Rima Haddad looks at how exchange-traded products can fit into a scheme portfolio
- In 2015, ETP assets surpassed those held by hedge funds for the first time, standing at just over $3trn globally as at the end of October.
- The increasing use of ETPs is part of the growth in passive investing.
The UK pensions market has been significantly affected by regulatory reforms. There are a couple of themes at the core of these reforms that are particularly relevant in the context of this article:
• Costs and performance
We will briefly consider why exchange-traded products (ETPs) are a relevant investment tool for trustees and advisers to consider when evaluating investment strategies with a particular emphasis on costs and performance.
In 2015, ETP assets surpassed those held by hedge funds for the first time, standing at just over $3trn (£2.29trn) globally as at the end of October. This represents a 10-year compound annual growth rate of 24.2%.
ETPs are open-ended investment vehicles that generally track an underlying benchmark and are listed on an exchange. ETPs are transparent instruments to the extent that index and product holdings are openly published. Additionally, as they are exchange traded, prices are quoted intraday providing both transparent price discovery and accessibility.
Although liquidity and transparency are additional benefits, the increasing use of ETPs is as much a reflection of the growing influence of passive investing more broadly across the asset management industry. Investors are now questioning whether active managers are able to consistently outperform their benchmarks and are invariably turning to passive instruments, like ETPs, to provide consistent risk-adjusted market returns.
Value for money
The Pensions Regulator published its new draft DC code on 24th November 2015. In this report it emphasises the importance of assessing whether schemes offer "value for money" (VFM). Although there is not a prescribed definition of VFM, costs and charges are highlighted as being an important consideration.
Fund management fees and portfolio transaction costs are referenced in particular. On these two cost metrics, ETPs are generally more cost efficient than actively managed funds. The asset-weighted expense ratio (not including portfolio transaction costs) for passive funds was only 0.20% in 2014, compared with 0.79% for active funds.
The above figures are particularly relevant when considering the charge controls on default arrangements in certain occupational pension schemes. Lower-cost passive solutions become more relevant when taking into consideration the 0.75% p.a. cap that has recently been implemented. Add lower portfolio transaction costs to this and the case for using passive instruments like ETPs to manage scheme costs begins to resonate with an increasing number of investment managers.
Cost, however, should not be considered in isolation. In its guidance for DC pension schemes The Pensions Regulator states: "As investment returns net of charges have such a major impact on member outcomes, trustees should pay particular attention in any VFM assessment to the investment return delivered to members."
In effect, costs are a component of total investment returns, therefore it is prudent for us to turn to the wider argument of how passive returns compare to actively managed funds and how ETPs can be implemented in schemes to improve risk-adjusted returns.
Comparing active and passive investment returns
The regulatory focus on costs and performance are not exclusive to DC schemes. The government-commissioned Hymans Robertson report looked at how the Local Government Pension Scheme (LGPS) could be reformed.
The report specifically questioned whether active managers are providing consistent above benchmark returns to justify their higher overall costs. Indeed it was concluded that over an extended period of time active equity returns across various geographical regions failed to outperform the benchmark, and that this trend was particularly prevalent in the case of developed market equities.
The conclusions in this report are consistent with the findings in a recent Morningstar study that compared active and passive returns across various US equity size and style categories. The research found that over a ten-year period, aggregate passive funds outperformed active funds across eight of the nine defined categories.
In light of growing evidence of active manager underperformance, the value proposition that they offer is being questioned by an increasing number of investment managers. Trustees assessing whether schemes are offering VFM should be aware of the potential benefits of using passive instruments like ETPs either alongside or in place of certain active funds.
A smarter way forward
With the future in mind, one area of particular growth has been in smart beta products. Their goal is to provide improved risk adjusted returns (either increase returns and/or reduce risk) and enhanced diversification over the long term. The strategies implemented are non-market cap weighted and deliver exposure to systematic investment factors or alternative weighting schemes.
Investors can now access a variety of smart beta equity and fixed income exposures, allowing one to gain exposure to a risk premium in a cheaper systematic way. In the new era of VFM ETPs generally, and specifically smart beta exposures, provide an additional tool for managers to use in member pension schemes.
Rima Haddad is head of UK institutional sales at ETF Securities
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