Recent surveys conducted by Greenwich Associates in the US (April 2010) and the EDHEC Risk Institute in Europe (May 2010) indicate continued growth in use of ETFs by institutional investors. This is consistent with our experience. Institutional clients of all sizes are engaging us in conversations around how ETFs can help to solve their investment problems.
Public filings reveal significant use of ETFs by well known and closely followed US institutions including endowments such as Yale and Harvard. Closer to home, there was keen interest in the US$300bn China Investment Corporation’s surprise filing on February 5th, 2010 to the U.S. Securities and Exchange Commission. This disclosure revealed significant investments in ETFs.
In this article we explore some of the real life common strategies that we see being used by our institutional clients.
The strategies we will explore can be grouped into 3 types (see Figure 1):
Interim beta
Cash equitisation refers to strategies aimed at maintaining target market exposure, helping to eliminate or reduce cash drag from the portfolio. Transition management addresses the problem of how to maintain target market exposure when transitioning between fund managers or portfolios.
Both have been popular uses of ETFs by both asset owners and asset managers. The Greenwich Associates survey showed that of the 70 institutional investors using ETFs that they surveyed, 31% of the plan sponsors and 63% of the money managers used ETFs for cash equitisation. The survey also found that 38% of the plan sponsors and 31% of the money managers used ETFs for transition purposes.
Futures and swaps are also frequently considered. However, there are at least 2 good reasons why ETFs are often the preferred choice:
- Broad range of ETFs available
- Operational simplicity
Range – Often, there may not be a single future (at least one that trades meaningfully and offers liquidity) written on the benchmark exposure required. Construction of a futures basket will be required for broad exposures and it may be impossible to implement narrow exposures with futures. Swaps can be customised of course but introduce other issues.
Operational simplicity – The ETF can simply be bought in one trade, held, and then sold in one trade when cash is required. Extensive documentation is not required and it is simple to manage. Futures will require the contract rolls to be managed, and active rebalancing of the futures basket. Swaps require more documentation, are Over-The-Counter instruments and introduce counterparty risk.
Overall performance will be a function of a few variables. Some of the considerations are set out in Figure 2.
The key point is that analysis should be done on a case by case basis and not to assume that any one of the products above is always “superior”. In many cases, even where analysis shows some performance improvement for the other products, we observe that investors may still choose ETFs for operational simplicity or due to internal investment guidelines and restrictions.
ETF overlay
ETFs are excellent vehicles for obtaining strategic beta exposure. The extensive range of ETFs available gives access to most market exposures that an investor might want often in just one single ETF trade.
What is perhaps more interesting though is the interest from clients in putting together portfolios of ETFs. We think there are three key drivers:
- Taking more control
We have noticed a strong trend and interest amongst our larger institutional clients towards (i) wanting to take more control of their portfolio management in-house, and (ii) putting more focus on risk management and asset allocation (rather than relying so heavily on outsourcing to active fund managers and bottom up security selection skill as a source of performance).
- Better risk budgeting and combining alpha with beta
This is not a repeat of the index vs. active debate. It is a move towards thinking more clearly about how the risk budget is being spent and constructing mixed portfolios of index (including ETFs) and active investments in an efficient way.
- Greater flexibility
Many clients realise that if they construct a portfolio of ETFs to implement one particular beta strategy, then this ETF layer or “overlay” in their portfolio can then provide for a lot of added flexibility beyond their original motivation as implementation of other beta strategies is possible.
As an example, consider an asset owner or a money manager investing in the emerging markets. There are many ETFs available that target this asset class as their investment objective. It is possible to implement this beta exposure through one single ETF trade.
However, there are other ways to slice and dice this particular index as shown in Figure 3.
Due to the choice and availability of ETFs now, an investor can build this index universe at the broad regional level, or can refine exposures at the single country level. Almost every single country in the emerging markets listed above is now accessible through an ETF.
Why might an investor want to construct a portfolio of ETFs in this way? Three examples are:
- Portfolio rebalancing.
- Alpha / beta management.
- Tactical adjustments.
Portfolio rebalancing
In the September 2010 issue of Investment Insights (BlackRock’s investment research journal) Lydia Chan and Sunder R. Ramkumar wrote about the benefits of a “tracking error” rebalancing approach, particularly in stressed market conditions. One of their insights was that there is a trade-off between portfolio tracking error vs. the strategic policy benchmark, and transaction costs due to rebalancing trades. They examined this trade-off in some detail in order to reach some conclusions about the efficacy of different rebalancing schemes.
A key benefit of ETFs of course is that they can actually be more liquid than the underlying assets, and provide price improvement in the form of tighter spreads. This is by no means universal, and not all ETFs provide this price improvement. However, for well established ETFs with healthy secondary market trading volumes (whether on or off exchange) the cost of trading an ETF can be less than the cost of trading the actual underlying assets themselves. As such, rebalancing broad market beta through a well chosen portfolio of ETFs has the potential to improve investment outcomes. This implementation strategy should be particularly effective in more illiquid markets, for example emerging markets, Asia and fixed income.
Alpha / beta management
This is an extension of portfolio rebalancing in pure beta space to the active manager reality of packaged alpha and beta. The problem is this. A typical investment process used by asset owners (e.g. pension funds) is to set the strategic asset allocation, and then to “populate” the asset allocation with active fund managers. To keep things simple, let us assume a typical 60/40 equity/bond strategy, with two managers. Manager A is an active equity manager, manager B is an active bond manager. Assume that equity markets are up 10%, bond markets are down 10%, manager A outperforms by 2% and manager B underperforms by 2%.
A normal rebalancing strategy would dictate that the asset owner should sell out from manager A, and buy in to manager B, in order to preserve the strategic policy allocation. For many investors this is counterintuitive. If an ETF layer or overlay has been established, then the ETF layer can be used to preserve the strategic policy allocation independent of the active manager allocations, solving the problem.
Tactical adjustments
The breadth and depth of ETF coverage, from broad exposures to more granular, targeted exposures, means that many tactical views can be simply expressed through ETFs. For example, assume that benchmark weights are EM EMEA 17.5%, Latin America 25% and EM Asia 57.5%. If the investor has a positive view on Latin America and Emerging Asia then the investor might allocate as follows: EM EMEA 12.5%, Latin America 27.5% and EM Asia 60%. The investor has simply under-weighted EM EMEA and used this to fund over-weights in Latin America and Emerging Asia.
Return enhancement
As well as contributing to performance through any of the above strategies, there are a number of other ways to use ETFs to directly generate additional returns using their stock characteristics. One example is securities lending. Yields available can vary tremendously but this can opportunistically be an effective way to generate index+ performance.
Securities lending does introduce an element of additional risk. There can be operational and regulatory hurdles depending on the investor or fund’s jurisdiction. However, if the risk can be managed and if the operational and regulatory issues are overcome than many investors might prefer the certainty of a known securities lending yield to the uncertainty of active alpha.
Conclusion
ETFs are very versatile. Their combination of stock and fund characteristics can be used in a variety of ways. Their versatility is encouraging many large institutional investors to consider the merits of using ETFs not just for interim beta, but to actually make a strategic allocation to ETFs in the form of an ETF overlay in their portfolios.
The iShares Asia Research and Investment Advisory group conducts investment research, develops investment insights and advises clients on implementation strategies using ETFs. For further details or to subscribe to our research publications please send an email to: [email protected].
