What type of Exchange Traded Fund (ETF) products proved most popular with institutional investors in 2006, and why?
ETFs are very popular among institutional investors, because they make access easier in classes such as emerging markets, which may be more difficult to invest in. Stock picking analysis would be more difficult for a European manager in emerging markets or for a Korean manager investing in a European market, for example. The use of an index is therefore justified and access through an ETF is easier and cheaper. It can be used for the following purposes:
• Wrapping derivative products as commodities into a Ucits III wrapper, avoiding the restrictive regulations normally attached to derivative products;
• Enabling fund structures based on underlyings such as real estate to adjust their delta hedging through the only liquid product available on this asset classes : an ETF;
• Opening the opportunity for specific adjustments of managers to broad indices through sectors or style and size ETFs, neutralising the bias in broad indices while enhancing the leverage according to their own analysis;
• Sharpening bets through exposure to sub-indices through ETFs.
What types of ETF products have performed best in 2006, and why?
In 2006 sector rotation, emerging markets, commodity and real estate ETFs were winners: commodities and real estate for their specificity in packaging or underlying terms, and sectorals because of thematic ETFs being very popular and sectoral rotations more and more common. Finally, emerging market ETFs are the most liquid tools for exposure to emerging markets, while representing an economic tool to the asset manager lacking specific analysis capacity in the area.
A growing ETF market in 2006 has seen emerging market ETFs attract strong inflows on the back of recent good performance. What are the best buys in the ETF market for
2007, and why?
2007 is going to see development of new asset classes and access to fewer liquid classes and products, with more products imported from the trading room and the introduction of specific underlyings for sharper allocation in emerging markets. We will also see the emergence of second generation ETFs such as structured ETFs or ETFs based on second generation indices such as ‘buy write’ indices or ‘bear’ indices. Structured ETFs are also going to become more developed .
What are the costs that institutional investors need to be aware of when investing in ETFs?
Institutional investors have to be aware of :
• The spread of illiquid underlyings for specific ETFs;
• Access via brokerage fees;
• Shorting via borrowing platforms.
Total Expense Ratios (TERs) are not always equivalent to management fees, especially in offshore funds. Always try to optimise ETFs held on a long-term basis through lending.
How do ETFs compare to using futures, certificates and swaps?
ETFs are legally considered funds, and have the flexibility of futures without the administrative hassle needed to settle the futures trades. ETFs are multi-priced, like futures but unlike certificates. They are quoted on an exchange, like futures, and don’t need counterparty risk agreements or ISDA agreements to be set.
ETFs trade in real time and can be shorted, like futures; in certain cases, such as the GSCI Index, ETFs extend the liquidity of the index to off-futures hours. Unlike futures, ETFs don’t have maturities to be rolled over or margin requirements to be taken care of; the manager of the ETF rolls over the maturities of bond or commodity ETFs and also manages coupon reinvestments and margin requirements. ETFs are lendable, helping optimise the medium term carry, which amounts to free beta. ETFs also have an official net asset value, which can be checked at the end of the day.
How are ETFs used for tactical asset allocation?
ETFs have been used for tactical allocation since the range of underlyings has been enriched with a variety of asset classes. Allocations are shorter term or leverage-biased exposure.
In tactical allocation, it is the flexibility of the ETF that attracts the manager. It is often the only tool available with a liquid bias in specific markets. Managers can therefore diversify the allocation in their portfolio.
To study the effect of using an ETF on the efficient frontier of the portfolio (a measure of how allocation to a specific asset class creates return, while reducing overall risk), the concept of a risk budget can be used.
A risk budget is attributed, and an average return is studied within this risk budget through the added value imported via de-correlation. Such an efficient frontier shows commodities for instance are more de-correlated to equities when bearing a high weighting in energy rather than to bonds when the weighting to non-energy stocks is more important.
As a whole, de-correlation via commodities in a global portfolio would find its efficient frontier at about15 to 20 per cent of the allocation, depending on the nature of the commodity or the components of the portfolio.
Mathematical systems to determine tactical allocation are often applied, through specific modules for different asset classes within global portfolios. De-correlation is studied for each pair of assets and combined within a global allocation programme.
For hedging against inflation, ETFs in energy-based commodities or an Inflation Index can be invested, depending on the volatility budget and the other components of the portfolio.
Real estate is another diversification bias, but it is tightly correlated to the stock market globally, while specifically targeting a sector of the economy of a growing country that cannot be neglected.
Thematic ETFs are also developing fast and enabling managers to target a specific area of interest without having to conduct time-consuming analysis. ETFs are so convenient for a specific immediate exposure that they are nowadays used as a main tool in transition management and cash equitisation.
A recent study by business school EDHEC found that while equity ETFs are popular, bond ETFs and style ETFs are being used a lot less. While 45 per cent of the 112 institutional investors and asset managers surveyed were using equity ETFs, 13 per cent were using government bond ETFs and only 6 per cent were using corporate bond ETFs. Some 21 per cent of survey respondents saw no use for sector ETFs and 40 per cent were uninterested in style ETFs. Why, in your view, are bond ETFs, sector ETFs and style ETFs proving less popular than equity ETFs?
Bond ETFs are not being used yet at the level which they merit. They do not represent ‘new access’ to an asset class such as bonds, and so they are not part of a revolutionary new asset allocation. But bond ETFs do make the life of a global asset manager so much easier. There is no coupon management: coupons are invested with EasyETF iBoxx in the money markets every month and reinvested in the bonds on a quarterly basis. There is also no need to replicate bond lines for such an underlying. Rebalancing of the index, especially with short-term maturity exposures, is unnecessary.
EDHEC has underlined the fact that ETF bonds are really worthwhile because of all the administrative time savings at such a low cost. On the other hand, EDHEC confirmed there will be wide interest in corporate bond ETFs in the future.
Style ETFs are a very good adjustment tool according to the ‘completeness bias’ that EDHEC cherishes. They enable the manager to sharpen the broad index exposure according to his own bets and anticipatory analysis, neutralising the bias in the broad index while enhancing a leverage bias according to the results of the managers’ analysis.
Unlike emerging markets and commodities, bonds or style are available through underlying cash. Emerging market indices are an answer for managers willing to take an exposure on these markets without stock picking.
Commodities ETFs enable investors to invest in commodities without having to face the derivative constraint regulation. Ucits III packaging opens up an array of commodities investments through the EasyETF commodity platform, based on GSCI indices, to investors unable to invest in commodities up to now because of their exclusive availability through derivative instruments.
To what extent are ETFs being used in core-satellite investment portfolios?
ETFs were known as a passive management instrument in the past, when they were available on broad indices exclusively. Today they have become a tool used to achieve a wide range of exposure to different types of underlying asset classes and within each class, to very specific regions, segments or sectors.
In the core portfolio, for the medium to long term, ETFs are seen as a free beta, very optimised tool, thanks to the lending process. Lending ETFs enables cashing in on the equivalent of management fees for the period of the loan.
The satellite approach sees in ETFs a tool that fits the specificity needed through the wide scope of ETFs available and their timing accuracy, thanks to the high level of flexibility and easy access of ETFs.
In association with BNP Paribas Asset Management.
BNP Paribas Asset Management is a leader in the European asset management industry, with €274 billion of assets under management* and 1,400 staff serving clients in 60 countries. It offers a range of management capabilities with a shared focus on excellence, robustness and consistency of investment processes as well as accuracy of risk control, through a multi-specialist approach. Socially Responsible Investment is one of BNP Paribas Asset Management’s key investment themes. Specialised fund management teams are active in the world’s major financial centres including Paris, London, New York, Tokyo and Hong Kong. *Figures as at 31 December 2005, assets under advisory included
