The degree to which the evolution of the ETF landscape is changing perceptions of how the product can be used is perhaps best displayed by the take-up on the part of pension funds.
As ETF Stream wrote recently, the usage of ETFs by pension funds is nudging up year-on-year, up to 26%, according to the survey from CREATE Research.
This is despite pension funds not necessarily needing the utility of intraday liquidity offered by ETFs due to their generally long-term investment horizons.
Indeed, the report suggested that exposure to ETFs among pension fund managers is set to increase.
So what lays behind their growing enthusiasm? Mark Northway at Sparrows Capital points out there are still certain execution advantages for pension funds that come from using ETFs, notably around stamp duty.
“Even at the underlying portfolio level stamp duty is only payable on the actual value of underlying portfolio shares purchased,” he explains. “This means that a market maker can often be incentivised to bid above the intrinsic value of the ETF (bid-side NAV minus stamp duty minus creation costs) to avoid purchasing and delivering to the manager the underlying shares.”
Northway cites the example of the iShares Core FTSE ETF which, at the time of writing, was quoted on a 0.03% bid/offer spread which is, he points out, is “substantially below” the cost of running through stamp duty and ETF creation/redemption charges.
Meanwhile, he adds State Street’s team will provide a pre-trade liquidity report (on request) to investors on its SPDR ETFs, analysing current market pricing and depth of liquidity while comparing the attractiveness of the various execution methods available.
The growth of the ETF market and the sheer scale of the market today is also changing perceptions, says Armit Bhambra, director and head of UK asset owners at BlackRock.
He says on-exchange trading of ETFs can result in significantly reduced transaction costs compared with other fund structures.
“For example, fixed income ETFs have reached $1trn in assets globally over the past two decades, and some products are today extremely liquid,” he says. “It is for reasons such as this that pension funds are turning to ETFs to help with tactical asset allocation, helping to manage transitions more effectively or even to implement liquidity sleeves.”
Beta time
A more fundamental change is also taking place around how pension funds consider their beta exposure. Here efficiency is the name of the game and pension funds are achieving their aims using whichever products best suit including index futures, stock portfolios, index funds and ETFs.
With ETFs, the simplicity of the product combined with its low-cost characteristics and reliable market liquidity make them “an ideal tool,” according to Northway.
“The more sophisticated institutional investors will monitor all mechanisms simultaneously and will select the most favourable pricing at the point of trade; they will also switch the between the available instruments to extract value from relative pricing anomalies over time,” he adds.
Bhambra agrees, suggesting there are some “easy wins” for pension funds thinking more holistically about beta.
Just by considering the best passive vehicle available, he suggests pension fund managers may be able to extract valuable basis points of performance from their portfolios.
Here, the total cost of ownership takes centre stage where transaction costs are considered as much as the annual management cost.
The former has decreased due to the increasing volumes traded on exchange and it is this, combined with the lowered fees, that Bhambra says is “part of the story behind why ETFs are now being used by many pension funds”.
“But further to this, the depth of exposures available in ETF format is far wider than in other types of funds structures,” he adds. “For example, pensions funds wishing to be more specific and deliberate in their asset allocation may seek exposure to certain sectors, certain geographies, certain factors or even ESG, and may look to ETFs as an effective route to market.”
However, there are other issues that might preclude the use of ETFs in certain circumstances, even if they prove to be the most efficient vehicle, says Northway.
The inputs into tracking difference – that is the divergence over time between the total return of an ETF and the implied total return of its associated index – include fund costs, management charges, index royalties, replication method (synthetic versus full physical replication versus partial physical replication) and stock lending.
“Pension funds are likely to have internal policies on some or all of these aspects, which may at times exclude the use of the most efficient vehicle,” says Northway. “For most institutional investors there will also be an overriding requirement for ETFs to reflect a minimum AUM and daily turnover.”
Still reduced ETF charges are still a big input into tracking difference and therefore highly relevant to the attractiveness of an ETF provided they’re not accompanied by increased tracking error.
“Lower bid/offer spreads, particularly where the underlying portfolio would attract significant execution costs and/or taxes, should be on every investor’s radar,” says Northway.
Changing landscape
One point to be made about the data from CREATE Research earlier this summer is that though the changing nature of pension fund ETF usage is gradual, it is happening and is on the increase.
Moreover, the ETF market is itself evolving with the emergence of active ETFs, inverse ETFs and the whole arsenal of smart beta.
The CREATE report noted that smart beta usage was at the same percentage as ETF usage overall among the pension fund managers surveyed, which suggests as Amin Rajan, chief executive at CREATE said at the time, that more pension funds are moving to these systematic strategies because they are seen as “combining the best of active and passive investing”.
Northway points out that while pension funds’ usage of ETFs is on the increase – witness the 300 basis-point year-on-year rise found in the CREATE Research data – it is not yet “pervasive”.
Yet he predicts we will see more innovation in the medium-term. “We expect to see the development of hybrid ETFs (UCITS vehicles capable of issuing both units and shares to cater for both mutual fund and ETF investors) to address the requirements of the whole market from a single commingled fund and to overcome the legacy custody and platform constraints experienced by many institutional and retail investors,” he says.
Bhambra, concludes the “misconception” that pension funds cannot use ETFs because of their structure is being dispensed with as the utility of ETFs becomes ever more apparent.
“Today the ETF is a valid part of any tool kit and in markets that continue to be challenging, we believe that having another tool in the toolkit is no bad thing.”
ETF Insight is a new series brought to you by ETF Stream. Each week, we shine a light on the key issues from across the European ETF industry, analysing and interpreting the latest trends in the space. For last week’s insight, click here.
