Stock markets may have been weighed down since 2000, but even in this environment, the popularity of exchange-traded funds has taken off. These investment vehicles, say their providers, can offer pension funds the chance to keep equity portfolios closer to their benchmark, especially during transitions.
Exchange-traded funds (ETFs), are baskets of securities that can be traded in exactly the same way as a single security. An ETF might be based on a widely-used market index such as the FTSE 100 or S&P 500. As such, an ETF is an instrument that allows an investor to have exposure to a large group of securities or index, but without the complications of dealing in all the individual components.
Among their selling points is that they can be traded instantly, and more cheaply than buying and selling the components separately.
Alain Dubois, head of European exchange traded funds at State Street Global Advisors, which markets its own street TRACKS brand of ETF, says ETFs tend to be used at present by smaller pension funds with large portions of internally managed money: “These funds have to be careful with costs and have a policy not to outsource, but they will use ETFs for sector rotation to try and beat the benchmark, or to introduce a pure core/satellite exposure.”
Probably the most popular use of ETFs for institutions is in the equitisation of cash, says Mark Roberts, head of product strategy at iShares. A pension fund manager who has a benchmark of equities, for example, can use ETFs in place of cash as it liquid funds flows in and out of the fund. “Whether it’s a good thing or a bad thing to be investing in equities, your job is to be invested in equities,” he says.
Deborah Fuhr, head of ETF research, Europe and Asia at Morgan Stanley, says that by standing in for cash, ETFs can make pension fund portfolios more efficient. “The alternative is that you sit on cash and have cash drag,” she says.
Apart from their use in equity investment, ETFs can also help managers of bond portfolios stop straying from their benchmark. Investment in corporate bonds may have been on the increase, but in the bond world, futures contracts are still only available on government bonds – and not corporates. So corporate bond funds seeking to ‘bondise’ their cash would not be able to match their benchmark using only futures. However, since there are several corporate bond ETFs available, managers now have access to a much more appropriate tool for credit funds.
ETFs offer many investment opportunities, including core equity holdings, sector and style plays, international diversification and portfolio hedging.
“They’re a useful tool,” says Fuhr. “What you’ll find is that both active and passive funds use them as an alternative to futures, programme trading and traditional active and passive funds.
“Now that managers are able to use ETFs, they can equitise cash, and also underweight and overweight Europe, US and global sectors,” she says. As well as this, styles can be overweighted or underweighted, such as mid cap or large cap.
Demand for ETFs has grown partly as a result of the tendency for investors to use passive or index funds as part of their overall portfolios. Now, between 30 and 40% of US pension assets are indexed. “Expense ratios tend to be lower on ETFs than on conventional funds,” says Gary Gastineau, managing director of ETF Consultants in the US. “You don’t have the record-keeping costs on behalf of shareholders.”
ETFs are used by retail investors, and in that market, one of their main advantages is cost. But in the institutional market, ETFs are generally not cost-effective in the long term. When institutions use ETFs, it is not usually to replace index funds. Because of their size, institutions have access to index funds at very low rates – they can get them more cheaply than using ETFs.
It is in the shorter-term investment situations, the experts say, and for their flexibility rather than their cost that ETFs really come into their own for pension funds. In the short term, ETFs cost less in absolute terms than they would as long-term holdings.
ETFs can be useful trading tools for pension funds that are not able to use derivatives to effect their more nimble moves. This may be because of local regulation or their own investment restrictions, but since ETFs are listed stocks, they are permitted.

The cost of transitions – moving funds from one asset manager to another – has traditionally been high for institutional investors. This changeover can be made easier by hiring a transition manager, but this route is often not viable for the smaller pension funds.
Instead, ETFs can be used. The pension fund can swap holdings in a certain portfolio for ETFs. This move gives the fund a trading tool, which is liquid – providing a similar advantage that cash would provide – but which also keeps that part of the fund’s assets exposed to the equities market.
And when the time comes to implement the new equity strategy, says Mark Roberts, if the assets are already held in ETFs, they can either be sold and the cash used to buy different equities, or they can be redeemed directly for the underlying stocks. This ability to redeem will get you part of the way towards your strategy, he says. “Ultimately, this will reduce the overall trading costs in a transition event.”
ETFs can be useful when a pension fund is dealing with a one-off cash injection, of the type sometimes made by governments to cover pension fund obligations.
Where did ETFs come from? The idea began in the early 1980s with programme trading. At the time, this was the new ability to trade a whole portfolio with a single order. That portfolio would often consist of all the stocks in the S&P 500, for example.
Out of this, developed the demand for a basket product that could be readily traded. Over the next decade came several products which more or less fulfilled this need, culminating in the S&P 500-based Spider, which was developed by State Street in conjunction with the American Stock Exchange, in late January 1993. Probably the most visible US ETF has been the fund tracking the Nasdaq 100 index, known by its ticker symbol ‘QQQ’. But it was not until 1999 that ETFs gained widespread acceptance.
There are now 289 ETFs in existence, listed on 27 exchanges around the world. Although the ETF concept began in the US, Europe now has the largest number of the instruments – 122, more than the US’ 114, according to figures from Morgan Stanley. However, assets under management are far higher in the US, at $121.2bn (e104bn), compared with $15.78bn in Europe.
Fuhr says there is a growing acceptance of ETFs. In June 2000, there were less than 500 investors worldwide holding the instruments, but three years later, this number has more than doubled to 1,300.
In terms of convenience, Fuhr says ETFs are just as easy to trade as shares, and settle in the same way as shares. The risk involved with ETFs is the same as buying a mutual fund, she says.

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