ETFs bear fruit

Pension funds

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The direction of financial innovation is typically such that new products emerge in the wholesale markets and then filter down to retail. But a couple of years ago, exchange-traded fund (ETF) groups at major banks in Europe realised they may have on their hands a product whose path of adoption could move in the opposite direction. Increased competition among providers drove the cost of ETFs down, and banks and pension consultants began to tout ETFs as an essential new tool for pension fund managers looking to diversify into new markets and as an efficient instrument for dynamic asset allocation.

Speak to some consultants and large pension fund managers today, and it is easy to get the impression that the hard sell of yesteryear has born little fruit. Take PGGM, for instance. The EUR70 billion Dutch pension fund for the healthcare and social-work sector only makes limited use of the product itself, and even then indirectly, in that some of its external managers are occasionally active in ETFs.

The decision to use ETFs as an alternative to futures or stocks lies with the investment manager, explains Marc Nuijten, head of external alpha mandates at PGGM. "To generate alpha, the most important decision is whether to increase or decrease exposure in markets. And this should be done as efficiently as possible with the instruments that are available," he adds.

Internally, PGGM uses ETFs very rarely and for strategic reasons - for instance, gaining exposure to emerging markets or particular stock market sectors. This is for the beta part of its portfolio, which is made up of passively managed securities, such as index products that track broad market exposures. "We do not use ETFs often because their liquidity in many markets is not large enough and they are reasonably expensive given the management fee that is included. This makes them a costly alternative," says Nuijten. Instead, given the efficiencies of scale that such a large pension fund can achieve, PGGM typically uses futures and equities rather than ETFs.

However, the cost of trading ETFs has reduced over recent years. On an asset-weighted basis, the average total expense ratio for European ETFs that are five or more years old was 29 basis points a year as of July 2007, a drop of 20bp from the July 2002 figure, according to Lipper, a New York-based fund research company that is part of Reuters.

Lipper defines the total expense ratio as the 'drag' on fund performance caused by all annual operating costs including the annual management fee. "ETFs are one area among funds open to retail investors where competition is pushing down fees," says Ed Moisson, director of Lipper's European fiduciary operations in London.

Despite the drop, the cost of ETFs is considered prohibitive in some circles. "In my experience, only a small minority of pension funds use ETFs, although my clients are predominantly medium and large funds," says Ralph Frank, European director of consulting at Mercer Investment Consultants in London. "For an institutional investor, there are better-value ways to gain the same exposure to various markets, such as institutional pooled funds."

ETF management fees are currently around three times as large as those of institutional pooled vehicles. Mercer's Frank says the most common form of institutional pooled fund in the UK are operated by insurers that group clients' money in a common fund, from which units are issued to the pension funds. Elsewhere in Europe, vehicles such as open-ended collective investment schemes called societe d'investissement a capital variables and communal contractual funds are also popular.

Despite competition from these kinds of vehicles, the current picture is not actually as gloomy for the institutional client-seeking ETF providers as it might appear. Dealers say small and medium-sized pension funds are, in fact, making greater use of ETFs in their investment portfolios. For instance, a EUR630 million pension fund of Hanover-based automotive parts manufacturer Continental AG and Inarcassa, a Rome-based EUR3.5 billion social security fund for engineers and architects, have made significant use of ETFs.

And even some larger funds, which may not make extensive use of ETFs as investments per se, are using the instruments when switching external managers. "We have seen larger-sized pension funds using ETFs for transition purposes - for example, they may use ETFs when they are in transition from one mandate to another," says Axel Lomholt, head of ETF products for iShares at Barclays Global Investors in London.

Increasingly, European pension funds are adopting a so-called core-satellite strategy, where the core section of their portfolio is passively managed to track the market (beta) and the satellite is actively managed to generate alpha - or outperformance that is uncorrelated with broad market moves.

Small and medium-sized pension funds are typically using ETFs to generate beta. Daniel Draper, London-based head of ETFs at Lyxor, a subsidiary of French bank Societe Generale, says emerging market ETFs are especially popular because of the difficulty of finding managers who are consistently strong in this area.

Those few funds that are trading ETFs to generate alpha appear to have reasoned that the cost of using these instruments is acceptable when taking into account the relative cost and hassle of developing infrastructure and expertise to trade stocks or futures in certain sectors themselves.

Alpha can be generated via market timing or security selection, and contrary to the view espoused by PGGM's Nuijten, Lyxor's Draper says the liquidity of the ETF market is good enough for the product to be used in both contexts. "ETFs can be implemented to generate alpha through market timing. They are listed, very liquid and you can trade them very quickly through a number of competing brokers," he says. He adds that the wide variety of underlying asset classes are now available beyond equities, including commodities and fixed income, which has also made ETFs a viable tool for security selection-based alpha generation (see box).

Deborah Fuhr, head of investment strategies at Morgan Stanley in London, agrees that ease of use is a major reason for the explosion in European ETF trading volumes witnessed in recent years. "An ETF is simple to invest in. The client is just buying and selling a product that trades and settles like a share, without needing to figure out what stocks to buy or worry about settlements, dividends, corporate action or index rebalances," she says.

Another reason for the dramatic growth in volumes is the sheer breadth of underlyings that can now be accessed in the ETF format. In Europe, 26 new ETFs were launched in the first quarter of 2007, taking the total number of ETFs to 299, with assets under management of $98.7 billion - a 10% increase from the end of 2006.

The European market has been growing at a much faster rate than the US market during the past few years. According to research carried out last year by the Edhec risk and asset management research centre in Nice, total ETF assets under management grew by 61.7% in Europe in 2005 while the figure for the US was 33.6%. The European ETF market began in 2000, while the still larger US market got off the ground in 1993.

Meanwhile, global average ETF daily trading volumes increased by 73.9% over the first quarter of 2007, based on dollar 20-day average daily volumes. Average daily trading volume in ETFs in the first three months of this year was $42.7 billion, or 732 million shares, according to Morgan Stanley's ETFs - 1st Quarter 2007 Global Review, published in May.

Mathieu Guignard, co-head of the EasyETF platform at Axa Investment Managers in Paris, says that as the market has grown in breadth and depth, institutional investors' perception of ETFs has changed markedly. "They were previously seen as a pure passive product for passive investors. Now, investors are aware of other uses, such as for active management to generate alpha in a core-satellite strategy," he says. "They can be useful for getting a quick and simple exposure to quite hard-to-access asset classes, such as commodities - either for diversification purposes or to gain a higher risk/return rate."

EasyETF is a joint venture between Axa Investment Managers and BNP Paribas. "The use of our ETFs by European institutional investors, including pension funds, has grown over the past 12-18 months, but it is hard to estimate how much because they often invest in our ETFs through exchanges or through a broker," says Guignard. "The ETFs of particular interest to them now are those linked to commodities and listed real estate."

Mercer's Frank agrees that commodities are one example of an underlying where, in theory at least, pension funds' use of ETFs could take off. But he emphasises the issue of cost will ultimately limit how extensive the use of ETFs is among European pensions. "Their use may become more widespread if the fees come in line with the institutional pooled funds," he says. "But at the moment, ETFs are in many cases a fantastic source of revenue for the ETF providers, so there is not much incentive for them to reduce their earning streams."

DIVERSE UNDERLYINGS

A whole host of exchange-traded funds (ETFs) with more unusual underlyings have launched this year. In July, Axa Investment Managers and BNP Paribas launched a series of ETFs that track various iTraxx credit derivatives indexes. The move followed Deutsche Bank's launch of three ETFs tracking different iTraxx credit derivatives indexes in May.

ETFs that offer some form of commodity or energy exposure could also appeal to institutional investors. Beyond the spate of ETFs that track indexes composed of commodity futures contracts, some providers have decided to take a slightly different tack. Barclays Global Investors, for instance, launched an ETF linked to clean energy on the London Stock Exchange in July. The iShares S&P Global Clean Energy is the first so-called clean energy ETF to list in Europe.

The S&P Clean Energy Index comprises the stocks of clean energy producers, including solar, wind and bio-based energy producers, which makes up 35% of the index, and clean energy technology and equipment providers, such as wind turbine manufacturers and photovoltaic cell suppliers across the globe, which accounts for the remaining 65%.

Aside from commodities, institutional investors have also had an appetite for real estate ETFs. In March, BGI launched its iShares FTSE EPRA/NAREIT UK Property Fund, which offers exposure to property company stocks and real estate investment trusts (Reits) domiciled in the UK. In aggregate, these companies and Reits hold a diversified portfolio of properties from the retail, office and industrial sectors.

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