ETFM asks a panel of experts to discuss the role that ETFs play in the pensions industry and how they compare with other products
What are the benefits of using ETFs for pension funds?
Mark Rodino: They can play an important role both tactically and strategically. As listed securities ETFs are easy to access and are extremely flexible instruments to use short or long-term to provide the market return at relatively low cost and with very high levels of transparency and liquidity. All of these benefits are in demand following the credit crisis. In the short-term ETFs can be excellent tools for transition and tactical exposure management.
Matthew Holden: There are several advantages of using ETFs as an investment tool. ETFs provide exposure to various asset classes, are transparent and are generally as liquid as their underlying holdings. The tax efficiency most ETFs offer is a key benefit most pension fund managers seek. Market access to asset classes and regional/country indices has lowered the barriers to entry of historically difficult areas to gain exposure. In addition, as credit/counterparty risk has played a greater role in investment decisions, consultants and managers have favoured the reduced counterparty exposure offered by Ucits III ETFs over certificates and swaps. This, along with their exchange traded nature completely eliminates the requirement for ISDAs and allows the investor to trade with multiple counterparties to achieve best execution.
In Europe, in recent years, some of the lesser-known key benefits have come to light as the bourgeoning ETF market has matured here. ETFs allow an investor to more easily capitalize on stock lending revenues that occur on their index exposure by firstly offering a return on the lending of assets within the ETF, and from being an instrument that itself can be lent out as a secondary stock loan. In addition to this, ETFs are now being put to work as collateral in securities financing transactions.
Denis Panel: In today’s environment of increased risk surveillance, ETFs are gaining ground, especially with pension funds, as they offer more transparent and liquid access to a wide investment universe. So when you compare ETFs to a swap, for example, there is not just one single counterparty: investors have access to multiple market makers, there is no counterparty risk and ETFs are not derivatives, which many pension funds are barred from using.
Michael John Lytle: Pension funds benefit from many of the same characteristics that draw the broader market to ETFs. Like many institutional investors over the past few years, pension funds have become significantly more sensitive to the issues surrounding counterparty risk, transparency, liquidity and the all-in cost of investing. Unlike futures and total return swaps, ETFs are cash products. The mechanics of using and managing derivative positions can result in meaningful operational costs (eg margin calls, rolling). Furthermore, in certain European countries, the accounting treatment of ETFs is more favourable than with derivatives. When compared to traditional funds, ETFs generally have a lower tracking error and lower total expense ratio, with the additional advantage of being easily traded intraday both on-exchange and OTC through multiple counterparties. ETFs allow pension funds to gain efficient exposure to a broad range of indices across all asset classes and regions. They are simple and flexible products, which allow investors to react quickly, particularly in volatile markets, to short-term and long-term opportunities, and adjust their portfolios intraday as required.
To what extent do pension funds use ETFs? Is there greater use in certain parts of Europe?
Matthew Holden: ETFs have a wide reaching scope of applications within pension funds. They can be used in asset allocation, cash equitisation, liquidity management and portfolio completion. More importantly, due to the ease and flexibility in which they are traded, they are popular instruments for use in transition management trades. The Nordic pension schemes in particular have been quick to adopt US and European listed ETFs in all areas of their management.
In the recent counterparty risk environment, we have also witnessed customers who have traditionally used swaps in asset allocation models, shift to the adoption of ETFs. For European institutional investors, the most popular use of ETFs has been in asset allocation strategies. Countries such as Germany and Italy have recently expanded their use more towards portfolio completion and liquidity management.
Michael John Lytle: The use of ETFs within the pension funds community is increasing across the board but at different rates and from different starting points. In France and the Nordic countries, pension funds are already actively invested in ETFs. We are also seeing significant growth in ETFs assets in Switzerland, Germany and the UK. Iberia, Italy and Eastern European countries (C4) are moving more slowly. Inevitably, the use of ETFs by all pension funds will increase significantly as the European ETF market develops.
Denis Panel: We know that all pension funds in France and over 80% of those in the main European countries use ETFs, but we also have strong demand from Eastern European countries.
ETFs offer many advantages over other products. Compared with a basket of securities, ETFs have low administrative management, as there is only one single transaction. This is one reason why pension funds want to use them. And if you compare ETFs to futures, you don’t have any maturity rolls or margin requirements, so these factors can make ETFs very appealing.
Mark Rodino: The relevance of ETFs is clear in Europe, with over 70% of assets under management coming from institutional investors including pension funds. For smaller and medium-sized schemes making smaller asset allocations, ETFs are particularly relevant. Traditional mutual funds are not designed for tactical trading while using derivatives can be problematic for some pension schemes. ETFs can offer precision in exposure management not easily matched by most other investments.
Do ETFs compete with any other products e.g. index funds?
Michael John Lytle: ETFs and index funds both offer passive exposure to a variety of investment benchmarks. There is a continuing trend toward passive investing reinforced by multiple studies that have highlighted the efficiency of passive investing, particularly in bear markets. However, although ETFs and index funds both offer passive exposure, ETFs are often the more efficient investment vehicle using both physical and synthetic replication methods and offering competitive management fees, a continually evolving range of benchmarks and intraday execution which enhances the efficiency of investment entry and exit points.
Denis Panel: When you compare ETFs with index funds, the main difference is the real time transaction, so that’s the main advantage. With ETFs, there are no subscription or redemption fees. It’s true that for the biggest pension funds which want more customisation in the index and the management, it’s much easier to offer index funds or mandates. But ETFs are well adapted for short term and tactical investments, due to their liquidity and the real time transaction.
Matthew Holden: There are many products with which ETFs compete or can be used interchangeably. ETFs can be utilized in the same manner as index funds, futures or swaps and certificates. In a similar fashion to futures, ETFs can be used for quick deployment for beta exposure. ETFs compete with futures in terms of providing liquidity in most common benchmarks, but have a greater variety of tracking indices on offer (narrower benchmarks, emerging, inverse etc) and have the advantage of avoiding roll costs. Swaps and certificates are another tool for a pension fund that compete with ETFs. Their advantages lie in their customizable nature, but expose their holders to direct counterparty exposure. They are also cumbersome to establish with requirements for ISDAs and term sheets, which call for them to be drawn prior to trading.
Many of the established index funds that compete with ETFs have lower costs due to their scale, but have limited scope of benchmark indices, and only allow the investor to enter the fund at NAV. One of the key advantages of ETFs is they allow an investor to enter and exit their exposure at almost any point, and with many counterparties. This is particularly important for consultants and transition managers as the costs of entry and exit of funds is greatly reduced by effectively eliminating slippage during transitions.
Mark Rodino: The advantages of ETFs are firstly the ability to buy and sell throughout the trading day and at a known price. This compares well with a mutual fund, which will typically deal at one point during the day and at a price which is not known at the point the instruction to buy or sell is made. The second advantage is the transparency of costs, with the total expense ratio (TER) reflecting total costs, which compares well with index funds where the Annual Management Charge (AMC) does not include all costs and expenses. The third advantage relates to the management of the tracking error, with the ETF manager rebalancing an ETF portfolio versus the benchmark through efficiently transferring stock ‘in-specie’, dealing in baskets of stock in co-ordination with the market maker. The manager of an index fund, by contrast, must typically balance cash inflows and outflows from investments and redemptions within the fund and then trade lines of stock to rebalance. This creates a potential inefficiency within index funds which contributes to the tracking error.
Are there any types of ETFs that are particularly popular among pension funds in terms of underlying/structure/issuer?
Matthew Holden: Emerging markets ETFs have been hugely popular. ETFs offer exposure to asset classes which have been historically difficult to gain inexpensive exposure to. The scope of asset classes offered by ETFs has allowed fund managers to easily invest in fixed income and commodities. Fixed income ETFs have given fund managers a clearer window of transparency into the asset class and as a result $50bn of AUM has been placed in these funds over the last 18 months.
Cash-based ETFs have tended to be more popular than swap-based ETFs but as the market has matured, ETF providers have done much work in educating their investors on the composition of these structures.
Denis Panel: The main trend we have noticed in the market is towards fixed income ETFs. Since the beginning of the year, more than 20% of the inflows have been coming into fixed income ETFs in general.
The rest of the demand is for the core ETFs on developed countries, like the EURO STOXX 50. We are also seeing demand for emerging markets equity, for example for our recently launched Next 11 ETF, an emerging markets fund that we are currently promoting to provide access to new emerging markets. For certain investors, the BRIC countries are viewed less as ‘emerging’ as they become more developed. So we find many investors are looking more for pure emerging countries, hence us launching Next 11, which offers access to Vietnam, for example.
We offer both synthetic and cash replication. When we want to have access to a certain type of asset class, like commodities, we need to use swaps to replicate the GSCI or other commodities indices. We also have cash replication, which we use, for example, with the EURO STOXX 50. These days it’s quite difficult to stick to one replication method. It’s interesting to see that ETF providers are opening up replication methods.
Michael John Lytle: ETFs provide convenient investments delivering access to both conventional markets as well as those that have in the past been difficult to access. Pension fund investment has driven asset growth in traditional indices such as MSCI Europe, EURO STOXX 50, MSCI USA as well as MSCI Emerging Markets, Russia, China and Brazil. Some ETF structures also offer significant counterparty diversification using a combination of physical investments enhanced by synthetic replication in order to achieve highly efficient tracking while balancing and spreading counterparty exposure. Recent market gyrations have taught investors that counterparty exposure is inevitable. Investors benefit from understanding and monitoring the range of exposure inherent in their portfolios. Source has shown through the performance of its funds that it is possible to deliver highly accurate benchmark tracking with negligible counterparty exposure.
Mark Rodino: Our view is that the less complex and greater transparency in the approach, the better, while well known indices in established markets are the most popular. However, different approaches to replication suit different types of investment and each has their own benefits and drawbacks. We are pragmatic in terms of the approach we select for our own ETFs. All of our current ETFs are physical replication. A manager will typically buy the underlying stocks to physically replicate the risk and return characteristics of the index. The advantage of this approach is the low tracking error versus the index. It is also the most straightforward approach to understand. The disadvantages are that full physical replication incurs the highest potential custody and transaction costs and is harder to achieve if the index contains smaller less liquid constituents. Optimisation is a variant on the approach which seeks to replicate the risk and return characteristics of the index by creating a representative portfolio but avoiding turnover and trading costs in illiquid names. This is cheaper and more efficient but can lead to a higher tracking error. The alternative to buying all or most of the stocks in the index (physical replication) is to use derivatives, typically a swap. This is typically lower cost and produces a lower tracking error but it potentially increases counterparty and regulatory risk.
Is pension fund usage of ETFs likely to increase and are there any regulations that may impact on demand?
Mark Rodino: According to Towers Watson senior investment consultant Christopher Sutton, many UK pension funds have increased their allocation to corporate bonds over the last year. However, liquidity only materialises at the new issue of the bond. To get around this liquidity bottleneck some pension funds are using the ETF to buy the corporate bonds when they want to. They then move out of the ETF into underlying bonds as new issuance brings to the market the type of bonds they require, in terms of duration and credit rating.
Fixed income ETFs are tradeable on an intra-day basis compared with the underlying bond markets which are OTC, with no on-exchange pricing transparency. The prices managers get in order to manage their own portfolios in fixed income will vary with their relationships and the size of their funds. For example, larger pension funds are more likely to get better pricing and more of the available liquidity to manage their portfolios so might need ETFs less.
Smaller pension funds can also benefit from using fixed income ETFs because they usually don’t have the specialist bond expertise to research the enormous range of bonds from which to select. Earlier this year bond buyers could have paid a 6% spread between the bid and offer. If on the other hand you buy a corporate bond ETF, the maximum spread allowed is only 3% in the UK market.
Matthew Holden: The growth of ETF listings entering the market in Europe is being driven by the growth of adoption by the pension funds. Additionally, there has been a steady layering of regulatory changes that have aided growth and continue to do so. The Ucits III rules allowed for an increase to 20% (from 5%) as a percentage a Ucits approved fund could hold in another fund. Most of the recent regulatory pushes have been focused on the retail and intermediary markets with moves such as the RDR (Retail Distribution Review) from the UK’s FSA that will encourage financial advisors to expand their range of products in areas such as ETFs. Other indirect factors at play are the entry of banks into the ETF provider space. The synergies between ETF trading and prime brokerage operations creates efficiencies that will benefit the end investor.
Denis Panel: In the current environment, with investors looking for more transparency, I’m sure the ETF market will continue to develop. We know, for example, that there is a trend among the stock exchanges to be more transparent regarding the OTC transactions. This is quite interesting for certain ETF providers, because we know a large part of our trades are done OTC, and it’s good for the investors to know that through EasyETF we offer excellent conditions for creations and redemptions over the counter.
We don’t need to have a very large range of ETFs to offer to pension funds or institutional clients. We focus on a core ETF range with a few flagships on the mainstream indices. Our main objectives are to offer the best performances, the tightest spreads and the biggest AUM for the investors. ETFs need also to offer diversification and innovation. That’s what we have with our full range of EasyETFs on commodities.
Michael John Lytle: As mentioned before, there is significant growth in ETF ownership within the pension funds across Europe but the pace of growth and starting point is different country by country. Tax and investment regulation plays an important role in driving this differential development. ‘Solvency II’ will impact the balance between equity and fixed income investments. Ucits IV will further increase the operational efficiency of ETF structures. However, the most important factor in the development of the European ETF market is trading liquidity. A more liquid secondary market offers investors a greater range of inexpensive execution options and truly differentiates an ETF from other passive investment vehicles. Mifid II is likely to bring increased post-trade transparency to ETFs but only market participants can create a more efficient trading environment. Source is focused on bringing more trading capital to the table with focused liquidity in our ETFs.
Matthew is managing director, head trader for the ETF trading desk in London. Matthew is a 10-year ETF industry veteran with a core focus on market making and institutional sales. He joined Knight in June 2009 from Newedge where he was Head of ETF Trading Europe.
Michael is a managing director and founding partner at Source with specific responsibility for marketing and broader involvement in product creation and design. Prior to joining Source, Michael was an Executive Director at Morgan Stanley in London. He has a Bachelor of Arts in Economics and Government from Dartmouth College.
Denis joined BNP Paribas Asset Management (BNPP AM) in 2007 as Head of the SIGMA (Structured, Indexed and Generation of Multi-Alpha) team, located in Paris, Brussels and Hong Kong. Denis has over 15 years of experience in investment strategy and investment management.
Mark is head of ETF Sales for Europe, Middle East and Africa (EMEA). He joined HSBC in May 2010, and is helping the bank launch its suite of HSBC -branded ETFs and also build out of a pure-play ETF trading platform. Prior to joining HSBC, Mark was head of ETF sales for Europe at Knight Capital.
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