop a range of products to give it exposure to a mix of specific risks, such as size, momentum, growth and volatility.
“That was one new idea we developed this year,” says Johnson. “Another was a series of products called iShares Bonds, which actually have term dates associated with them, as opposed to the usual fixed-income ETF that has no maturity date. We think that an ETF that trades like a share but has an end date like a bond will prove very attractive to institutional investors.”
Sometimes the advantages that ETFs can offer institutional investors are not the obvious ones that appeal to retail investors and get the most press – easy-access passive exposure to a wide variety of markets at low cost. But the industry is working hard to outline those advantages, and offer products more specifically designed for this investor base. Now may be a good time to re-assess their place in the European pension fund toolbox.