Exchange-traded funds (ETFs) are a huge success story. Issuance is increasing, investors are pouring money into them, and the range of asset classes covered continues to expand. But the demand for different types of ETFs is not equal. It’s the equity ETFs that have the pulling power.
A new study from Edhec highlights the fact that the popularity of equity ETFs far outstrips the popularity of bond ETFs, with 61 per cent of current or planned users of the former but only 26 per cent for the latter. And this pattern of usage is fairly homogenous across the different types of users, whether institutional investors, private bankers or asset managers.
One reason for the predominance of equity ETFs could be that the offer is much more limited in the range of bond ETFs. Bond ETFs are also handicapped by the fact that the products have been around for less time, are therefore less well established.
“What exists mostly are equity ETFs,” says Felix Goltz, research engineer at Edhec. “You can replicate any style index, sector index, country index, anything you want. With bond ETFs there is a lot less on offer.”
But perhaps the bond market is generally less comfortable with the idea of a bond-based instrument that is traded and structured like an equity. ETFs are, after all, equities. “A bond is usually traded by an over the counter trading desk in an investment bank,” says Frank Henze, head of product development, iShares Europe. “A bond trading on an exchange takes an infrastructure you normally have in the equity world and transposes it on to the bond world. It’s a mindset shift in the bond trading community that says we have a product here that we can transact like an equity where the underlyings are bonds.”
Costs too high
 | The cost of ETFs can be an issue for some investors, according to François Millet, director of index linked products at SGAM Alternative Investments: “In an ETF you are paying management fees of 20 to 65 basis points, whereas a pension fund which is well organised can have a segregated account for index exposure at 10 basis points or below, so in general for buying vanilla ETFs it’s interesting for momentum management and tactical allocation, but not for the buy and hold part of the portfolio.” |
Millet: our fund is both active and liquid
Not everyone agrees with this point of view though. Some say it is the type of ETF and the amount of the investment that determine whether they are cost-effective.
“For certain major stock market indices, for example the S&P500, tracker funds that are not exchange traded are cheaper in terms of total expense ratio, but it’s not much of an issue if for other segments like style indices or sector indices,” said Mr Goltz. “Typically you don’t have index funds for those segments and given it’s the only choice over something like a swap or future, the cost seems to be an advantage for an ETF.”
Chris O’Brien, vice president of sales and marketing for Europe and Asia at Standard and Poor’s, agrees that a large pension fund investing $1bn or more has the financial clout to get fees of just a few basis points by going directly to an institutional index manager. However this is not the case for smaller institutional investors, he says.
“Smaller institutional investors, with $10m, $20m or $30m to invest, are going to be subject to a regular institutional fee base. The cost of an ETF can range from 7 basis points to 100 basis points for very exotic exposure, mutual fund fees go from 40 basis points to 200 basis points, depending if it’s actively or passively managed, or if it’s foreign exposure, emerging market or developed markets. For smaller institutional investors ETFs are going to have certain appeal, they are going to be able to have free access to a whole host of products at a very low cost.”
ETFs are proving popular for implementing tactical assets allocation, by providing an easy means to underweight or overweight sectors. State Street’s energy and healthcare sector ETFs are one example. “People take bets on sectors and ETFs are a safe way to do that,” says Alain Dubois, head of ETF marketing Europe at State Street. “You can use a swap, but an ETF is less difficult to handle. You don’t have the legal work to handle, you don’t have to go into a relationship with a third party, you just buy an ETF on the exchange.”
Jan de Bolle, manager of commercial affairs at Flow Traders, also notes an increasing use of ETFs to get exposure to sectors, regions and styles. He highlights particularly the use of exchange traded commodities (ETCs): “ETCs allow exposure to commodities to those investors who do not wish to use futures - for example, an asset manager’s mandate does not always allow the usage of futures.”
ETCs have garnered a huge amount of attention recently, in the wake of increased investor focus on commodities as an asset class. ETF Securities reports a sharp growth in the popularity of oil ETCs this year, with the value of its oil ETCs rising from $66m in January to $180m in November and a growth spurt of 15 per cent in October alone. Its two ETCs, listed on the London Stock Exchange, are based on two major crude oil benchmarks, WTI oil contract and the Brent oil contract.
Investors are both institutions and private banks managing high-net-worth money, says ETF Securities’ head of sales and marketing, Hector McNeil. The ETCs are being used as a way of getting a ‘pure play’ on the commodity price.
“A lot of people have been trading equities, like BP and Shell, on the commodity story for a long time but because they are diversified businesses exposed to factors other than the oil price they don’t give you a pure play on the rise and fall of the commodity price,” says Mr McNeil. “BP and Shell are more closely correlated to the S&P and the FTSE than to the oil price itself. We have been explaining the product and people realise they can get a pure play into the oil price itself.”
Management fees of 49 basis points are the only costs. ETF Securities offers 31 other commodity ETCs, 21 of which are single commodities and 10 broad based indices.
Mr McNeil thinks the index products are being used longer term for asset allocation purposes. “I think the individual ETCs are being used as a tactical play on where they think the commodity price is going,” he says.
Going forward, it is likely that ETFs will expand into even more diverse and exotic areas. Already they have moved away from pure index based products: in 2005, SGAM Alternative Investments launched actively managed ETFs, as have some US providers, like Rydex. Two alternative models for actively managed ETFs are used; the first takes an existing index and customises it by underweighting or overweighting stocks selected via a quantitative model to create a new index.
A new dimension
SGAM’s product follows a different format, which involves using active management on top of capital protection. “While using the constant proportion portfolio insurance technique, there is a dimension of active management on top of that,” says Mr Millet. “Every quarter we have the possibility to change the parameters that determine index exposure in order to increase the safety level for capital or maximise exposure to the index in order to have a good payoff while keeping capital protection.” The first indices selected for these kinds of products are the CAC40, the FTSE Eurofirst 80, and the DJStoxx50.
“Our structured ETFs could be interesting for a pension fund because they are a way to buy a CPPI as a risk outsourcing tool at low cost compared to any kind of structured products and above all any product that has a dimension of active management and is totally liquid,” adds Mr Millet.
Respondents to the Edhec survey were keen to see more ETFs based on alternative investments, with popular areas for expansion emerging markets mentioned by 49 per cent, commodities (36 per cent) and alternative asset classes (41 per cent).
In the bond arena this could translate into more products based on high yield, emerging markets and even derivatives like credit default swaps (CDS).
“The CDS market is huge and the governing legal framework of ETFs allows these sorts of underlying to be used. You will see a lot more exotic bond exposure over the next year or year and a half,” says Mr Henze.
Hedge funds present a bigger challenge. Though investible hedge fund indices already exist it is a big step from these to an ETF based on them.
“Liquidity would be an issue,” says Mr Dubois. “Someone has to produce a basket of shares to provide a return. You have to build a hedge fund universe that is as investible as the market, which might be difficult.”
Mr Goltz at Edhec does not rule it out, but questions whether there would be any demand for it.
“There are of course investible hedge fund indices which mostly come as funds of funds, that are not exchange traded. They come in the form of certificates and then the certificates are exchange traded, which are like an exchange traded derivative. There doesn’t seem to be a lot of demand for this compared to equity indices, for example. People seem to associate alternative investment with something that doesn’t have to do with indices, where they are trying to select the best hedge fund manager rather than buying an index.”
However, while many new and exotic ETFs come to market the demand for the long established equity index products is likely to remain strong over the coming months. “With any issuer you will always have one or two products that are leading the pack,” says Mr Dubois. Products can multiply in more niche areas, but mainstream products are likely to remain the most popular.
