For all those involved in the exchange traded fund (ETF) markets, 2006 was a performance of operatic stature. Figures reached a record pitch for nearly every aspect of the market.
According to the score from the sector’s bible, Morgan Stanley’s Year End Global Review, there was an increase of 27 per cent in the number of institutional investors reporting holding one or more US-listed ETF or HOLDRS in the past year and that figure was up 61 per cent for hedge funds.
One statistic after another screams ‘feed me’ to the industry. Assets under management in Europe went up by 63.3 per cent in 2006 to $89.7bn (€66.7bn), trashing the global assets under management growth rate of 39.26 per cent. Both figures beat the world’s dominant market for ETFs, the US, which recorded an increase of 35.88 per cent.
“There’s an impression that Europe is lagging behind the US, but the growth to come in terms of both fund numbers and assets under management shows there’s an exciting gathering of momentum,” says John Davies, senior director at S&P Index Services.
A help in hand
In part, this momentum has been helped by regulatory and tax changes. In the UK the abolition of stamp duty on overseas-domiciled ETFs trading on the London Stock Exchange is expected to boost both the number of listings and trading of ETFs on the LSE. In some cases stamp duty taxed each of the underlying holdings (which should reflect the index) and Greece is the latest jurisdiction to tackle the issue.
 | “It’s inevitable that we’ll see more ETF providers come to the UK, but that’s a healthy thing and a further endorsement of the instrument,” says Tim West, European chief operating officer for iShares at Barclays Global Investors. BGI is the largest ETF manager globally with assets of $284.6bn or 49.6 per cent market share. |
The new Ucits III regulations which came in to effect in February this year, allow for up to 100 per cent of a Ucits fund’s net assets to be invested in Ucits-compliant ETFs as opposed to a limit of 5 per cent in the past. (There are some detailed exceptions.) It also means that ETFs have more flexibility in the way they are structured and what can be included as underlying asset. This is leading to a proliferation in commodity-based ETFs (ETCs).
“The advent of ETC furthers one reason for their success - strategic asset allocation and also giving low correlation to other assets,” explains Nik Bienkowski, head of listings at ETF Securities. In October 2006 it listed 31 ETCs on the Deutsche Börse, following a launch of 29 ETCs on the London Stock Exchange in September.
Natural evolution
This development is generally seen as an natural evolution considering ETFs have opened a whole new panorama of investment opportunities to both individual investors and institutional money managers.
“The advantage of ETFs, especially to smaller institutional investors, is access to emerging markets or sectors which would be too expensive otherwise, for example just on custodial charges,” explains Mr West.
Low expense ratios and the developing ranges of ETFs by companies like State Street and Lyxor have benefited small and large institutions alike. “We can offer institutions building blocks to develop sophisticated and cheaper strategies in the conventional and alternative asset space,” says Mr West. Another advantage is that for funds that prohibit derivatives, well-used ETFs can replicate some derivative strategies.
Apart from offering an inexpensive opportunity to diversify an asset base, ETFs can also provide a cost-effective transitioning tool. “You can’t move into private equity, infrastructure or property overnight and normal vehicles have long lock-ups and transaction sizes can be an issue. ETFs offer the flexibility along with liquidity,” says Mr West.
And indeed there has been an explosion of products that could be named as following the alternative investment trends. “Sounds strange, but at the turn of the century with the equity markets going south and FRS 17 pressuring trustees to monitor managers and performance while generating alpha, new strategies were needed,” explains Mr Davies. “Everyone wanted some of the business and index strategies proliferated, also opening access to more diverse markets.” Similar pressures were on pensions and asset managers throughout Europe.
“We’ve had comment about two years ago saying there was already a glut of ETFs in the market – evidently that’s not the case and more and more investors see how useful they are,” points out Gareth Parker, business unit head, FTSE Group.
Understanding costs
But as new products exploit the excitement over plays like property and private equity, there are concerns over whether some investors understand the full underlying costs and structure of some products, especially some of the newer ones. Up until now, however, ETFs have managed to avoid any regulatory scandal. “I haven’t ever had a customer that has returned and said the ETF product bought wasn’t what he had wanted,” points out Mr West.
But investors need to be careful that they’re getting what they want. “The key issue of having an index is to represent what you’re looking to replicate and it must be liquid,” Mr Davies warns. And the issue of liquidity may not be as straight forward as one might expect. “To a great extent it comes down to the players. The bigger ones can effectively replicate the index and can also cross-list,” he adds.
On top of that can be deviation from an index. For example, how dividends are paid can affect performance. Some of the unit trust-based ETFs only pay dividends on a periodic basis. According to Morgan Stanley a lag in dividend reinvestment can cause small underperformance in rising markets and small outperformance in falling markets.
Then there is the structure of the ETF to the index. “We’re clear and open on how an index is constructed and although we know an ETF does its best to match the underlying index, it’s often not a mandated requirement to be 100 per cent accurate. We’ve seen ETFs based on competitors indices with tracking errors of up to three per cent,” reveals Mr Parker.
Complex strategies
But as ever-more imaginative ETF-type products come to market, issues concerning the fundamental understanding of the underlying construction and using it to successfully follow a predetermined strategy will become more complex.
Mr Bienkowski accepts that with some more sophisticated ETCs there could be concerns: “Some investors might not fully understand the underlying aspects of ETCs but they want exposure to the commodity and base the decision on the reputation of the index.”
The ETFs range are based on Dow Jones-AIG Commodity Index family and the underlying instruments are futures to provide liquidity. There are also issues with finding an accurate reflection of a commodity view: a bullish viewpoint on Brazilian wheat prices will disappear in a global futures market that might see Australian and US production fall.
But even more esoteric views are now coming to market.
GETTING TO GRIPS WITH THE COMPLEXITIES OF THE PRODUCTS
Concerns that institutional investors might not have a full grasp of the underlying nature and idiosyncrasies of ETFs, are generally thought to be overblown.
In straight forward terms, exchange traded funds (ETFs) are essentially open end index funds that are listed and trade on exchanges like stocks. However, as the instrument takes ever-larger amounts of investors’ cash, the products are set to get more complex. Even the humble ETC is a step up from the ETF utilising underlying commodity futures indices.
“What's pivotal is the next generation of ETFs and what is robust as an index or ETF,” warns John Davies, senior director at S&P Index services. That future, he says, can be seen in the range of ETFs emerging from US company WisdomTree.
“Big names like Jeremy Siegel, the Wharton finance professor [and consultant to WisdomTree] and Bruce Lavine are now saying that market cap indices aren't the best way and you should be looking at earnings, income and dividends of companies,” says Mr Davies.
It seems the question as to why passive tracking in ETFs should not be active is the latest trend. “People are questioning the efficient market hypothesis of market cap indices,” agrees Gareth Parker, head of institutional business at the FTSE.
For WisdomTree the move has been to question precisely that idea of efficient market. It has launched a family of 20 ETFs that shun what it considers overpriced stocks, focusing on dividends. Those stocks that pay the highest yield have relatively low prices and the value players argue that “value stocks” have outperformed growth shares since 2000.
“Based on its algorithm S&P has produced indices that are based on core earnings for WisdomTree,” explains Mr Davies. He makes no comment on the validity of the strategy in which S&P has created indices representing this identified underlying base of the market.
“It's not the index providers job to tell investors or product developers how to calculate value,” he adds. And he expects a proliferation in these sorts of ETF products.
“There are ways to generate alpha with an ETF structure by identifying a quant algorithm based on an active strategy and mechanise it,” says Mr Parker. “Essentially you're valuing a company in a different way to market capitalisation and basing an index on another set of weightings, the capacity for these sorts of products is massive,” he points out.
In some cases there are expectations that these ‘active’ ETFs can produce up to 200 basis points per annum above an index performance with the attraction being diversification and alpha through an ETF style.
So far, however, these theories remain unproven.
