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The EDHEC European ETF Survey 2008

In view of the growth and development of ETFs in Europe, and in view of their growing popularity as investment media for both index management and the construction of benchmarks, EDHEC has devoted significant resources to research into ETFs. In 2006, with the support of iShares, we published the first EDHEC European ETF survey. The present survey, an update and extension of the 2006 survey, sheds light on recent developments and trends in ETF investing.


The EDHEC European ETF Survey 2008 relies on a questionnaire that elicited responses from 111 European institutions to analyse the current use of ETFs by European investors and asset managers. In addition, we provide an outlook on future use by (i) asking respondents to comment on future developments and (ii) providing a methodology for using ETFs in a state-of-the- art dynamic risk budgeting process. Thus, we hope to provide insight into how ETFs could be used to further benefit investors. The current survey also provides insight into developments over time, as we can compare results with an earlier survey EDHEC published in 2006.



Current Use of ETFs

Overall, the analysis of responses we obtained to our questionnaire leads us to the conclusion that, while ETFs are very popular and widely used among European investors and asset managers, 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. Dominance of broad market ETFs

When using ETFs in constructing equity core portfolios, 94% of respondents use ETFs on broad market indices, while only 19% use style ETFs that track finer subcategories of the equity market. Consequently, the possibility of using ETFs to construct optimal core portfolios composed of different equity styles or segments is largely neglected. This neglect is surprising, as the advantage of the wide range of ETFs is precisely that it makes it possible to design precise allocations that correspond to the investor’s long term risk/ return objectives, as opposed to accepting an allocation inherent to a broad market index. The dominance of broad market ETFs in respondents’ core portfolios is not limited to equity investments, but is also found with government bond and corporate bond portfolios.

2. ETFs in the satellite

ETFs are now widely used in satellite portfolios. 54% of respondents make use of ETFs in their satellite portfolios, which corresponds exactly to the percentage of respondents using ETFs in the core. This result is interesting, as one of the initial precepts of the core-satellite approach was to use very active instruments in the satellite. However, the outperformance of the satellite may of course be generated by exposure to different forms of beta (smallcap stocks, value stocks, credit risk, and so on) rather than to manager alpha. Our survey results suggest that current industry practice acknowledges the role played by such beta management in the satellite portfolios.

3. ETFs for alternative assets on the rise

Our survey results likewise suggest a substantial increase in the popularity of ETFs and ETF-like products for investing in alternative assets. The percentage of respondents using ETFs for commodities, real estate, or hedge funds has increased considerably since our earlier survey in 2006. For each alternative asset class mentioned, 30% to 50% of respondents actually use ETFs. In 2006, only 5% to 15% of respondents used ETFs for a given alternative asset class. Thus, it seems that recently launched products such as real estate ETFs, commodity ETFs, and investable hedge fund products are now widely used by European investors and asset managers. Moreover, along with emerging market products, ETFs on alternative asset classes rank most highly on the wishlist of European investors and asset managers for future product development. Finally, when asked where they see the greatest increase in their future use of ETFs, 44% state it will be in accessing new types of asset classes.

4. ETFs still focus on equity investing

ETFs are still most heavily used for equity investing. Indeed, they make up more than 20% of the average respondent’s equity investments. For bond investments, ETFs do not quite make up 10% of assets. This result is confirmed when looking at the percentage of respondents using ETFs for a given asset class. 78% of respondents use ETFs in equity investing, while less than half use ETFs in fixed-income investing, commodities, and real estate. Satisfaction with ETFs is also higher in equity investing. In fact, 92% of respondents are satisfied with their equity ETF investments, while only 66% (85%) are satisfied with their corporate bond ETFs (government bond ETFs).

5. Advanced features of ETFs are underused

Possibilities such as ETF securities lending, trading options on ETFs, and short-selling ETFs are used by only a fraction of respondents. Even if we include the respondents who say they may use the feature in the future, no more than 13% of respondents are current or potential users of any one of these features. Inverse-performance ETFs, by contrast, are or will be used by more than 30% of respondents. The number of respondents who will use these features in the future is high with respect to the number of current users, suggesting that growth can be expected in ETF lending, ETF options trading, and the short selling of ETFs.

6. ETFs and futures are the preferred indexing instruments

We ask respondents to compare ETFs to futures, traditional index funds, and total return swaps across a number of criteria. In terms of liquidity, transparency, and cost, ETFs are considered advantageous by respondents, although they are less well regarded than futures with respect to some criteria. ETFs are viewed as the best in terms of available range of indices and asset classes. It is clear then that European investors and asset managers are well aware of the product diversity of exchange-traded funds, which has increased greatly in recent years. Futures are perhaps the most serious rival of ETFs, but ETFs are preferred for their lower minimum subscription, fewer operational constraints, and friendlier tax and regulatory regimes. The implementation concerns with futures (margin calls, applying exact allocations even for small-sized portfolios) give ETFs an advantage.

7. Passive ETFs with full replication are the preferred choice of investors

A large majority of respondents prefer passive ETFs. Active ETFs are preferred by only about 11% of respondents. Likewise, only 16% of respondents say they would like to see the development of more actively managed ETFs. For the construction of passive ETFs, the majority of respondents prefer pure replication of the index by holding all components at the required weight. Synthetic replication and statistical replication are seen as less attractive than full replication. Synthetic replication through derivatives, however, is significantly more popular (with 20% of respondents) than statistical replication (with 7% of respondents). It should be noted that the low acceptance of statistical replication may constitute a potential barrier to the further expansion of ETFs in asset classes with low liquidity, where full replication may not be feasible.

8. "Indexing" is on the rise. ETFs will benefit most, without harming other indexing vehicles

We ask respondents to identify the instrument they are most likely to use more in the future. Intentions of future use of ETFs, futures, total return swaps, and index funds reveal that future use is trending upward for all four categories. Moreover, ETFs are the instruments that will benefit most from increased use of indexing instruments. 69% of respondents plan to increase their use of ETFs, while only 3% plan to decrease it. For futures, 36% of respondents plan an increase, while 2% plan a decrease. For total return swaps, only 18% plan to increase their use, and 9% of respondents plan to decrease it. Index funds are the only instrument for which an increase in future use is not pronounced: 23% intend an increase and 19% a decrease. Overall, it seems that the anticipated increase in ETF use will not necessarily hinder the further development of other indexing vehicles.

Compared to the earlier survey conducted by EDHEC in 2006, one can see that the perception of the comparative advantage of ETFs has remained similar but that the use of ETFs has been growing across all asset classes. The table below provides a comparison of the key results of the two surveys.

As these results show, the use of ETFs in the equity universe has increased from 45% to 78%. In addition, for the other asset classes, ETFs are used by 30% to 50% of respondents to our 2008 survey, as opposed to 5% to 15% in the previous survey. Satisfaction with ETFs has remained at high levels or increased slightly for equity and bond ETFs. For ETFs or ETF-like products on alternative asset classes, satisfaction rates have advanced tremendously. Overall, the 2008 survey points to a continuation and even to an acceleration of the trends suggested by the 2006 survey.

ETF use 2008 vs. 2006: percentage of users and satisfaction



New Risk Budgeting Techniques: Applications with ETFs

In addition to providing an analysis of the current use of ETFs in the industry, we provide an overview of novel ways of making ETFs part of portfolio management. We show how various ETFs may be used in the context of dynamic risk budgeting.

Core-satellite portfolios are usually constructed by placing assets that are supposed to outperform the core in the satellite. However, during some periods these assets may underperform the core. The dynamic core-satellite approach described in more detail in the full report makes it possible to reduce the impact of a satellite on performance during a period of relative underperformance, while maximising the benefits of the periods of outperformance.

In our illustrations, we implement the dynamic core-satellite approach (Amenc, Malaise, and Martellini 2004). This method allows asymmetric tracking error management. It leads to an increase in the fraction allocated to the satellite when the satellite has outperformed the benchmark. Indeed, the accumulation of past outperformance results in the potential for a more aggressive (and hence higher tracking error) strategy in the future. If the satellite has underperformed with respect to the benchmark, the method leads to a tighter tracking error strategy in an attempt to ensure the guarantee of the relative performance objective.

To provide a feel for the results in the full document, we summarise two examples. In the first, the investor chooses to add an ETF of value stocks to generate outperformance. In the second, we use the dynamic risk budgeting approach to construct an absolute return fund based on ETFs. We now provide a glimpse of the results of these two examples.

1. Optimal packaging of value exposure

The evidence of a value premium in academic finance has led many investors to tilt their portfolios in the direction of high book to market stocks or, more broadly, towards stocks with low valuation ratios. A straightforward way of accomplishing this value tilt is by adding an ETF based on a value index as a satellite portfolio.

The figure below indicates the cumulative outperformance of the value index over the large-cap index. As the figure shows, a period of underperformance is followed by a period of overperformance of the value index.

Value minus large-cap spread. Cumulative returns

The table below provides risk and return statistics for different investment strategies with ETFs. The first line shows the performance for an investor who holds large-cap stocks over the test period, that is, for the investor who holds a core without a satellite. Line 2 shows the performance of the satellite, represented by an index for value stocks. Line 3 shows the performance for an investor who adds value stocks as a satellite to his large-cap core portfolio in such a way that they make up 25% of the overall portfolio. In this static core-satellite approach, the weight of the satellite is fixed. Line 4 now shows the dynamic core-satellite approach, in which the weight of the satellite is readjusted so as to control tracking error in an asymmetric manner.

Risk and return statistics for investment strategies with ETFs

As the average returns in the first column of the table show, the value index does not provide much outperformance over the entire period. Consequently, the static core-satellite portfolio adds little performance to the core portfolio (6.08% average annualised returns versus 5.95% for the core). However, adding the satellite in a risk controlled manner through non-linear risk management yields an annualised average return of 8.22%. Thus, the dynamic core-satellite approach adds an annual value of roughly 200 basis points over the static core-satellite portfolio.

2. Designing absolute return funds with ETFs

Absolute return funds have become popular in the asset management industry in recent years. These funds claim to provide relatively smooth returns with a limited level of risk. To illustrate how dynamic risk budgeting may be used in designing absolute return funds with ETFs, we combine a core portfolio that invests in medium-term bonds with a satellite portfolio that invests in an equity ETF. The objective of the proposed strategy is to achieve smooth returns because of the low volatility of the core portfolio, as well as to benefit from the returns on the stock market ETF if stocks outperform bonds, all the while ensuring protection from the downside risk of the equity investment.

The figure shows the cumulative returns of the strategy we use, as well as of the core and the satellite portfolios. In addition, to highlight the built-in protection of this investment strategy, the level of the floor is displayed as well.

Absolute return fund: evolution of core, satellite, and DCS portfolios

From this figure, a number of conclusions can be drawn. 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 over the last two years of the period. For the satellite portfolio, returns are higher if we look at the entire period. More importantly, the fluctuations in the value of the satellite portfolio are tremendous, with a sharp rise to the year 2000 and a plunge from then until 2003, followed again by a steady increase until the end of 2007. The dynamic core-satellite approach combines the advantages of each of its ingredients— the smooth performance of the bond core with 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 the satellite alone. It is also interesting to note that as the value of the dynamic core-satellite fund increases, the floor is pulled up to increase the level of protection.

As these examples show, the dynamic packaging of beta exposures makes it possible to outperform naïve static allocation to this beta exposure. In the first example, the dynamic core-satellite technique provides access to the outperformance of value stocks, even though that outperformance is not consistent over the entire time period. In the second example, the conservative nature of the core and the dynamic risk management process both attempt to ensure smooth returns over time. Through the risk-controlled exposure to the equity ETF (the satellite), the absolute return fund provides access to the upside potential of the stock market, while conserving the defensive properties of the core.

The wide range of ETFs on potential satellite assets and the tradability of these ETFs make them ideal for these dynamic allocation strategies.


Conclusion

The results of our survey convey a clear message: ETFs are now widely used and practitioners are highly satisfied with their features. However, the use of ETFs is largely limited to passive holdings of broad market indices. The wide range of ETFs for subcategories and styles is not used to its full potential. Likewise, most practitioners do not benefit from the possibilities of trading options on ETFs, selling ETFs short, or lending them out. ETFs undeniably provide value when it comes to passive exposure to a traditional or alternative asset class. However, we believe that there is considerable value-added in making use of an important feature of ETFs—namely, that they can be bought and sold like stocks. Thus, they are ideally suited for dynamic risk management in portfolio construction. The last part of our study shows that such dynamic risk budgeting has substantial benefits. While the examples provided there are not meant to be complete solutions, we hope to have provided some food for thought on the future use of ETFs.


The EDHEC European ETF Survey 2008 was produced with the support of iShares.