European investors are upping their use of exchange-traded funds, ETF providers say, as liquidity concerns, the need to be nimble in uncertain markets and regulatory demands on the derivatives market begin to take hold.
Sources suggest uptake is being driven by two segments of the institutional market in particular: money management firms in general, and, more specifically, in outsourced chief investment officer strategies. The vehicles have struggled to gain a foothold among Europe's institutional investors, and executives at consultants and pension funds say while they have seen pockets of increased use, a wholesale shift has not yet been witnessed.
As of the end of February, European ETF assets under management totaled $584 billion, an increase of 7.7% from the end of 2016 and 19.7% compared with the end of 2015, according to research and consultancy firm ETFGI. The firm found 881 institutions in Europe reported owning at least one ETF or exchange-traded product in 2015.
As of the end of February, European ETF assets under management totaled $584 billion, an increase of 7.7% from the end of 2016 and 19.7% compared with the end of 2015, according to research and consultancy firm ETFGI. The firm found 881 institutions in Europe reported owning at least one ETF or exchange-traded product in 2015, up from 875 a year previous.
“In institutional segments, it has been a difficult market — I've been in the industry many years and it is a difficult sell in ETFs,” said Andreas Zingg, Zurich-based head of exchange-traded fund distribution management for continental Europe at Vanguard Group. The issue traditionally has been ETFs' higher expense ratios compared to the institutional share classes of index funds, he said, although that is now changing as investors also look at trading costs, tax costs and the overall fees they are paying for investment strategies. He noted it is also changing as ETF expense ratios come down in core products, making them increasingly competitive with index funds.
While costs vary, the weighted average expense ratio for ETF strategies in Europe is 31 basis points, according to a Deloitte publication in January. It said a number of ETFs have expense ratios of less than 10 basis points.
Mr. Zingg said while ETF usage among European institutional investors is increasing, it is a smaller asset pool, growing at a maximum 2% to 3% per year. That compares with his estimates in the private client space, where growth is about 7% to 8% annually.
Tough sell to pension funds
An executive at a U.K. corporate pension fund, who spoke on the condition of anonymity, said the fund used an ETF in its portfolio for about nine months, selling down the exposure in recent weeks. In the only time executives have used ETFs, they wanted to gain corporate bond exposure over a short period of time, less than one year, ahead of and while identifying a number of new allocations. “With transaction costs of buying and selling corporate bonds being high, it worked out as more cost effective to invest in the ETF, at least in the short- to medium-term, rather than in a passive fund, which would have given us similar exposure,” he said.
Executives at a number of other pension funds said as a rule they do not use ETFs in their investment strategies. However, others noted use among their external money managers.
A spokesman for the €451 billion ($480.3 billion) APG Asset Management, which runs the assets of the €389 billion ABP, Heerlen, said in an email that the firm “does not use ETFs on a structural basis, but opportunistically as a trading tool in situations where ETFs are the most efficient (or fastest) way of acquiring the underlying securities.”
The £5.4 billion ($6.8 billion) Lothian Pension Fund, Edinburgh, holds only one ETF to gain exposure to gold. A spokeswoman said the fund holds no other ETFs and “has no intention of increasing its use of ETFs.”
While gaining short-term, tactical allocations is a tick in the ETF box for some funds, cost is a major factor for others in deciding against the use of ETFs.
Swiss federal pension fund Publica, Bern, which has 38 billion Swiss francs ($37.9 billion) in assets, does not use ETFs “as they are more expensive than mandates, given the size of the fund,” said a statement provided by a spokesman.
Pontus Lidbrink, senior portfolio manager, equities, at the 312 billion Swedish kronor ($34.7 billion) AP4, Stockholm, said the fund is currently not invested in any ETFs, although it is part of its investible universe. “Given our size and that we have internal management, we tend to implement such positions by trading the underlying equities ourselves.”
And while the 32.4 billion franc portfolio of the Swiss federal social security funds, compenswiss, Geneva, contains hardly any ETFs, “mainly due to their uncompetitive cost structure for an institution of our size,” the fund's external managers do use the vehicles, said a spokesman. “In rare cases and to a very small extent, some of our external managers may use ETFs to gain exposure to the markets they deal in.”
Increased use has also been noted among money managers by consultants. Kate Hollis, London-based senior investment consultant at Willis Towers Watson PLC, said money managers use them for tactical allocations. Also, in her capacity as a manager researcher, “I have definitely seen institutional fixed-income asset managers using them more as a way of getting quick and cheap access” to certain exposures.
Ms. Hollis said her colleagues had also noted usage among European clients. “Some of our small clients will use them, or we have seen some of our competitors who run fiduciary mandates use them. If they themselves do not run a particular niche strategy for example, but want to allocate, they might do it tactically via an ETF,” she said.
Andy Barber, London-based technical leader of the manager research team at Mercer Investments, agreed that “probably most of the use is by fund managers managing money on behalf of institutional clients. You see them sometimes in diversified growth products, where a manager may be allocating to a market using an ETF as opposed to a future,” he said.
Increased use due to the growth of OCIO programs has not gone unnoticed by ETF providers. Claire Perryman, London-based U.K. head of SPDR ETFs at State Street Global Advisors, said: “For those that outsource their investment decision, ETFs have for a long time been a tool that their fund managers have used within their portfolios to express investment views.”
ETF providers say there are a number of reasons for the increased presence of ETFs in institutional portfolios.
“I think it's fair to say the way investors are using ETFs is changing,” said Adam Laird, head of ETF strategy, Northern Europe, for Lyxor ETF. “When they were first introduced, ETFs were being used as a liquidity tool — a way to quickly and easily buy a basket of stocks. We're now finding them being used for longer-term uses; often that means access,” he said. Lyxor ETF has €57.4 billion ($61.1 billion) in assets under management as of March 31.
Ashley Fagan, London-based head of the BlackRock (BLK) Inc. (BLK) iShares U.K. institutional team, said at a recent media event that increased use among pension funds includes in fixed income, with less liquidity in primary markets pushing up the costs of trading bonds. Regulatory demands on banks and the derivatives market also has increased costs of futures. The European iShares' ETF business has $289 billion in AUM.
She said another use is a “liquidity sleeve” — mirroring a section of a portfolio allocation with ETFs, which can be used for liquidity purposes and traded quickly.
Jack Lejk contributed to this story.