Going The Extra ETF Mile For Pension Funds
August 01, 2012
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Alan Miller, founder and CIO of SCM Private, a fund of funds manager using ETFs exclusively, believes the costs of mutual funds can be significantly higher than pension funds realise due to a relative lack of disclosure.
“ETF charges may look high due to their transparency, but the best way to look at it is their net performance against the index plus the costs of buying and selling them,” argues Miller.
“Particularly for smaller pension funds, the headline costs of mutual funds look reasonably low, but they can’t see what the real cost is. The costs are quite often two or three times the level they think.”
iShares, the most widely-used ETF provider worldwide, also urges investors to look beyond the TER and to focus on the other drivers of the total cost of ownership of an ETF. According to iShares, the TER of an ETF can be offset with a range of value-adding activities, such as securities lending.
Over the year to 31 May 2012, for example, the post-TER tracking difference against its index benchmark of the iShares Euro STOXX 50 ETF, which charges 35bp a year in expenses, was a positive 46bp, with the outperformance of the ETF being driven partly by securities lending revenue.
[The securities lending opportunities inherent in the Euro STOXX 50 and comparable European equity indices, the reasons behind them and their impact on fund tracking error are covered in more detail in IndexUniverse.eu’s feature article “ETF as Precision Tool?”]
After an estimated 10bp of trading costs, iShares says investors buying its funds are still likely to be 36 bp better off a year later than if they’d received the return from the fund’s benchmark, the Euro STOXX 50 with dividend income reinvested net of withholding taxes (although brokerage fees, which vary from investor to investor, will need to be considered on top of this).
David Gardner, head of EMEA sales for iShares, says: “This is an example of where looking at TER alone does not give an accurate indication of the total cost of ownership of an ETF, which needs to be considered when investors are making comparisons between ETFs or between ETFs and other passive index tracking funds."
Securities lending in ETFs may raise other concerns for pension funds, however.
Counterparty risks arising from securities lending or synthetic (derivative-based) ETF structures are proving another significant limiting factor in pension funds’ uptake of these funds, particularly since global regulators have spoken out on the topic over the last two years. According to Towers Watson’s Amos, ETF issuers need to cut charges to justify pension funds’ involvement in detailed due diligence work.
“Underlying risk, particularly counterparty risk, in ETFs can be harder to understand than in more traditional passive institutional investment products,” says Amos.
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