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The role of Exchange Traded Funds in investment management

Date 29/10/2008

Deborah A. Fuhr
Managing Director, Investment Strategies, Morgan Stanley

Exchange Traded Funds (ETFs) are a useful tool embraced by many retail and institutional investors and stock exchanges around the world. In a world in which new financial products come and go at the blink of an eye, ETFs may be the leading financial innovation in the past two decades.

Since the first ETF was launched in the United States in 1993, ETFs have opened a new panorama of investment opportunities. Essentially, ETFs are index funds (not a derivate) that are listed and traded on exchanges like stocks. They allow investors to gain broad exposure to entire stock markets of different countries, sectors, styles, emerging markets, commodity and fixed income indices with relative ease on a real-time basis and at a lower cost than many other forms of investing.

Most ETFs are backed by baskets of securities, which are designed to track an index and provide diversified exposure at lower expense ratios than traditional funds. On most exchanges ETFs can be used to go long and short. For ETF investors, the lending revenue, which can be earned by lending their ETF shares, can at times more than cover the annual total expense ratio (TER). They can be purchased on margin, are lendable and are purchased on a commission basis just like any other share.

ETFs are transparent, as the fund manager discloses the underlying basket of shares to the market every day; also, unlike traditional funds, they are not subject to style drift. ETFs are liquid as they afford investors two forms of liquidity: via the trading of shares on a secondary basis on the exchange, and via the ‘creation’ process where an ‘authorised participant’ or ‘market maker’ purchases the underlying basket of shares in the local market and deposits the basket ‘in kind’ with the ETF manager in exchange for more shares in that ETF. The redemption process works in a similar fashion: the ‘authorised participant’ or ‘market maker’ delivers ETF units to the ETF manager and takes delivery of the underlying basket of shares. This unique creation/redemption process means that the liquidity in the ETF is driven by the liquidity in the underlying shares.

As the job of most portfolio managers has expanded to cover all the developed, emerging, fixed income and commodity markets, we have found that many managers are admitting that they do not have the time, resources or foreign investor status to allow them to pick stocks or bonds in all markets. As such, they are embracing the use of ETFs to gain low cost beta exposure to many equity, commodity and fixed income markets. This allows them to have more time to capture alpha by selecting stocks or bonds in markets where they feel they can add value. Hence the alpha-beta or ‘asset management barbell’ approach to investing.

As institutional investors are increasingly using ETFs as core and satellite holdings and for tactical asset allocation, we have seen an increase in the size of their investments as well as an increase in the length of their typical holding period. In other cases, ETFs are most commonly used to equitise cash or to establish an over or underweight position. ETFs make it easy to implement exposure to hundreds of benchmarks. They are a substitute for a program trade, using futures or traditional funds to gain exposure to equity sectors, styles, country, regional, international and emerging market indices, government and corporate bond indices as well as commodity indices at real-time prices during the trading day. Some new ETFs offer leverage or inverse exposure to indices.

Over 2,200 institutional investors worldwide reported using one or more ETFs listed on exchanges around the world. Over the past nine years, the number of users has increased 1,242%. There was a 36% increase in the number of hedge funds reporting using ETFs over the past year.

Today the ETF toolbox is well stocked with a wide array of products.

The ETF toolbox

2007 was another year of significant growth for the ETF industry. At the end of 2007, there were 1,171 ETFs with 1,909 listings on 41 exchanges around the world, which represents a 64% year on year increase in the number of ETFs during the year. Assets under management (AUM) were USD796.6bn, which is a 40.8% year on year increase. There are plans to launch a further 547 ETFs: 90 in Europe, 399 in the US and 58 in the rest of the world.

Worldwide growth of ETF numbers and assets under management

Of the 75 managers of ETFs, 14 launched their first ETFs during 2007. Forty-one exchanges have official listings of ETFs of which four listed their first ETFs during 2007. In 2007, the worldwide 20-day average daily trading volume in US dollars increased by 143.2% to USD59.7bn from USD24.6bn at year-end 2006.

Worldwide, ETF AUM increased by 40.8% YTD in 2007, which is greater than the 7.1% rise in the MSCI World benchmark in USD terms. Europe-listed ETF AUM increased by

43.1%, ETFs in the US increased by 42.7% and ETFs in Japan declined by 1.3% compared to the MSCI Europe Index (+10.6%), MSCI US (+4.1%) and MSCI Japan (-6.4%) in USD terms. We forecast ETF Assets to exceed USD2tr in 2011.

Institutional users of ETFs

We expect ETF AUM to exceed USD2tr in 2011. This forecast is based on a number of factors driving the growth such as is: 1) continuing increase in the number of institutional and retail investors who use ETFs and view them as useful tools for tactical and strategic exposure, 2) funds making larger allocations to ETFs based on recent regulatory changes in the US, Europe and in many emerging markets, 3) the expansion in asset classes and the number and types of equity, fixed income, commodity and other indices covered, 4) development and growth of investment products that employ ETFs and other low cost beta products 5) the plans of many stock exchanges to create ETF trading segments and list ETFs and 6) the expectation that there will be a number of new issuers/managers of ETFs.

Major players in the ETF market have traditionally been large institutional investors seeking to index core holdings or pursue more aggressive market timing and sector rotation strategies. However, since smaller institutions and retail investors can trade in small lots, they can invest on the same terms as larger investors. ETFs offer numerous applications, which can be appealing to institutional and retail investors. Benefits of this approach include the following:

A framework for an entire portfolio. Investments for each market segment can be held in their proper weightings with occasional rebalancing of portfolios.

The formation of the core portion in a portfolio. Those seeking an approach with more active trading may find a core/satellite investment strategy appropriate. In this case, the model can serve as a core. In an effort to increase returns, shorter-term tactical strategies, such as stock, sector, style, or country overweights, may then be employed as satellite investments. Core holdings can help ensure that a portfolio’s performance does not deviate widely from established benchmarks, while satellite investments constitute active plays in an effort to increase returns.

Equitisation of cash flows. This can be done in relatively small increments — a single share of an ETF typically can be bought at a price ranging from approximately EUR7 to EUR200. ETFs can be a good alternative to using futures to manage cash flows: they can be bought in smaller sizes than futures, they do not require any special documentation or accounts, and investors do not have to worry about roll costs and margin requirements. In addition, ETFs cover many benchmarks for which there is no futures contract

Effective asset allocation. For settlement and administrative purposes, ETFs are a more efficient way of investing than purchasing a basket of individual stocks to track a given benchmark. They can also be a core holding in a multi-asset portfolio, providing a level of diversification that would otherwise be time consuming and expensive to attain by purchasing the underlying shares. ETFs can be used to target sectors where there are no futures contracts.

Reduction of portfolio risk. ETFs can form the core holding in a portfolio with the aim of reducing portfolio risk. A core holding can help to ensure that a portfolio’s performance does not widely deviate from an established benchmark.

Switching between sectors. ETF products can be used to implement sector rotation and sector allocation strategies. They can also be used to adjust style or country exposure.

Hedging of a sector or country. ETFs can be used to hedge sector, country or regional exposure. They can be sold short to hedge a portfolio of stocks, allowing an investor to preserve a portfolio while protecting it from overall market losses.

Transitions. ETFs can be used as a low cost product to park assets when a manager is being sacked and/or a new manager is being hired.

Tactical asset allocation. ETFs can be used as a tool to implement exposure to equity, fixed income and commodity indices.

In the current uncertain economic climate, we can expect continuing growth in the demand for ETFs worldwide.