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The EDHEC European ETF Survey 2006

The EDHEC Risk and Asset Management Research Centre has carried out an in-depth study on the use of ETFs (Exchange-Traded Funds) by European investors.

The questionnaire for the EDHEC ETF survey was addressed to the top 1000 European asset managers and institutional investors in the summer of 2006 and generated responses from 112 European institutional investors and asset managers.


European market development
Given that the European exchange-traded fund (ETF) market has been enjoying outstanding development since its inception in 2000, this survey analyses the use of ETFs among a representative sample of European investment managers and institutional investors.

In fact, assets under management (AUM) in ETFs has risen steadily since 2000 and reached $71.34 billion by the end of June 2006.

The increasing popularity of ETFs is reflected in the responses of survey participants. More than half of respondents are current or planned users of ETFs in equity investments (61%), and this is also the case for more than a quarter of respondents (26%) for bond investments.

In addition, European institutional investors and asset managers agree that the future development of ETFs will be stronger than that of other forms of indexed investing, as becomes apparent from the answers to the following question shown below.

How would you predict your future usage of the following instruments?

When asked about which types of ETFs will develop the most strongly in the future, respondents placed the emphasis on ETFs based on emerging market indices, alternative assets and commodity indices. This provides some evidence for further growth of the ETF market in the near future to be concentrated in such alternative asset classes.

Core-satellite portfolio management

As a result of tight tracking error constraints, only a limited part of traditionally managed portfolios is actively managed, while the essential part of the portfolio passively replicates its benchmark. A paradigm change is taking place in asset management with the core-satellite approach that advocates a clear separation of a core portfolio managed passively from one or more very actively managed satellites. In terms of tracking error management, the core portfolio closely replicates the benchmark, so that the tracking error comes from the tracking error of the satellite portfolio. Investors may therefore make use of very active satellites and still ensure an overall tracking error that is relatively low, because the satellite has a low weight in the overall portfolio. Separating alpha and beta management by using a core-satellite approach allows for the following:

1. a better distinction between good and poor performers;
2. manager diversification in the satellite portfolio;
3. greater transparency and costefficiency.

From our survey, it becomes evident that a majority of European institutional investors and asset managers have come to appreciate the benefits that the core-satellite approach to portfolio management offers, as can be seen from the following graph.

Have you implemented (or are you going to implement?) a "core-satellite"-type organisation of your allocation?

ETFs provide a natural investment vehicle in such an approach since they may be used to construct a benchmark of ETFs (i.e. a core portfolio) and they may also be used in the satellite portfolio (in the case of a tactical allocation strategy between different ETFs).

Benefits of optimal allocation in the core portfolio: Risk reduction obtained through allocation techniques in empirical examples across different data sets

Optimal allocation in the core

The above table summarises the results of a number of empirical examples that are presented in more detail in the survey’s background section. It can be seen that optimal allocation between indices for subcategories (such as distinct equity or bond investment styles) allows for significant risk reduction compared to a global index. In addition, it can be seen that the dynamic core-satellite approach has potential to reduce the risk of a static allocation between a core portfolio of ETFs and a satellite portfolio of ETFs.

Optimal allocation between the core and the satellite

Investors generally realise that the tracking error associated with the satellite portfolio is not necessarily bad. Just like with good and bad cholesterol, there is “good” tracking error, which refers to the outperformance of a portfolio with respect to the benchmark, and “bad” tracking error, which refers to underperformance with respect to the benchmark. By severely restricting the amounts invested in active strategies as a result of tight tracking error constraints, investors forgo an opportunity for significant outperformance, especially during market downturns. A relative risk version of constant proportion portfolio insurance (CPPI) actually allows investors to gain full access to good tracking error, while maintaining the level of bad tracking error below a given threshold, based on an optimal dynamic adjustment of the fractions invested in a passive core of ETFs versus an active satellite portfolio of ETFs.

In the following example, we consider a core-satellite portfolio, where the core is simply made up of the MSCI EMU index (large cap stocks) and the satellite is made up of the MSCI Small Cap EMU index (small cap stocks). This example allows us to show how it is possible to reduce the risk of the anomaly effect sometimes observed between the return of large cap and small cap stocks and encountered during the first period of our study. As illustrated below, in the long run, small cap stocks outperform large cap stocks. Our approach makes it possible to benefit from the small cap premium while not suffering from the short-term unfavourable period.

Relative returns of Small Cap versus Large Cap

This graph shows the relative return of small cap versus large cap during the whole period of January 1994 to December 2005.

The results obtained with the dynamic core-satellite approach are contrasted with those obtained with the static core-satellite approach in the table below. It can be seen that the static core-satellite portfolio suffers significantly more from the poor performance of the satellite in the first period than the portfolio constructed using the dynamic approach. What is more, the dynamic approach also outperforms the static portfolio in the second period, where the satellite outperforms the core.

Benefits of the dynamic core-satellite approach

ETFs in equity investing

In the field of equity investments, 45% of respondents are seen to be using ETFs at present, and 16% stated that they would start using ETFs soon. This result is consistent with the fact that ETFs are becoming increasingly popular. However, there were still as many as 37% of respondents who were not using ETFs, and not considering using them any time soon, which means that there remains considerable room for ETFs to develop. More importantly, among those that use Equity ETFs, 92% were satisfied, an extremely high level of satisfaction. The graph below shows several reasons why respondents declared their satisfaction. For 45% of responses, the most distinct reason for satisfaction was the reliability of the tracking error. 23% were satisfied with the performance of ETFs, while 21% were pleased with the level of liquidity, and only 4% cited the reduced expense of ETFs. Interestingly, half of the respondents who were not satisfied with Equity ETFs pointed to the poor level of liquidity of ETFs.

Are you satisfied with the use of ETFs in equity investment?

ETFs in bond investing

As stated above, ETFs are significantly less popular in bond investing than they are in equity investing. Only 13% of respondents were trading treasury bond ETFs at the time they responded to the questionnaire and another 13% were considering the use of ETFs in the near future. This reluctance of practitioners to use ETFs for the fixed income class comes in spite of the potential benefits of active allocation between bond ETFs, which have been documented in the literature.

When respondents are asked about their satisfaction with bond ETFs, a considerably larger fraction expresses dissatisfaction than in the case of equity ETFs. Among the respondents who are users of government bond ETFs, 80% found ETFs were satisfactory. 35% named the reliability of the tracking error, 30% the reduction in expenses and 15% the good level of liquidity. But there remained 5% of users who were dissatisfied with the poor level of liquidity of ETFs, while another 15% were not content for different reasons.

Are you satisfied with ETFs in your government bond investment?

The problems with treasury bond ETFs are apparently exacerbated when it comes to the case of corporate bonds. There are as many as 73% of respondents that do not use ETFs in this segment. Only 6% were trading corporate bond ETFs and 13% were planning to use them soon.

In terms of satisfaction, low expense was the most popular feature of this investment instrument and was cited by 42% of users. 17% of users claimed they were satisfied with the reliability of the tracking error. However, the poor level of liquidity of corporate bond ETFs was cited by 17% as a reason for dissatisfaction.

Are you satisfied with the ETFs in your corporate bond investments?

A potential additional explanation for the relatively poor acceptance of bond ETFs would be that more product development is needed in the fixed-income arena before European institutional investors and asset managers would consider increased use of such instruments.

ETFs for other asset classes

Concerning the main future axes of development for ETFs, a clear majority of survey respondents quotes emerging markets (49%), commodities (36%), and, more broadly, alternative asset classes (41%). However, currently, only a small percentage of respondents are using such funds.

In the hedge fund universe, investable index products were not as popular in hedge fund investments as in the traditional field due to their relatively recent appearance. Only 7% of respondents were trading them. However there were 15% of respondents who were planning to use such instruments in the near future.

Among the small group of users, only 27% were actually satisfied with the product they use. This can probably be explained by the fact that investable indices providers seek to promote track records that optimise the performance of their investment support “in sample”, a well known commercial practice that leads to favouring backward-looking performance optimisation, instead of considering the robustness of future performance.

In the area of real estate investment, only 6% of respondents were trading ETFs and 11% were planning to start trading such instruments soon. This is consistent with the fact that real estate ETFs are newly invented instruments. Half of users stated that real estate ETFs were satisfying because of the good level of liquidity they provided, the reliability of the tracking error and their good performance. Among the other half, liquidity was the main issue leading to dissatisfaction.

Although, like real estate exchange-traded funds, commodity ETFs have only been introduced recently, they were more popular among respondents. 15% of respondents were trading commodity ETFs and another 20% showed their interest in stepping in soon. The percentage of satisfied users was also greater than that of the alternative investment classes above. Among the 65% of satisfied users, 30% appreciated the performance of commodity ETFs, 20% cited the reliability of the tracking error and another 15% declared benefits from the level of liquidity. But there remained 10% who cited the poor level of liquidity as a reason for dissatisfaction.

Comparison between ETFs and other indexing vehicles

Survey respondents were asked to rank exchange-traded funds, futures, total return swaps and index funds according to various criteria. The responses we obtained allow for a few general conclusions.

First, in terms of liquidity and transparency, ETFs were considered as advantageous although they were less well-ranked than futures with respect to some criteria.

Second, ETFs were ranked as the best in terms of tracking error and the available range of indices and asset classes. Therefore, European investors and asset managers seemed to be well aware of the product diversity of exchange-traded funds, which has been dramatically enhanced in the past few years (see part I of this document).

Third, futures seemed to be ETFs’ most serious challenger, but ETFs were perceived as superior with regard to minimal subscription, operational constraints and the tax and regulatory regime. Therefore, it appears that implementational concerns with futures (such as position rolling and margin calls, and applying exact allocations even for small-sized portfolios) put ETFs at an advantage.

Fourth, respondents consider that ETFs perform much better than total return swaps under each criterion.

These findings may be explained by a lack of familiarity with total return swaps to some extent, as a large bulk of respondents did not reply. However, even among those who did reply to the question on total return swaps, these instruments were not considered to be superior.

Conclusion
The results in our survey show that following their rapid development, ETFs have established themselves as a widely used instrument among European institutional investors and their asset managers. ETFs are widely used for a variety of asset classes such as equity, fixed income and alternative asset classes. However the main area of usage remains in equity portfolio management where more than 90% of respondents who make use of ETFs are largely satisfied with their properties.

However, only a low percentage of respondents use ETFs for asset classes other than stocks. In particular bond ETFs, especially for certain maturity segments, are not widely used. This is surprising given that more efficient bond benchmarks (or core portfolios) can be constructed using an optimal allocation between subcategories and that alpha-generating strategies (or satellite portfolios) have been shown to be achievable using tactical allocation between such indices.

When comparing ETFs to alternative methods of indexed investing, European investment management professionals quite clearly favour ETFs over instruments such as futures, traditional index funds and total return swaps.

Consequently, 55% of respondents think that the use of ETFs will increase in the near future, while only 34% have the same opinion about futures, and other instruments achieve even lower scores.


The EDHEC European ETF Survey 2006 was sponsored by iShares.