GLOBAL - Global ETF provider iShares has hit back at claims by consultancy firm Watson Wyatt suggesting ETFs are in most cases an unattractive investment for most institutional investors, and argued the pricing of products is in many cases equal to that of passive index investments.

Watson Wyatt today issued a statement arguing ETFs were not a wise long-term investment for most pension funds because "they generally have higher fees than many institutional index products", and further argued: "The case for their inclusion in institutional investment portfolios is not yet obvious as we wait to see more competitive fees and transparent structures."

However, Nizam Hamid, head of sales at iShares Europe, described the arguments presented by Watson Wyatt as "a bit simplistic" as most pension funds - especially larger European pension funds - would not use them for long-term investment anyway, while any analysis of indexed investments and ETFs would make ETFs seem more expensive if you look only at the TERs, he argued.

"When you talk about the high fees, a focus on the total costs of ownership would show it is typically lower [to use ETFs] than the exchange ratio. If you only focus on the headline TER, you will have a headline expense ratio which is more expensive. But the equation changes when you take into account the total cost of ownership, the bid/offer spread in trading, and the additional revenues that can be earned through securities lending," said Hamid.

Both Watson Wyatt and iShares seemed to agree that ETFs are being used as "tools for transition and short-termer market exposure". However, the consultancy argued it would "rather press for genuine innovation in the investment context of index products".

Hamid countered this claim by suggesting in many cases what pension funds might be seeking is emerging markets exposure, such as Brazil and Mexico, where they want to hold ETF products for a longer periods of time, in part because currency costs could increase the overall charge if they trade rapidly. Similarly, holding such assets could contribute to a fund's overall weighting rebalancing, and securities lending can take place to help earn revenue.

One of Watson Wyatt's main claims, however, is there may be a hidden counterparty risk for ETF holders, such as "significant amounts of counterparty risk inside ETFs". Chris Sutton, senior investment consultant at Watson Wyatt, said he felt "it is not clear that investors are being adequately compensated for having to take these risks when holding an ETF".

Yet Hamid argued 98% all ETFs are very transparent because they are based on physical underlying securities and can therefore be tracked daily on an ETF platform. He acknowledged swap-based ETFs, which make up approximately 2% of the global ETF market, may not be as transparent given the complexities of the collateral pricing and assets held to produce the swap but suggested their level of transparency was no different to many swap products already in existence, which Watson Wyatt is advocating the use of.

"We believe there is a place in the market for swap-based ETFs where you can't physically own the asset. And these are managed using the same securities lending platform for collateral management as everything else at our company, so would be on the same platform as a passive mandate. There is actually more risk in futures contracts where you are trying to forecast dividends you might not receive," added Hamid.

Watson Wyatt's argument is the development of indexation is now likely to provide passive investors with a broader range of investment options and better risk-adjusted returns than those currently available through ETFs.

If you have any comments you would like to add to this or any other story, contact Julie Henderson on + 44 (0)20 7261 4602 or email julie.henderson@ipe.com

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