Exchange Traded Funds - Aon Exchange Traded Funds Summary An Exchange Traded Fund ... 2 Exchange...

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1 Exchange Traded Funds Exchange Traded Funds

Transcript of Exchange Traded Funds - Aon Exchange Traded Funds Summary An Exchange Traded Fund ... 2 Exchange...

Page 1: Exchange Traded Funds - Aon Exchange Traded Funds Summary An Exchange Traded Fund ... 2 Exchange Traded Funds ... Below we present an example trade-off between a pooled

1 Exchange Traded Funds

Exchange Traded Funds

Page 2: Exchange Traded Funds - Aon Exchange Traded Funds Summary An Exchange Traded Fund ... 2 Exchange Traded Funds ... Below we present an example trade-off between a pooled

1 Exchange Traded Funds

Summary

An Exchange Traded Fund (“ETF”) is a collection of assets designed to provide performance in-line with a specified market index, similar to a passively managed pooled fund. The main difference is that access is gained via shares traded on an exchange and not by transacting with the underlying manager as with pooled funds. Due to this, ETFs can offer an attractive alternative to conventional investment funds in some circumstances, due to their underlying features and trading flexibility.

ETFs now feature alongside futures, pooled / mutual funds and total return swaps as the major vehicles to gain market exposure as well as expressing asset allocation views. ETFs offer a number of qualities, some also provided by other passive vehicles, including:

Flexibility / versatility – ETFs can be used for single or multiple market or sector exposure;

Diversification – a single ETF can provide exposure to a large index;

Transparency - holdings are published regularly (often daily) on fund providers’ websites and costs are known.

Contact:

Chris HawksworthAssociate Investment Consultant

+44 (0)113 [email protected]

Contact:

Tom Spence Senior Investment Consultant

+44 (0)20 7086 9306 [email protected]

Contact:

Phil True Head of Equity Manager Research, UK

+44 (0)20 7086 [email protected]

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Application for Pension Schemes

Based on our experience of using ETFs and our knowledge of the market, we have identified a variety of potential ways ETFs can be effectively used and implemented by pension schemes.

Tactical allocations — ETFs can be used to take short- to medium-term tactical positions in markets. For example, attaining temporary exposure to emerging markets could be implemented via an ETF quicker and at a lower cost than a pooled index fund.

Temporary allocations — Some investors with limited governance frameworks may wish to attain immediate exposure to an incoming asset class prior to conducting a thorough review of specialist active managers. Alternatively, an investor may wish to immediately exit a manager following a period of poor performance, however they want to retain exposure to an asset class. ETFs can be used to mitigate cash drag and trading risks under these circumstances.

Transitions — ETFs can be used during transitions between investment managers and asset classes to mitigate out of market risk.

Passive core — ETFs can be used as an alternative to pooled funds as part of a passive core approach. In particular we have observed a number of US pension schemes gaining access to markets via this approach to supplement their actively managed portfolios.

Growth in ETFs

ETFs started in the US and Canada in the late ‘80s. Standard & Poor’s Depository Receipts were developed to track the S&P 500 in 1993. Its success led to the significant increase in ETFs in the US and consequently in other regions. ETFs are generally managed by assets managers, typically those that currently offer passive fund ranges.

The number of ETFs listed globally has risen dramatically over recent years, with around 450 in existence in 2005 and approximately 3,500 listed today.

With respect to UK pension funds specifically, a FinEX survey carried out in 2013 found that 34% of UK pension funds are planning to increase their usage of ETFs, including 17% that are planning to increase their ETF investment by more than 10%. The key factors when investing in ETFs cited by respondents included diversification, efficiency and liquidity.

The key players within the ETF market are BlackRock iShares, Vanguard and State Street. BlackRock iShares is the biggest provider of ETFs globally with over 760 ETFs, approximately half of the market share and over £960bn of assets under management.

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Dec-13

219 297 300357

524883

1,5412,220

2,694

3,5434,311

4,759

4,988

5,000

4,000

3,000

2,000

1,000

0$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

$2,200

$2,400

Ass

ets

($b

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# of

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79 109 146 218319

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1,156

1,483

1,525

1,944

2,401

Source: BlackRock

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Difference between ETFs and pooled index funds

ETFs offer similar features to pooled index funds but with a few important differences discussed in more detail below.

One major difference is that investors buy and sell ETF units on a stock exchange through a broker-dealer, much like they would any other type of stock. In contrast, pooled fund units are not listed on stock exchanges. Rather, investors buy and sell pooled fund units through a variety of distribution channels.

Pricing also differs between pooled funds and ETFs. Pooled funds are “forward priced,” which means that although investors can place orders to buy or sell units throughout the day, all orders placed during the day will receive the same price the next time it is computed. In contrast, the price of an ETF share is continuously determined on a stock exchange.

Notably, there can be significant cost savings by utilising ETFs over short periods of investment. This is due to the considerably lower spread costs of entering and exiting the interim allocation, even though an ETF (usually) has higher ongoing management costs.

Below we present an example trade-off between a pooled emerging market equities fund and the equivalent ETF, and a break-even chart to illustrate this:

Transition costs (round trip in and out)

Ongoing costs (per annum)

Pooled fund 0.70% 0.16%

ETF 0.025% 0.66%

For a six month holding period of £100m:

Transition costs Ongoing costs Total costs

Pooled fund £700,000 £80,000 £780,000

ETF £20,000 £340,000 £360,000

Break-even point of Pooled Fund v ETF

It is clear, for this particular pooled fund and ETF, that from a cost point of view, the shorter the interim investment is held, the more cost advantageous it is to hold the ETF instead of the pooled fund.

Benefits of ETFs

Aside from the lower overall cost of ownership under shorter holding periods, ETFs offer a number of benefits to pension schemes, which include:

Wide range of types — Exposure to a wide range of asset classes and markets can be attained ranging from traditional stock market indices, such as the FTSE 100 Index to Brazilian oil companies.

Accessibility — The ETF market is never closed to investors and no minimum investment requirements exist, which allows nimble access to different markets

Securities lending — It is common practice for ETFs using physical replication to participate in securities lending within the ETF. The objective of this is to reduce investors’ net costs through generating additional income. The ETF itself can also be lent out — sometimes generating significant revenue that can substantially offset ongoing holding costs.

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200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

Tota

l Cos

t (£)

4 8 12 16 20 24

Pooled fund ETF

Months

Break-even point of Pooled fund v ETF

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Potential limitations/issues with ETFs

We have identified various limitations of using ETFs and these include the following:

Governance — A brokerage or custody account will be required to trade in ETFs, which will not be an issue to larger pension schemes. However, we are aware that small to medium sized pension schemes may not have either of these accounts and therefore this consideration would need to be given if ETFs were of interest.

Tracking error — Due to the structure and cost of an ETF it is expected that the underlying will not be tracked exactly. However for the most liquid markets, such as the UK equity market these differences are minimal.

Synthetic ETFs – We do not advocate the use of synthetic ETFs due to the complexity of these products and the additional underlying risks that clients could be exposed to, such as counterparty risk.

Conclusion

ETFs have a variety of potential applications for pension schemes over short- to medium-term time horizons, which range from tactical asset allocation to efficient transition management. In particular, we have found that there are instances when ETFs can be cheaper to implement than the equivalent pooled fund investment. However, the benefits of using ETFs over pooled index funds from a cost perspective are generally mitigated when holding investments over the longer-term.

The growth in the ETF markets has been significant in recent years and has extended from traditional asset classes, such as equities and bonds into alternative asset classes, including commodities and infrastructure. The latter could be of interest to investors seeking short-term, liquid exposure to alternative asset classes.

Although ETFs offer a number of attractive benefits to investors, we also believe that an understanding of their limitations and the barriers to investment should be considered before making an allocation to an ETF.

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Disclaimer

Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone.

Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated. This document is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by any third party. This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinion or assumption in this document is not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance or compliance with legal, regulatory, administrative or accounting procedures or regulations and accordingly we make no warranty and accept no responsibility for consequences arising from relying on this document.

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