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The EDHEC-Risk European ETF Survey 2009

In view of the growth and development of ETFs in Europe, and of their growing popularity as investment media for both index management and the construction of benchmarks, EDHEC-Risk has devoted significant resources to research into ETFs.

The EDHEC-Risk European ETF Survey 2009 presents the results of a comprehensive survey of 360 institutional investors and private wealth managers conducted in January and February 2009. It also provides an overview of the ETF market and of the mechanisms behind ETFs, and shows how advanced techniques involving dynamic allocation strategies can be carried out with ETFs, in particular to implement the beneficial core-satellite approach to investment. The current survey also provides insight into developments over time, as we can compare results with earlier surveys published by EDHEC-Risk in 2006 and 2008.


Exchange-traded funds (ETFs) are perhaps one of the greatest financial innovations of the last decade. ETFs are investment vehicles that usually track an index. Unlike the units of conventional index funds, ETF units trade on stock exchanges at market-determined prices, thereby combining the positive aspects of mutual funds and common stocks. Although the first European ETF was made available only in 2000, assets under management of ETFs amounted to around EUR 100 billion by the end of 2008. In less than ten years, ETFs became a serious alternative to other financial products, such as futures, that provide exposure to financial indices in a single trade. And the ETF market is still growing: the aim of the first ETFs was to replicate the performance of broad equity market indices, but newer products venture into more exotic markets and asset classes, such as emerging markets and alternative investments. Remarkably, the financial crisis has not stunted this growth: ETF providers launched new ETFs in the first months of 2009.

As the market is maturing, it is essential for ETF investors to be informed of the views and practices of their peers. This survey intends to contribute to this understanding by analysing the current and potential uses of ETFs, as well as European investors’ perceptions of ETFs. The EDHEC European ETF Survey 2009 was taken with the aid of an online questionnaire and email sent to European asset management professionals. For a read on the possibly diverging views and opinions across the industry, this survey targeted institutional investors as well as asset management firms and private wealth managers.

In total, we received 360 responses from European ETF users, providing us with a survey that is largely representative of European ETF investors. The aim is to provide insight into the current uses and views of ETF products. As ETFs are also a very convenient means of improving asset allocation, this document also illustrates new ways of using ETFs for asset allocation. In particular, we show how ETFs may be used in the context of the dynamic core-satellite investment approach, a new risk-budgeting technique. ETFs are a natural for core-satellite investments as they are easily traded in dynamic strategies and provide exposure to a wide range of asset classes and subclasses. This study shows how investors can benefit from the potential outperformance of a satellite portfolio all while keeping risk in check. Risk control can be implemented in a customised fashion, since the approach allows various definitions of investors’ risk budgets. We will now present some of the possible applications of ETFs for dynamic risk budgeting. After having shown these possible uses of ETFs, we will provide an overview of the current uses of ETFs in the industry.

New Risk-Budgeting Techniques: Dynamic Asset Allocation Based on ETFs

Core-Satellite Approach

We provide various illustrations of how ETFs can be used in the dynamic core-satellite approach. The core-satellite approach allows investors to separate their portfolio management into the construction of a strategic benchmark and the generation of outperformance of that benchmark. The benchmark is constructed in the core and outperformance is sought in the satellite. Core portfolios may be made up of an allocation to broad market indices or indices for specific segments. Satellite portfolios may try to generate outperformance by deviating from the core portfolio, either with exposure to other asset classes or segments or with exposure to actively managed funds. Indexing vehicles such as ETFs may thus be used in both the core and the satellite.

The separation of portfolio management into benchmark construction and outperformance generation allows investors to structure their portfolio management tasks in a coherent manner. Moreover, it allows straightforward tracking error management. Since the core portfolio is by definition free of any tracking error with respect to the benchmark, the satellite portfolio is the only source of tracking error. The tracking error of the overall portfolio is thus determined by the weights attributed to the core and the satellite. By fixing the weights of a satellite with a tracking error of 20%, for example, at 10%, 20%, or 30%, the tracking error of the overall portfolio is 2%, 4%, or 6%.

However, such static allocation, in which the proportions invested in the core and the satellite are constant, does not distinguish between “bad” (underperformance of the benchmark) and “good” tracking error (outperformance of the benchmark). The full potential of core-satellite portfolio management is reached only when the allocation to the core and to the satellite is adjusted dynamically. The dynamic core-satellite approach of Amenc et al. (2004) is a method for such asymmetric management of tracking error; the idea is to benefit from outperformance of the satellite while limiting the risk of downside tracking error.

Exhibit 1: Allocation to core and satellite allows control of tracking error risk

Dynamic Core-Satellite Portfolio Management

The dynamic core-satellite approach is a new concept that builds on the principle of constant proportion portfolio insurance (CPPI). This procedure enables asymmetric return profiles through systematic dynamic allocation rules. Dynamic core-satellite management extends this approach to asymmetric tracking error management. Investors will thus be certain that underperformance of the benchmark will be capped. Dynamic shifts in allocation are made not to a risky and a risk-free asset in the absolute sense but to the satellite portfolio and the core portfolio. The core is of course free of tracking error risk; the satellite is not.

Exhibit 2: This table compares the traditional CPPI and the relative CPPI approaches

The advantage of the dynamic core-satellite approach is that it allows an investor to truncate the relative return distribution so as to shift the probability weights from severe relative underperformance to more potential for outperformance. In the dynamic core-satellite approach, a floor determines the investor’s risk budget. If the difference between the floor and the total portfolio value increases, i.e., if the cushion becomes larger, the investor’s risk budget increases and more assets are allocated to the riskier satellite. By contrast, if the cushion becomes smaller—that is, if there is less room in the risk budget—the share of investment in the satellite falls. In standard dynamic core-satellite investment, this floor is a constant fraction of a given benchmark value; it thereby protects the portfolio from severe relative losses. Depending on the investment purpose, however, different floors might be used to exploit more fully the benefits of core-satellite management. Indeed, core-satellite management can accommodate more complex or even multiple floors.

The most commonly used alternative floors are the capital guarantee floor, the maximum drawdown floor, and the trailing performance floor. The capital guarantee floor, usually used in CPPI, attempts to preserve the initial invested wealth. Maximum drawdown floors are designed to prevent the total portfolio value from falling more than a specified fraction of the highest asset value it has ever attained. So this particular floor is suitable for absolute return funds. Finally, the trailing performance floor is meant to prevent a portfolio from posting negative performance over a trailing horizon (twelve months, for example).

Besides imposing different floors, dynamic core-satellite management can also incorporate so-called investment goals. Instead of imposing a lower limit for the total portfolio value, an investment goal (or cap) restricts the upside potential of the portfolio. Although at first glance they may seem counterintuitive, goal-directed strategies reflect the possible failure of an investor to gain additional utility once some level of wealth is reached. In other words, once this wealth is reached the hope of realising more gains becomes the fear of losing the accumulated wealth. By forgoing this possible extra wealth, investors benefit from a decrease in the cost of downside protection. These investment goals may be constant or they may be a deterministic or stochastic function of time.

We use several examples to illustrate the benefits of the dynamic core-satellite investment strategy. In several of these examples, we take dynamic allocation to a defensive bond core (government bond ETF) and a risky equity satellite (Euro Stoxx 50 ETF). We provide an overview of this set of examples in the next two sections.

Dynamic Core-Satellite Portfolio Management with ETFs: Absolute Return Funds

In the first example, we look at the management of a portfolio with an absolute return objective. Investors interested in absolute return strategies expect market conditions not to have a great negative impact on portfolio performance; they expect drawdown not to be substantial. So in our example we rely on a dynamic core-satellite investment with a maximum drawdown floor. Moreover, we impose a restriction that the twelve-month trailing performance of the portfolio shall not be negative and define an investment goal to limit the risky upside potential of the investment. The core consists of a broad government bond ETF, the satellite of a broad equity ETF. Furthermore, to limit overall risk the maximum allocation to the satellite is restricted to 50%.1

Exhibit 3 shows the cumulative returns of this strategy, as well as those of the core and the satellite. In addition, to highlight the built-in protection of this investment strategy, the floor is displayed as well.

Exhibit 3: Absolute return fund: cumulative returns of the core, the satellite and the dynamic core-satellite portfolio

We can draw a number of conclusions from this figure. The dynamics of the core portfolio confirm the conservative character of the core investment. However, we also see that the performance of the bond core was quite flat for extended periods, such as from 1998 to 2000, or from 2004 to 2006. By contrast, the returns of the equity ETF in the satellite portfolio were negative over the entire period. More importantly, the fluctuations of the large-cap equity ETF in the satellite are tremendous, with a sharp increase in value before 2000 and the steep falls from 2000 to 2002 and in 2008. The dynamic core-satellite arrangement combines the advantages of each of its ingredients: the smooth performance of the bond core and the upside potential of the equity satellite. As a result, performance is smooth over the entire period, and cumulative returns at the end of the period are actually higher than those of both the core and the satellite. The graph also shows the dynamics of the floor. It is instructive to look at the portfolio performance during the stock market downturns in 2000 and 2008.

In fact, the dynamic core-satellite portfolio is little affected. As the portfolio value approaches the floor, the allocation shifts to the core. This shift is also shown in the following graph, which shows the weight of the satellite.

Exhibit 4: Absolute return fund: changes in the allocation to the satellite

Controlling the Risk of Tactical Bets with Dynamic Core-Satellite Portfolios of ETFs

The previous example shows that dynamic risk budgeting can provide sound absolute return management and that it is easily implemented with ETFs for traditional asset classes (equity ETFs and bond ETFs). What makes it remarkable is the absence of reliance on forecasts. The systematic allocation based on past values of the bond core and the equity satellite portfolio means that the investor takes on no forecasting risk.

Of course, investment houses may have access to proprietary forecasts that they may wish to use to shift the allocation from the core to the satellite or from the satellite to the core. We test the ability of such a strategy to obtain absolute return properties similar to those of the dynamic core-satellite approach described above.

To do so, we run simulations in which we assume that a tactical manager has positive forecasting skill; that is, that he correctly forecasts monthly satellite outperformance seven times out of twelve (his hit ratio, in other words, is at least 7/12). We assume hit ratios from 7/12 to 11/12. Our scenarios also assume that the manager will allocate 0% of the portfolio to the satellite if he thinks the satellite will underperform the core the following month and 50% if he thinks that it will outperform.

The resulting scenarios show that though they obviously have attractive average returns such strategies suffer from severe drawdown. Even with extremely high and clearly unrealistic hit ratios of 11/12 maximum drawdown is considerably higher than in the absolute return portfolio based on the dynamic core-satellite approach we described above.

It is natural to wonder whether it is possible to combine the return potential of forecasting and downside risk management that would mitigate the high maximum drawdown. We thus integrate the active manager’s forecasting ability into the dynamic core-satellite investment concept. Since the main objective is to reduce the drawdown statistics that result from the errors of skilled forecasters, we define the floor so as to impose a maximum drawdown of 10%. If the manager expects the satellite to outperform the core, the multiplier is set to m=5. But if he expects the satellite to underperform, the multiplier is set to m=0. In such situations, the portfolio is fully protected from the expected negative performance of the satellite.

Exhibit 5 shows the percentage by which combining the DCS (dynamic core satellite) framework and forecasts reduces the maximum drawdown found in standard tactical allocation (forecasts alone).

Exhibit 5: Reduction of the maximum drawdown when forecast-based tactical asset allocation is made part of the dynamic-core satellite framework.

The table clearly shows that risk control leads to significant benefits, especially when the hit ratio is comparatively low. In short, dynamic risk budgeting makes it possible to limit the severe drawdown resulting from forecast errors in the standard tactical allocation strategy. The same forecasting ability was used for both strategies.

The two examples summarised here show that the dynamic core-satellite approach provides a coherent framework with which to structure portfolios that allow investors to gain exposure to the upside potential of certain asset classes and to keep risk, either absolute or relative to a benchmark, under control. It is kept under control by rebalancing the positions in keeping with the investor’s dynamic risk budget. Since ETFs are easily traded, they are a natural medium for such strategies. In addition, the wide range of indices tracked by ETFs makes it possible to further customise the core and the satellite. These examples, then, are some of the possible applications of ETFs. We turn now to the survey responses.

Current Use of Exchange-Traded Funds by European Investment Professionals

In general, the survey shows that ETFs are very popular and widely used by European investors and asset managers. However, the current use of these products stops short of harnessing their full potential. We summarise the main results of this analysis in the following key conclusions.

1. ETFs Experiencing Strong Ongoing Growth

The survey highlights the ongoing growth in the use of ETFs for all asset classes. When the use of ETF and ETF-like products over time is analysed, the tremendous growth of this financial product becomes apparent. Exhibit 6 shows that ETFs for all asset classes gained popularity over the past three years. ETF use in the equity universe has increased from 45% to 95%. ETFs in government bond investments have seen the biggest increase: 80% of respondents reported using them, up from 40% the year before.

Exhibit 6: Use of ETFs and ETF-like products over time

2. ETFs are Used Predominantly for Equity Investing

ETFs are still most heavily used for equity investing. Indeed, as exhibit 7 shows, they make up more than a third of the average respondent’s equity investments (and 22% of commodity investments). The dominance of equity ETFs can be attributed in part to the satisfaction with equity ETFs: 94% of all equity ETF investors report that they are satisfied with their choice of investment.

Exhibit 7: For each asset class, indicate the percentage of total investment accounted for by ETFs or ETF-like products

3. Dominance of Broad Market Indices and Static Strategies

Exhibit 8 shows how frequently survey respondents use ETFs for various purposes. It is clear that ETFs for broad market coverage are more frequently used than ETFs for specific sub-segments. Likewise, long-term buy-and-hold investment is more frequent than short-term (tactical) investment. These results are surprising; after all, two of the clear advantages of ETFs are that they offer investment media for tracking particular sub-segments of the market and they are a liquid and easily traded instrument.

Exhibit 8: How often do you use ETFs for the following purposes?

4. ETFs for Alternative Assets Face Challenges

ETF products for the alternative investment universe are currently up against challenges, probably as a result of the current financial and economic crisis. Although ETFs are still gaining market share in the alternative asset class, growing dissatisfaction suggests that these gains may be hard to sustain. As exhibit 9 shows, satisfaction with real estate and hedge fund ETFs has fallen in 2009. In fact, dissatisfaction with hedge fund ETFs has resulted in a fall from 7% to 5% in the share of total hedge fund investment accounted for by ETFs.

Exhibit 9: Satisfaction with ETFs and ETF-like products over time

5. Advanced Features of ETFs are Little Used

Advanced uses of ETFs, such as securities lending, trading options on ETFs, and short selling ETFs are used by only a small fraction of respondents (less than 15%). Inverse-performance ETFs, by contrast, are used by almost 30% of all respondents (see exhibit 10).2 As our survey shows, the failure to use advanced ETF products and advanced ETF trading strategies is not a result of unawareness of such techniques: as it happens, fewer than 10% of all ETF users report that they are unaware of them. Although they are not yet widely used, the survey shows that these features are twice as likely to be used as they were twelve months earlier. It is likely that this increase will continue.

Exhibit 10: Advanced uses and forms of ETFs

6. ETFs and Futures are the Preferred Indexing Instruments

We ask survey respondents to rate ETFs, futures, total return swaps, and index funds on several criteria. The responses indicate that in terms of liquidity, transparency, and cost ETFs are considered advantageous, although on some criteria they are less well regarded than futures. Next, ETFs are ranked highest for the range of indices and asset classes they make available. Futures are perhaps the most serious rival to ETFs, but ETFs are preferred for their lower minimum subscription, fewer operational constraints, and the friendlier tax and regulatory regimes to which they are subject. Implementation concerns (margin calls, applying exact allocations even for small portfolios) give ETFs an advantage over futures.

7. Future Developments

Emerging market equity ETFs (47%) are the ETF product respondents would most like to see developed (exhibit 11). About a third of the respondents would also like to see products developed in alternative asset classes, especially in commodities (35%), currencies (30%), and hedge funds (28%).

Exhibit 11: What type of ETF products would you like to see developed further in the future?


The objective of the EDHEC European ETF Survey 2009 is to provide insight into current and potential uses of ETFs. To reach this objective, we analyse the uses to which European investors and asset managers put ETFs as well as their perceptions of these instruments. We also provide an introduction to dynamic core-satellite portfolio management and show how investors can structure risk-controlled portfolios of ETFs to meet particular risk objectives. Taken together, our illustrations of dynamic core-satellite portfolios highlight the potential benefits of combining the tradability of ETFs and dynamic risk management. Although core-satellite investments can be static, the illustrations show that their full potential is reached when the allocation to the satellite and the core is adjusted dynamically. The main benefit of this dynamic adjustment is that it allows investors to take advantage of rising markets and, at the same time, limits their risk. As a result, dynamic core-satellite strategies often offer a better risk/return trade-off than core or satellite investments. In addition, maximum drawdown, i.e., extreme risk, is limited.

The uses to which European investors put ETFs provide a few interesting insights. First, ETFs are now widely used and practitioners are highly satisfied with their features. Indeed, ETFs are now the preferred indexing instrument. They are considered to have an edge over total return swaps and traditional index funds for their liquidity, transparency, and cost; futures are a more serious challenger. However, respondents appreciate the wide range of products and asset classes made accessible by ETFs (futures do not provide access to quite such a wide range). Second, in some specific market segments, ETFs are currently dealing with challenges. Indeed, dissatisfaction with ETF products for corporate bonds, real estate markets, and hedge funds is growing (probably as a result of the current financial crisis). In these asset classes, the combination of adverse market conditions and relatively illiquid underlying assets presumably poses problems for ETF product providers. Third, our survey shows that ETFs are not yet used to their full potential. For example, the use of ETFs is largely limited to passive holdings of broad market indices. In fact, more than two-thirds of all ETF users report that they frequently use ETFs to obtain broad market exposure; and for more than 50% ETFs are predominantly long-term or buy-and-hold investments. Fewer than 50% of respondents report that they frequently rely on ETFs for short-term investment or for exposure to specific market sub-segments. Nor do most practitioners trade options on ETFs, sell ETFs short, or lend them out, although they are more likely to do so than in years past.

The EDHEC-Risk European ETF Survey 2009 was produced with the support of CASAM ETF.