Change In The Air: Overseas Investors Taking To ETFs

(Editor's note: This article also appears at IU.com's sister site IndexUniverse.eu.)

The proportion of European investors using equity ETFs has more than doubled since 2006, according to the recently released EDHEC European ETF Survey 2009.

The EDHEC research team surveyed 360 professional users of exchange-traded funds from across the region, and showed that the breadth and depth of their ETF use has increased dramatically over the last three years.

At the same time, the popularity of certain types of ETF, whether classified by asset class or fund type, has increased by more than that of others. And the survey's respondents vary in how they use ETFs within their portfolios.

IndexUniverse.eu contacted leading ETF issuers in Europe with a selection of EDHEC's findings and asked them to comment on the results.

EDHEC's survey results show that the use of equity ETFs within European portfolios has risen from 45% to 95% within three years. The question of usage was addressed only to those investors who take a core-satellite approach to investment, and around a third of those initially surveyed replied that they had never invested in ETFs, and did not complete EDHEC's questionnaire. Nevertheless, the increase in equity ETF use among survey respondents is still notable. Government bond ETFs were used by 40% of those surveyed in 2008, and by 80% in this year's survey. Corporate bond and commodity ETFs were also used by more than half the 2009 survey's respondents. ETFs are clearly now a mainstream financial instrument for European institutional investors.

The EDHEC team asked the survey respondents to compare ETFs with other types of tracker products, notably futures, total return swaps and index funds. While the responses varied according to which attributes were being assessed—liquidity, costs, tracking error, transparency, product range, minimum trading size, operational constraints and regulation were some of the criteria used—83% of those surveyed expected their use of ETFs to increase further. By contrast, more respondents expected to reduce than to increase their use of index funds and total return swaps. Futures saw a smaller balance of respondents in favour of increasing their usage.

ETFs should therefore continue to gain market share in Europe at the expense of other "delta-one" financial instruments.

When asked which type of ETF they prefer, a large majority of those surveyed replied that they prefer passive ETFs (82%) using pure (or full) replication (76%). To be fair to advocates of synthetic or swap-based replication, the EDHEC authors concede that they did not ask respondents to reply whether the perceived lower costs and lower tracking error of swap-based ETFs outweighed this initial preference.

EDHEC's survey revealed that investors were most satisfied with ETFs tracking equities (94%), government bonds (78%) and commodities (79%). Fewer were satisfied with ETFs tracking corporate bonds (61%), real estate (55%) and hedge funds (28%). IndexUniverse.eu asked some leading ETF issuers what, if anything, can be done to make the last three fund types more attractive?

Nizam Hamid, head of sales strategy for iShares, countered that inflows into corporate bond ETFs had been extremely strong during the first four months of 2009, to some extent contradicting investors' survey responses. Having said that, he added, investors are increasingly looking at ways of accessing the corporate bond market by sector, so this is an area likely to see additional product development.

Will Rhind, head of sales at ETF Securities in London, explained that the broad-brush approach and market-capitalisation methodology of many corporate bond indices meant that investors were pushed into owning larger amounts of poor-quality financial and auto company debt (to give two examples) than they might like.

The lower satisfaction level with real estate ETFs, added Rhind, could be explained by the fact that real estate investment trusts (REITs), which are heavily represented in indices tracked by ETFs, are a relatively new invention in Europe, and are also highly correlated to equity market movements.

Manooj Mistry of db x-trackers, which launched a hedge fund ETF earlier this year, queried the survey response regarding that category of tracker funds, saying that hedge fund ETFs had not existed in Europe prior to 2009, so it was not clear what lay behind the relatively low levels of investor satisfaction.

Elsewhere in the survey, EDHEC reported that ETFs account for 36% of the surveyed investors' equity allocation, and 22% of their commodity allocation, but only 17% of the government bond and 12% of the corporate bond allocations. IndexUniverse.eu asked issuers whether ETFs will "catch up" in bonds.

According to Hamid of iShares, "bond ETF usage is affected by tax issues, which differ from country to country. Effectively, ETFs are not classified in the same way as the underlying securities that they hold. This means that fixed income ETFs have to be always marked to market, whilst single bonds can be categorised on a "held to maturity" basis, meaning that they do not fall under daily mark-to-market rules for some long term investors. We expect that fixed income ETF usage will increase among multi-asset managers, as they seek efficient exposure in a market that typically lacks transparency."

Mistry of db x-trackers added that bond ETFs were introduced to European investors later than equity ETFs, so it would be normal to expect their usage to catch up over time.

EDHEC's survey revealed that more investors (28%) use inverse ETFs than short sell ETFs themselves (only 14% do this). Meanwhile, only 12% of investors lend their ETF units. We asked issuers why there was greater interest in using inverse ETFs than in shorting, and whether lending of ETF units would increase.

Hamid of iShares pointed out that inverse ETFs have proved popular with investors, especially for short-term trading, though holding them for longer periods of time can lead to performance that is significantly divergent from expectations. Since inverse ETFs are "non-delta-one" products (that is, they do not give a return of minus one times the index if held for longer periods), iShares expects trading to shift towards shorting ETFs, he added, though up to now only a limited number of investors have been able to do this.

Both Hamid and Rhind of ETF Securities pointed out that the market for lending or borrowing ETFs is less well developed in Europe than in the US, and this can mean that the cost of borrowing even a relatively well-known fund in order to create a short position can be quite expensive, making investors less willing to contemplate this route.

Hamid added that a more efficient market in borrowing and lending ETFs should develop in time, since "there is only a limited number of liquid futures contracts, so borrowing and shorting ETFs on difficult-to-access market segments is likely to become more attractive in terms of efficient implementation."

In their survey commentary, EDHEC's researchers point out the importance of style factors in portfolio construction. In particular, choosing different investment styles helps to build a more diversified portfolio, they argue, since these styles tend to be relatively uncorrelated by investment returns over time.

However, EDHEC's survey respondents seem to be relatively conservative in their choice of equity ETFs. Seventy-two percent of investors use broad-market, capitalisation-weighted equity ETFs in their core portfolio, whereas style and sector ETFs tend to be used as satellite investments.

We asked ETF issuers whether they expected to see broader use of style and sector ETFs as core holdings.

According to Hamid of iShares, "style and sector tilts tend to be tactical rather than long-term, and we would expect this to remain the case. European investors may focus on style shifts - from value to growth, for example - but this tends to be a less well-defined trend than in the US market. Sector ETFs in Europe should enjoy greater usage as investors should differentiate their sector exposure, depending on expectations of any economic recovery."

Mistry of db x-trackers pointed out that the wide range of ETFs on offer now allows investors to construct portfolios with different building blocks, as they see fit.

Rhind of ETF Securities added that the variety of available noncap-weighted indices—whether earnings- or dividend-weighted, or based on methodologies such as Research Affiliates' fundamental indexation, tend to come under the "value" style category. Therefore, if markets were perceived to be in an environment benefiting value stocks, such ETFs could come to be seen as core holdings.

EDHEC's European ETF Survey 2009 shows that ETFs are now very much a mainstream product amongst institutional investors this side of the Atlantic. Exchange-traded funds continue to gain ground at the expense of other tracker products, and investors' planned use of them looks to rise still further.

The survey responses also suggest that ETF market product development will be focussed on filling in some remaining gaps in asset coverage, encouraging investors to make greater use of short-selling and ETF lending, and on continuing to expand the options of investors who would like a variety of index construction methods.