Institutional interest boosts sector

An increasing number and range of institutional investors are using exchange traded funds but the take up varies across countries as well as the way they use them.

ETF providers are seeing pension funds, asset managers, hedge funds, funds of funds, insurance companies, endowment funds and private banks using the funds.

Asset managers, including wealth managers, are the biggest users, making up nearly three-quarters of all global institutional investors in the first nine months of 2008, according to research from Barclays Global Investors. Hedge fund use also increased last year making them the second biggest group of users.

Providers say the credit crunch has brought in new users. “Last year gave us a shift in the way people invest,” says Nick Shellard, head of institutional business for iShares, Europe.

“Funds of funds are now using passive as well as active strategies and so beginning to use ETFs. They are a simple way to get exposure to areas where they believe active managers will not outperform,” he adds. The fallout from the crisis has also increased the amount of hedge fund use in Europe.

“Hedge fund use in Europe is small but growing quickly as a result of the credit crisis and also concerns about counterparty risk with over the counter derivatives like swaps,” says Daniel Draper, global head of Lyxor ETFs.

Part of the growth has been fuelled by new products catching the attention of hedge fund managers, says Mr Shellard. But in spite of increasing take up, European hedge funds are still lagging behind their US counterparts, which were among the first users of ETFs.

Among the newcomers on the ETF scene are multi-asset managers, which often lack their own research in a particular area, such as credit, and see ETFs as a straightforward way in, he adds.

“We have seen big inflows into our credit ETFs this year,” he says.

He also sees private banks, which have mostly used their own products, opening to third-party products and ETFs, because they cover a broad range of assets.

But pension schemes in much of Europe and the UK have been slow to move to ETFs compared with their US counterparts. Perhaps it is not surprising as Manooj Mistry, head of db x-trackers UK, says ETFs “have existed in the US longer than Europe so penetration among institutional investors such as pension funds is much higher than in Europe”. The US accounts for two-thirds of the 2,700 global institutional investors using ETFs, while Europe only has just over 20 per cent, says the BGI report.

Mr Draper attributes Europe’s slow take up to the investment consultant community, which “has been slow to recommend and understand ETFs”.

Deutsche’s Mr Mistry agrees. “In markets such as the UK where there are consultants and trustees as gatekeepers, the take up has been disappointing.” This contrasts to some European countries that use ETFs as part of a core-satellite strategy, he says. Dutch, German and Scandinavian pension plans took the plunge into ETFs several years ago. He believes raising awareness of ETF benefits will help.

“Pension funds do a lot of due diligence first but when they do go in, they go in big,” says Hector McNeil, head of sales and marketing at ETF Securities. In the next three years he expects to see a large number of pension funds moving into ETFs.

So how are institutional investors using ETFs?

In the current market turmoil investors are becoming more concerned about counterparty risk, transparency, liquidity and the use of derivatives and structured products, says Deborah Fuhr, global head of ETF research and implementation strategy at Barclays Global Investors. “As a result, the use of ETFs to gain exposure to cash, fixed income, commodities and equity indices is becoming more popular.”

Hedge funds are increasingly using ETFs instead of futures and over the counter derivatives such as swaps. On the commodities front, they often focus on a single product such as wheat, platinum or palladium through an exchange traded commodity (listed securities backed by a commodity).

Pension funds now use them as part of core or satellite strategies whereas previously ETFs were used purely in a satellite approach, says Ms Fuhr. In a core-satellite portfolio, where there is a mix of active and passive investment styles, the satellites are investments expected to bring in higher returns.

However, Mr Draper maintains most European pension funds use ETFs to access satellite investment opportunities such as emerging markets and alternative asset classes. Dutch and Scandinavian pension funds are the most advanced at doing this, he says.

On commodities, gold ETFs are proving to be a first step for many pension funds because they see it as a safe haven, says Mr McNeil.

After dipping a toe in the water, they often move on to other commodities and to equities, he adds.

Pension funds such as Hermes, the BT pension scheme and some of the big Dutch pension plans are “good adopters of commodities now”, he says.

Investors are also moving into emerging markets – often seen as difficult to access – through selecting a country-specific ETF such as Brazil or China, says Mr Shellard.

“We are seeing investors increasingly allocating on broad emerging market indices then adding a country ETF,” he says.

Overall providers see a shift to greater understanding and use of ETFs. Institutional investors are becoming more comfortable about including ETFs with active strategies in the same fund, says Mr Draper.

“At the moment, ETFs account for 4-5 per cent of total mutual fund assets under management in the US, compared to less than 1 per cent in Europe. But we expect Europe to catch up with the US over the next three years,” he says.