ETFs getting attention of transition managers

Transition managers are using the growing number of U.S. exchange-traded funds as investment vehicles during the shift from one investment manager to another because of their diversity and nimbleness.

"Not only has the ETF market become much more diverse, the liquidity allows for a great deal of (detail) in our trading," said Mark Keleher, president of Mellon Transition Management Services, San Francisco. "Sometimes ETFs are actually more liquid than futures or might be more tailored in that they're tracking a particular sector or style."

Brad Pope, business development officer at Barclays Global Investors, San Francisco, said some of the biggest users of the firm's ETFs, known as iShares, are transition managers. He said ETFs give "targeted exposure … in a very efficient and cost-effective manner."

According to data from Morgan Stanley's ETF strategies unit in London, the number of ETFs worldwide has reached nearly 400, with $248 billion under management as of Sept. 30, up from 338 and $176 billion a year earlier.

In the United States, there are almost 150 ETFs now, compared with 115 in 2003.

ETFs have expanded from tracking broad-market indexes such as the Standard & Poor's 500 to include large-cap, midcap and small-cap equities, each in growth or value, as well as international equities.

Plan sponsors typically have three investment choices — futures, ETFs and index funds — when moving from one money manager to another. Depending on the type of assets and the length of time before those assets are moved to the new manager, each vehicle offers pros and cons, but officials in transition management said ETFs are likely to become more popular.

"I think ETFs are a great tool. They're here to stay and the market's going to grow," said Mr. Keleher. "They provide a very valuable, tradable investment option for plan sponsors."

Mr. Pope said more pension consultants are asking about using them for their clients. In meetings with consultants, he said, "they all wanted to learn more (about ETFs) so they could either monitor the transition managers that were using iShares or so they could manage a transition themselves for smaller clients."

Kevin Hardy, global director of transition management at Northern Trust Corp., Chicago, said ETFs are "vital" to transition management.

"Many clients are using transition managers to seek liquidity and exposure to various benchmarks, and ETFs do that," Mr. Hardy explained. "They allow people to do that in a very inexpensive way. We use them extensively."

Still, ETFs do not provide a cure-all for managing assets during a transition because they carry a management fee, and some remain thinly traded.

"Where they're useful is where there is a strong two-way market, meaning a lot of people are trading these ETFs across a trading day where a spike in volume is not going to affect the price or cause someone to need to create liquidity," explained Ross McLellan, managing director at State Street Global Markets LLC, Boston. Among his company's ETFs are SPDRs, based on industry sector indexes .

"But you don't need S&P 500 or Russell 1000 ETFs," Mr. McLellan said. Those are easy to create using derivatives. You can optimize a basket of S&P 500 and S&P 400 stocks using derivatives with a tracking error of less than 50 basis points and low transaction costs."

Mr. Hardy said, in general, ETF expense ratios are high but not exorbitant when compared with other options, depending on the plan sponsor's goals. "Most people will look at the expense ratios, see them as quite expensive and want to run the other way," he said. "Some expense ratios are reasonable and some are unreasonable."

At BGI, the annual expense ratio of the firm's iShares is 35 basis points, Mr. Pope said. In switching to an international manager, for example, a transition manager could use an optimized basket of futures that would cost 170 basis points of tracking error. "So if you knew you were going to hold it for a month, you're now at one-twelfth of 35" for an equivalent iShare, he said.

"It's much cleaner and efficient."

On State Street's most popular ETF, the S&P SPDR, the annual expense ratio is 10 basis points.

Mr. McLellan said futures typically have lower transaction costs than ETFs, shorter settlement terms and in some cases more liquidity, all of which can make them better investment choices for a transition.

"The problem with using ETFs is that if you look at small cap value or esoteric asset classes that you want exposure to, there's no bid or offer that will satisfy the liquidity you want," he said. "So brokers will create liquidity by trading the stocks in the underlying account," which could increase costs despite making the ETF more liquid.

"A lot of clients, if they want some small-cap exposure, for example, may not want the Russell 2000. They may want to segment into value and growth, and there's no future available for that. So they're forced to use ETFs," he added.

Mr. Keleher said some plan sponsors are prohibited from using any kind of derivative instrument while ETFs "are a reasonably liquid, tradable medium that allow us to maintain a fully equitized position."

But Mr. McLellan estimated that fewer than 25% of pension plans had restrictions on the use of derivatives. Among those that allow derivatives, the plan sponsor gives explicit instructions.

"We're not making a market direction call," he added.

Northern Trust's Mr. Hardy said the length of time the assets need to be invested before moving to the new manager can play an important role in determining whether ETFs, futures or index funds are used. "If a manager is not going to be selected for six months, there are a number of (futures) rolls and you have to manage the cash in line with what is fair value," he said. "If you get that wrong," the futures method could end up being expensive.

Index funds are likely the most cost-effective investment for a plan sponsor that has terminated one manager but is not likely to choose a replacement for six or more months.

"For a longer term hedge where someone might be investing cash for six or nine months, it might be more effective going into an index fund," said Mellon's Mr. Keleher. "But most investment contracts are not designed for large cash flow in and out within three or four days. One of the prime advantages of the ETF is that you can do into it for three or four days and back out at a relatively low cost."