Alexis Marinof looks at what ETFs can do for pension scheme investment strategies
- The ETF market has expanded rapidly but remains relatively niche in pension scheme investment
- ETFs have been perceived as being more expensive than competing structures
- ETFs have multiple applications for the institutional investor
The exchange-traded fund (ETF) industry continues to expand rapidly - total global assets surpassed $3trn (£2.1trn) for the first time in 2015 - but continue to ‘fly under the radar' for most UK pension schemes. This is surprising given that many schemes have been investing in ETFs indirectly for years through outsourced fund management arrangements and fiduciary mandates.
The relatively low penetration of ‘direct' investments can be attributed to a few key reasons, notably the high level of intermediation and propensity for schemes to outsource most or all investment functions. There might also be a lingering perception that ETFs are more expensive than competing structures and thus not appropriate for widespread use. However, UK schemes could be well served to start evaluating ETFs alongside other, more common implementation options.
With rapid growth in asset gathering comes lower costs to the investor, and the range of investment exposure available has also grown notably. Today, there are many segments of the investment landscape - e.g. emerging markets local currency bonds, small cap stocks and smart beta - where few, if any, traditional passive pooled fund options are available; so for schemes seeking such assets, ETFs may be the only investable option.
Main uses of ETFs for UK pension schemes
For schemes considering ETFs for direct investment, there are multiple options:
1. Cash equitisation: ETFs can be used to reduce cash drag within portfolios. Unlike other vehicles used for cash equitisation, their inherent simplicity and transparency make them an efficient tool for this purpose
2. Passive core: ETFs can be used as an alternative or alongside other passive pooled funds or segregated accounts. Their cost-efficiency, ease of use and wide range of exposures make them ideal for as core investments
3. Liquidity sleeve: For schemes with relatively frequent cash flows or rebalancing requirements, holding some liquid and easy to trade ETFs may make sense
4. ‘Building Blocks' for outcome orientated portfolios: 'Outcome-oriented' investing, where the goal is to produce a portfolio that aligns more closely with a specific investor need rather than one that tracks or outperforms a cap-market weighted benchmark is increasingly popular. ETFs are well-suited building blocks for schemes looking to implement an outcome-oriented strategy. For example, as part of a ‘growth' portfolio or for a multi-asset allocation that targets high levels of income
5. Asset class exposure: Asset class segments like high yield and emerging market bonds, small cap stocks and smart beta are not widely available in pooled index funds and futures contracts are largely non-existent. ETFs can obtain both strategic and tactical exposure to such asset classes
Are ETFs cost efficient for UK pension schemes?
One concern aired by some schemes is cost relative to other implementation options, such as index futures, pooled funds and segregated accounts.
In some cases, there might be more cost-efficient ways of passively tracking a particular benchmark. However, when total implementation costs are considered, ETFs are often most efficient.
Our research, which compared total returns of ETFs against their equivalent equity index futures over 12 months, found ETFs were most cost effective.
So, what costs should ETF investors consider?
1. Total expense ratio: All management, custody, legal and administration fees.
2. Withholding and other taxes: Investors should factor in all taxes that apply to an ETF's underlying securities. For example, equity ETFs typically track indices where tax treatment is similar - the difference being index providers usually quote returns net of the highest possible tax rates, unlike ETFs, which may be domiciled in countries with more efficient tax rates. Fixed income ETFs usually track total return or gross indices.
3. Tracking difference: This measures how much net-of-fee ETF total return differs from index return. Tracking difference can be positive or negative and is influenced by a number of variables. If the tracking difference is negative, it is a cost that investors must consider.
4. ETF trading costs: Implementation costs are an important part of an investor's overall costs. While bid-ask spreads can be a useful estimate, investors should ensure they get an accurate picture of current trading costs.
5. Standard brokerage commissions: Brokerage and custody charges are relatively low on ETF trades. The above costs may be offset by securities lending within the fund, which would show in results over time, and, for those entering ETF lending programmes, income generated from lending their ETF shares.
For a variety of reasons, UK pension schemes have not widely adopted ETFs for direct investment. Recent positive developments within the industry, from lower investor costs through to greater choice, mean the time may be right for them to take another look at this investment vehicle.
Alexis Marinof is managing director of State Street Global Advisors and EMEA Head of SPDR ETFs
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