The use of exchange-traded funds (ETFs) has boomed in current volatile markets. Although equities have fallen in the last few quarters, assets under management in ETFs are at record levels, at $796bn at end-January, and the progressive increases in take-up have coincided with spikes in volatility.
Evidence suggests that fund managers are moving into an ETF and buying an entire market when they are unsure about which stocks or specific assets to play, but do not want to risk a market bounce without having some participation. Buying the relevant ETF is therefore a way to maintain broad and low-risk exposure to a given market.
“The big trend has been to play beta,” says Dan Draper, global head of Lyxor ETFs. “This is identical to what happened in 2002-3 in the US market.” Some investors are also using ETFs to gain quick exposure to buying opportunities in markets that have recently dipped, such as India, and sectors that look oversold, particularly banking, for example, where visibility is poor and investors are confused about which stocks to back, adds Mr Draper.
Investors are similarly switching their orientation from growth to value stocks using funds like Lyxor MSCI EMU Value fund, a quick and easy way to shift the balance of a portfolio if a manager has little conviction about which stocks to select.
Fund managers are also consciously using ETFs to tightly track their benchmark with a core of their portfolio, allowing decisions about chasing additional alpha to be highly deliberate and targeted. “One use of ETFs is as a tool to achieve a closer return of the index, so that you can take more risky active positions,” says Frank Henze, head of product development at iShares. “Volatility is risk and so staying close to the benchmark helps to cut out risk the manager doesn’t want to take.”
For Diversified Growth Funds, the successful multi-asset funds targeted at cash plus launched in the last two years by big names such as Barings, JPMorgan, Fidelity, Credit Suisse, ABN Amro and BlackRock, ETFs can provide access to areas of expertise that may be lacking in the manager’s armoury. For instance, Schroder’s Diversified Growth Fund uses ETFs to provide access to emerging markets which have no corresponding futures. The fund took over £1bn in just 16 months, and is finding favour among small and medium-sized pension schemes that don’t have the governance to invest in a wide range of assets directly.
Hard to reach markets
Similarly, Iain Stewart, manager of the Newton balanced fund, has been using ETFs to deliver returns from agricultural commodities, one of the house’s big themes, to complement holdings in stocks that relate to agriculturals such as fertilisers, proprietary chemicals and supply chain managers.
“Diversified growth funds and fund of funds are increasing their allocations to ETFs to obtain exposure to certain markets, most obviously emerging markets, that are hard to research and access,” says Manooj Mistry, head of db x-trackers UK, Deutsche Bank. “The range of ETFs available mean you can be a head of asset allocation instead of a stockpicker, so you can better manage volatility, removing the hassle of buying stocks in different bourses and of currency exchange.”
Similar use can be expected of the new db tracker linked to the so-called frontier markets such as Cambodia, Kazakhstan and Vietnam, based on the S&P Select Frontier index.
As well as obtaining exposure to specific asset classes or markets, fund managers use ETFs to maintain exposure to broad markets. It is easier to buy MSCI Europe than to buy a series of futures on each individual market, for example, and the tracking error is also superior.
Johanna Kyrklund, head of UK Multi-Asset at Schroders Investment Management, says she sometimes uses ETFs for passive equity exposure where a fee budgeting exercise has indicated there are fewer opportunities to outperform. Rather than targeting a marginal outperformance over the benchmark from every holding, her strategy is to bleed more from the best opportunities identified, occasionally using ETFs simply to provide exposure to a particular market.
Ms Kyrklund also uses ETFs to buy industrial and business stock sectors that don’t have corresponding futures, and sees the logic of using ETFs to manage cash, as a way of putting the money to work without losing immediate access to it. She is less convinced that ETFs are effective for gaining exposure to private equity or infrastructure, where part of the return is driven by the asset’s characteristic illiquidity.
“In order to garner the diversification benefits of investing in alternative asset classes, it’s important to gain direct exposure to the asset class rather than investing in an ETF,” says Ms Kyrklund. “When we invest in alternatives, we are seeking to gain exposure to risk premia that are not available through equity investment. In many cases, an illiquidity premium is an important driver of returns for alternative investments and direct investment is necessary to benefit from this premium.”
Researched and published in association with Lyxor ETFs.
