In a press release issued last week, investment consultant Watson Wyatt argued that exchange-traded funds are an “unattractive long-term investment option for most institutional investors.”

According to Watson Wyatt, “ETFs generally have higher fees than many institutional index products; may have tax implications that require specialist advice; and often contain counterparty risks which investors may not be compensated for.”

While accepting that ETFs can be useful tools for transition management, the consultant argues that most index investment strategies “can be implemented more cheaply and efficiently using index funds, index futures or swaps.”

Watson Wyatt’s comments carry weight: the consulting firm is widely seen as the leading advisor to institutional pension funds, representing over half the FTSE 100 member companies’ retirement schemes. In addition, Chris Sutton, the senior investment consultant quoted in the press release, used to work as Chief Executive of iShares Europe.

On a headline basis, there’s plenty of evidence that institutions can obtain a lower management fee by investing directly in an index fund than by using ETFs. One asset manager charges 5 basis points per annum for clients to invest in an equity index fund and 7-8 basis points to invest in government bonds, according to a recent client report.

By comparison, according to Deborah Fuhr of Blackrock, the average equity ETF in Europe has a total expense ratio of 37 basis points and the average fixed income ETF has a total expense ratio of 16 basis points.

“Index funds may be available at a lower cost in terms of management fees than ETFs,” conceded Manooj Mistry, head of equity ETF structuring at db x-trackers, “but only to the very large institutions. Watson Wyatt’s comments don’t apply across the board, and should be seen as reflecting the consultant’s own client base, a large part of which consists of institutional pension funds.”

Furthermore, argues Nizam Hamid, head of sales strategy at iShares Europe, investors should be sure to compare like with like and to include all the relevant costs of investing when making a fee comparison between different types of fund.

“If you look at the headline TER (total expense ratio) then there’s no doubt that a passive index fund can charge substantially less than an ETF. But some of the costs of coming into and out of institutional passive mandates can be relatively high. There are spreads between buying and selling prices in institutional index funds to ensure that investors entering and leaving the fund bear the costs of underlying transactions. Therefore investors should bear in mind the total cost of ownership when comparing different types of index-tracking fund, and not just focus on the headline expense ratio,” said Hamid.

The attractiveness of different types of tracker vehicle depends on the likely holding period, Hamid went on. “If you’re an institution investing in a developed equity market and want to hold your position for two to three years or more, then an index fund will probably be the cheapest option. But the trade-off between an institutional index fund mandate and an ETF requires much closer examination if you’re looking at holding for periods of a year or less,” he said.

“If you’re tactically managing positions, then you’d certainly want to consider holding a portion of your indexed exposure in ETFs,” Hamid added.

What about Watson Wyatt’s assertion that index futures and swaps can also be used to implement index investment strategies more efficiently and cheaply than ETFs?

As far as swaps are concerned, both Mistry of db x-trackers and Hamid of iShares note that over-the-counter derivative transactions such as swaps incur full counterparty risk to the bank concerned, far outweighing any inherent risk in ETF structures. “If one looks at recent market trends, institutional investors have been moving away from uncollateralised vehicles such as swaps towards collateralised ones such as ETFs,” said Hamid.

The ETF versus futures comparison is a complex one, Hamid continued. “You have trading costs and roll and execution risks when executing a futures transaction but you also have potentially significant tracking error.”

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