Part of the toolkit
However, two notable trends could push more institutions, including DB pension funds, towards ETFs. As institutions of all varieties increasingly diversify and pay greater attention to short-term market movements, whether for tactical asset allocation or risk management reasons, ETFs’ liquidity, tradeability and transaction costs, make them attractive. According to Dowdall: “We are moving more towards tactical asset allocation and ETFs could be an important part of that toolkit.
It will be a big challenge for pension funds to control risk when gilt yields return to normal. ETFs could be a useful tool to do so.” He also sees ETFs as access vehicles to niche markets or strategies. “I would look at ETFs for short exposure,” he says.
ETFs are proving popular in less vanilla areas, particularly where mutual funds are less established and given the difficulty finding active managers who can consistently outperform. The newer generation of ETFs offering alternative asset classes or weighting methodologies, or increasingly granular access within asset classes or regions, have relatively greater attractions versus their mutual fund alternatives. Pricing levels are much more comparable, but liquidity and tradeability become paramount, and here, ETFs have the edge.
“In more esoteric asset classes institutions are likely to be more dynamic, not just buy and hold investors,” Towers Watson’s Sutton says. “While fees may still be lower in mutual funds, ETFs have the advantage on trading costs and stamp duty as well as in the sheer volumes being traded and the number of liquidity venues. In turn that means bid- offer spreads on ETFs are lower versus the equivalent mutual funds.”
Sutton estimates for the two example mandates outlined above, the trading costs for the ETF solution could be as little as half that for the bond fund, so if the holding is short term (e.g. a transition) the ETF would be an attractive route.
If the expected consolidation does occur and liquidity becomes more concentrated in fewer products, the costs and tradeability, and therefore attractiveness, of ETFs should improve further.
“Liquidity would be the key factor in making an ETF attractive,” Dowdall says. “Price is about balance, but liquidity is more important than price.”
For some however, price will inevitably remain top of the agenda. In a world where performance is harder to achieve, cost efficiency becomes more important and for defined contribution (DC) schemes looking to offer low-cost diversified funds, ETFs can prove competitive and offer a broader range of markets and asset classes. This has become particularly pertinent since the introduction of auto-enrolment in 2012.
The Pension Quality Mark (PQM) has toughened its standards on the charges members pay. From April 2013 the cap on total charges will decrease from 1% to 0.75% per year on default funds, which includes annual management, administration, contribution and consultancy charges.
“There is a real push for schemes to follow the National Employment Savings Trust’s (NEST) example and create diversified investment strategies at low costs,” according to Bob Campion, marketing and institutional business director at Evercore Pan Asset. “Many of the DC schemes established because of auto-enrolment are targeting annual fees of 0.5%.”
Evercore’s research comparing index-tracking funds with ETFs found ETFs have greater tradeability and transparency, but also offer investors a much larger universe of asset classes and markets than are available in traditional index- tracking funds. “There is much greater variety in ETFs,” Campion says. “They are far better for building liquid, diversified portfolios.”
As institutions continue to diversify and increase their tactical exposures, consolidation in the ETF market should create a virtuous cycle of greater liquidity, lower prices and tighter spreads. With performance increasingly hard to find and cost at the top of many agendas, institutions will likely find the lure of ETFs ever harder to ignore versus their mutual fund counterparts leading to increased inflows and competitiveness.
As Ben Johnson, director of European ETF research at Morningstar says: “I would expect continued growth and competition within the industry will continue to drive down costs. One thing is clear: when fund providers battle to bring down fees, investors win.”
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