ETF flexibility put to a multitude of uses

Exchange traded funds (ETFs) are now routinely used by multi-managers and funds of funds, and their qualities are harnessed for a multitude of almost contrary applications. For instance, they are used to provide access to illiquid assets such as commodities and other alternatives but they are also often the choice for assets in the more efficient, developed markets where active management may not add value. Their low cost means they are useful for frequent tactical trading and transition management, but it also makes them suitable for long-term core positions. They are used to take alpha bets but they are also often used simply to hedge existing portfolio positions.

“There is an increasing trend in multi-manager and funds of funds to use ETFs both to complement existing holdings and to replace traditional holdings,” says Claus Hein, head of Lyxor ETF in the UK. “Multi-managers in general realise ETFs are very liquid implementation tools and very competitively priced and they can add asset classes such as developed markets, emerging market equities, fixed interest and inflation-linked bonds and commodities in a very flexible way.”

Even diehard active multi-managers such as Skandia are now considering ETFs. “ETFs are currently under discussion as there are more and more funds to choose from, and they would definitely help us implement different views on different asset classes,” says Ryan Hughes, senior fund manager at Skandia Investment Group. “We’re an active house so I would not expect to use them as a straightforward equity replacement but for direct exposure to commodities and currencies.”

In the current climate, ETFs are increasingly used a place to park funds while a manager waits for visibility to improve. “We see ETFs used for two main purposes,” says Mr Hein. “As the core position in actively managed funds that gives exposure to developed or global equities, but also if a multimanager is not pleased with the performance of an active manager and is considering leaving a fund and reallocating to another vehicle, then he may use an ETF as an effective transitioning tool, exposing the portfolio to the same benchmark, as he unwinds the position. Or he may park cash into an ETF to keep exposure to a particular market if can’t identify a suitable strategy.”

For managers experience difficulty in calling the market, or in finding consistently outperforming active managers, ETFs are now seen as a credible holding strategy.

Philip Philippedes, head of institutional sales at iShares, agrees that investors increasingly use ETFs tactically to maintain a presence in a market. “Perhaps they know they have a good manager, but the asset class is not performing well, so rather than search for a new manager, they may invest in an ETF and wait until the manager recovers,” he says.

“ETFs offering the more exotic and thematic exposures may be particularly appealing in asset classes where it is hard to find a manager with a good long-term track record,” adds Mr Philippedes.

A perfect blend

There is a growing belief that blending active and passive is the optimal way to structure a portfolio, and active risk can then be dialled up and down.

“Multi-managers are taking it upon themselves when to go active and when passive,” he explains. “A few years ago, multi-managers tended to focus on good active managers but as the active/passive debate strengthened with the volatility in the market, a lot of managers are buying passive while they find a manager who can make alpha and has a performance track record.

“Multi-managers and multi-asset class fund managers look after both the asset allocation and the manager selection and some are trying to decouple the asset two,” says Mr Philippedes. “So for example if they want to retain the asset allocation but the manager is not performing or has a high tracking error, then they can assign more to passive exposures to ride out that volatility. If a multi-manager has allocated money to a certain exposure and is performing poorly, an option they have is to top up the asset allocation with a relevant ETF, parking money on an interim basis and then reviewing the manager later.”

One of ETFs’ strengths is that they are, as the name says, exchange traded, which is so much easier than opening an array of unit trust accounts. “The fact that an ETF settles like a share makes it very powerful,” says Charles Morris, a director of HSBC Global Asset Management who manages an Absolute Return fund. “If a fund manager buys a unit trust then it will have to open an account with that manager and carry out the necessary due diligence. But if he invests in an ETF, he is entering into a market based transaction.”

The recent move by iShares to issue swap-based ETFs is a direct response to client demand for exposure to markets or asset classes that can be hard to access due to operational or liquidity constraints. The first two swap-based iShares offer exposure to the Russian and Indian stock markets. Market-wide swap-based ETFs have been launched at break-neck pace, widening the range of assets available.

“Sometimes we may use ETFs for exposure to developed and very liquid markets such as US equities, European equities and also to provide exposure to investment styles where the ETF is liquid, such as growth or value and sector exposure say, energy or finance,” says Christophe Belhomme, chief investment officer at FundQuest Europe. “This will be because clients do not authorise the use of futures, or there is no futures market in that particular asset class. We’ve used ETFs for a long time and our use is not growing but there are now many more providers and greater choice of funds. What’s new is increasing access to niche markets such as EM debt which wasn’t available two years ago,” he explains.

“For most liquid asset classes the replication is good – but not so good for emerging markets, small cap or credit where there is more illiquidity and transaction cost are higher. The bid/offer spreads in these markets will also be higher and you may achieve better pricing at the close of the market, although in doing that you lose an element of flexibility. What we often see is that some clients use ETFs only for the most liquid markets – eg US equities, European equities and Japanese equities, but wouldn’t use it for emerging market equity where they would prefer to go for active management.”

In some cases ETFs can be used to achieve positions that are impossible using other instruments, for example where there is no futures market, or in strategies involving short positions. Uri Landesman, president of Platinum Partners, a multi-strategy hedge fund based in New York, says that ETFs are only used in one of their books and then for going short on a sector or sub-sector such as technology or semi-conductors, typically balanced against a specific long position. “It is easier to research individual long ideas than individual short ideas but we need to maintain a maximum 15 per cent exposure to certain positions and so we need to go short ETFs to get there.

“Typically 25-30 per cent of our short exposure will be through ETFs,” he says. “It’s a much quicker and easier way of obtaining short exposure, particularly for mid-cap names. In theory, we might use ETFs for commodity exposure but we are more likely to use futures. We’re not going to use an ETF where we can use the actual commodity futures because trading the equity rather than the commodity is a lot more volatile.”

One activity that has seen a lot of growth is using ETFs to take currency positions. “Many fund managers find it difficult to hold foreign currencies for administrative reasons but currency markets are likely to be interesting over the next few years,” says Mr Landesman. “The dollar is having a difficult time, so there has been a growth in (pure) currency ETFs – as distinct from foreign bond ETFs which also carry a layer of duration risk. The yen, dollar and Asian currencies are popular.”

ETFs do have their limitations, however. Mr Morris says it is a myth that ETFs are cheap to trade, particularly not in large sizes. “If one is trading intraday with a large amount of money, (rather than at the closing price) then you will need a broker to tact on your behalf. The exception is the large US based ETFs, such as the SPDR, where $100m can be traded relatively easily. However you may not want to use US ETFs as they are taxed as income and not as capital for UK investors. Luxembourg Ucits multi-managers tend to use European ETFs.”

It is also critical to look under the bonnet. “Passive has moved a long way in the last 10 years, but you do need to look at the quality of passive funds,” says Richard Philbin, CIO at Architas Multi-manager. “No two passive funds are the same. There are a number of factors that make them different such as whether they are fully replicated, or swap-based or based on physical stocks. There is a need to be mindful of these issues – for example, Legal and General was hit as it lent stock to Lehman Brothers and this took a while to correct.

“Big is beautiful in this market because the big ETF players can minimise their costs by crossing (their stock purchases and sells). There is also an advantage compared with a unit trust that at the close of trading you know exactly what price you are getting.”

Some multi-managers have held back from using ETFs however, arguing that they can develop proprietary hedging products that better reflect their requirements. Robin Lowe, the leader of Man Group’s equity team, says: “A lot of people using these are destroying value because they don’t have any extraordinary skill about when to apply them. ETFs are a good flexible tool but in the wrong hands they can not only compound bad decisions but extend them.”

Man’s multi-manager prefers to use proprietary hedging instruments which are structured as funds insofar as a manager can dip in and out of them, but more accurately reflect the precise nature of their long exposure.

The majority of multi-managers and funds of funds now include ETFs in their armoury, however, and one contentious dimension is their impact on charging structures. Alan Miller, the former New Star fund manager and now senior partner at SCM Private, which runs managed portfolios of ETFs – a growing model industry-wide - says investors do not understand how much they are charged for supposed active management. He thinks that multi-managers would like to use ETFs more widely but if they did they would have to justify their high fees.

“In the UK, ETFs are mostly used by institutions but they are semi-hidden in portfolios, despite that they offer greater diversity, and high returns and lower fees,” Miller says. He calculates that the running costs of using ETFs in a multi-manager environment are 0.3-0.4 per cent, compared with at least 1.3 per cent for active underlying funds, and that’s assuming the multi-manager got them at an institutional rate of a 1 per cent, plus 0.3 per cent fund expenses. This is a big saving for the multi-manager, compounded over time, and Miller’s case is that as use of ETFs grows, clients will expect a portion of the cost savings to be passed back.