Already popular in the US, ETFs have begun to take hold in Europe but many pension funds overlook the advantages of this type of investment as Helen Fowler reports
Whenever UK and US pension funds have sought out passive investment products, they have tended automatically to turn to index funds. But more are beginning to embrace exchange traded funds (ETFs) as an alternative.
ETFs are as yet a relatively small market in Europe in comparison with the US market. However, despite this there are strong signs that pension funds, hedge funds and other investors are beginning to embrace these products. While in the US institutions account for around half of all ETF assets, in Europe the figure is substantially higher.
“ETF usage is growing and will continue to grow,” said Towers Watson investment consultant, Chris Sutton. According to a survey from US-based Greenwich Associates, more than half of the US institutions using ETFs expect their usage of the product to increase in the next three years. A fifth of them expect the amount of assets dedicated to ETFs to grow by 5% to 10% in that period.
Index and exchange traded funds are superficially similar, both of them aiming to replicate as closely as possible the returns from their chosen index. But whereas an index fund lives up to its name by actually being a fund, an ETF is in fact a security that trades on an exchange like an equity. There are important differences between them both, not least in terms of how much they cost to own.
ETFs have certain advantages not shared by index funds. These include intra-day liquidity, (making them easier to access quickly), the availability of hard-to-obtain asset classes such as commodities and emerging markets, along with cheaper entry and exit fees.
Yet, despite the benefits of ETFs, the ‘vast majority’ of pension fund tracker assets continue to be held in more established index funds, according to Sutton. But as funds more generally raise their allocations to passive products that may be set to change. As investors find out more about the ETF market they may well choose to allocate a proportion of their investment to this market.
“Over the last year or two, pension funds have moved more into passive products,” said Sutton. “We have seen a resurgence in growth in passive assets.”
Towers Watson estimates that pension funds typically hold around a quarter of their assets in passive assets, adding that the figure can be as much as a third. Since UK defined benefit pension schemes hold at least £800bn ($1.2trn) in assets, according to the National Association of Pension Funds, that means between £200bn and £260bn is invested by UK schemes in tracker products.
ETFs still tend to be viewed as a last resort by pension funds, when the appropriate index funds or futures cannot be found. This was a finding of the Greenwich Associates report published earlier this year into how firms use the products.
But institutions are finding ETFs helpful in specific portfolio management tasks such as cash equitisation (the process of gaining rapid exposure to an asset class), found Greenwich. ETFs are also popular for short-term or tactical purposes, such as manager transitions, implementing investment ideas as well as for gaining longer-term exposure to certain asset classes.
One university endowment told Greenwich: “For emerging markets, ETFs are used to gain target allocations, while an active strategy and managers are implemented and hired.” Using ETFs to gain temporary market exposure for cash holdings has become widespread, according to Greenwich.
The $1trn ETF industry offers investors a choice of more than 2,300 products listed on 43 exchanges around the world. “Where ETFs come into their own is the greater diversity of types of assets you get in them than in index funds,” said Sutton at Towers Watson. “For example, sectors, commodities, currencies, different durations of the bond markets and short-term liquidity. Most pension fund ETF activity is in hard-to-obtain asset classes.”
ETFs trade continuously throughout the day, offering intra-day liquidity to investors who want to achieve exposure in certain asset classes quickly. “When someone is trying to buy an ETF they are expressing a view immediately, rather than waiting until the end of the day,” said Deutsche Bank ETF analyst, Christos Costandinides.
The ability to trade ETFs throughout the day, with continuous price discovery, is more than a technicality. It became vitally important during the 2008 crisis, when funds could not value their holdings. “Mutual funds are priced at the end of the day by a fund accountant who works for the administrator,” said Costandinides.
During the crisis, it became impossible to obtain a valid quote for a mutual fund, as stocks collapsed in value. “Because ETFs are shares trading intra-day you have an independent measure of how much they are worth,” he continued.
Greater liquidity makes ETFs cheaper to buy and sell than index funds, something that their providers go to great pains to promote, (although this tells only part of the story). iShares head of UK and Ireland institutional sales, Philip Philippides said: “On a bid/offer basis ETFs should be as efficient – and in some cases better – than buying just the underlying securities.”
According to Philippides, it would typically cost around 120bps to buy and sell a FTSE100 index fund. This compares to just four bps for the equivalent iShares ETF bought on an exchange. Similarly, the US-listed Emerging Markets iShares ETF costs as little as 1bp to buy and sell versus a 30bps spread on the underlying securities.
So why are pension funds not rushing to use ETFs, if they are so much cheaper? The answer lies in the fact that, while entry and exit fees on an ETF may be less than on index funds or the underlying basket of stocks that makes up the index, the annual charges (known as total expense ratios) on ETFs are often much higher.
Unless a pension fund is planning a rapid turn-around, only holding a fund for a few days to park cash while it arranges longer-term solutions, ETFs are not as attractive as they might appear if you looked only at the commission paid to buy and sell them.
ETF providers like to point out that buying and selling their products can usually be cheaper than for index funds, but that misses an important part of the story. “The cost of getting in and out of an ETF is lower,” admits Sutton. “But the management fee is higher. And the longer you hold the product, the more the entry benefit dissipates.”
Sutton added: “My sense is that if you were going to hold the product for more than two years then the lower management fee on the index fund is going to more than offset the higher trading costs.”
Management fees for ETFs range from 15 basis points up to 1%. “On average they are about 40 or 50 bps,” said Sutton. “Index fees are typically less than half that amount.”
Higher costs are holding pension funds back from using ETFs more frequently. More than a third of US institutions that do not use ETFs say cost is the reason they abstain, according to Greenwich. Even Philippides admitted that total expense ratios on ETFs are ‘a barrier’ preventing greater uptake. “In general ETFs may have a higher cost in terms of total expense ratio than an index fund on a headline basis,” he said. “From a total cost of ownership perspective they can be very competitive.”
However, the comparison between ETFs and index funds can come down to how long a fund is planning to own the product, according to investment consultants. “If a fund is looking to buy and hold for the long term, an index fund is likely to be better value,” said Towers Watson’s Sutton. “For the more transitional or tactical work, an ETF will probably be a better bet.”
ETFs also suffer from being something of an unknown quantity in Europe, where they have only been around for 10 years, despite notching up $230bn in assets. Even the more established $716bn US market has only existed for 17 years, while index funds have been around for decades. “Index funds are more familiar products,” said Sutton.
Nearly a third (30%) of institutions that do not use ETFs say they lack familiarity with the product, according to Greenwich. Investment consultants have been slow to warm to the products. Many of them are not currently recommending ETFs or even discussing the products with their clients, according to Greenwich.
“Providers should take it up themselves to educate institutions directly, through both dedicated sales efforts and through leadership programmes that convey the benefits of ETFs,” said Greenwich Associates consultant Chris McNickle.
Providers are keen to increase awareness of ETFs among pension funds and promote the products’ benefits. “We want to dispel some myths prevalent in asset owners’ minds,” said iShares’ Philippides. “It has to be through more education and familiarising people with the product and what it can offer.”
Despite their drawbacks, ETFs are attracting increased attention – and assets. According to Greenwich, nearly two thirds of US money managers expect to be devoting more assets to the products over the next year, while more than half of pension plan sponsors plan to do the same. ETFs may be a relatively new arrival on the investment scene, but they look set to make their mark.
For more on ETFs visit our sister title at etfmonline.co.uk
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