ETFs in the Institutional Asset Management Area

EDHEC Institutional Days & ETF Summit2006

1

The EDHEC European ETF Survey 2006November 21st, 9.00 – 11.00am

ETFs in the Institutional Asset Management Area

Sponsored by

Jean-René GiraudDirector EDHEC Risk and Asset Management Research Centre

EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 2

Layout

• Introduction• An overview of the ETF market• Methodology of the European survey• The role of ETFs in the asset allocation process• ETFs in practice• The pros and cons of ETFs, futures, total return swaps and index

funds• Concluding thoughts


IntroductionThe very first Survey on the use of Exchange Traded Funds by European Institutional Investors

• This survey is a response to the extraordinary development that the European exchange-traded fund (ETF) market has been enjoying since its inception in 2000;

• It analyses the use of ETFs among a representative sample of European investment managers and institutional investors;

• Not only does it analyze the current and foreseen usage of ETFs, it also reviews why and how institutional investors include them in their portfolio and how they compare to other vehicles.



• This European survey is structured in three sections:– The Methodology section gives details on how the survey was

conducted;– The Background contains an overview of the market for ETFs and

EDHEC’s ideology on the different areas addressed in the survey, and notably includes a discussion on the advantages of using ETFsin the core-satellite approach to investment management and the ways in which asset allocation can be carried out with ETFs;

– Finally, the Results section contains the respondents’ answers to our questionnaire.

• This morning’s focus is on the last section.



• Overall, the results suggest that European investors and asset managers are well aware of the advantages of ETFs;

• However, our survey also reveals that the full potential of these instruments for asset allocation is not currently being exploited by the majority of investment management professionals;

• We will explore these various areas and analyse in more detail how and where ETFs are likely to develop in the near future.


IntroductionSetting the scene for the future of the European ETF market

• 55% of European institutional investors are predicting an increase in their usage of Exchange traded funds;

• While respectively 41% and 36% of respondents predict a decrease in the use of TRS and Index funds, only 4% think the same of ETFs.

How would you predict your future usage of thefollowing instruments?


An overview of the ETF marketOld America, new Europe

• Initiated on the Toronto Stock Exchange (TSX) in 1990, ETFshave flourished significantly worldwide;

• In Europe, the first ETF appeared in April 2000 and was issued by Merrill Lynch to track the Euro STOXX 50. Although the European ETF industry started late and the US still leads the market, thefaster uptake of ETFs in Europe (61.7% of asset growth in Europe in 2005 compared with 33.6% in the US) is rather remarkable.


An overview of the ETF marketA steady growth in assets and number of funds

• Consistent and significant growth in assets under management (CAGR of 75% from 2001 to 2005);

• Significant development of the number of listed funds (from 6 to 216 in 6 years);

• H1 European growth of 29.9% compared to 16.7% globally (Source MSDW).

Assets under Management and number of ETFs in Europe from 2000 to the end of June 2006

Source: Morgan Stanley Investment Strategies, Bloomberg, August 2006


An overview of the ETF marketA mature landscape of providers

• A mature group of leaders well established in the European marketplace;

• A significant number of new entrants representing both local groups or branches of large US ETF providers;

• Major European exchanges involved with significant market shares:

– Deutsche Börse XTF (44.9%)– Euronext (23.7%)– London Stock Exchange (14%)

ETF issuers in Europe ranked by AUMas of end of June 2006

Source: Morgan Stanley Investment Strategies, Bloomberg, August 2006


Methodology of the European SurveyA very broad European sample

• The questionnaire for the EDHEC ETF survey was addressed to the top 1,000 European asset managers and institutional investors in the summer of 2006;

• Among institutional investors, we targeted finance group directors for major corporations, or chief investment officers and chief finance officers for pension funds;

• The study generated responses from 112 European institutional investors and asset managers (investment/asset management companies, pension funds, banks and insurance companies, fund of hedge funds, industrial and commercial enterprises).


Methodology of the European SurveyA highly representative sample: breakdown by country

• France, the UK and Switzerland represent the large bulk of our sample with 26%, 24% and 12% respectively. These countries also make up 20%, 32% and 12% of the population;

• Apart from the UK and Germany (under-represented) and Italy (over-represented), the breakdown by country in our sample is very close to that of the population.

Breakdown of respondents by country


Methodology of the European SurveyA highly representative sample: breakdown by category

• Our survey mainly covered asset management companies and pension funds, accounting for 64% and 21% respectively;

• Many other actors participated in the survey: banks, insurance companies, funds of hedge funds, etc.

Breakdown of respondents by category


Methodology of the European SurveyA highly representative sample: breakdown by category

• In terms of the size of the asset management company or the investor, we cover respondents representing assets under management of their institution between 2.7 million to 70 billion Euros, with an average size of 6.985 billion Euros.

Breakdown of respondents by category


The role of ETFs in the asset allocationETFs and core-satellite portfolio management

• The core-satellite strategy is widely regarded as an effective way of organizing asset allocation;

• As highlighted by recent research ETFs can be a desirable instrument not only in the core portfolio (for strategic allocation purposes) but also in the satellite in order to make tactical bets;

• Nevertheless, according to the responses provided, only 48% of European investors have implemented a “core-satellite” approach to construct their portfolios.



• 9% of respondents are to implement a “core-satellite”-type organization in the near future;

• But while only 7% respond they are not familiar with the approach, a significant proportion of respondents (36%) are not considering using the core-satellite approach at all.

Have you implemented (or are you going toimplement?) a "core-satellite"-type organization

of your allocation?



• While 28% of respondents used ETFs in the core portfolio, almost as many (24%) traded them for the satellite;

• A notable bulk (37%) of respondents do not clearly include ETFs in their asset allocation, as they stated that they were not using ETFs in the core portfolios or in the satellite portfolios or for the purpose of representing a geographical zone or asset class.

What role do ETFs play in your allocation?



• Among those respondents who responded “other”, 46% had implemented the C-S strategy, which means that only 17% of all 112 respondents that applied it were actually using ETFs in ways other than that mentioned;

• As 48% of all respondents had employed a C-S strategy, we can deduce that 65% of investors who had applied a C-S strategy were using ETFs in the specific ways mentioned.

Breakdown of the 37% of respondents that appear in the category “other” according to their response to the question: Have you implemented (or are you going to implement?) a

"core-satellite"-type organization of your allocation?


The role of ETFs in the asset allocationETFs and core-satellite portfolio management – equity investments

• When evaluating the usefulness of different types of equity ETFs, European investors appeared to have a particular preference for geographic ETFs (83% of respondents considered them a useful tool);

• Sector ETFs were perceived as beneficial by 74% of investors, and most of them stressed their usefulness in core portfolios;

• Regarding style (growth/value) ETFs, as many as 40% of investors did not think they were useful in equity investment. But interestingly, style ETFs are regarded as a useful tool in the satellite portfolio by as many as 21% of respondents, which is the highest percentage among the three categories.


The role of ETFs in the asset allocationETFs and core-satellite portfolio management – equity investments

• One can observe that style ETFs are clearly less popular than sector or geographic ETFs, especially for use in the core portfolio. Only 18% of respondents consider style ETFs to be useful in both the core and the satellite;

• This seems surprising given that the academic literature has widely agreed on the importance of style factors.

Do you think the following types of ETF are useful in equity investment?


The role of ETFs in the asset allocationETFs and core-satellite portfolio management – fixed income investments

• Compared to equity investment, respondents to the survey are less convinced of the role of ETFs in bond portfolio management;

• Regarding government bond investments, our respondents showed surprisingly uniform opinion on the usefulness of countryETFs and maturity segment ETFs;

• The bulk of respondents (over 40%), however, did not think either of them was useful in the field of government bond investing;

• Responses for corporate bond ETFs are broadly in line with those for government bond ETFs, showing again that bond ETFs are considered less useful than equity ETFs.



• The weak score for government bond ETFs may reflect that respondents do not fully realize the potential benefits of active investment strategies in the field of government bond investing:

– For example, different maturity segments are natural supports for tactical timing strategies (in the satellite);

– In addition, the different time-series behavior of such instruments, due to their differing exposure to interest rate changes, also makes them a useful vehicle for constructing an efficient core portfolio.

Do you think the following types of ETFare useful in government bond investment?



• The responses given in the survey may be explained by the fact that only a minority of investors engage in active asset allocation between subcategories for their bond portfolio;

• This view contrasts with the findings of academic studies that derive significant benefits from active allocation between narrower categories of the bond market such as maturity segments (see e.g. Amenc, Malaise and Martellini, 2004).

Do you think the following types of ETFare useful in corporate bond investment?


ETFs in practice

• In this section, we examine how European asset managers and institutional investors use ETFs in practice and whether the users were satisfied with the performance of ETFs or not. Furthermore, we give considerable attention to exploring how investors perceive ETFs or similar vehicles in the area of alternative investments;

• After having reviewed the usefulness of ETFs for equity, bond and other underlyings, we will discuss more advanced uses of ETFs, such as short selling and derivatives.


ETFs in practice Usefulness of ETFs for equity investments

• 45% of respondents are using ETFs at present, and 16% stated that they would start using ETFs soon;

• However, there were still as many as 37% of respondents who were not using ETFs, and not considering the use of them any time soon, which means that there remains considerable room for ETFs to develop.

Do you use ETFs for your equity investments?


45% Yes, becauseof the reliability of the t racking error

4% No for a different reason

23% Yes, because of their good performance

21% Yes, because of the good level of liquidity

4% Yes, because of the reductionin fees/expenses

4% No, because of the poor levelof quality

ETFs in practice Satisfaction with ETFs for equity investments

• Among those that use ETFs, 92% were satisfied;

• For 45% of responses, the most distinct reason for satisfaction was the reliability of the tracking error. 23% were satisfied with the good performance of ETFs, while 21% were pleased with the good level of liquidity, and only 4% cited the reduced expense of ETFs.

Are you satisfied by the use of ETFs in equity investment?


13% No, but we will soon

73% No

7% No answer

6% Yes


66% No

8% No answer

13% Yes

• In line with the judgment on their usefulness above - only 13% of respondents were trading ETFs as of the end of August 2006 and another 13% were considering the use of ETFs in the near future;

• This statement by practitioners comes despite the potential benefits of active allocation between bond ETFs, as documented in the literature.

ETFs in practice Usefulness of ETFs for fixed income investments

Do you use ETFs for your fixed income investments?

Government bonds

Corporate bonds


ETFs in practice Satisfaction with ETFs for fixed income investments

• Among the respondents who are users of government bond ETFs, 80% found ETFsto be satisfying. 35% named the reliability of the tracking error, 30% the reduction in expenses and 15% the good level of liquidity;

• Consistent with the fact that over 40% of respondents do not perceive corporate bond ETFs as a useful tool, there were as many as 73% that do not use such ETFs.

Are you satisfied by the use of ETFs in fixed income investment?

Government bonds

Corporate bonds



9% No answer

7% Yes

68% No

ETFs in practice Usefulness of investable indices for hedge fund investments

• Investable index products are not as popular in hedge fund investments as in the traditional field due to their relatively recent appearance;

• Only 7% of respondents were trading them;

• However there were 15% of respondents who were planning to use such instruments in the near future.

Do you use investable index productsin your alternative investments (hedge funds)?


ETFs in practice Satisfaction with investable indices for hedge fund investments

• Among the small group of users, only 27% were actually satisfied with the product they use;

• The problems with investable index products in the area of alternative investments are well known and ways of addressing these problems have been proposed in the literature (see Goltz, Martellini and Vaissié (2006)).

Are you satisfied with investable index products in your alternative investments (hedge funds)?

7% Yes, because of the reliability of the tracking error

7% Yes, because of the reduction in fees/expenses

13% Yes, because of the good level of liquidity

13% Yes, because of the poor level of liquidity

13% No, because of the difference in returns between investable indices and non-investable indices

13% No, because of theirpoor performance

7% No, because of thelack of reliability of hetracking error

27% No, for a different reason


ETFs in practice Usefulness of ETFs for real estate investments

• In the area of real estate investment, only 6% of respondents were trading ETFs and 11% were planning to try soon;

• This is consistent with the fact that real estate ETFs are newly invented instruments.

Do you use ETFs in your real estate investments?


74% No

9% No answer

6% Yes


ETFs in practice Satisfaction with ETFs for real estate investments

• Half of the users stated that real estate ETFs were satisfactory because of the good level of liquidity they provided, the reliability of the tracking error and their good performance;

• Among the other half, 20% of total users ascribed their dissatisfaction to the poor level of liquidity and another 10% complained of a lack of reliability in the tracking error.

Are you satisfied with ETFs in your real estate investments?


ETFs in practice Usefulness of ETFs for commodity investments

• Although, like real estate exchange-traded funds, commodity ETFs have only been introduced recently, they were more popular among respondents;

• 15% of respondents are trading commodity ETFs and another 20% showed their interest in stepping in soon.

Do you use ETFs in your commodityinvestments?


ETFs in practice Satisfaction with ETFs for commodity investments

• The percentage of satisfied users is also greater than that of the alternative investment classes above;

• Among the 65% of satisfied users, 30% appreciated the good performance of commodity ETFs, 20% cited the reliability of the tracking error and another 15% said they benefited from a good level of liquidity.

Are you satisfied with ETFs in your commodity investments?


ETFs in practice Benefiting from ETFs’ distinct features

• ETFs distinguish themselves from other indexing instruments by a number of features:– Possibility of shorting an ETF– Possibility of borrowing/lending an ETF– Derivatives on ETFs

• There is a considerable share of respondents who were actually not familiar with these features of ETFs, showing a potential need for investor education on these issues;

• The following pages show how these features are perceived by European investors and asset managers.


ETFs in practice Shorting ETFs

Do you short ETFs?


ETFs in practice Borrowing/Lending ETFs

Do you do securities lending with ETFs?


ETFs in practice Derivatives on ETFs

Do you use options on ETFs?


7% No answer

4% Yes

9% Not familiar with it

9% No, unlikely to in the futu re

65% No


• Introduction• An overview of the ETF market• Methodology of the European survey• The role of ETFs in the asset allocation process• ETFs in practice• The pros and cons of ETFs, futures, total return swaps and

index funds• Concluding thoughts


Pros & Cons of various investment vehicles

• In this section, we will compare four investment instruments: ETFs, futures, total return swaps (TRS) and traditional index funds. All these instruments allow the simple execution of trades in large baskets of stocks;

• Our evaluation criteria are loosely based on Rubinstein’s (1989) early examination of such instruments. We look at the advantagesand drawbacks of each instrument and then emphasize specific issues concerning total return swaps, futures and ETFs;

• We also assess the future use of these instruments by European institutional investors and asset managers in order to identify certain trends.


Pros & Cons of various investment vehiclesLiquidity

• Results show that respondents do value the ability to trade immediately with futures and ETFs, unlike standard index funds;

• This is in accordance with the academic literature that finds a “value of immediacy”in exchange-traded funds (see Comer et al., 2002).

Rating with regard to the level of liquidity


Pros & Cons of various investment vehiclesCost of liquidity

• Concerning the cost of liquidity, respondents' preferences are quite similar to those for liquidity;

• Responses show that futures still got the best rank, followed by ETFs. Index funds and, even more so, TRS were rated as weak.

Rating with regard to the cost of liquidity


Pros & Cons of various investment vehiclesCost

• Concerning cost, most respondents voted in favourof futures;

• 61% classified exchange-traded funds as “good”, but only 21% voted for them as very good and 13% considered they were “poor”with regard to this criterion;

• Index funds did not fare well either when compared to ETFs and futures.

Rating with regard to cost


Pros & Cons of various investment vehiclesReliability of Tracking Error

• Exchange-traded funds obtained the best evaluation from respondents;

• Futures and index funds can be ranked second as 54% classified them as good or very good at providing reliability of tracking error;

• Total return swaps were evaluated as good as well, but it must be taken into account that almost half of the respondents did not express their opinion on them.

Rating with regard to the reliabilityof tracking error


Pros & Cons of various investment vehiclesAvailable range

• On the available range, exchange-traded funds were ranked first. This is consistent with the recent developments in the ETF industry and has been stated as an advantage of ETFs in the literature (see e.g. Demaine (2002));

• ETFs now offer exposure to a wide range of indices; this is a notable difference to futures, which have less of a diversified product range.

Rating with regard to the available range


Pros & Cons of various investment vehiclesMinimal subscriptions

• Concerning the minimal trading subscription, ETFs gained overwhelming favour from European investors with 71% advocating them and only 1% objecting to them;

• Index funds were also considered to accommodate small subscriptions well by 55% respondents;

• Surprisingly, futures were ranked only slightly behind index funds, with 51% of respondents rating them as “good” or “very good”.

Rating with regard to the minimal subscriptions


Pros & Cons of various investment vehiclesOperational constraints

• Exchange-traded funds and index funds were perceived to be suffering less from operational constraints than the other two instruments;

• These results confirm that dealing with derivatives is still subject to considerable implementation problems;

• What is more, there appears to be a very pronounced difference between exchange-traded (futures) and over-the-counter derivatives (swaps).

Rating with regard to theoperational constraints


Pros & Cons of various investment vehiclesRegulatory regime

• Respondents preferred ETFs, with 65% ranking them as good and only 3% ranking them as poor;

• Interestingly, ETFs were also the category with the least non-responses suggesting high familiarity among respondents with the regulatory regime that applies;

• Likewise, index funds and futures were mostly regarded as good;

• However, there existed considerable dissatisfaction with the regulatory framework for total return swaps.

Rating with regard to theregulatory regime


Pros & Cons of various investment vehiclesTax regime

• Concerning the tax regime, respondents to the survey agreed with academic research papers (e.g. Poterba and Shoven 2002) that stress the tax efficiency of exchange-traded funds;

• In fact, the majority of respondents (55%) ranked ETFs as very good and fairly good in terms of the applicable tax regime;

• However, index funds and futures are also considered to be good by only slightly fewer respondents (47% and 44% respectively).

Rating with regard to thetax regime


Pros & Cons of various investment vehiclesSpecific issue: Total Return Swaps

Is the fact that they are tradedover the counter good or bad for you?

Is the counterparty risk aproblem for you?


Pros & Cons of various investment vehiclesSpecific issue: Futures

Is the fact that they are derivativeinstruments a problem for you?


Pros & Cons of various investment vehiclesSpecific issue: Futures

Is the requirement to roll overpositions a problem for you?

Are the margin calls a problemfor you?


Pros & Cons of various investment vehiclesSpecific issue: Exchange Traded Funds

• Responses are rather surprising given that an empirical study by Engle and Sarkar (2004) for the US finds that domestic ETFs have highly efficient prices, though their finding is different for international ETFs;

• In fact, these authors find that premiums or discount with respect to the funds’ NAV are typically small and disappear very quickly, supporting the view that the creation and redemption mechanism of ETFs effectively limits arbitrage opportunities.

Is mispricing with regard to theNet Asset Value a problem for you?


Pros & Cons of various investment vehiclesSpecific issue: Exchange Traded Funds

What type of ETF do you prefer? If the answer is “Passive ETFs”,which of the following do you prefer?


Pros & Cons of various investment vehiclesMeasuring TE and liquidity qualities

How do you assess the trackingquality of the different investment supports?

How do you assess the liquidityof the different investment supports?


Concluding thoughtsLooking forward

What type of products wouldyou like to see developed in the future?


Concluding thoughts

• Overall, the results of the survey reveal that asset managers and investors are well aware of the advantages of ETFs;

• However, it seems to be the case that the full potential of these instruments for asset allocation is not currently being explored by the majority of investment management professionals;

• Given that our results suggest that the use of ETFs and the organisation of portfolio management into a core-satellite approach are bound to increase, we may expect a significant impact on investment management practices and on the development of the ETF industry in the future, as these tendencies can be expected to be mutually reinforcing.

ETFs in the Institutional Asset Management Area

Documents

Transcript of ETFs in the Institutional Asset Management Area