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European investors fail to take full advantage of ETF features, says Edhec


While exchange-traded funds are now widely used by investors who are highly satisfied with their features, their use is largely limited to passive holdings of broad market indices and the

While exchange-traded funds are now widely used by investors who are highly satisfied with their features, their use is largely limited to passive holdings of broad market indices and the wide range of ETFs for sub-categories and styles is not used to its full potential, according to a new survey by the Edhec Risk and Asset Management Research Centre and iShares, the world’s largest ETF provider.

The Edhec European ETF Survey 2008, unveiled at last week’s Edhec Institutional Days conference in Paris, also argues that most practitioners do not benefit from opportunities to trade options on ETFs, sell ETFs short or lend them out.

The authors of the survey believe that there is considerable added value in making use of an important feature of ETFs, the ability to buy and sell them like stocks, which makes them ideally suited for dynamic risk management in portfolio construction. The Edhec study argues that such dynamic risk budgeting offers substantial benefits.

The Edhec European ETF Survey 2008, which examines the use of ETFs by European investors, is based on a questionnaire that was addressed to industry participants which generated responses from 111 institutions.

The survey’s key findings include the dominance of broad market ETFs. In constructing equity core portfolios, 94 per cent of respondents use ETFs based on broad market indices, while only 19 per cent use style ETFs that track narrower sub-categories of the equity market. Consequently, the opportunity to use ETFs to construct optimal core portfolios composed of different equity styles or segments is largely neglected.

ETFs are now used by 54 per cent of respondents in satellite portfolios, the same proportion that use them in core portfolios. This result is interesting, the study’s authors say, since one of the initial precepts of the core-satellite approach was to use highly active instruments in the satellite portfolio. However, the outperformance of the satellite portfolio may be generated by exposure to different forms of beta, such as small-cap stocks, value stocks or credit risk, rather than to manager alpha.

The survey results suggest a substantial increase in the popularity of ETFs and ETF-like products for investing in alternative strategies. The proportion of respondents using ETFs for commodities, real estate or hedge funds has increased considerably since Edhec’s previous survey in 2006, with between 30 and 50 per cent of respondents using ETFs in each asset class, compared with 5 to 15 per cent two years ago. Today products such as real estate ETFs, commodity ETFs and investible hedge fund products are widely used by European investors and asset managers.

ETFs are still most heavily used for equity investing, making up more than 20 per cent of the average respondent’s equity investments, compared with just under 10 per cent of bond investments. This emphasis is also reflected in the fact that 78 per cent of respondents use ETFs in equity investing, but fewer than half for fixed income, commodities and real estate.

More sophisticated techniques such as ETF securities lending, trading options on ETFs, and short-selling ETFs are used by only a fraction of respondents. Even including those that may do so in the future, no more than 13 per cent are current or potential users of any of these approaches.

Inverse-performance ETFs, by contrast, are or will be used by more than 30 per cent of respondents. However, the number planning to use sophisticated ETF techniques in the future is high compared with current users, suggesting that growth can be expected in ETF lending, options trading and short-selling.

Asked to compare ETFs with futures, traditional index funds and total return swaps in a number of areas, respondents rated them advantageous in terms of liquidity, transparency and cost, albeit less so than futures in some aspects, and best in terms of the available range of indices and asset classes.

The study’s authors say futures are perhaps ETFs’ most serious rival, but the latter are preferred for their lower minimum subscription level, fewer operational constraints and less constrictive tax and regulatory regimes. Implementation concerns with futures such as margin calls and applying exact allocations for small-sized portfolios give ETFs an advantage.

ETFs are set to benefit most from increasing interest in indexing, although other products are also set to enjoy wider use, the authors say, as respondents expect to increase use of ETFs, futures, total return swaps, and index funds in the future.

Sixty-nine per cent plan to increase use of ETFs, while only 3 per cent expect a decrease, compared with 36 and 2 per cent respectively for futures and 18 and 9 per cent for total return swaps. While 23 per cent of respondent plan to use index funds more, a sizeable 19 per cent see a decrease in use.

Compared with Edhec’s earlier survey, the perception of the comparative advantage of ETFs has remained similar but use of ETFs has been growing in all asset classes, especially equities, where it has risen from 45 to 78 per cent. Satisfaction with ETFs has remained at high levels or increased slightly for equity and bond ETFs, and increased strikingly for ETFs or ETF-like products based on alternative asset classes.

‘Edhec’s research shows that ETFs have become a mainstream investment product, and supports our own findings that ETFs are being used in ever more increasingly sophisticated ways by investors,’ says Axel Lomholt, head of ETF products at iShares.

‘However, the findings also show there is still work to be done on educating the market about the full potential of ETFs. Investors have yet to take advantage of the more advanced uses of ETFs, particularly securities lending, trading options and short-selling. We will continue to work closely with clients to educate them on how they can add real value to an investment portfolio.’

Edhec Business School, founded in 1906, has 4,700 students, of whom more than 25 per cent are from outside France, at its campuses in Lille, Nice, and Paris, and 100 full-time faculty. The Risk and Asset Management Research Centre, which has 35 staff, aims to produce asset management and alternative investment research and facilitate its corporate use, including six industry-sponsored programmes focusing on asset allocation and risk management in traditional and alternative investment.

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