[This article first appeared on our sister site, IndexUniverse.eu.]

Despite the rapid growth rate of the ETF market, these funds have yet to make significant inroads with pension schemes, with high costs often cited as a reason for the slow take-up. What needs to change to prompt more wide-scale adoption of ETFs amongst institutions?

Exchange-traded funds saw record worldwide inflows of US$105 billion during the first half of 2012, according to BlackRock. Yet the pension fund sector has so far remained a fairly hesitant buyer of these listed tracker funds.

In the US, the most established ETF market, Greenwich Associates recently found that only 14% of institutions (including corporate funds, public funds, endowments and foundations, and institutional asset managers) use ETFs in their portfolios. Outside the US, in less mature ETF markets, penetration is even lower.

Fees appear to be ETFs’ biggest barrier to entry into institutional portfolios. As Ana Moreno, communications manager at the Pension Protection Fund, explains: “We don’t use ETFs, but we’re not against them in principle. Where we have thought about using them we found them more expensive than other routes.”

According to figures from Towers Watson, the cost for an institutional investor of a typical passive global equity portfolio of over £50 million in size would be between 10 to 15 basis points (bp) a year. Meanwhile, comparable ETFs charge 25 to 50 bp.

“That is quite a big fee gap,” says Roz Amos, senior investment consultant at Towers Watson. “ETFs would have to become a lot cheaper if they want to compete with mainstream institutional products.”

However, some asset managers and ETF providers say pension funds are too focussed on ETFs’ total expense ratios (TER) and are not comparing ETFs with comparable passive investment products, such as mutual funds, on a true, like-for-like basis.

In particular, they say, when tracking difference is taken into account the true cost of ETFs, by comparison with index-tracking mutual funds, is significantly decreased or even eliminated.

For example, if the FTSE 100 index rose 10% over a year, an index-tracking fund with a 10 bp cost should rise 9.9%. However, says, Christopher Aldous, chief executive of Evercore Pan Asset, a fund manager, the performance gap is often bigger.

“In many cases index funds only rise 9.8% due to undisclosed stamp duty or dealing costs,” notes Aldous. “An ETF can go up by 9.9% or 10%, though. On the basis of tracking difference against the index, ETFs are generally as cheap or cheaper by a couple of basis points, as well as offering the additional benefit of liquidity.”

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