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Exchange-traded funds - a useful tool for institutional investors Back  
In advance of the Irish Stock Exchange launching the first exchange-traded fund (ETF) of Irish stocks, Deborah Fuhr gives an overview of the development of the ETF market to date, and the role ETFs can play in institutional investors’ portfolios.
IIIn a world in which new financial products come and go at the blink of an eye, exchange-traded funds (ETFs) may be the leading financial innovation of the last decade. Since the first ETF was launched in the US in 1993, ETFs have opened a new panorama of investment opportunities. Essentially, ETFs are index funds that are listed and traded on exchanges like stocks, they allow investors to gain broad exposure to entire stock markets of different countries and specific sectors with relative ease on a real-time basis and at a lower cost than many other forms of investing. ETFs also can be used to short an index. They can be purchased on margin, are lendable and are purchased on a commission basis just like any other share. During the past two years some fixed income ETFs have been launched.

At the end of 1993, there were globally three ETFs with $811 million in assets. At the end of the first quarter of 2004, there were globally 302 ETFs with 363 listings, assets under management (AUM) of $229.306 billion and, during March this year, an average daily trading volume of 258 million shares or US$13.69 billion. Thirty-five managers of ETFs now manage ETFs with official listings on 28 exchange platforms.

During the first quarter of this year, the global ETF market increased on many fronts. Globally, the average daily volume traded grew by 64 per cent in terms of US dollar volume and 50 per cent in terms of number of shares; assets under management increased by 8 per cent; and the number of products by 7 per cent.

Assets under management (AUM) have increased by 8 per cent to $229 billion globally. Europe is up 22 per cent, which is the largest increase, followed by the US, up 7 per cent, and Japan, up 3 per cent. During the first quarter, the MSCI World index increased 2.2 per cent, MSCI Europe by 2.9 per cent, MSCI USA by 1.0 per cent, MSCI Emerging Markets Free by 8.9 per cent and MSCI Japan by 14.6 per cent.

ETFs can be effective tools for both active and passive institutional managers and for retail investors. They are a flexible tool that are not derivatives, but allow investors to quickly be able to react to short and long-term needs or opportunities. As such, they are an alternative to futures, trading baskets of shares trades and the use of traditional active and passive funds.

We have seen significant growth in the number of institutional investors reporting holding one or more US listed ETFs, rising to over 1,300 in June 2003, from less than 500 three years ago (based on data from Thomson Financial’s Carson Geo database of 13F and other fund filings).

The growth in the use of ETFs has been fuelled partially by investors’ attempts to avoid accounting, earnings and other stock specific risk. They can be bought and sold at market, limit or as stop orders. They do not have any sales loads, although they do like mutual funds have annual total expense ratios (TERs), albeit less than traditional funds, ranging from 0.0945 per cent to 0.99 per cent. In fact, ETFs have some of the lowest expense ratios among registered investment products.

The annual expenses are deducted from dividend payments, which typically are paid out on a quarterly, semi-annually or annual basis, although some ETFs do reinvest their dividends.

Many investors believe that asset allocation is the primary driver of investment returns, as demonstrated in a study conducted by Brinson, Hood and Beebower in 1987, which found that nearly 92 per cent of the variation in pension fund returns were attributable to the asset allocation decision.

Many mutual funds have embraced the idea that ETFs are tools that can help them to equitise cash, are a substitute for futures, used as a cash management tool, implement a hedge or short strategy and gain exposure to sectors, styles, country, regional and international markets at real-time prices during the trading day.

Major players in the ETF market traditionally have 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 are discussed below.
• A framework for an entire portfolio. Investments for each market segment in their proper weightings and occasionally rebalance their 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 with the price of a share ranging from approximately €7 to €200. 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 sector 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.

ETFs settle just like any other shares on the exchange. They 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 afford investors two forms of liquidity: 1) via the trading of shares on a secondary basis on the exchange and 2) 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.

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

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