One of the main attractions of the versatile ETF wrapper is its ability to be used flexibly within a wide range of portfolios. From a strategic asset allocation tool to an efficient way of managing risk and liquidity, there are many strings to an ETF’s bow.
A more recently identified use case is one being utilised by the ETF issuers themselves, the curious case of holding an ETF within an ETF. It is important to note this is different from multi-asset ETFs, which hold a diversified portfolio of ETFs at the price of one ETF wrapper.
For example, currently, the top holding of the $183m iShares MSCI EM Latin America UCITS ETF (LTAM) is the iShares MSCI Brazil UCITS ETF (IBZL), housing $313m assets under management (AUM) and accounting for 8.6% of the ETF.
While using LTAM as an example, BlackRock is not the first and will not be the last ETF issuer to use such a strategy but what is the reasoning behind this?
Cynically, it is easy to assume this is an attempt from ETF issuers to gather assets in two ETFs at once as well as enabling them to “double dip” when charging investors within the ETFs, getting paid twice to house one of their own products.
However, there are several reasons an asset manager might choose to hold an ETF within an ETF and while it does, in some cases, create cost efficiencies for the issuer, it is primarily about gaining access to a market that might be cumbersome to gain exposure to in the first instance.
A market access tool…
Every ETF launched on an issuer’s platform must be done so as a separate legal entity, meaning if it is looking to get exposure to a particular market directly it must go through an account opening process within that country, delaying a potential launch by several months.
This is particularly true of emerging markets, where access can be laborious, but can also occasionally be the case in developed markets too.
As Christopher Mellor, head of EMEA equity and commodity ETF product management at Invesco, said: “Instead of delaying the launch of an ETF because you have not been able to open in one or two markets, which can take over six months, you can use another vehicle to fill that gap until you can access directly.”
Invesco used this tactic in 2020 to include Saudia Arabia and Kuwait in the Invesco FTSE RAFI Emerging Markets UCITS ETF (PSRM) and Invesco FTSE Emerging Market High Dividend Low Volatility UCITS ETF (EMHD), respectively, after the countries were upgraded from frontier markets three years earlier.
Instead of delaying their entry into the MSCI benchmarks until it had set up its investing accounts, Invesco used its existing ETFs, the Invesco MSCI Kuwait UCITS ETF (MKUW) and the Invesco MSCI Saudi Arabia UCITS ETF (MSAU), to capture the markets.
This could also be the case for BlackRock’s LTAM. However, IBZL accounts for just 8.6% of the ETF, a fraction of its 54.4% allocation to Brazil
Brett Pybus, head of iShares investment and product strategy for EMEA at BlackRock, said: “ETFs are efficient building blocks that are used in many portfolio applications, including by BlackRock, within certain other ETFs themselves.
“In some instances, such as when accessing areas of emerging markets or more niche segments of developed markets, ETFs are used as access tools within ETFs, which can be more efficient than seeking exposure to the underlying market directly.”
…or double dipping?
As well as gaining access to niche markets, the strategy also comes with other efficiencies such as the impact of low tracking error.
For example, if Invesco’s Saudia Arabia ETF has the exact same subset of companies as the parent benchmark that is being tracked, Mellor said there are “no implications on tracking error”.
Where it can differ, according to Mellor, is with more complex weighting methodologies such as high yield as this can lead to higher tracking error.
“However, it is better to have some deviation than no exposure at all,” he added.
Despite this, ETF issuers are keen to stress investors are not paying double the fees as a result. Mellor said Invesco does not make any additional profit, with investors only bearing the running costs.
For example, investors could be charged an additional 0.10% for holding the ETF – the cost of running the investment – instead of the headline total expense ratio (TER) of 0.50%. “Effectively, the ETF that is investing in the ETF would only bear the 10bps cost,” he added.
Commenting on waiving the fees of the ETF inside the ETF, Pybus said: “BlackRock investors pay only the fee of the wrapping ETF.”
Mellor added: “We have 0% [profit] margin on the investment in the underlying fund. We are not double dipping which is important to our clients.”
He added it is a technique also used by active managers in mutual funds that hold an ETF to get exposure to a particular market at cost price.
“It is the portfolio completion tool approach,” Mellor said. “If you have an active manager who is great at picking stocks in the US or Europe and they have a global benchmark, if they did not have much insight into Japan, buying an ETF to cover that part of the market would make a lot of sense.”
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.
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