When the Nasdaq-100 was launched earlier this year, it fast became one of the financial success stories of the 1990s.
Offering investors access to the largest 100 non-financial US and non-US companies listed on the Nasdaq exchange in a single trade, the unit investment trust-backed initiative attracted over $1bn in investor interest in its first quarter and boasted an average daily volume of $3.4bn – just under half of that attracted by the market leader, which had been around for six years.
Much of Nasdaq’s success has been down to market timing – it recognised the growing importance of sectors in the institutional portfolio and launched a product that predominantly focused on the most successful and highest-performing sector of them all – technology. The argument goes that, in this market, investors are wasting their time and money employing active managers to beat the index, they should just follow it.
An exchange-traded fund (ETF) such as Nasdaq’s is essentially a low-cost hybrid of an open ended and a closed ended investment fund, developed by AMEX in the early 1990s to track a regional or industry specific index, with the most popular product, SPDRS (Standard & Poor’s Depositary Receipts) run by State Street in Boston. The product is structured as a unit investment trust but trades like a stock, with each unit giving the investor exposure to the underlying basket of securities in the portfolio. ETFs have traditionally been used in equitising the cash portions of institutional portfolios and, because of the ease in which investors can switch in and out of them, they are also used by investors taking a long/short approach or for running core/satellite strategies. Taking these strategies into account, the emergence of industry specific ETFs has been a natural progression and the popularity of the Select Sector SPDRS, which divide the S&P 500 into nine major industry sectors, reflects the growing acceptance of sector indexing in the US. According to recent Morgan Stanley figures, Select Sector SPDRS have an open interest of around $1.1bn, with an average daily volume of $1.5bn in the first quarter of 1999.
The growth of indexed sector investing in the US market is based on a story not dissimilar to that emerging in Europe, with institutional investors looking for index exposure, based on the low proportion of active managers who are beating the benchmark. Recent surveys in the US claim less than 20% of managers could beat the S&P 500. Reflecting this, today there is over $16bn invested in ETFs in the US, the vast majority of which resides in SPDRs, which hold around $12bn. To give an idea of how popular this particular product is, typically the SPDR is in the top five stocks traded on the AMEX on a daily basis. “Some institutions have gone into exchange-traded funds and have been able to offset the fee and sometimes even create a profit by actually lending the SPDRs,” says Doug Holmes at SSGA in Boston.
In Europe however, this phenomenen is yet to take off, despite post-Emu declarations that sector investing would replace a geographical approach, at least within the ‘new domestic’ marketplace. While HSBC in 1997 launched its own exchange-traded product FTSE 100 TRAINS, which tracks the FTSE100 index , little has been heard since from the bank or from any other manager apart from Morgan Stanley. In fact, on the funds side, Morgan Stanley remains the only provider of sector-specific indexed products for European investors at present.
The Luxembourg-domiciled OPALS (Optimised Portfolios as Listed Securities) are constructed along the lines of the US-style ETFs, though OPALS are exchange-listed, as opposed to exchange-traded. These open ended products seek to track the performance of a specific benchmark in a single trade, with the levels of liquidity in the vehicle reflecting those of the underlying stocks, and the pricing closely linked to the fund’s NAV. OPALS currently run six MSCI pan-European sector indices – autos, banking, insurance, energy sources, health and personal care, and telecommunications, and there are plans to introduce more sectors into the OPALS range in the near future. This is in addition to the range of country OPALS Morgan Stanley runs.
“Our marketplace for the OPALS product is purely insitutional,” says Debbie Fuhr at Morgan Stanley in London. “We had many clients who are pension plans, private banks, asset managers and insurance companies who want to easily get exposure to the MSCI indices, and with the debate of countries versus sectors we introduced s
ix European industry OPALS.” However, she notes that – while the sector products are attracting interest – European institutional investors have not yet reached the point where they are looking to break down their portfolio to such a degree. Most investors are looking at gaining broader indexed exposure, she admits, as opposed to looking at the markets on a sectoral basis.
“What has been more important to people is, because of the introduction of the euro, what most plans have been looking at is that their benchmarks are coming up for question. They are looking at ‘should I just be investing in my single country or investing across the euro-zone or across Europe’ so most of the interest we have seen in terms of new interest would be people investing in the MSCI Europe OPAL.”
However, she notes that the reorganisation of asset managers’ investment departments along sectoral lines signals a change in opinion. “Our quantitative team a couple of months ago introduced a sector rotation model for Europe. You couldn’t do that until the dynamics of sectors were driving performance more than countries. And so since that was happening their model assumes that you are going to buy exposure, not just pick stocks, but buy exposure to that whole sector.”
The two largest players in the indexed fund market, Barclays Global Investors and SSGA, are yet to make their move, though both signal their intentions to launch similar products into the market in the near future. Doug Holmes at SSGA in Boston hints strongly that the manager will be importing its expertise to Europe pretty soon. “I would definitely feel that they can be exported,” he asserts. “And I am confident that you are going to be seeing some over in Europe in the not too distant future.” Whether these will take the form of the US-style products, is not clear. As John Demaine at BGI points out, there is not much of a profile for ETFs in Europe, so simply launching a set of them would do little to arouse the market. “The issue is, there is no equivalent so you can’t just say, ‘we are going to do one of those’,” says Demaine. “There is very significant potential for the European marketplace, but the proactive interest from clients has been limited since OPALS. But then that is no surprise given the level of profile that these products have.”
And, as Holmes at SSGA adds, the attraction of sector ETFs lies in their efficiency for investors implementing long/short strategies. For long-term investors, however, a standard pooled fund vehicle may be a better move. “Our pooled funds for eligible clients are very efficient and if they are long-term buy-and-hold investors then they might be better off going into a standard pooled fund,” he says.
The signs from the continent indicate that, whatever shape or form the products take, the interest is there. Some investors have been approaching indexed sectors via warrants, a vehicle which continental European investors are familiar with, according to Rick Lacaille, head of structured equity at Gartmore. “They have been very popular there, where the investors are used to buying bonds and warrants,” he says. “That has been a hot area for quite a while.”
In the German market, indexed certificates have also been used to gain indexed exposure to industry sectors. Bayerische Hypovereinsbank is one of a number of German banks that operate a series of certificates – or indexed participation units as they are also known – and these have been popular with domestic institutional investors, says Peter Wright at the Deutsche Börse. “We have seen a lot of activity in that area,” he says referring particularly to investor interest in Euro Stoxx indices. “It is pretty cost-efficient and gives the sector index exposure. Especially on a pan-European basis, this can be hard to manage.”
Brussels player Eurobenchmarks is keen to list its own set of indices, IN.SECTS, on the Belgian stock exchange and to go the same route as its US counterparts by introducing fund type products for investors to gain easier access to the indices.
Currently IN.SECTS, which stands for Indices on Sectors, cover 10 sectors priced in dollars and euros – autos, building materials, financials, non-durable goods, oils, pharmachemicals, raw materials, technologies, telecommunications and transport. And according to Koen de Leus at Eurobenchmarks, the company has seen interest from some Belgian banks in introducing fund products to track these sector indices. Furthermore, the Belgian Stock Exchange itself is actually in the process of developing a SPDRS equivalent for the Belgian market, according to Leus. And the Deutsche Börse has indicated that some German fund managers are considering listing similar funds not only on the Deutsche Börse but on other European stock exchanges.
Other players in the market are biding their time, however. Northern Trust Global Investments, while providing specialist portfolio indexed products in the US, has yet to introduce them to Europe. The pension fund market does not seem quite ready yet, thinks Danny Sharp. “There isn’t the same breakdown of asset allocation at the same level of detail at this point,” he says.
“What we have seen is investors who want pan-European passive exposure but excluding key sectors which they want to manage actively,” says Gartmore’ Lacaille. Daniel Broby at Unibank in Copenhagen, which is developing its thematic investing side, is sceptical as to whether taking a fund approach to sector indexing is really worthwhile. “If you go for an index fund in the first place, effectively you are saying that you can’t beat the market. If you are going for a sector only then what you are saying is you can beat the market by taking a style bet against the market. So you are buying a segment of the market at the expense of the others so, as a result, you might as well go for an active manager who takes a sector style bet.”
He continues: “The difficulty you have in indexing is when you have a large index and then you have to do various sampling to get the correlation with the index. With a sector, say you have got 30 stocks in a sector, an index fund is just owning all 30 of them in the right proportions. So, to say that no one offers it, I mean no one offers it as a product because I would imagine every fund manager could achieve a zero tracking error to a selection of stocks in a small sector.”
However, Morgan Stanley’s Fuhr argues that the same logic should apply to outperforming the entire index as it should outperforming sections of it. “For some of the sectors where there are a small number of stocks, you can still suffer if somebody is picking the wrong stocks, and not tracking the index. So if you decide to use an active manager, you still go back to the challenge that over time it is still very hard for active managers to beat the index.”