Jonathan Reynolds from Capital Cranfield, ETFGI's Deborah Fuhr, iShares' Mark Johnson, JLT's Peter Martin and Simon Riviere of PTL discuss whether trustees are set up to make direct investments in exchange traded funds in the final part of this three-part debate.
Simon Riviere: Trustees would need to be very well advised and understand the nature of ETFs. This would require some training or education – they would need to have the time to understand the aim and technicalities. But I can see a time where trustees would consider ETFs – it is part of the overall options.
Peter Martin:
I can see a time where trustees would consider ETFs – it is part of the overall options
Simon Riviere, PTL
We have seen occasions when trustee bodies have said, ‘Philosophically, we will not apply active management. It must be passive all the way through, with every single asset class.’ The question is then, what is the most appropriate form of passive exposure? That is where I see the majority of the ETF discussions currently.
Riviere: Is that over traditional index funds?
Simon Riviere: Trustees would need to be very well advised and understand the nature of ETFs. This would require some training or education – they would need to have the time to understand the aim and technicalities. But I can see a time where trustees would consider ETFs – it is part of the overall options.
Peter Martin: We have seen occasions when trustee bodies have said, ‘Philosophically, we will not apply active management. It must be passive all the way through, with every single asset class.’ The question is then, what is the most appropriate form of passive exposure? That is where I see the majority of the ETF discussions currently.
Riviere: Is that over traditional index funds?
Martin: Yes.
Mark Johnson: But then it is about the cost comparison mentioned earlier.
Riviere: Yes, you are then thinking about time horizons and cost.
Johnson: In a situation where one is saying: ‘I want passive exposure to that market’, which may be because of cost or investment beliefs, one has choices and it is important to evaluate those on a case-by-case basis.
But a recent example – which is very live at the moment and seems to resonate – is the availability of investment-grade credit. The impact of Basel III on the banks is that the cost of capital for the banks in holding inventory has gone up. That means the availability of investment-grade credit in the secondary market has become more limited.
A group of trustees may wish to invest in investment-grade credit, but it can be difficult for their managers to ramp up that exposure quickly. There just is not the depth of liquidity at the moment because of the lack of inventory. In that circumstance, ETFs, as an example, can be a very easy way for you to get liquid, diversified exposure.
Martin: The word transparency has been used a lot here. From my experience I have found some ETF providers, but not all, are not overly transparent. They may not explain sufficiently what they do, how they do it and how they pursue their tracking index.
The opaqueness also seems to be stronger the more they have used derivatives in gaining underlying exposure. We believe in ETFs that use physicals rather than derivatives. This is not all or nothing, although that is our general preference.
There just is not the depth of liquidity at the moment because of the lack of inventory. In that circumstance, ETFs, as an example, can be a very easy way for you to get liquid, diversified exposure
Mark Johnson, iShares
Nonetheless, you cannot get away from the fundamentals – whoever you are using has to have a credible passive approach and can track an index. This is a wrapper, but if they cannot track an index for toffee you do not want to use them.
Q: But a typical DB scheme will use all kinds of derivatives for other parts of its investment strategy. Why are ETFs any different?
Jonathan Reynolds: I would not say they are. But the key thing is the phrase which was used earlier: ‘I do not know.’ If your trustees start using the phrase: ‘I do not know,’ that is when the alarm bells start to ring.
Q. Do you think trustees really understand how an inflation swap works?
Reynolds: The ones that use it should do. That is the key. If you are using it, you need to understand it. If that is the line you have gone down, you better have the training budget to make sure you have done it. You better have done the due diligence on it to make sure it works. If you have not, your head is on the chopping block. That is the key thing on this.
I have absolutely no problem with the use of ETFs if you have the budget to do the training, to understand what you have and how it fits with your SIP [statement of investment principles]. If your governance budget is there, it is fine. But – and it is quite a significant ‘but’ – that is not always the case.
It is not easy to go to the finance director of a company and say: ‘I know you are already paying these recovery contributions. Under the new funding code we are also going to have get quite an expensive employer covenant review. But on top of that we want to do…’ The list gets longer and longer. In the end, there is always a compromise. You have to say: ‘What can we do? What can we not do?’ That is never ideal. In an ideal world you could afford to do all of these things. That is great, but that is not reality for the majority of schemes.
Martin: Understanding is definitely important for trustees. But as a trustee, [you must] focus on the outcome and how this helps you achieve what you need for the scheme and that you have a range of tools with which to achieve that. What is it trying to achieve? If it is the most appropriate thing to do, that is fine.
I am just saying that for direct use, ETFs are probably of limited usage. There is probably, from the fund management toolkit, some greater use to come from defined contribution and self-invested schemes. It is never all or nothing. There is always something in between. It is where it is appropriate.
Q. What is the difference between the risks associated with physical ETFs and derivative-based ETFs?
Deborah Fuhr: You would find that most investors prefer something that is simple – that is really what it is about. It is not necessarily about counterparty concern.
If getting from point A to B is easiest by just walking down the street, you are going to do that rather than go around the corner, across the bridge and around. If you are going to buy an ETF that is providing exposure to Japan and it is buying a basket of Japanese equities – it is pretty easy for people to understand how that works. The challenge was when we talked about buying a synthetic exposure to Japanese equities.
For many of the providers in France, for the ETF to be tax-efficient in the PEA schemes [a long-term savings vehicle], they would have to be holding 70 per cent of the fund in eurozone securities. I then have to describe to you how a fund that is holding 70 per cent eurozone securities using a funded or unfunded swap is giving you exposure to Japan. That is complicated.
It is just easier for people to understand a physical ETF. It acts like a normal fund, it buys securities and they feel comfortable with that. That preference has caused many of the providers to change the way they run their ETFs today.
A number of the larger ETF managers who were historically doing synthetic products have, based on investor preference, moved their product set to being physical, or having some physical products.
