Investors hear a lot about exchange traded funds (ETFs) and why they are the next big investment solution, but in my experience, they don’t fully understand why this is.
The first thing that needs to be understood is that an ETF is just a different delivery mechanism. As with a mutual fund, it’s an open-ended investment fund, where new units are always being created that investors can purchase on a stock exchange. Also similar to a mutual fund, the value of ETF units—referred to as the net asset value per unit—should approximate the underlying value of the securities held by the ETF.
The big difference between an ETF and a mutual fund is that an ETF trades on the stock exchange and is bought and sold in the secondary market like stock; a mutual fund is directly purchased from the mutual fund provider.
The fact that ETF providers don’t have to build the infrastructure to sell directly to investors, creates cost efficiencies that generally make ETFs cheaper than a mutual fund that has a similar strategy or invests in the same asset class.
Essentially, the development of the ETF is one of technological advancement, similar to the switch from CD to digital music downloads. Both can offer the same content, but a digital download offers additional flexibility not available with a CD.
How are ETFs used?
The easiest implementation for ETFs was to have them track an equity index benchmark. This is the easiest type of managed solution to use, and the low-cost and intraday trading features of the ETF enhanced the appeal of implementing an index strategy.
As the popularity of equity indexing increased, so, too, did the number of ETFs that could be used as indexing strategies in a variety of asset classes beyond equities, including fixed income and commodities.
As a result, ETFs have largely been used by institutions to get direct market exposure to an index or commodity that fits into their asset allocation strategy. For pensions and endowments in particular, asset allocation is considered a better determinant of long-term performance than individual security selection. That is to say, being in the right asset classes delivers more of your potential return than having an expert select securities within those asset classes.
Statistics certainly seem to support this when it comes to stock selection, where the quarterly S&P Index Versus Active (SPIVA) report shows that the majority of active mutual fund managers are unable to outperform their benchmark equity indexes. For example, according to the year-end 2010 SPIVA report, nearly 62% of equity mutual fund managers benchmarked to the S&P 500 underperformed. In Canada, that number is even worse, with only 2.53% of actively managed mutual funds outperforming their index.
What this means is, the majority of investment returns are beta—the broad return of the market index. Increasingly, institutions are using ETFs to get primary exposure to certain asset classes. It makes sense. ETFs cost less and deliver essentially the same—if not better—returns as a mutual fund, so the investor ultimately ends up ahead.
Keep in mind that indexing has limitations, with downside risk protection being a big one. Investors shouldn’t be surprised to see a whole new wave of ETFs being launched that are managed by portfolio managers actively seeking to outperform the market or deliver better risk-adjusted performance. The low-cost nature of ETFs increases the odds that the manager could outperform his or her benchmark, since high fees are a big determinant in long-term underperformance of mutual funds.
Certain thinly traded markets, such as Canadian corporate bonds or preferred shares, can benefit from low-cost active management since portfolio execution—the actual buying and selling of the securities—can be much more difficult.
Illustrative example of why fees matter
Potentially even more attractive than their cost is ETFs’ flexibility to be used as tactical portfolio tools. Most institutional funds don’t have the robust derivatives or commodity trading desks enjoyed by larger pension plans or financial institutions, so an ETF offers the next best alternative. Investors can get quick and precise exposure to an asset class without having to go through the expensive process of developing their own in-house expertise or having to pay a premium to use a third-party asset manager.
Probably the most cited research of institutional ETF usage is an annual study conducted by New York-based Greenwich & Associates, which interviews 70 institutional investors who, together, manage more than $7.5 trillion in assets. This year’s survey found that about one-third of institutional funds plan to increase their ETF usage in the next two years.
Almost two-thirds (63%) of participants said they use ETFs for transition management purposes; that is, to maintain market exposure in the absence of a selected investment manager. This was up from 38% in 2010.
Institutional investors are rapidly adopting ETFs as a tactical investment vehicle, meaning ETFs are used for shorter-term trades to take advantage of market conditions. The use of ETFs for rebalancing purposes within investors’ portfolios almost doubled to 44%, up from 24% the year before. The survey also found that 53% of the respondents used ETFs to gain tactical exposure to international equities, and 43% used them for exposure to domestic equities.
There are some notable institutions that use ETFs in this manner. The $26-billion Harvard Endowment Fund’s top five equity holdings were all ETFs as of November, and the majority of these were emerging market equity ETFs. Similarly, according to Morningstar data, the massive Teacher Retirement System of Texas had more than 34 million units of Vanguard MSCI Emerging Markets ETF as of March 31, 2011.
Without in-house ability to find the appropriate stocks in these fairly exotic markets, having equity ETF exposure gives the investor the majority of the sector’s return at a cost point that is better than most actively managed mutual funds.
ETFs cost less and deliver essentially the same—if not better—returns as a mutual fund, so the investor ultimately ends up ahead.
The same concept applies to other asset classes such as bullion and crude oil, which are once again used in asset allocation strategies for diversification. In the past, direct investment in commodities was the exclusive domain of large commodity trading desks at financial institutions and large pension plans.
Many investors of all sizes now opt to use an ETF that invests directly in gold bullion or oil futures, rather than paying someone to manage those positions.
If you look at the asset allocation of large pension plans such as the Ontario Teachers’ Pension Plan (Teachers’) or the California Public Employees’ Retirement System (CalPERS), you see broad-based asset allocation to a huge range of asset classes. According to Teachers’ 2009 annual report, the fund had $41 billion in equities in both indexing and actively managed strategies, $6.4 billion in fixed income, $45.9 billion in inflation-sensitive securities (which includes $8 billion directly in infrastructure and timberland) and nearly $2 billion directly in commodities.
Teachers’ can invest directly in these asset classes and take partnership roles in real estate, infrastructure, etc.
Since ETFs are relatively inexpensive, they enable smaller investors to implement similar investment strategies.
Are ETFs the right choice for pensions?
I would argue that there is an ETF alternative for every mutual fund mandate in Canada. It would just be appropriate due diligence to look at an ETF and determine whether it offers a lower cost or more efficient way to invest in a certain asset class.
ETFs already have heavy penetration among direct investors, institutions and, increasingly, financial advisors. But in Canada, they have relatively low take-up on pension platforms. If a pension plan, particularly a DC plan, is not using ETFs, then plan sponsors or even plan members would be well served to ask, Why not?
If a plan can achieve the same investment results at a lower cost point and with greater flexibility and transparency, why wouldn’t you use that solution? It’s incumbent on plan providers to answer that question.
Howard Atkinson is the CEO of Horizons Exchange Traded Funds.