Exchange-traded funds have been one of the success stories of the last decade. These neatly packaged products, which give the performance of an entire index in a single stock, have grown in popularity with retail and institutional investors alike since they came into existence.
Like an index fund, they give exposure to a whole market, but like a stock, they can be traded instantly. With pension funds increasingly happy to rely on passive portfolios – at least for portions of their assets – the advent of ETFs has added another implement to their toolbox.
Chris Sutton, head of index investment strategy at Barclays Global Investors in London says institutions are using ETFs more and more. “But we would still judge that the use is greater in North America that it is in Europe,” he says.
One reason for this is familiarity. While still relatively new products, exchange-traded funds have existed for around nine years in the US and Canada, but the first ETFs geared towards European investors were only launched in 2000.
Also, the maturity of the North American markets in ETFs means that US and Canadian investors have a broader choice of the ETFs available, and the cost of access is generally lower.
Although one of the major selling points for ETFs in the retail investment market is cost, on the large scale required by institutional investors, ETFs are generally not cost-effective in the long-term.
However, where the instruments really come into their own, providers of the product type say, are various shorter-term investment situations.
“We find institutions are using them, but not to replace index funds,” says Sutton. “They are using them more as short-term holdings.” It is primarily investors in the retail market who use ETFs as longer term alternatives to trackers, he says. Institutions, however, use them more as a trading tool.
This makes sense, says Sutton, since in the UK, institutional investors can have access to index funds at very low rates – lower than the charges on ETFs.
Pension funds can be de denied use of derivatives, either by local regulation or by their own investment restrictions. This rules out futures contracts on stock indices, but since ETFs are listed stocks, they are permitted.
There are three main ways in which ETFs are currently used by institutions as trading tools, he says – in transition management, as part of their completion strategies and to facilitate shorter term asset allocation moves.
Explaining how ETFs can be useful during transition management, Sutton says the cost of moving funds from one asset manager to another has traditionally been high for institutional investors. One way of smoothing this changeover is by hiring a transition manager, he says, but this is easier for the larger institutions to put into effect than it is for the smaller ones.
In this situation, the pension fund, for example, can swap its holdings in a certain portfolio into an ETF. This then gives the fund a trading tool. “An ETF is a very liquid and very easily tradeable entity in its own right, so you’ve bought flexibility at a low price,” he says.
Chris O’Brien, director of market development at Standard & Poor’s, based in Paris, adds that ETFs can be useful for pension funds managing transitional investments when they are dealing with a one-off cash injection. Governments frequently make one-time payments to meet the obligations of a pension fund, he says.
This may face a pension fund manager with the immediate problem of how to invest E300m, for example. “Rather than trying to make investment decisions, you can buy the ETFs and when your asset allocation decision is finished, you can either redeem those ETFs for cash, or EFP (exchange for physicals), and only sell those stocks you no longer need,” says O’Brien.
In this way, at a time of transition, the fund remains fully exposed to the market, while at the same time maintaining the flexibility to change this on a daily basis.
ETFs are also used in completion strategies, says Sutton. In the current equities environment, Sutton says many institutions want to take less rather than more risk. This means it is important for them to ‘plug holes’ in their portfolios that may have emerged through market swings in prices of certain stocks or sectors.
If a fund finds itself underweight in, for example, utilities, energy or consumer staples, it can buy a sector ETF to fill the gap and round off its equity strategy.
In cases where a fund makes a change to its asset allocation, it can use ETFs as an immediate or short-term alteration to the asset mix. There are three ways of doing this – by buying or selling the future, by using ETFs or by buying or selling a basket of large companies, says Sutton.
“The way people have traditionally done that in the past is by going in via the futures market. It’s been our observation that that has become a more expensive thing to do in Europe than in the US.”
This is partly due to the fact that a futures contract only has a three-month life, which means it must be rolled over at the end of that period. Over time, the cost of the roll over has become larger, he says. Also, investors face the problem of the temporary performance gap between the future and the market it is trying to track.
One of the most prevalent uses of ETFs for institutional investors is as cash equitisation, says O’Brien. Any pool of assets is likely to have about 5% of its volume at any one time in the form of cash, which is used for subscription redemption, or making payments.
But this cash holding is a drain on the fund, and will potentially drive the fund’s performance away from its benchmark, O’Brien points out. A pension fund, he says, can use this 5% in cash to buy ETFs – either in the US market or Europe – and in this way can keep its portfolio fully exposed to the market, without sacrificing liquidity.
Secondly, he says, ETFs can be used to re-weight a portfolio. If, for example, a fund manager takes the view that within a European portfolio, the Euro-zone will outperform, in order to increase exposure to that region it would be necessary to initiate many different transactions.
However, an alternative way to overweight the Euro-zone within that portfolio would be by buying a Euro-zone ETF. “You can do it for styles and for sectors,” he says. “You can short the ETF – the financial sector, for example – and you can use them for sector rotation. That’s how they (fund managers) are going to generate alpha.”
ETFs can be used to effect core satellite investing, says O’Brien. Private banking groups frequently use this pattern, where the core holding is a broad-based ETF and the satellite holdings are, perhaps, sector ETFs.
“If you look at pension funds, 80% of any pension fund holdings are pretty stable,” he says. Where the vast majority of a fund’s holdings are large cap stocks, ETFs can potentially be used to make finer adjustments – such as bringing in foreign index exposure.
As long-term alternatives to tracker funds, ETFs are expensive because they are products designed to have features which are simply not necessary for a long-term investor. An ETF gives you something you don’t need – through-the-day liquidity, says Sutton. “We’re beginning to see some of the brokers doing 24-hour markets in some ETFs.”
“As a pension fund or an insurance company, do you need that for 90% of your investment?” he asks.
O’Brien agrees that an ETF is not a cost effective way for a pension fund to hold passive assets in the long-term.
“Although an ETF can be a flexible product, it is in general not a core holding for a pension fund,” he says. This is simply because as investors, pension funds are large enough to have a managed indexed account run especially for them with full replication.