By Mark Johnson
When awarding mandates or making investments into active mutual funds, pension funds and consultants often judge them on track record, their historical ability to achieve above market returns and deliver specific strategies.
In recent years passive investing has gained traction with pension funds due to an increased focus on cost and risk management, and exchange traded funds (ETFs) are a key component of this growth. A 2013 US survey by Greenwich Associates reported that 25% of US pension funds invest through ETFs. Similarly in Europe, a 2013 survey of 144 European pension funds by FinEx Capital Management indicated that 42% expect to increase their allocation to ETFs over the next three years.
But as more and more pension funds look to use ETFs in their investment process, the question arises: how do you select the right ETF? The criteria used to evaluate passive funds are different to those used to select active counterparties. One key illustration is around the size of a fund or its assets under management (AUM). In the active space, if a fund increases its AUM this can cause capacity constraints in implementing some strategies. However, increasing AUM can instead be beneficial in the passive space.
The AUM of an ETF can impact its cost of trading and its ability to replicate an index. For example, an ETF’s liquidity is determined by the liquidity of its underlying exposure and its AUM. As the AUM of an ETF increases, its spreads generally decrease because there is more buying and selling activity in the secondary market.
In some cases, particularly in asset classes which are mainly traded over-the-counter such as fixed income, the on-exchange spreads of large ETFs can actually be tighter than the spreads in the underlying market. This difference in spread can be significant in reducing the cost of trading for large institutional investors, because they can trade into an ETF without needing to have new units created for them on the primary market.
Furthermore, as pension funds look to use ETFs to gain exposure to difficult to access markets, liquidity and size can be extremely important in determining which ETF to select.
Pension funds can also benefit from larger ETFs because size gives them an enhanced ability to replicate an index. For example, when funds first launch they usually have a low AUM which may make the purchase of all holdings in an index virtually impossible if the index is very large in size, so they hold a sample of the constituents of that index instead. The bigger the ETF becomes however, the more able it is to purchase more constituents of the tracked index and get close to fully replicating the benchmark index. Larger physical ETFs can thus provide superior replication
It is forecast that pension funds will invest through ETFs more and more. Although size isn’t everything when evaluating an ETF, size can matter in passive management. Sub-scale ETFs are more likely to reduce the liquidity and increase the trading costs of a fund, and for this reason, size should be an important determinant in the selection process.
Mark Johnson is head of UK sales at iShares
Comments