Despite the rapid growth rate of the ETF market, these funds have yet to make significant inroads with pension schemes, with high costs often cited as a reason for the slow take-up. What needs to change to prompt more wide-scale adoption of ETFs amongst institutions?

Exchange-traded funds saw record worldwide inflows of US$105 billion during the first half of 2012, according to BlackRock. Yet the pension fund sector has so far remained a fairly hesitant buyer of these listed tracker funds.

In the US, the most established ETF market, Greenwich Associates recently found that only 14% of institutions (including corporate funds, public funds, endowments and foundations, and institutional asset managers) use ETFs in their portfolios. Outside the US, in less mature ETF markets, penetration is even lower.

Fees appear to be ETFs’ biggest barrier to entry into institutional portfolios. As Ana Moreno, communications manager at the Pension Protection Fund, explains: “We don’t use ETFs, but we’re not against them in principle. Where we have thought about using them we found them more expensive than other routes.”

According to figures from Towers Watson, the cost for an institutional investor of a typical passive global equity portfolio of over £50 million in size would be between 10 to 15 basis points (bp) a year. Meanwhile, comparable ETFs charge 25 to 50 bp.

“That is quite a big fee gap,” says Roz Amos, senior investment consultant at Towers Watson. “ETFs would have to become a lot cheaper if they want to compete with mainstream institutional products.”

However, some asset managers and ETF providers say pension funds are too focussed on ETFs’ total expense ratios (TER) and are not comparing ETFs with comparable passive investment products, such as mutual funds, on a true, like-for-like basis.

In particular, they say, when tracking difference is taken into account the true cost of ETFs, by comparison with index-tracking mutual funds, is significantly decreased or even eliminated.

For example, if the FTSE 100 index rose 10% over a year, an index-tracking fund with a 10 bp cost should rise 9.9%. However, says, Christopher Aldous, chief executive of Evercore Pan Asset, a fund manager, the performance gap is often bigger.

“In many cases index funds only rise 9.8% due to undisclosed stamp duty or dealing costs,” notes Aldous. “An ETF can go up by 9.9% or 10%, though. On the basis of tracking difference against the index, ETFs are generally as cheap or cheaper by a couple of basis points, as well as offering the additional benefit of liquidity.”

Alan Miller, founder and CIO of SCM Private, a fund of funds manager using ETFs exclusively, believes the costs of mutual funds can be significantly higher than pension funds realise due to a relative lack of disclosure.

“ETF charges may look high due to their transparency, but the best way to look at it is their net performance against the index plus the costs of buying and selling them,” argues Miller.

“Particularly for smaller pension funds, the headline costs of mutual funds look reasonably low, but they can’t see what the real cost is. The costs are quite often two or three times the level they think.”

iShares, the most widely-used ETF provider worldwide, also urges investors to look beyond the TER and to focus on the other drivers of the total cost of ownership of an ETF. According to iShares, the TER of an ETF can be offset with a range of value-adding activities, such as securities lending.

Over the year to 31 May 2012, for example, the post-TER tracking difference against its index benchmark of the iShares Euro STOXX 50 ETF, which charges 35bp a year in expenses, was a positive 46bp, with the outperformance of the ETF being driven partly by securities lending revenue.

[The securities lending opportunities inherent in the Euro STOXX 50 and comparable European equity indices, the reasons behind them and their impact on fund tracking error are covered in more detail in IndexUniverse.eu’s feature article “ETF as Precision Tool?”]

After an estimated 10bp of trading costs, iShares says investors buying its funds are still likely to be 36 bp better off a year later than if they’d received the return from the fund’s benchmark, the Euro STOXX 50 with dividend income reinvested net of withholding taxes (although brokerage fees, which vary from investor to investor, will need to be considered on top of this).

David Gardner, head of EMEA sales for iShares, says: “This is an example of where looking at TER alone does not give an accurate indication of the total cost of ownership of an ETF, which needs to be considered when investors are making comparisons between ETFs or between ETFs and other passive index tracking funds."

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