Institutions are all over exchange-traded funds (ETFs), according to data from BlackRock, which shows institutional investors planning to increase their use of the products over the coming year. Active asset managers are widely seen as leading the charge, with global asset managers boosting their use of ETF s from $105 billion to $125 billion between 2011 and 2012. Active manager use of ETFs is becoming big business as investors look for better ways to achieve alpha in balanced funds, asset allocation funds, DC funds and even annuities, iShares noted.
But, according to a new paper put out by Lyxor Asset Management, active managers ought to be watching their spreads when they use ETFs, something many aren’t doing. In “Measuring Performance of Exchange Traded Funds,” Marlène Hassine and Thierry Roncalli conclude that the liquidity spread is a key parameter for active managers using ETFs in the implementation of tactical asset allocation. The problem is, most active managers aren’t in a position to properly evaluate ETFs because they’re too focused on information ratios (i.e., the measure of risk-adjusted return).
In the case of ETFs, however, information ratios don’t stack up because the tracking error volatility of the index fund is so small. In essence, ETFs by their very design are meant to present a very low tracking error compared with the benchmark.
So what’s the alternative? The authors propose a value-at-risk framework that is adapted to passive management and ETFs. It hinges on three key variables: performance difference, tracking error volatility and liquidity spread. Together, those factors ought to add up to an efficiency measure that active managers can use to really assess whether or not a given ETF is a good fit.
While you might not buy Hassine and Roncalli’s model, the paper raises some interesting questions about how ETFs can and should fit within an active strategy. The three variables the authors point to aren’t always front and centre for investors looking to manage passive investments, but as investors find new ways to use ETFs to make their portfolios more efficient, they would do well to understand the dynamics of how they work within a traditional active portfolio. And new ideas and research into those very dynamics are what is needed most right now.