Moving towards specialisation

As the ETF market becomes more mature and efficient providers are looking for opportunities elsewhere. Nina Röhrbein examines the evolution

At the end of February 2008, there were 1,223 exchange-traded funds (ETFs) with 2,043 listings and assets of $742.6bn (€470.3bn) being managed by 78 managers on 42 exchanges around the world, according to Morgan Stanley’s Industry Snapshot - End of February review on ETFs.

And with the number of ETFs continuing to increase sharply through 2008 and assets forecast to exceed $2trn in 2011, the ETF market is expected to be one of the largest growing financial sectors of the future, according to Deborah Fuhr, managing director for investment strategies at Morgan Stanley.

But where lies the attraction of ETFs?

Essentially ETFs are open-end index funds that are listed and trade on exchanges like stocks.

According to Morgan Stanley’s Year End 2007 Global Industry Review, “broad-based ETFs can serve as diversified core-holdings, while style and sector ETFs can be used to complete parts of a portfolio or for tactical strategies”.

Their liquidity and transparency of the underlying - showing all the risk characteristics, durations and exposures in an open manner - make them popular with investors, who range from asset managers and institutions including hedge funds to retail investors. They also offer less counterparty risk, a lack of correlation to credit spreads found in swap pricing and an operational platform over derivatives such as futures or swaps, according to the What Is? Exchange Traded Funds report by Chris Sutton, senior investment consultant at Watson Wyatt.

Pension funds tend to use ETFs for short-term cash management, asset allocation implementation, the quest of new betas, returns as a result of securities lending, transition management, long-short implementations and index reconstitution, says Sutton.

“Investors use ETFs mainly because they have specific asset allocation needs,” says Frank Henze, (pictured left) head of product development at iShares, the ETF arm of Barclays Global Investors (BGI) that listed its first European ETF in March 2000. “ETFs give them exposure to certain asset classes, offer access to difficult-to-access markets and offer flexible trading. Swaps are another way of covering asset classes, but these represent less flexible options and have counterparty risk.”

However, operational risks, a limited choice of providers, tax considerations and product proliferation, which makes it difficult for poorly advised investors to choose the right product among the increasing number of ETFs, are the disadvantages of ETFs, according to Sutton.

ETFs possess risks related to stocks in their underlying indices, are subject to tracking error risks, can be affected by premiums or discounts of net asset values and come with fees and expenses, states the Morgan Stanley global industry review.

To buy and hold an ETF an investor needs to pay a commission to the broker at purchase, half the bid-offer spread on entry, and the management fee and custody fees for the ETF security itself, according to Sutton. So in particular the total expense ratio includes a number of costs that a pension fund may well not need, including branding and liquidity, says Sutton in his report.

“While ETF fees are extremely competitive it is possible for a very large pension fund with a big enough portfolio to go to the larger passive managers and negotiate a more competitive fee rate for a disgressionary passive portfolio,” concedes John Davies, director of market development at S&P Index Services. “However, due to the product provision by several competitors the costs of more generic, plain vanilla ETFs have fallen from around 50 bps to around 15 bps.”

“Overall transaction costs have come down due to the fact that the market has become more mature and efficient,” agrees Henze.

But for Danièle Tohmé-Adet, co-head of BNP Paribas’ and AXA Investment Managers’ EasyETF platform, costs are not an issue. “The question is what the costs are covering,” she says. “It is more expensive for an asset manager to establish a specific desk, for example on commodities, unless he already has a dedicated desk or enough swap positions.”

“The fees are designed to be very stable and have been pitched correctly given the long-term returns from fundamentally weighted indices,” agrees Tim Mitchell, head of investing institutions at Invesco. “If you wanted to physically buy and maintain, for example, the individual components of the FTSE Allshare in their correct proportions, it would cost a lot more money than buying and owning the corresponding ETF. Investors do not need to pay stamp duty, while dealing commissions are low or can even be zero. In fact, with the current stock-lending market proving very profitable, particularly in the small and mid-cap areas, investors lending their ETFs could achieve a positive total expense ratio, in other words, generate alpha.”

“Costs are still an issue for our clients and the combination of tracking error and total expense ratio are very important to them, unless they are short-term traders such as hedge funds for whom trading liquidity is most important,” admits Dan Draper, global head of ETFs at Lyxor Asset Management, a Société Générale subsidiary of that launched its first ETF in 2001. “However, the annual expenses are lower than for many traditional index-tracking mutual funds. For many alternative asset classes, such as emerging markets and commodities, there are no trackers available and ETFs are the only options.”

“While the ETF market in the US is split 50:50 between retail and institutional investors, in Europe the institutional share of the market is around 70-80%,” says James Oates, (pictured right) head of marketing at specialist ETF provider SPA ETF. “One of the reasons for that is that in the US there is more of a stock-owning culture which suits ETFs, and the ETF market is more developed so there is more choice of funds for investors.”

While it has been widely accepted that the UCITS III regulation has benefited the advance of ETFs, the credit crunch - as bad as it may have been for markets in general - has been lending more recent support. “Although it had no specific impact on the ETF sector it highlighted some of their attractive features,” says Mitchell.

“The credit crunch has seen incredible spikes in volatility in the markets,” says Alex Claringbull, portfolio manager fixed income solutions at iShares. “And we noticed that in times of increased volatility - such as February, August and November 2007 - the volume trading in ETFs increased dramatically. And when markets deteriorated further this year, we saw even bigger trading volumes than last year. Trading volumes of our ETFs, for example, soared to three times the normal trading volume in late January. We believe this is down to people being able to quickly move in and out of markets. In times of market stress, investors look for that kind of ease and liquidity.”

“ETFs have proved particularly useful and flexible to investors over the last six months,” says Oates. “In periods of heightened volatility it is easier to return to cash or take up a defensive decision with ETFs than it would be with mutual funds that may take a longer time to redeem.”

“Investors also wanted to be exposed to the whole market rather than individual stocks following the credit crisis,” adds Thorsten Michalik, head of db x-trackers - Deutsche Bank ETFs, which only entered the ETF business in January 2007.

“The current market conditions are actually helping ETFs,” says Draper. “We saw a similar period in the last bear market in the US in 2000-01 when the focus was on risk control, expenses and the quest for efficient beta.

“Despite the impact on assets under management by price declines, we see net creations and interest levels increasing at the moment across our ETF product range, particularly for emerging markets. Declining equity markets also provide us with an opportunity to reiterate the important role that ETFs can play with regards to asset allocation and risk management.”

Henze agrees: “Providers need to offer specialist ETFs that can be used as satellites as well as the core, which is at the heart of people’s asset allocation. Over the last six months we have seen traditional equity and fixed income ETFs being bought as a way to reduce the risk around benchmark replication. So although new asset classes are being brought to the market - in line with the underlying trend to increase, for example, allocation to alternatives - the current focus of the asset management industry seems to be on risk-control through standard equity, fixed income, cash and commodity ETFs.”

“Transparency and non-liquidity were issues in the credit crisis, which has helped attract new investors because they now want to invest in tools that are liquid enough to change the allocation very quickly,” confirms Tohmé-Adet. “Risk-budgeting has also become more important and ETFs allow precise risk monitoring through their tight tracking errors.”

According to Michalik, the general trend in the ETF sphere is that they are no longer simply purchased for market access but also as part of an asset allocation solution. “Investors are able to invest in commodities, currencies and other asset classes through ETFs,” he says. “And so few ETFs are still launched on classical indexes. The focus is now on short and leverage, emerging markets, money market and bond products.”

New ETFs include fixed income, emerging markets, commodities, inverse and leverage, value growth, fundamental, real estate, Shariah, thematic, infrastructure and various sector ETFs.

Some like Mitchell believe that the market for ETFs that track well-known cap-weighted indices, such as the S&P500 or the FTSE100, is saturated. “The market has come up with more specialist products, which traditionally have been difficult to access areas, in particular commodities and emerging markets, and we see plenty of interest for these,” he says. “We, for example, have just launched an ETF in the US that gives exposure to the growth in nuclear power generation.”

“Recently there has been an explosive evolution in terms of moving away from traditional standard equity ETFs to open up more illiquid asset classes such as fixed income, property and commodities,” says Davies. “And any niche provider who wants to be a major part of the ETF space has to embrace these new developments.”

Claringbull says that iShares will be looking at second generation fixed income ETF opportunities over the next 12 months. “The plain-vanilla type products are already available in the market, so we need to look for opportunities elsewhere,” he says.

Davies reports a still healthy appetite for S&P’s standard, plain vanilla indices, although he admits that the provider has also issued several thematic indices such as renewable energy, clean energy, water and Shariah which have been used as ETFs. “Another key area for us are strategy-type indices such as 130/30 or multi-asset type strategies and indices with narrower exposures for which we have already seen good demand from ETF providers,” he adds.

Amalgamating the idea of two asset management companies, the EasyETF platform has concentrated on innovative ETFs that give exposure to listed real estate, commodities, infrastructure, socially responsible investment and Shariah-compliant investing since its start in 2005.

“Initially our ETFs were globally concentrated but we quickly realised the benefit of developing innovative access with the sub-sections of the new asset classes in terms of style or size, as more and more pension funds and other investors looked at alternatives for decorrelation,” says Tohmé-Adet. “

She adds: “What were are trying to do with the Shariah ETF is pool the administrative burden of the Shariah as a whole and benchmark it against important benchmarks like the Dow Jones Islamic Market Titans. The investor saves a lot of time and money by going through the ETF, in particular as many standard investment tools are not Shariah compliant.”

“Some new providers also stay away from market cap-weighted indices and use more fundamentally-weighted indices,” says Davies.

One of these is SPA ETF, a specialist provider of second-generation ETFs. Rather than tracking a traditional benchmark index, SPA ETFs utilise the performance of fundamentally-driven equity indices created by MarketGrader, an independent US research provider.

“We believe that active management often underperforms relative to index investing,” says Oates. “But market cap indices were not designed as well balanced stock portfolios and we believe that by creating an index of stocks that are fundamentally attractive we can generate outperformance.”

“Investors can use fundamental ETFs, for example as satellites, alongside traditional benchmark, core ETFs to improve their risk-return characteristics,” he adds.

François Millet, (pictured left) head of ETFs at SGAM AI ETF, Société Générale Asset Management’s alternative investment subsidiary, confirms that one of the directions the market is taking is ETFs based on fundamental quant models. “The other direction is trying to tilt or enhance an index yield or reduce the risk and volatility not by over- and underweighting stocks but by adding value offshore features or insurance portfolio techniques,” he says. “New ETF products have different risk profiles but still centre around the concept of capturing the beta of the market.”

“Everyone in the market is keen to see how the advent of active ETFs develops,” says Davies. “The recent granting of exemptive rights by the US Securities & Exchange Commission (SEC) is a major milestone for the business and some providers are now keen to launch their active ETFs. There has been a wave of movement towards more passive strategies in the institutional investor space recently but it is a logical step to have been taken.”

Recently troubled US bank Bear Stearns was the first provider to launch an active ETF in the US.

“We have just launched an active ETF in the US, which is a milestone for the ETF industry,” says Mitchell. “But at this stage it is difficult to say what the take up will be and what assets will flow to it. The developments for active ETFs are US-centric for the time being, as European regulations may have issues with it. It would be wrong to view active ETFs as a substitute for active fund managers that track the portfolio every day as there are restrictions on the amount of activity and trade that can take place. Active ETFs are more of an enhancement to the passive investing because they permit the portfolio manager to react to opportunities and threats in the market.”

Draper has watched with interest the recent launch of the first active ETFs in the US. However, he cautions: “It is important to remember that true ETFs must ensure liquidity and transparency. The jury is still out on whether active ETFs can really deliver on providing enough transparency and liquidity to garner the support of the ETF marketmaker community. At Lyxor we are more focused on the fundamental indexing area, which we believe has the potential to generate alpha through the index construction.”

“True ETFs in Europe, with permanent and full transparency on the portfolio content, are not active,” Millet says. “At best there is a qualitative process with some systematic rebalancing of the portfolio. However, some of these ETFs, like ours, are semi-active as they are based on the constant proportion portfolio insurance (CPPI) or dynamic portfolio insurance process (DPI), aimed at reducing volatility.”

“We define active as alpha-generating and have a strong philosophy of alpha and beta separation,” says Henze. “The beta is low cost and offers reliable index replication, while the alpha at BGI is high quality and sustainable. At the moment most ETFs in Europe are beta products but in the future there may also be pure alpha ETFs, such as the Bear Stearns active ETF in the US.

“BGI has also filed for an active iShares ETF in the US. In the meantime there are only algorithm or fundamentals-based products in the market in Europe that aim to deliver enhanced index returns. We feel that these products do not deliver what investors want because they want beta products for risk control and market return and alpha products for outperformance.”

In general, Claringbull expects more ETF providers to emerge. “Inevitably as the market grows, it will bring with it increased competition, not only on products but also on providers,” he says.

“The European ETF market has been growing at around 40-60% per annum over the past two years,” says Tohmé-Adet. “And within these two years we have seen more providers coming onto the market, not only from the ETF but also from the asset management and banking space.”

Michalik agrees. “Deutsche Bank has demonstrated to other potential competitors how quickly and successfully you can build up an ETF business and there are still plenty of opportunities out there,” he says.

“And because competition is fierce, particularly in the cap-weighted space, there is still a lot of marketing going on,” concedes Mitchell.

But what some view as marketing, others see as necessary education. “For many years, ETFs were successfully sold through the story of equity,” says Claringbull. “But now it is the time to start educating on non-equity asset classes such as fixed income, currencies and commodities. The days have gone when investors only looked at ETFs as tools to manage cash while waiting to implement an asset allocation strategy. Instead ETFs are now being used as investment tools within an asset allocation strategy to gain exposure to certain segments of the market.”