FTMandate: Having overcome a level of institutional investor scepticism over the last five years, are such investors now important players in the exchange-traded fund (ETF) market? What sort of investor makes up the greatest customer base for ETF products?
Daniele Tohmé-Adet: ETF products evolved from core long-term passive strategic investment, to satellite, active management through tactical allocation as a diversification tool. Today, they are also used as cash and transition management or hedging tools.
Known as passive indexation tools, ETFs no longer apply just to passive management. With the variety of underlyings ETFs cover, there is a wide choice of asset classes to allocate to within a very active portfolio.
This has widened the universe of ETF users to:
- Institutional investors seeking to gain access to new asset classes;
- Structurers in trading rooms for hedging their investments in illiquid asset classes;
- Family offices opening an array of new underlyings with Ucits III compliant tools;
- Asset managers for their allocation to satellite investments and wide spectrum of asset classes covered by ETFs;
- Multi-management platforms;
- Retail investors looking for access to underlyings with a suitable size, price and liquidity.
FTM: One of the fears institutional investors had with ETFs was their liquidity? Have fears of product liquidity been overcome? Why?
DTA: Liquidity of ETFs is the liquidity of their underlyings. As long as the stocks composing the index are liquid on the exchange, there is significant room for the market makers before reaching capacity.
Proxy stocks with higher liquidity can be used. Emerging markets could be a little less liquid but ETF providers have overcome this and even emerging market ETFs trade with tighter spreads than in the past. However, spreads will depend on the underlying index. Large trades can be booked directly via the market maker with very tight spreads.
FTM: Why do institutional investors use ETFs?
DTA: ETFs are flexible, simple to use, low cost funds traded on a real time basis on several exchanges .
Furthermore, they are lendable and can be sold short. They have the flexibility of a future without its maturity management and administrative hassle, the liquidity of swap markets without the consideration of a counterparty risk; the diversity of certificates with a multiplicity of pricing.
FTM: Can ETFs help investors faced with the requirements of IAS 39?
DTA: According to IAS 39 rules, financial information takes account of the right value rather than the historical value.
It has also a great bias to transparency and liquidity as it acknowledges the exact valuation at the closest to market pricing. This is exactly what an ETF offers in terms of characteristics.
Nevertheless, IAS rules state the non-sale of investment before maturity: with regard to ETFs on stock indices there is no maturity to be considered, whereas ETFs on bonds and commodity futures have a possibility of hosting the holdings under AFS (available for sale) classification.
ETFs would be the ideal tool for wrapping underlying assets or strategies in countries where transparency rules are very strict (such as Germany for instance). IAS rules are a very good excuse for having more strategies developed in the shape of ETFs.
FTM: What sort of ETF products have proved to be the most popular with investors and why?
DTA: ETFs are popular in the allocation to a region where stock picking analysis is poor for investment managers. For instance, emerging markets or an unfamiliar geographical zone out of the specific scope of analysis of the asset manager. As previously stated, ETFs are also very popular for accessing new asset classes and for gaining exposure to commodities and bonds without having to manage administrative burdens such as cash or futures.
FTM: How far does Europe lag the US in terms of ETF product development? How long will it take for Europe to catch up with the US?
DTA: Europe started developing ETFs in 2000 while in the US the first ETFs had been launched back in the early-1990s with the Spider and QQQQ. Today, Europe has a total of $75bn under management in 250 ETFs compared to a total of $350bn in around 260 ETFs in the US. Europe quotes ETFs on more than 15 exchanges and is very innovative in the creation of ETFs on new asset classes.
The ETF market in Europe differs to that in the US in two respects: cross listing and obligation to report to the exchange when over-the-counter (OTC) deals are done.
Although most institutional investors do not require the ETF to be registered in their home country for them to invest into it, the ETF must still be quoted on the local exchange when targeting retail investors. Costs of registration and listings regulations are different in each European country.
Large deals are often conducted via the market maker directly on the primary market and do not have to be reported on the exchange with the consequent effect on official numbers.
FTM: What will the next five years bring in the ETF market in terms of product innovation and demand?
DTA: ETFs will definitely continue to widen the universe of asset classes to investors and asset managers.
Enhanced ETFs and ETFs on active indices are definitely the trend for 2007.
ETF providers should continue their efforts to educate the financial community and be very clear with regard to communication of ETF developments in order to avoid any confusion for the investor, because of the free access to the ETF market.
ETFs accessibility is going to help transform the European investor who had a limited access to end products because of their lack of access to the intermediary market. Today, investors are free to invest in a wide array of asset classes through very simple, flexible tools such as ETFs.
FTM: Are ETFs an appropriate alternative to passive funds for ‘core’ portfolios?
DTA: ETFs are a very good alternative to passive funds in tactical allocation on account of their high degree of flexibility.
They are additionally very suitable for core portfolio exposure as they constitute a “free beta” allowing the cash back of management fees through lending–borrowing platforms.
Such platforms are developed to enable the short selling process since one needs to borrow an ETF to sell it short.
FTM: Are ETFs a suitable alternative to single strategy or funds of funds vehicles for investors seeking exposure to investments such as hedge funds, private equity, real estate and commodities?
DTA: Real estate exposure can easily be gained through ETFs; users will tell you it is the best tool for getting exposure to listed real estate for its liquidity and representativity.
Private equity and hedge funds strategies could definitely be a point of future development, even if the liquidity of such underlyings would be far from real time, ETFs could open the door for more flexibility and transparency in these two classes. It is all going to depend on daily real time pricing and transparency of the underlying.
Lock-up periods and transparency constraints, valuation lags and discrepancies between valuation methods and risk analysis for single strategies and hedge funds are not the ideal conditions for developing ETFs. There exists though, active management indices in these asset classes with a higher degree of flexibility and liquidity than the one encountered in general practice in alternative investments. This could be a first step to enlarging access to such asset classes and is a very good direction for further development for the coming year.
FTM: Do institutional investors in Europe encounter any problems in using ETFs to gain exposure to exotic asset classes?
DTA: Replication methods in ETFs from full to sample to synthetic open up the array of underlyings to a very large range of asset classes. It enables investors to invest in “capital markets” types of investments thanks to Ucits III compliance. This opens up a whole spectrum of new asset classes to investors as conservative as pension funds, endowments, family offices or some insurance companies thanks to the protection a Ucits III labelling provides. ETFs are a perfect wrapper for classes like commodity index components. Ucits III compliance enables investing in derivative type of products for those for whom the use of derivatives is prohibited. Consequently, the diversification of asset classes imported from trading rooms is extremely interesting .
Decorrelation between these classes and the traditional equity/bonds components is very valuable to the portfolio, often improving performance while lowering overall portfolio’s volatility significantly increasing the sharpe ratio of the portfolio.
Moreover, this type of ETF often represents a specific asset class (emerging markets, style/growth themes, real estate) with specific management skills requirements and therefore fully justifies the use of an indexed-based investment rather than a stock-picking internal analysis.
FTM: How effective a strategy is the lending out of ETFs for reducing holding costs and is short-selling of ETFs widespread?
DTA: ETFs are, in most European countries, less expensive than traditional funds. As they trade on an exchange via a broker, brokerage fees need to be added.
They are lendable especially when held as a core investment for a medium-term horizon. The break even point of an ETF holding cost is 18 months in terms of fees versus a traditional fund in continental Europe. Moreover, lending an ETF would offset most of the management fee if not the total expense ratio for the holder in Europe where the delivery market is not yet as developed as in the US. Lending benefits make ETFs a totally free beta asset. Lending/borrowing platforms enable ETF users to sell ETFs short, as they need to borrow an ETF on a monthly rolling basis before being able to sell it when they don’t hold it in their portfolio and want to play the downside of an underlying.
FTM: Can ETFs play a role in transition management?
DTA: ETFs are the perfect tool for different types of needs in the asset management:
- They enable core medium-long term investments at a very low cost through the free beta process.
- They also constitute excellent short term investment tools in transition management or cash equitisation process.
In association with EasyETF.
EasyETF is a product range of Exchange Traded Funds developed jointly by BNP Paribas and Axa Investment Managers. It allows all investors to implement exposure strategies for different asset classes (equities, real estate, bonds, commodities) and a variety of industrial sectors. The EasyETF product range now includes 25 ETFs with €4.3bn under management as of August 2006. All EasyETFs benefit from the combined expertise of AXA Investment Managers and BNP Paribas in fund management, market-making, as well as distribution.
