SPONSORED CONTENT | Regulatory changes and a desire for more efficient ways to implement strategies have prompted growing use of exchange-traded products, which institutional investors are embracing as alternatives to more traditional tools, such as futures and options.
Once investment chiefs and portfolio managers have decided on a strategy, the next decision is which of the many vehicles available is the most appropriate instrument for the particular situation or market conditions. In recent years, exchange-traded funds (ETFs) have entered this mix for consideration.
How asset owners and managers approach these decisions was the focus at a recent Investment Magazine roundtable, held in partnership with BlackRock, on the topic: ‘Lowering Implementation Costs and Regulatory Risks’.
The ETF market’s expansion rate is particularly rapid in fixed income assets.
BlackRock’s data shows about 52 per cent of all institutions that use ETFs have replaced a derivative with one in the last year. There is US$4.5 trillion ($6 trillion) in the ETF market, a figure that is expected to rise to at least US$5 trillion by 2020.
In fixed income alone, the ETF market has grown to US$700 billion since it opened in 2002.
“This has been driven by regulatory change, which has caused bank balance sheets to shrink. Now, they’re not warehousing risk and so that liquidity has moved into the ETF market,” said Katie Petering, BlackRock director, head of asset manager sales, iShares Australia, who was one of the nine experts participating in the roundtable.
For Deutsche Bank head of Australian ETF trading and inventory management Glyn Roberts, the regulatory environment, the soft futures market and the increasing breadth of the ETF market have led the bank to a growing reliance on the instruments.
“Our use has also been convenience- and efficiency-driven, allowing us to improve operational efficiencies,” Roberts said.
He explained that transparency before and after trades around transaction cost is a big advantage of ETFs.
“We have clients actively requesting the implicit cost associated with trades,” Roberts said. “We’re looking for alternatives that offer more efficient implementation, particularly around the use of derivative structures versus fully funded options. That’s [brought] an increase in focus around futures versus cash executions and balancing swaps versus ETFs for exposure.”
Regulatory changes that have reduced margins in interbank trades, as well as more opaque over-the-counter derivatives markets with instruments such as equity swaps are other factors motivating a move to exchange-traded products.
The proliferation of ETFs is allowing fund managers to express a growing number of medium-term investment views using these instruments.
AMP Capital assistant portfolio manager Heath Palos told how the when the fund recently wanted to take a position on US banks, but found the futures market wasn’t deep enough for the exposure it required, used an ETF to implement the investment idea.
“It is simpler to use an ETF for this, given we go through an investment committee,” Palos said. “Investing in an ETF is an easier process, which also makes it cheaper to implement,”
Palos said AMP Capital has a growing interest in alternative risk premium managers and when assessing their merits, implementation framework is a key consideration for the team. ETFs’ efficient nature gives them a competitive advantage over products not traded on an exchange, he said.
“Investment process and asset selection are very similar between managers,” Palos said. “So how they improve implementation efficiencies is what matters.”
BlackRock’s Petering said ETFs play a key role in her job of helping clients solve implementation problems. “We have a broad capital markets team, so we have various businesses that help clients solve problems,” she said.
Palos said tracking error is not a concern. “The price is moving with the steepness of the curve – it’s tracked that very well; it’s amazing.”
But Petering noted it’s tracking difference, rather than tracking error, that’s important in the ETF market. She used an emerging-markets ETF to demonstrate her point.
Tracking difference is the gap between the volatility of the ETF and the index every day. The emerging markets ETF is tracking positive to the index at the moment. This is because it is cheaper than buying an emerging markets futures contract to receive the same exposure.
“If you add back basket lending revenue you get from the ETF, your cost is about four basis points for a one-year period,” Petering said. “The cost to express this would be 90 basis points through a futures contract, depending on your funding. So, you get huge savings using an ETF because you’re being more efficient.”
AMP Capital has found ETFs a useful tool for accessing emerging markets. Palos said: “We use active emerging markets fund managers. We don’t want to change them too often, given the spreads on trusts. So, ETFs are an efficient way to express that emerging markets view in the medium term.”
Transparency is another advantage of using an EFT to access emerging markets, which are typically relatively opaque compared with developed markets, as they allow investors to understand the underlying securities easily.
Horses for courses
While ETFs are becoming more popular due to their efficiencies, low costs and other benefits, it’s important to use the right instrument for the right situation.
“What’s key is working out the risk/return profile for an asset class and then deciding the right hedging instrument,” REST Industry Super investment implementation and due diligence manager Turab Bank said. “This involves measuring the performance of each instrument and then setting up the right implementation strategy.”
ETFs will often be the right solution for medium-term positions. But other instruments might be more suitable for shorter trades.
Petering said: “If you’re looking at a one-year holding period, often an ETF will work for the investor. But if you’re only holding a position for a very short period of time, then a future will often look better. The idea is to look at the different instruments you have in the toolkit and use analysis or a framework to look at the underlying holding costs and work out which one is better for you, given what you’re trying to implement at the time.”
Others agreed futures might be the right choice for a fast-moving signal or market.
First State Super senior analyst, treasury and dealing, Stuart Corradini said: “The faster settlement cycle suits that more traditional approach. But you want to have all those tools available at your disposal to execute a decision.”
BlackRock’s Hong-Kong based head of trading and liquidity strategies, Asia-Pacific, Sam Kim, said investors need to consider a broad range of choices and select the right tool for specific circumstances.
“Whether it’s futures or ETFs, depending on what kind of exposure the investor wants and whether they seek to outsource or use in-house resources, just having that ability to be tactical is a big part of it,” he said.
Regulatory changes are another factor influencing some implementation decisions.
In particular, the Australian Securities and Investments Commission’s new Regulatory Guide on Disclosing fees and costs in product disclosure statements and periodic statements (RG 97) is increasing transparency around fees and charges. In light of this, the transparent fee structure of ETFs is prompting some asset owners and managers to consider them in a new light.
EISS Super chief investment officer Ross Etherington noted the regulations place more pressure on investment managers to bring costs down.
“We’ll also be able to compare one manager to another,” Etherington said. “If one fund costs twice what another one does, we have evidence to point to them to ask what they’re doing.
“For asset managers, RG 97 is going to be a big task and there will be a lot of pressure from asset owners like us to bring those transaction costs down.”
Bank agreed that funds are under pressure to achieve increased transparency on fees, but predicted it would take time before more institutional asset owners embrace ETFs. “RG 97 adds more transparency, but investment philosophies and processes still need to change to accommodate a low-fee world,” he said.
Mercer Sentinel principal Tricia Nguyen, reflecting on her work guiding clients’ implementation decisions, said superannuation funds are seeking “end-to-end cohesion” when implementing solutions to address upcoming regulatory changes.
“That’s the key in terms of reducing cost and risk,” Nguyen said. “Compliance, trade reporting – whether it’s one way or two way and whatever jurisdiction you’re in – will be a big focus from now on.”
Willis Towers Watson investment consultant Matthew Conacher said this is especially important for medium-sized and smaller funds. “It’s important to make them aware there are specialists out there who can [help them] be more efficient at implementing a decision once they’ve made it,” he explained.
Conacher said he has been encouraging clients to put in place appropriate governance arrangements for a low-return environment to meet new regulatory requirements.
“We’re going right back to the basics and reviewing the mission and the investment beliefs of the investment committee,” he said. “That flows into sourcing models and the structure of different committees, delegation powers and capital market assumptions. The fund manager line up falls out of those things.”
Conacher said it is essential for super funds to measure their decisions and track their progress. “Having that monitoring in place in the execution phase is essential.”
Ultimately, the instruments investors use to implement their investment decisions will continue to change, as will the counterparties with whom they trade. And regulatory change is an international phenomenon.
BlackRock’s Kim said the firm spends “considerable time” looking at what and how it trades and how they are likely to evolve in response to the European Union’s Markets in Financial Instruments Directive (MiFID).
“That’s critically important and is going to shape investment strategies,” Kim said. “Certain strategies that may have worked in the past may not work now. So, we really need to understand how the market structure is going to change so that we can be informed and work with our clients to make that investment strategies are properly aligned with the regulatory changes.”
It’s an ongoing and evolving process as investment managers continue to negotiate ever more complex investment markets constantly grappling with regulatory change.