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The ETF industry has seen phenomenal worldwide growth in the last ten years, yet UK pension fund managers are still afraid to take the plunge. Francesca Fabrizi finds out why and explores the scope of ETFs for pension funds Exchange traded funds (ETFs) are already big business in the US and Europe, and the stage is now set for considerable growth in the UK. Bring them up in conversation at your average pensions industry get-together, however, and you’ll still get the odd blank face. So what exactly is an ETF and what can it bring to a pension fund? In simple terms, ETFs can be defined as baskets of shares either representing an index (for example the FTSE100) or a market sector (for example you can buy an ETF that just invests in bank shares or technology shares). The ETF is a collective vehicle that, while it looks, behaves and acts exactly like a share, in terms of ease of use it is more like a unit trust. Plus ETFs provide all the diversification benefits of traditional collective investments, but as ordinary company shares. Since their launch in the US in 1993, ETFs have grown to over 281 funds globally trading on 27 exchanges around the world with over $140 billion in assets under management. Originally known as WEBS (world equity benchmark shares), the most well known in the US today are called SPDRs (or spiders) and QQQs, which track the S&P500 and NASDAQ 100 respectively. In Europe the
speed of growth in terms of institutional take-up has been phenomenal,
in particular among European investors investing in the US. Adam
Seccombe, sales director at Barclays Global Investors (BGI), managers
of the iShares range of ETFs, comments, “One of the things
that we are watching is the rate at which European institutions
are using not only the local products but also the products in the
US – and in Europe the use of the US-listed ETFs by institutional
investors has grown 20 per cent faster over the past year compared
to the overall growth in the market.” Manooj Mistry, ETF product manager at Merrill Lynch, which launched the first ETFs in Europe under the LDRS (pronounced leaders) heading, explains, “Institutional investors or pension fund managers can use ETFs in a number of ways: for asset allocation either on a short or long-term basis; as a trading tool; or to equitise any cash that they have. “For example, if they have a mandate to track the European market and they have a large cash position within their fund, they can either go out and buy shares with that cash or they can hold their cash and, in order to equitise it efficiently and avoid missing out on any upturn in the market, they can use an ETF. They can buy, say, a European index-tracking ETF and hold that for a week, two weeks or even a day – so they are equitising their cash in the short term until they actually decide which underlying shares they want to buy.” And it’s not just Europe you can track. ETFs are being issued all the time around the world which means that scope for investment is huge. David Franklin, director at Christows stockbrokers and portfolio managers – which last year launched the first ever multi-manager portfolio service to include both conventional funds and ETFs – can’t praise them enough. Franklin says, “While there aren’t so many ETFs quoted on the London market, there are countless numbers of them being issued all the time around the world which means that, for the professional money manager, it is now possible to access virtually every major and minor market sector using ETFs.” A big advantage of ETFs over conventional funds is that they trade in real time. Franklin explains, “The fact that ETFs trade in real time means you can get your money into or out of the particular market or basket of shares (or whatever the ETF is invested into) then and there. This contrasts greatly with the forward-pricing arrangements in conventional funds. With an ETF your money is out then and there – and in today’s market that’s quite important.” They also offer cost advantages. Franklin continues, “Because ETFs are not actively managed, they don’t have a fund manager but just a custodian, so there are no fund manager charges to take into account. The typical annual money charge on ETFs is in the region of 30 basis points, whereas on conventional investment funds/unit trusts you have fund managers to pay so there are huge differences between the underlying running costs to the investor in ETFs compared to a conventional fund.” The
risk factor They also, by their nature, avoid what Franklin calls “stock specific” risk. He says, “Imagine someone sitting there, managing their pension fund saying ‘I quite fancy the banks as they are all going up’ and decides on X Bank – well unfortunately, however much research he does, he may wake up to find that while all the other banks shares have gone up, X Bank’s shares have gone down. “What
he could have done was opt for a banking ETF – buying all
the banks – which would have allowed him to take a view on
a sector without having to buy the Franklin continues, “With an ETF you also avoid what I call fund manager risk and by that I mean, once again, imagine a guy sitting there managing his pension fund – he looks at all unit trusts available and decides X Fund is a great performing fund so puts all his money in that, and unfortunately he picks the one year where the manager gets it wrong and the fund underperforms. There is always the risk with active funds that you pick the wrong manager or the manager has a duff year; but with an ETF if you fancy the market you know you are going to get the market and not someone’s view of the market.” But it’s not all good news. One of the main problems with ETFs among institutional investors in the UK is not only a lack of awareness but also a lack of understanding, says Seccombe, in terms of which ETFs are relevant. In addition there seems to be a number of misconceptions surrounding them: “I think a lot of investors have been concerned that because the equity ETFs are available on equity indices, they suddenly have a bit of a look and feel of a futures or an options contract which have been mechanisms to play index exposure in the past on a commoditised basis and that simply is not the case – these things are not derivatives. “ETFs substitute stock-specific risk for market risk and they reduce the burden of administration because you can settle a whole collection of securities in one basket and only make one investment.” To support this, Mistry highlights the need for continued education: “I think it is an education thing – I would hope that pension fund managers are more aware of ETFs than they were a few years ago, but we are still very much at the tip of the iceberg and there is still a long way to go in terms of educating pension fund managers, pensions consultants and trustees about what they are and how they can be used.” Mistry continues, “Why I think ETFs have taken longer to catch on is that people are waiting to see how they trade, what the liquidity is and I guess a lot of institutional fund and pension funds are quite conservative in their approach. As with anything new, it is always going to take time to educate and inform them of what’s going on and how it all works.”In terms of allocation percentage, it’s impossible to say. Franklin concludes, “How much of a portfolio should be allocated to ETFs will depend entirely on the client’s brief – how mature the pension fund is and year to retirement and the level of risk or otherwise that a client wishes to take. Our view is that while using ETFs eliminates a certain amount of risk by eliminating stock and fund manager risks, nonetheless they are baskets of share which can go up or down so I think it is impossible to say x or y percentage should be in a fund – I think it all depends on the brief and the ultimate investments.” - Pensions Age July 2003 -
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