ETFs enabling diversity

The past year has demonstrated the benefits and importance of portfolio diversification across asset classes. While many investors in the traditional asset classes of equities, fixed income and property have suffered volatility and losses in capital values over the past year, alternatives like commodities have offered the opportunity for capital growth. For example, the gold price has risen above $1,000 (E630) an ounce this year and the oil price has broken through $100 a barrel barrier while other commodity and food prices have experienced significant rises. The increase in prices and therefore returns has been driven by the fact that demand, particularly from emerging markets, has outstripped supply and investors have been seeking low and non-correlated asset classes to equities and bonds. Exchange traded funds (ETFs), which first appeared in Europe in 2000, are well placed to benefit from investors looking to diversify away from equities and bonds. This is because the desire for diversification has come at a time when ETF providers have been expanding their offering away from the mainstream equity indices. ETFs are one way in which investors can gain access to movements in the actual price of commodities. Previously, investors who cannot buy gold bullion have often bought mining stocks as a way of trying to profit from any anticipated rise in the gold price, for example. Like other ETFs, those tracking commodity prices provide quick access through the purchase of just one share and for relatively low charges. The growth in demand for commodity ETFs is demonstrated by Lyxor Asset Management – a subsidiary of the investment banking arm of French institution Societe Generale - which has a commodity fund listed in London, Italy, Belgium, France, Germany and the Netherlands. This has attracted $700m in assets since the start of the year and currently holds $3.25bn in assets. It is not just commodity ETFs that are enabling investors to diversify their portfolios. Another growth area is money market ETFs. Both db x-trackers and Lyxor have EONIA (Euro Overnight Index Average) money market ETFs. Owned by Deutsche Bank, db x-trackers has raised more than E2.5bn in eight months for its EONIA ETF. Lyxor’s ETFs tracking the EONIA have attracted $1.4bn. Both providers offer access to the overnight rate for an annual charge of just 0.15 per cent. “Our ETFs hold sovereign bonds,” says Manooj Mistry, head of db x-trackers structuring. “In contrast, after the start of the credit crunch, many investors discovered their money market funds held CDOs and asset backed securities. Like all ETFs, our money market products are transparent, cheap and quick to access. Ours is providing a yield of 4.1 per cent at the moment.” Valerie Baudson, managing director of ETFs at Credit Agricole Structured Asset Management (CASAM), says their money market ETFs now have $5.2bn in assets, representing more than 4 per cent of the market. “We believe 2008 could be the year of money market ETFs,” she says. Mr Mistry says db x-trackers also offers ETFs that track Deutsche Bank’s currency indices. These provide long and short exposure to different currencies. “An advantage of currencies is their low correlation to equities and bonds,” he adds. “As a new player to the ETF market, we recognised we need to offer the standard ‘me too’ products but we have also been the first in Europe to offer ETFs on short indices, credit, currencies, inflation linked indices and new markets such as Vietnam.” Daniel Draper, head of ETFs for UK and Ireland at Lyxor Asset Management says active asset allocators have been using single country ETFs, including recent launches tracking Taiwan, Hong Kong, Malaysia and Thailand. He identifies a demand for Africa, Middle East, Russia and Eastern Europe ETFs.

‘We believe 2008 could be the year of money market ETFs’ - Valerie Baudson, CASAM

ETFs enable investors to use instruments that have been used by hedge funds, such as shorting indices and gaining leverage. “One of the most popular ETFs recently has been Bear ETFs, which provide a short exposure to indices,” says Francois Millet, director of index linked products at Societe Generale Asset Management (SGAM) Alternative Investments. “ETFs use futures to provide leveraged exposure. They can also provide ongoing capital protection of 80 per cent. Under this approach, 20 per cent is invested initially with leverage to gain index exposure not exceeding 100 per cent. There is automatic rebalancing and quarterly adjustments to exposure. The quarterly adjustments allow active changes to exposure conditions,” he adds. There has been a growth in so-called active or fundamental factor ETFs. These ETFs use quantitative processes to select stocks and their weighting for an index according to factors that can range in number from four to 50 rather than their market capitalisation size. These factors can include sales, cash flow, book value, dividends and earnings. These ETFs have been developed, says Deborah Fuhr, head of Morgan Stanley’s Investment Strategies Group, because of the argument that “market cap weighted indices are systematically over-weighting over-valued stocks and under-weighting under-valued stocks”. Lyxor’s Mr Draper says such ETFs often have a bias to value and small cap stocks. It has not been the most favourable time in which to launch these ETFs, however, given the criticism of the performance of quantitative funds last year. Beta not alpha But Frank Henze, head of product development for iShares, the specialist ETF unit at BGI, says investors need to understand the investment approach and types of returns these ETFs will deliver. “These ETFs are not really providing active investment management. It is more enhanced beta than enhanced alpha. The returns of these ETFs may closely follow those of the market cap weighted index.” Given the proliferation of ETFs, it is hardly surprising that some have low levels of trading or have cyclical trading patterns. Managers, however, say this is generally not an issue for providers because ETFs are inexpensive to establish and manage. This diversification of ETF products is reflected in the growth of the industry in Europe. At the end of 2007, there were 423 ETFs in Europe, according to Deborah Fuhr of Morgan Stanley. There were $128.4bn in assets in these ETFs, which had 1,041 listings and were offered by 28 managers on 18 exchanges. The assets under management in European listed ETFs increased by 43.1 per cent during 2007.

‘Like all ETFs, our money market products are transparent, cheap and quick to access’ - Manooj Mistry, db x-trackers

Ms Fuhr says there were also 56 exchange traded commodities (ETCs) in Europe at the end of last year. These had $4.9bn in assets, with 209 listings from two managers on five exchanges. In 2007, assets under management in ETCs grew 134.3 per cent. Germany has the greatest number of ETF listings in Europe at 157, followed by France (119), the UK (84) and Switzerland (21). The continued proliferation of ETFs into 2008 means that at the end of February there were 541 ETFs listed in Europe if multiple listings are disregarded, says Mr Henze. Barclays Global Investors (BGI) is the largest manager of ETFs in Europe through iShares, whether it is measured in terms of number of funds (137) or assets under management ($57.7bn). This means BGI, through its iShares ETFs, has a market share of 44.9 per cent. Lyxor Asset Management is the second largest with 87 ETFs and $31.5bn in assets, representing a market share of 24.5 per cent. Mainstream prevalent Credit Agricole’s Ms Baudson says that despite this proliferation of “alternative” products, however, the European market is still dominated by funds tracking the main indices. For example, Ms Baudson says ETFs that track the Euro Stoxx 50 index have $19bn in assets. This represents 14 per cent of the European ETF market, which totals $135bn in assets. The next most popular ETFs are those tracking the main country indices, such as the Cac, Dax and FTSE 100 with $17bn of assets or 12 per cent of the market. The third group are linked to US indices such as the S&P 500 and Dow Jones indices. They have $5bn in assets or 4 per cent of the market. Ms Baudson joined CASAM in January 2008 to expand the asset manager’s ETFs offering, which currently comprises three products. In the first stage of expansion, Ms Baudson says CASAM will launch ETFs tracking the major equity indices because of their continued dominance of assets under management. As well as the proliferation of new ETFs, there has also been a growth in new providers in Europe. These have included db x-trackers, Powershares (which was bought by Invesco) and SPA ETF. Ms Baudson says many small providers will expand to compete with the few large providers in the future.

‘ETFs use futures to provide leveraged exposure. They can also provide ongoing capital protection of 80 per cent’ - Francois Millet, SGAM

An ongoing issue for ETFs is their tracking error to underlying indices. Managers say the tracking error on the major equity indices is low and the accompanying table suggests this is the case. Where tracking error can rise is on indices tracking smaller cap and emerging market indices in particular. Morgan Stanley’s Ms Fuhr says that among the factors affecting tracking error are fees and expenses, premiums/discounts, dividend reinvestment, optimised replication, rebalancing and non-concurrent trading hours. SGAM’s Mr Millet says the degree of replication largely depends on the method used. “The best two methods are the direct holding of the underlying stocks or using swaps to gain the performance of the index. “The former involves transaction costs of buying and selling stocks while the latter involves the cost of the swap, which may be Libor. Another method is to use futures but there can be a difference between the spot price and the futures price.” Through using swaps, the counterparty guarantees the performance of the index, says Mr Mistry of db x-trackers. The risk is of the counterparty going bankrupt. Institutional investors continue to be the dominant users of European-listed ETFs. Mr Henze from ishares says around 80 per cent of assets have come from institutional investors. There is a belief among providers, however, that interest among retail investors will grow. This belief is partly based on the fact that an increasing number of financial advisers have and are moving to a fee-based model. Generally, ETFs do not pay commissions to intermediaries. Mr Mistry says: “Currently, around 15 per cent of inflows in Europe come from retail investors but in the US the figure is 50 per cent to 60 per cent where the market is dominated by fee-based advisers.” The retail market may also expand through the launch of funds of funds. “We are receiving two or three enquiries from Europe every month about the launch of funds of funds,” says Lyxor’s Mr Draper. “This is one way in which ETFs can be distributed to retail investors.”