Private banks embrace ETFs in fund products

The universe of passive investments has grown exponentially in recent years. By the end of April, 1678 exchange traded funds (ETFs) with assets of $706.87bn (€525bn) were listed on 43 exchanges around the world, and while year to date assets had fallen by 0.5 per cent, relative to other investments, the sector has grown and the 0.5 per cent decline is markedly less than the 3 per cent fall in the MSCI World index.

“The reality is that there has been a seismic shift in the use of passive vehicles, not only because of lower costs but also because of regulatory change,” says Eleanor Hope-Bell, head of wealth sales at iShares. “Investors are looking at the level of transparency, in both the underlying investment and the fees, and whether there are any kickbacks payable to the distributor by the asset manager. This is something of a slow burner but it is a factor in ETFs becoming more and more prevalent.”

Disappointment with active funds has also prompted a re-think, particularly as active funds are often thought to outperform in bear markets. According to a Standard & Poor’s study issued in April , this is a myth, and in reality in the five years 2004-08, the S&P 500 outran 71.9 per cent of active large cap funds, the S&P MidCap 400 outran 79.1 per cent of mid cap funds and S&P SmallCap 600 outperformed 85.5 per cent of small cap funds. These results are similar to the previous five year cycle from 1999 to 2003.

Style differences do not appear to help much either. The majority of active funds in eight of the nine domestic equity style boxes lagged the index in 2008, and benchmark indices also outperformed the majority of active fixed income funds in every category over a five-year horizon.

The current focus is the rally in shares, and there have been particularly big inflows into emerging markets, notably China and India which are recovering fast, and for certain markets such as Korea and Taiwan where an investor would otherwise need foreign investor status.

“A lot of investors feel they have missed the equity rally in the last two to three weeks,” says Dan Draper at Lyxor. “Suddenly they are not content with low interest rates and low yielding returns on risk-free assets like Gilts. Therefore, they are rushing to put some portion of their cash to work. ETFs give them immediate access to the broad equity markets. The Lyxor FTSE 100 ETF has gained 41 per cent additional assets in the last three months, and other big benchmark indices have also seen huge inflows. It is clear that investors do not want to be too granular in their investment decisions now. They prefer top-down macro investing over stock picking.”

Efficient diversification

ETFs are used by asset managers to achieve a high level of diversification quickly and efficiently. “You can do great things with just a few trades,” says Charlie Morris, manager of the Absolute Return Service at HSBC Global Asset Management. “If the driver behind a trade is 90 per cent due to the market and 10 per cent due to the manager, then an ETF will win every time, particularly if the time horizon is a year or two. You may as well get the certainty, lower fees and ease of transaction,” he says. His funds have used ETFs for exposure to a range of markets such as South Africa and Taiwan.

“In Europe, the large private banks are using ETFs in their multi-manager funds, and more recently funds of ETFs. Some are being developed in a systematic way and some are available on a bespoke basis. These funds often involve strategic asset allocation, and sometimes more active tactical asset allocation, as switching between markets is clean, quick and simple,” adds Ms Hope-Bell.

Barclays Wealth, for instance, launched its Global Beta funds last September offering a range of globally diversified portfolios that invest in ETFs, while the Guinness family has launched a fund of ETFs to the retail public that replicates its own asset allocation.

“For the private wealth segment, ETFs continue to gain in popularity, and we increasingly receive calls about providing educational materials to support the use of ETFs in wealth managers’ asset allocation models,” says Lyxor’s Mr Draper. “The first wealth managers to use ETFs widely were family offices and ultra-high net worth individuals because they are typically highly influenced by charity and endowment sectors, which were pioneering ETFs in the US about a decade ago.

“There is a huge opportunity in the lower wealth management end, what we might call the core affluent market, which might include those with E1-2m of liquid assets or less,” he adds. This is the sector seeing rapid growth. ETFs are particularly useful in obtaining the full asset allocation required for multi-asset class portfolios. Some institutional funds have minimum investment sizes and various buying and selling restrictions.

“Using ETFs you can build a full strategic asset allocation portfolio across most asset classes and geographic markets, including Asian and European equities, commodities and bonds at much less cost than active funds. ETFs are very scalable building blocks to a holistic wealth management approach,” says Mr Draper. “In fact we are coming across a growing number of wealth managers interested in launching their own funds-of-ETFs being in order to highlight their asset allocation strengths, especially in Germany and the UK.”

Some wealth managers use passive funds systematically at the core of clients’ portfolios. KBC Asset Management, for example, has developed a flexible allocation system for the core, which is a mix of passive equity and bond funds and accounts for 70-80 per cent of the portfolio, with the remainder in alpha-seeking satellites, currently invested in Swedish kroner, emerging market equities, Asian infrastructure and high yield bond funds, using KBC funds.

The flexible allocation system used for the core is dynamically reweighted according to value at risk metrics such as market volatility. This can have three gears: 20, 40 and 60 per cent equities, with the remainder invested in bonds and cash. Having reduced the flexible allocation’s exposure to just 12 per cent in equities in June 2008, the equity portion was increased to 19.4 per cent in May as risk appetite returned, says Patrick Grauwels, head of institutional asset management at KBC Asset Management.

RISK MANAGEMENT

In recent months there has been greater interest from risk managers wanting to understand every part of the process. “In the professional wealth management space, one issue which is receiving consistent focus is counterparty risk,” says Ted Hood, the CEO of Source, the recently-formed ETF provider backed jointly by Goldman Sachs, Bank of America and Morgan Stanley.

“Wealth managers are now keen to find ways to deliver the same market performance but with reduced credit exposure,” he explains. “Those that were historically focused on structured products with inherent exposure to the issuer are now looking at ETFs. For those that were already purchasing ETFs, their screening processes tended to be relatively light weight and focused on cost. Their risk managers have begun to ask questions in order to understand every part of an ETF's construction, from counterparty risk to the causes of tracking error.”

Refocusing minds

“The market dislocation has refocused the minds of investors on how they are achieving their goals vis a vis the products out there,” says iShares’ Ms Hope-Bell.

“ETFs can be structured differently even though they may look similar on the surface. Swap based ETFs involve counterparty risk which suddenly became talked about last year, following the massive market dislocation,” she explains. “And regarding tracking, the level of error may be greater for optimized physical ETFs rather than full replication physical ETFs. Some providers claim that their swap ETFs involve zero tracking error but actually we’ve backtested this and that’s not always the case. There can be tracking error.”

Investors have also become more cognizant of liquidity. “While many funds have the right to put gates on redemptions, the exchange traded nature of ETFs means they are always as liquid as the underlying market, and there is more than one price source which is better for price discovery, and multiple market makers to get you in and out,” adds Ms Hope-Bell.

The uptake of short and leveraged ETFs has been surprisingly strong. “We thought the assets in these ETFs would be volatile, but the assets have been far more sticky than we had anticipated,” says Mr Draper at Lyxor. “Investors are using them as hedging instruments, not just as tools for speculation. Some wealth managers are using them for risk management purposes, although the majority of users are active traders, and prefer to use them over options because they don’t need the leverage inherent in options and don't want to worry about the potential time decay of options.”

Only six ETFs have futures issued against them and these are not popular, says Deborah Fuhr, managing director global head of ETF Research and Implementation Strategy at Barclays Global Investors, because for many people the current preference is not to use derivatives but to use fund type products that avoid counterparty risk.

While passive funds offer quick access to rising markets, pockets of opportunity are arguably better exploited using active management. “Clients see investments with a higher beta have been oversold and are looking at the valuations and accepting the logic that if the assets are 40 per cent lower, then there will be a bounce back,” says Jane Sydenham, investment director at Rathbone Brothers.

But in the commodities space, Ms Sydenham says there is a move away from ETFs and towards using funds because they are more leveraged to the market so there is greater opportunity to participate on the upside. For example, some gold shares have been on PEs of 2 or 3 and looked tremendous value relative to a gold ETF and active funds are better able to take advantage of these anomalies.

The return of the active manager

One body of thought is that the trend for all things passive could boost the opportunities for active managers, and this is the stance of committed active house Bank Vontobel Asset Management in Zürich.

“We see two camps,” says CEO Zeno Staub. “There are the people who were completely passive and rode the market right down and many of those now see a place for active managers. Then on the other side are people who are disappointed by performance quality, and that investment approaches did not behave as expected in times of stress. They are now flocking to passive funds at a time we think is the worst time of all as there are now a plethora of opportunities in the markets and also because there are fewer hunters chasing these opportunities.”

“One issue is that whilst the industry has set out to offer diversification benefits, asset correlation has risen,” says HSBC’s Mr Morris. “This realisation may mark phase 2 in the development of ETFs as investors look beyond traditional country and sector indices and towards asset quality. ETF providers may respond by developing a greater offering of semi-active funds. ETFs that follow some form of intellectual property will continue to be an area of growth, but few will be successful,” he predicts.