European investors seem keen on embedding active management strategies in indices, but not so much on active ETFs
For me, some of the most interesting debates at the Inside ETFs Europe conference last week were those on indexing and how the benchmarks used by exchange-traded and index funds should be constructed.
In “The Future Of Indexing In Europe”, there was a lively discussion between Paul Kaplan of Morningstar, in one corner, and Denis Panel of BNP Paribas Asset Management, promoter of the EasyETF range, in the other.
In France, said Panel, there’s a real demand for more efficient indices than the traditional capitalisation-weighted versions. Cap-weighted indexing is only efficient if you accept the framework of the Capital Asset Pricing Model of classical portfolio theory (where a cap-weighted portfolio represents the optimum weighting scheme from a risk/return perspective), argued Panel, but if you don’t (and there is plenty of empirical evidence to suggest CAPM is flawed), then you should look beyond this means of indexing. “Risk-based indexation is the future,” Panel concluded.
Not so, said Kaplan. Non-cap-weighted approaches, such as Research Affiliates’ fundamental indexation, are interesting, but they represent a value tilt and thereby a bet against the market, and should be recognised as such, he argued. Furthermore, continued Kaplan, there hasn’t always been “truth in advertising” by the promoters of non-standard index variants.
There’s no value bias in fundamental indexation, added a third voice, from a member of the audience. Fundamental indexing is indifferent to value—it’s cap-weighting that lands you with an inherent bias to growth stocks (and to overexposure to market bubbles).
In another index-focused session, Hartmut Graf, chief executive of index provider Stoxx, commented on the growing tension between index coverage and tradeability that is resulting from the increasingly widespread use of cap-weighting, while Isabelle Bourcier of Ossiam said that strategy, as opposed to cap-weighted indices, allows investors to manage risk more intelligently and efficiently.
Add in the debates from the second day of the conference over the most appropriate way to index equities, fixed income and commodities, and a substantial proportion of the event was devoted to sometimes abstract, but always interesting, theoretical questions of benchmark construction.
But there’s an increasing trend in Europe, it appears, towards the embedding of a wide variety of investment strategies within the indices that ETFs follow. These “strategy” ETFs usually come at a price premium to more traditional cap-weighted funds, and it’s worth remembering panelist Lars Kroijer’s comment that, if you apply the extra fees charged by strategy ETFs only to the portion of the portfolio where index weights differ from those used in traditional index trackers, then you end up with a management charge akin to a hedge fund fee (albeit without the performance kicker). On the other hand, it’s also fair to point out that a few years ago most systematic, rules-based equity selection strategies offered by fund managers tended to be offered only in hedge fund structures, with the equivalent (high) fees. Having such strategies available in ETF format, and at a lower, flat rate charge, is therefore a step forward for investors.
While the question of an ETF’s underlying investment strategy was the subject of broad debate at last week’s conference, there was almost no discussion of one of the hotter topics in the US ETF market, that of active ETFs.
As my colleagues in the US have reported, there’s been a flurry of applications in recent months to the Securities and Exchange Commission for the launch of active ETFs, many of them from fund managers who had previously been absent from the ETF market.
Although the SEC has so far only approved applications for “transparent” active ETFs—those that publish their portfolio holdings daily—it’s also sitting on a number of requests for non-transparent active ETF structures, which would publish their holdings less frequently.
As always, the more you move away from full transparency of the underlying fund holdings, the more difficult it is for market makers to price ETFs for intraday trading. The less transparency there is, the more we’ll charge in terms of bid-offer spread, one trader reminded a gathering of ETF specialists last week.
There have been some active ETF launches in Europe—Pimco Source’s recently listed Euro Enhanced Short Maturity ETF comes to mind, while last year’s MW Tops Global Alpha ETF is another variant, albeit of a very different investment profile.
However, despite the noise being made in the US market about such funds, there appears to be limited demand for them in Europe, a conclusion that was drawn in Edhec’s 2010 ETF survey, released late last year.
European ETF investors appear to be more interested in embedding active management strategies (or strategy tilts) within an index for tracking by an exchange-traded fund, rather than attempting to make the fund itself actively managed.