Burning bright

Sophie Baker assesses why Exchange Traded Funds have been one of the few recent investment success stories and whether they are gaining favour with UK pension funds

The UK financial press has not been a particularly uplifting read over the last year, with the seismic effects of the credit crunch and flailing markets dominating the news. However, one ray of light has pushed through in the shape of the Exchange Traded Fund (ETF).

The product, prevalent in a number of guises as an investment vehicle traded on stock exchanges, holds assets from a variety of sources and appears to have offered investors a safer alternative to more traditional asset classes.

In March 2009, ETF Securities, an issuer of ETFs and their close relations Exchange Traded Commodities (ETCs), recorded oil ETC volumes up 400
per cent year on year.

"There has been some phenomenal growth in the ETF market," explains Manooj Mistry, head of db x-trackers UK. "The ETF market in Europe has gone from €70 billion to €110 billion, and has been the one bright spot recently."

A measure of how far ETFs have clawed their way onto the investment radar was made evident by the recent establishment of a new research chair, Core-Satellite and ETF Investment by Crédit Agricole Structured Asset Management and the EDHEC Risk and Asset Management Research Centre. The chair will conduct three years' worth of academic research into ETFs. But what is it about these vehicles that has earned them this attention?

The success behind ETFs comes down to the structure of the products and the key differences that set them apart. Nizam Hamid, iShares’ head of sales strategy, says it is difficult to pinpoint the success of ETFs to just one of their advantages.

"It is a different proposition from active and managed funds, because we are giving investors access to low cost beta products across a very wide range of the market, from all different sectors such as the equity world, developed markets, emerging markets, large cap and small cap, to very differentiated parts of the fixed income space as well," he says.

Attractions
Deborah Fuhr, managing director, global head of ETF research and implementation strategy at Barclays Global Investors (BGI), believes it is possible to track back to when ETFs stepped into the limelight. "Since September 15th, the day Lehmans filed for bankruptcy, investors have become concerned about using swaps and structured products which have 100 per cent counterparty exposure."

This lack of counterparty risk is part of what makes ETFs such an attractive option to investors. They are low cost, which Nicholas Brooks, head of Research and Investment Strategy at ETF Securities, believes is a big tick on investors' checklists: "When markets are going up, investors are less concerned about fees and costs, so if you're paying five per cent upfront and one per cent management fee, people don't worry too much if markets are going up by 20 per cent a year.
But in this kind of environment, people focus back on basics, and that attracts them to ETFs."

"Market conditions have been difficult," agrees Mistry. "ETFs can be used to get back into the market and for quick exposure. ETFs offer a large range of products tracking indices and asset classes. They are regulated, so all comply with UCITS, which is a degree of comfort. They tick all of the right boxes."

Fuhr agrees that the current environment has presented an opportunity for ETFs, and cites a new interest in medium-term views on the markets as a contributor to their success. She says, looking back, that she has seen this in pension plans
as a way of gaining exposure to commodities. "But I also know many pension plans that have used certificates while they're waiting for fund allocations to external managers in equities and fixed income." When it comes to fixed income, there was a sudden explosion in volumes of these types of ETF, with assets under management increasing by 250 per cent from €9 billion to €31.7 billion at the end of February 2009.

Fixed income has not been the only area of ETFs that has seen immense growth over the last year. Brooks has seen gold and oil come on in leaps and bounds. "We've seen about a billion dollars inflow into each category since November. We've also seen rising flows into agriculture, and a little into industrial metals."
Brooks sees this gold-rush as a trend caused by the current environment: "A lot of investors seem to be interested in hard assets, and are especially looking for safe havens. Gold is a safe haven in times of economical and political instability."

UK interest
Despite the plethora of ETF products appearing on the market over the last year, they remain scant in UK pension fund portfolios, compared to Europe, says db x-trackers' Mistry. He puts this down to the traditional tardiness of the UK pensions market itself.

"The UK is changing slowly, especially with the pensions markets. There has been more success in Europe versus the UK. It is just the way the pension fund market is structured in the UK. There is a degree of a lack of education about providers like ourselves, but with interesting market conditions, ETF products are a perfect tool for managers to do that."

However, he is confident that they are on the up in terms of getting on investors' agendas. But iShares' Hamid disagrees, saying there is already a big market in the UK: "One of our biggest funds is the FTSE 100. There are quite a few large scale fund managers using ETFs in the UK, especially if they do not want to be tied into a long-term investment."

BGI's Fuhr is also positive about the UK's employment of ETFs as a vehicle for pension fund investment. "I would say the pension schemes themselves using ETFs to invest directly is really now starting to gain some traction, and that's partly because the toolbox of available ETFs has grown a lot, and it's also because of what happened last year with traditional mutual funds. We had active funds not beating benchmarks, putting restrictions on the ability to get out, and then the volatility last year".

Continued success?
It is all very well that ETFs have fared well in the current climate, and that providers have continued to churn out new products even in these difficult times, but can they continue at this successful rate? "I think [the market] will grow," says Fuhr, "because a lot of the new products that have come out recently on various fixed income indices are increasingly interesting to investors – that's a segment where people are interested in putting money right now – back to basics.

"Simple is better for many investors, so with ETFs you can trade with multiple brokers, any time of the day; they're transparent, they allow you to easily implement exposure to a lot of different benchmarks, all in a cost-efficient way."
Brooks agrees, and believes that the current environment will push forward this potential growth.

However, he warns that this will probably be to the detriment of mutual funds. "Given the current environment ETFs are going to continue to grow at a rapid pace and continue to take market share away from mutual funds because the bottom line is managed funds are inefficient vehicles – ETFs are cheaper and they track the index that they're supposed to track. There will always be investors who are looking for fund managers that outperform their indexes and are willing to pay a premium for that, but increasingly, as more and more investors become aware of ETFs, you're going to see the world move in that direction.

"In the US, ETFs are becoming increasingly dominant – and I think that is what will happen in the UK
and Europe."

- Pensions Age April 2009