Nadine Wojakovski explores whether ETFs are beneficial investment vehicles for pension funds

According to a recent survey conducted by FinEx ETF, the qualities found most attractive in ETFs were listed as diversification (41 per cent); efficiency (31 per cent) and liquidity (21 per cent). These benefits have led an increased number of UK pension funds to value the inclusion of ETFs in their portfolio as another important product in their toolkit.

An exchange traded fund is a collection of securities that tracks and represents the performance of a broad or specific segment of the market, for example US equities, small cap stocks or emerging market debt. It is similar to an index mutual fund but trades like a stock throughout the day on an exchange like the London Stock Exchange.

ETFs combine the features of index mutual funds with individual traded securities. Like index mutual funds, ETFs allow investors to track a vast range of indices. Like individual stocks, they give investors the flexibility to buy and sell on the major stock exchanges throughout the day, at the market price. In addition ETFs are wrapped under the umbrella of Ucits, which sets certain regulatory parameters to protect investors.

Lyxor Asset Management head of institutional ETF sales UK, Netherlands and Nordics Claus Hein says ETFs can be used as an effective implementation tool across passive investment strategies in pension portfolios. “They provide low-cost and liquid access to an extensive and diverse range of equity, fixed income, commodities and alternative indices,” he adds. They can be incorporated into portfolios as alternatives to or complementing other index-tracking instruments.

He explains: “For example, a pension fund looking to invest in emerging market equities via a passive fund and aiming to minimise tracking error could use an ETF consistently exhibiting a low level of performance deviation against the appropriate benchmark like MSCI Emerging Markets. For overlays or tactical asset allocation purposes, this ETF can also prove to be an efficient trading vehicle offering tight spreads and significant liquidity.”

“An ETF is another investment management tool and a pretty sharp one,” that can be used in “very innovative” ways, states SPDR head of UK Eleanor Hope-Bell. “For instance, while a consultant is looking for the right active manager the pension fund may use ETFs, so they keep a certain market exposure and it offers the liquidity to invest in and out quickly.” Additionally, pension funds also use ETFs to complete and diversify the portfolio by enabling them to invest in asset classes that they have not analysed yet, like emerging market index linked bonds.

In terms of cost, it depends on the asset class, but ETFs often are the same as or cheaper than mutual or index funds, says Hope-Bell. But, she points out, it is very important that cost should not be the only factor when choosing an ETF. With over 100 ETF sponsors globally, the evaluation of the provider is a necessary part of the process. The key characteristics to look for in a provider are, she says, company history, size and scale, commitment to the ETF industry, portfolio management expertise and product support capabilities.

ETFs are gaining most popularity among very large UK pension funds. This is especially relevant in beauty parades, where a scheme can remain exposed to the asset class while they are hiring one manager and firing the other. This is often referred to as transition management. Thereafter, if they like what they see, then they may start migrating to other ETF uses and upping their allocation.

More recently ETFs have also been increasing in the DC space thanks to the introduction of auto-enrolment. “Auto-enrolment has forced members, trustees and sponsors to make sure their DC section is as good as it can be,” notes iShares head of UK sales Mark Johnson. Quite often you will see within the default fund a component called the ‘diversified growth fund’ - this has lots of different assets with the specific goal of generating a return generally in excess of cash. The default funds that use diversified growth funds are becoming more and more popular and they typically use ETFs as one of the tools in their portfolio. “So a lot of DC members may not even be aware of the fact that they own ETFs indirectly,” adds Johnson.

In time Johnson even expects to see ETFs being offered as a standalone solution within DC schemes for more informed members, outside the default choice. Johnson is upbeat about the future and thinks the ways in which US pension schemes have used ETFs in the past 10-15 years will eventually be exported to the UK.

But in the shorter term the real problem is that many medium and small DB schemes do not understand the benefits of ETFs, or they seem to think they are only for retail funds, which is not the case. “Some consultants haven’t introduced them since they too do not understand their benefits and some even consider them a threat rather than a tool,” observes Hope-Bell.

CIO of specialist ETF investment house, SCM Private, Alan Miller strongly agrees. “It is shocking that many pension fund and charity consultants and advisers are failing in their professional responsibilities by not considering, let alone objectively evaluating such a substantial and transformational medium of investing as ETFs.” The veteran fund manager sums up the absurdity of the situation by saying he was told by a senior partner of an actuarial firm that whilst he only invested personally via ETFs he never advised his clients to do the same.

Miller argues that ETFs are highly efficient investment vehicles for delivering performance and are not used enough among UK pension funds. “The only time that the so-called pension fund advisers recommend ETFs for is transition management. They have not even begun to consider the potential advantages of using them on a medium- to long-term basis. They have lost sight of the unrivaled choice you have and the inherent advantages of combining extra transparency, efficiency, liquidity, and diversification.”

For example, he says that if you want to build a multi-asset portfolio with much greater depth of choice in emerging markets, currencies, and almost everything else possible, there are thousands of different ETFs offering unrivalled exposures to almost every conceivable investment opportunity. Many of these are not available through the ‘old-fashioned’ medium of mutual funds, he adds. Another major advantage is that you know the price of the ETF before you deal. Compare this to the purchase of mutual funds where, he says, you never know the price until after you have put on the deal, often based on the price the next day. The price you actually deal at can be materially influenced by the spread of the fund, which in itself can be significantly influenced by whether people are investing or redeeming the fund at any particular moment.

Miller also claims that index funds have much higher hidden costs than ETFs. Having just launched a calculator - which determines the real cost of holding any fund or investment - his findings are very interesting. With a typical FTSE 100 mutual fund index tracker, the extra hidden cost, which he measures as the extra underperformance against an index over and above the headline stated charges, is 42 per cent. Compare that with just 6 per cent for a comparable ETF.

He suspects that this lack of consideration or proper analysis may have something to do with the fact that consultants would not get large enough fees if they endorsed ETFs. He believes UK pension funds need to modernise the way they manage money on a long-term basis and should look to the US for inspiration. There, the ETF market is much more developed and is seeing a move away from transactional to more strategic usage.

Consulting firm Cardano UK CEO Kerrin Rosenberg does not share Miller’s optimism. While he agrees that ETF’s have become a very popular way for investors to access various asset markets he says their popularity with pension funds is low and not likely to change much. The main reason for this, he maintains, is that many ETFs provide a standard passive approach to indices like the S&P 500 and pension funds can achieve far cheaper access to the same indices through investing in institutional index tracking funds. Alternatively, he adds, if the pension fund wants to adjust its asset allocation quickly, it will probably find futures are cheaper.

The advocates of ETFs would agree to disagree with this point of view. Instead they are positive about the future of ETFs and firmly believe it is a mistake to disregard them without researching and understanding their merits, as opportunities may be missed. “Many hear they are expensive or difficult to implement and disregard them,” says Hope-Bell. “I would urge trustees, consultants and managers to be aware of how ETFs can be used in a pension fund. I believe that if a pension fund is not using ETFs they should ask why this is the case and if that’s appropriate.”

Written by Nadine Wojakovski, a freelance journalist

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