Weaving its way

Exchange traded funds – including Spyders – are versatile, easy to run and cheaper than standard collective investments. They are a big hit in America and seem set to take off in Britain, writes Vanessa Drucker in New York.

Exchange traded funds(ETFs) have been adopted enthusiastically in America by all stripes of investors: institutions, hedge funds, mutual funds and consumers. The ranks of ETFs have swelled to 800 worldwide, and incorporate about $800 billion (£400 billion) in assets. Yet in Britain, these versatile products are only just beginning to gain traction, since their launch in 2000. Why is it taking so long? Could we finally be on the verge of a critical breakthrough?

ETFs are baskets of securities that replicate an index or industry sector, or track a commodity. They provide a form of passive diversification in a given class, such as large, mid-cap or small stocks, growth or value securities, international, real estate and fixed income. The choice of subsectors has become finely diced, yet a key characteristic still defines the breed. The methodology behind an ETF must be fully transparent and rigorously maintained, whether it is based on market cap weighting, earnings, yield or any other criterion.

A hallmark is that they are quoted throughout the day, on an exchange. Unlike unit trusts and Oeics, which trade once a day, ETFs do so continuously. Although an ETF can trade at a premium or discount to its underlying components, in most cases arbitrage quickly narrows any disparity.

“Getting beta is cheap now,” explains Charles White, chief investment officer of ThomasLloyd Global Asset Management, in Pleasantville, New York. “Obtaining exposure to almost any index around the globe has become a commodity that you can buy for next to nothing.”

“These instruments are so flexible, and offer such a variety of benefits at low fees,” says Bruce Lavine, president and chief operating officer of New York-based Wisdom Tree Investments, an ETF sponsor. In general, ETF expense ratios average about 0.40%, which is cheaper than a standard Oeic or unit trust. At the higher end, even emerging market ETFs still only cost about 0.74%.”

Lavine is enthusiastic. “They’re so easy. Once people start using them, they rarely stop!” Investors no longer have to administer individual stocks, keeping tabs on dividends, splits and other activities, since the ETF takes care of all that for them. The funds often pay quarterly or biannual dividends. Plus, with the promise of transparency, purchasers will always know exactly what securities an ETF holds.

The list of benefits goes on. Tracking error – how closely a security mirrors its relevant index – tends to be modest. Nevertheless, error does range from an average 0.28% for Vanguard’s group of ETFs, to an average 0.71% for the PowerShares family. But tracking error may rise when the component securities are less liquid, such as those in emerging markets.

Dan Kemp is a fund manager and head of fund research at Williams de Broë, which was one of the first British firms to embrace ETFs, back in 2001. He points out how intraday liquidity can be significant. “Fund managers gain much faster access with ETFs than through an open-ended fund,” he explains. “In volatile markets, the time of day when you get in or out can make a difference. And you might even have to wait several days before moving from one fund to another.” Managers are under no commitment to hold an ETF for any particular length of time. For derivative contracts, on the other hand, they may face issues of size, monitoring and swaps, if another party wants to exit.

Notwithstanding this roster of advantages, many active managers are likely to counter that their role and mandate is to pick individual stocks. If they included ETFs, their investment committees might raise the question: why could you not pick the best securities of a sector? Put bluntly, managers are being paid to add alpha, so a more passive beta tracking approach will not help them to outperform.

Kemp disagrees. When he wants exposure to an equity market, he tends toward an ETF, unless he can find an active manager whom he is convinced can add value. He notes, “Everyone believes they can pick better stocks than everyone else. But ETFs can help capture the big themes that wash through, like commodities in recent years, or the technology boom of the 1990s. Few managers can adapt their styles to outperform in each of these areas.”

It comes down, in the end, to research and resources. One might have a view on a certain sector without the capability to apply the requisite research. For example, the manager of a small-cap blended fund, who is keeping watch on hundreds of stocks, may be able to identify an interesting sector, yet lack the resources to home in for a penetrating look. “Every organisation will have some gaps,” says Dan Draper, head of Lyxor ETFs UK and Ireland. “Other industries learn to outsource. Good time management frees them up to concentrate on their competencies.”

ETFs provide broad brushstrokes. With such a plethora of choice and variety, managers can allocate across ETFs if they wish, with a full range of investment alternatives around the globe. In America, all the main market sectors are covered, as well as a host of subsectors. The smaller sectors tend to be the most homogenous, and suitable as “fill-ins”, says Brian Bruce, director of the Finance Institute at Cox School of Business at Southern Methodist University, in Dallas. For instance, among the nine telecom companies represented in the S&P, it is often hard to find huge distinctions. A sector like healthcare, however, is more differentiated and less useful as a general proxy.

While still immature, the ETF landscape in continental Europe and Britain is finally gathering steam. According to Draper, over the past year, the European market has expanded by more than 61% in terms of assets under management. That number compares with about 38% in America, where penetration is already established. Barclays has led the pack in the Britain, focusing on its 49 listed iShares for foreign indices.

“The market needed consolidation,” says Jennifer Grancio, head of distribution iShares, Europe. In November 2006, Barclays bought IndEXchange Investment, Germany’s largest ETF provider, from Bayerische Hypo-und Vereinsbank.

Most recently, in March 2007, Barclays launched three ETFs,

designed to track investments in global water, British real property and private equity. The goal is to offer exposure to alternative asset classes that would be difficult to access. For instance, the latter fund comprises 25 stocks of publicly listed companies that operate in the private equity arena in Europe, North America and Asia Pacific.

“Innovation in Europe has actually raced ahead of the US,” comments Lavine. The first structured ETFs, introduced there in 2005, build either capital protection or leverage on top of exposure to an index, by bundling a swap inside a fund. Lyxor has just launched a FTSE ETF, partially using synthetic swaps instead of underlying securities.

Lyxor is a wholly owned subsidiary of Société Générale, which is the other leading European ETF provider, along with Barclays. It brought out three new ETFs this May, which give access to the whole British market. The Lyxor FTSE All-Share ETF shadows the FTSE All-Share index, which consists of 693 stocks, and is challenging to replicate without tracking error – so Lyxor uses total-return derivatives. Yet those inexpensive swaps only add up to an expense ratio of 0.40%. “Right now, just under 40% of all funds are benchmarked to the All-Share, so we are hoping it will become the ‘Spyder’ of the UK market,” says Draper.

To date, the most popular ETFs among UK fund managers track the three core indices: the S&P, the FTSE 100 and the Eurofirst 80. In America despite the variety of ETFs available, 80% of trades are Spyders and the Cubes that track the Nasdaq 100 index. When managers look at, say, Japan or emerging markets, they regard them as environments where active management can add value. In broader markets, however, ETFs can replace the value of active selection.

On the other hand, ETFs also play a role in specialised markets, which may be difficult segments to access. For instance, in offering the first international small-cap fund, Wisdom Tree has packaged dividend streams from 21 countries. “We pick up really local companies,” says Lavine. Van Eck Global, which also tries to pick niches with unique characteristics, entered the ETF space in May 2006, under the Market Vectors brand. First came its gold minors product. Next it introduced vehicles that centered on steel and global alternative energy, including wind, solar, biofuels, ethanol and thermal sources. “We can offer a sliver of a sector, where no mutual fund is available, like steel,” says Harvey Hirsch, ETF strategist at Van Eck Global.

The benefits of gaining exposure in specialised fields appeals to many fund managers, like Hilary Coghill, chief investment officer at City Asset Management. Coghill, who has hitherto been more active and avoided passive trackers, has not yet bought ETFs. Now they are attracting her interest, “since they have become more sophisticated in representing individual parts of indices”. Coghill says precious metals, soft commodities, infrastructure and water are potentially interesting plays.

“These specialised investments can be used to create core and satellite strategies,” Hirsch suggests. “In conjunction with a basic allocation among stocks, bonds and cash, you might add exposure to a slice like gold, which is not correlated with the other classes.” Or one might employ ETF satellite position to increase exposure to higher risk/return classes.

As the active and passive elements are more clearly delineated, various managers are less likely to duplicate, and added transparency ensures that there is less danger of style drift. By measuring exactly from where performance is derived, a firm is putting alpha-beta separation into practice.

Hedging is a related application that works well among industry sectors.

Consider a fund with a large long position in a particular company in waste management services. It can take the alpha of the waste management firm and give up the beta, by shorting the ETF index, and going long the security. White, who starts with a big-picture decision, uses ETFs to fine tune along a continuum of exposure. “We might not like a particular sector, like financial or homebuilders, but we can still buy ETFs for the underlying subsectors. Right now we are long the S&P, but short the financials through the ETF.”

White’s fund maintains a 25% net short, 125% net long position. “We want to be able to be short indices, without having to go through short sales. So we use the inverse S&P, Midcap 400 and Nasdaq 100, which are all easy to implement, especially where shorting can be difficult to implement.”

Among the hedge fund community, equitisation is paramount, to avoid a cash drag on performance. “Based on cash flows, it is impossible to put all the cash to work immediately,” says Greg Ehret, senior managing director and head of European sales and distribution at State Street Global Advisors. “The portfolios need to be fully invested, so they buy ETFs to cover whatever their benchmark is.”

Assuming an ETF is available to match the benchmark, there is little risk to holding it, with a short-term focus. It is a cheap solution, since the total expense ratio accrues on a daily basis, and settlement and back-office procedures are simple.

With so much to gain, why have British investors been holding back? Kemp blames it on “a quirk of regulation, more than anything else”. Because the regulatory environment has been conducive to structured products in Britain, investors have preferred to use tracker funds and index certificates to hedge. Banks in Europe can issue paper that tracks an index, and they can market it without any of the regulation an ETF provider must submit to.

Along with index trackers, derivatives prove competitive. “Institutional clients, and specifically hedge funds, have gravitated to swaps in particular,” Ehret notes. However, it is worth remembering that the ETF world has far exceeded futures in breadth. Consider that there are no futures today for classes like large caps or emerging markets. “People only trade liquid futures, and there aren’t that many available out there,” Lavine says.

Another drawback in Britain is that the loan markets are not as deep or liquid as their American counterparts. That results in an insufficient supply and liquidity for shorting. What is needed are lenders with long investment horizons, like pension plans, who will be willing to loan out their ETFs in return for fees. “We are beginning to see more signs of activity from investment banks in Europe, but not at the same level as in the US,” Ehret says.

The lack of a common platform for clearing and settling trades around Europe still remains a hurdle and adds another layer of complexity. American investors do not have to deal with a series of clearing linkages. They also stand to gain from tax benefits, since ETFs, unlike mutual funds, do not attract liability for distributing capital gains. British investors, who do not enjoy that distinction, have less to gain.

Institutional investors can of course buy globally as easily as locally. Although British fund managers have had the access to non London Stock Exchange (LSE)-listed vehicles, the communication has been missing. Financial Services Authority (FSA) guidelines only allow marketing of UK-listed products. “Eventually the promotion will catch on, from product providers, exchanges and trading desks,” predicts Grancio. Her firm has already partnered with the LSE to disseminate information, through a series of roadshows and academic speakers, a website, and increased investment in emails and direct communication.

Access to more variations and subsets would probably attract British investors’ interest. “If an energy or pharmaceutical sector were available, it might become a self-fulfilling prophecy,” Bruce predicts. So far, British fund managers have not shown much inclination towards tactical sector rotation. Indeed, when providers have launched a series of sector funds in Germany, these have not attracted many assets. There is not much demand for sorting large, mid and small caps at the regional level, either. “The market is almost ready for sectors,” Grancio says. “But in Europe the demand is still not quite there, and we don’t want to launch several subscale funds that are too small.”

It makes sense to proceed judiciously. ETFs beget indices, too, as they proliferate. Most of the popular indices already have long histories, but there is an ongoing drive to develop and license new indices for the creation of further ETFs. Hirsch sounds a note of caution: “There will surely be bumps in the road, and even a shakeout at some time. ETFs that have not attracted enough assets may not survive long-term, especially when the bull becomes a bear.”

Investors whose funds shut down may be liable for tax bills or additional commissions when they switch holdings. In the meantime, ETFs are poised to take off soon. A change in stamp duty legislation should provide fresh impetus. As of February 1, 2007, the British government abolished the tax levied on overseas ETF companies that sought to list in London. “Stamp duty is a good example of how the UK government is making efforts to build London as a centre for global finance. This removes the barrier that inhibited foreign-domiciled funds, and allows them to enter with a level playing field,” Grancio says.

Draper even foresees a “big bang” on the way. In the short term, he says, the aim is to reach out to the institutions, to build liquidity. Later on, the strategy will be to reach out to the various intermediaries, “to push the story out”. The retail public will then, hopefully, begin the “pull” process. At Lyxor efforts are directed to raising awareness, through education and the media. “We’re still at the push stage, but if we do it correctly, a lot of notice will be generated.”

It is a grassroots exercise. At the end of the day, the public may drive the issue, as in America, where consumers make up half of ETF demand. Historically, British financial planners and advisers have relied on a commission-based model, derived from their origins in the insurance industry. Since ETFs do not pay commissions, they have less incentive to steer clients toward them. But the higher echelons are moving toward a fee-based structure.

“Fund managers sell to individuals, so they do care,” reminds Ehret. “Acceptance of ETFs will come as the dynamics of the market evolve. What happens in the retail world will spill over, sooner or later.”

Exchange traded funds

The growth in exchange traded funds (ETFs) has exploded over the past five years. In about 2000, hedge funds began to use them as trend following instruments; two years later, fund managers and private clients joined the fray, employing them as asset allocation building blocks.

In just the first quarter of 2007, American companies listed 95 new funds, versus 12 in the first three months of 2006. The prediction is for a further 300 to launch this year, according to registration filings with America’s Securities and Exchange Commission.

It was not always so. From 1990 to 1994, Brian Bruce, director of the Finance Institution at Cox School of Business at Southern Methodist University, was working at State Street in Boston, initially on the international global indexing team. He was on the scene in 1993, when his colleagues created the first trust for Spyders, the original ETF that tracked the S&P 500. “Doug Holmes was sitting two offices down from me,” Bruce recalls. We all thought it an interesting idea, but we had no idea whether it would take off.”

By the end of that year, the Spyder was beginning to gain early attention. It was already demonstrating even more potential than the team had first expected. “Looking back at those days, no one was standing around with a camera and trying to document the event,” says Bruce.