EUROPE - Pension funds should not consider exchange-traded funds (ETFs) to be expensive compared with index-tracking because access to exposure to emerging markets investments, in particular, can be cheaper than dealing direct, according to DB X-Trackers.

In the latest IPE webcast, hosted earlier this afternoon by Brendan Maton, Manooj Mistry, head of DB X-trackers UK, rebuffed pension fund claims these products are widely more expensive, and said while it was true exposure to the more liquid big-name benchmark ETFs - such as Dax, S&P 500 and Eurtostoxx - may be more expensive compared with index-tracking investments, many of the themed and specialist sectors are likely to be cheaper and easier to access.

More specifically, whereas an investor might expect to lose 15 basis points in fees through exposure to a benchmark, Mistry revealed the ETF is likely to outperform the index because the facilities carry "enhancements" which smooth volatility and return some of the management fee.

"I would disagree. In terms of the management fees, the cheapest [ETF] is 15bps on the Dax or Eurostoxx50. I agree institutions can get better rate exposure through the index-tracking houses. But what you get is the convenience aspect, and within the largest index-tracking houses you don't necessarily get the diversity," said Mistry.

"What [people] don't see is the true impact of the performance of fees because of the real world factors, including things like tax. The inconsistency is more pronounced when you start to track the broader benchmarks, as it becomes more and more difficult [to track them, and this impacts performance," he continued.

He acknowledged the fees on ETFs might seem high in some cases, as MSCI emerging markets ETFs for example, have a fee of 65bp and a tracking error of 25-35bp, giving a potential total access cost of 95bp.

But, claimed Mistry, paying 95bp would give pension funds access to products as the S&P Select Frontiers which is an emerging markets equities index providing investment access in countries such as Pakistan and Turkmenistan - countries pension funds might be keen to gain exposure to but might not be able to invest in given the low number of funds currently available in these markets.

"Themes ETFs typically charge 60-70bp and this is a given because they are a niche product. If you were to access and research them it would take more time and money. You get the value-added because someone has done the research on these companies so you are paying a little extra [than on more liquid indices]."

ETFs delivered by companies such as dbx counteract the higher volatility of an index and the potential costs by delivering outperformance to traditional index tracking.
This is done by entering into a swap arrangement with synthetic replication, with Deutsche Bank, for example, being the counterparty to deliver more accurate tracking and a maximum tracking error equivalent to the total expense ratio of the fund.

Rather than simply paying for index-tracking, the performance fee is effectively rebated because the ETF pays enhancements earned through stock lending and reduction in withholding tax applied to dividends, on top of the index returns.

After the accrual of management fees as outperformance, what the investor actually gets is 54bp outperformance, rather than 15bp reduction, because the ETF earns dividend enhancements paid between April and July, according to an example presented by Mistry, and which he said then gives "steady but boring performance, rather than volatility".

As well as explaining why ETFs may be cheaper than index tracking, Mistry revealed DB X-Trackers is introducing new shorting ETFs next week, covering the oil, technology, telecoms and healthcare markets - the first of their kind in Europe - to be used as a hedging tool within pension fund portfolios.

A recording of the IPE webcast with Manooj Mistry will be available on IPE.com at a later date.

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