ETFs in the Institutional Asset Management Area

The EDHEC European ETF Survey 2006 November 21st, 9.00 11.00am ETFs in the Institutional Asset Management Area Jean-René Giraud Director EDHEC Risk and Asset Management Research Centre Sponsored by EDHEC Institutional Days & ETF Summit 2006 1

Layout Introduction An overview of the ETF market Methodology of the European survey The role of ETFs in the asset allocation process ETFs in practice The pros and cons of ETFs, futures, total return swaps and index funds Concluding thoughts EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 2

Introduction An overview of the ETF market Methodology of the European survey The role of ETFs in the asset allocation process ETFs in practice The pros and cons of ETFs, futures, total return swaps and index funds Concluding thoughts EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 3

Introduction The very first Survey on the use of Exchange Traded Funds by European Institutional Investors This survey is a response to the extraordinary development that the European exchange-traded fund (ETF) market has been enjoying since its inception in 2000; It analyses the use of ETFs among a representative sample of European investment managers and institutional investors; Not only does it analyze the current and foreseen usage of ETFs, it also reviews why and how institutional investors include them in their portfolio and how they compare to other vehicles. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 4

Introduction The very first Survey on the use of Exchange Traded Funds by European Institutional Investors This European survey is structured in three sections: The Methodology section gives details on how the survey was conducted; The Background contains an overview of the market for ETFs and EDHEC s ideology on the different areas addressed in the survey, and notably includes a discussion on the advantages of using ETFs in the core-satellite approach to investment management and the ways in which asset allocation can be carried out with ETFs; Finally, the Results section contains the respondents answers to our questionnaire. This morning s focus is on the last section. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 5

Introduction The very first Survey on the use of Exchange Traded Funds by European Institutional Investors Overall, the results suggest that European investors and asset managers are well aware of the advantages of ETFs; However, our survey also reveals that the full potential of these instruments for asset allocation is not currently being exploited by the majority of investment management professionals; We will explore these various areas and analyse in more detail how and where ETFs are likely to develop in the near future. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 6

Introduction Setting the scene for the future of the European ETF market How would you predict your future usage of the following instruments? 55% of European institutional investors are predicting an increase in their usage of Exchange traded funds; While respectively 41% and 36% of respondents predict a decrease in the use of TRS and Index funds, only 4% think the same of ETFs. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 7

An overview of the ETF market Old America, new Europe Initiated on the Toronto Stock Exchange (TSX) in 1990, ETFs have flourished significantly worldwide; In Europe, the first ETF appeared in April 2000 and was issued by Merrill Lynch to track the Euro STOXX 50. Although the European ETF industry started late and the US still leads the market, the faster uptake of ETFs in Europe (61.7% of asset growth in Europe in 2005 compared with 33.6% in the US) is rather remarkable. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 9

An overview of the ETF market A steady growth in assets and number of funds Assets under Management and number of ETFs in Europe from 2000 to the end of June 2006 Consistent and significant growth in assets under management (CAGR of 75% from 2001 to 2005); Significant development of the number of listed funds (from 6 to 216 in 6 years); H1 European growth of 29.9% compared to 16.7% globally (Source MSDW). Source: Morgan Stanley Investment Strategies, Bloomberg, August 2006 EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 10

An overview of the ETF market A mature landscape of providers ETF issuers in Europe ranked by AUM as of end of June 2006 Source: Morgan Stanley Investment Strategies, Bloomberg, August 2006 A mature group of leaders well established in the European marketplace; A significant number of new entrants representing both local groups or branches of large US ETF providers; Major European exchanges involved with significant market shares: Deutsche Börse XTF (44.9%) Euronext (23.7%) London Stock Exchange (14%) EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 11

Methodology of the European Survey A very broad European sample The questionnaire for the EDHEC ETF survey was addressed to the top 1,000 European asset managers and institutional investors in the summer of 2006; Among institutional investors, we targeted finance group directors for major corporations, or chief investment officers and chief finance officers for pension funds; The study generated responses from 112 European institutional investors and asset managers (investment/asset management companies, pension funds, banks and insurance companies, fund of hedge funds, industrial and commercial enterprises). EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 13

Methodology of the European Survey A highly representative sample: breakdown by country Breakdown of respondents by country France, the UK and Switzerland represent the large bulk of our sample with 26%, 24% and 12% respectively. These countries also make up 20%, 32% and 12% of the population; Apart from the UK and Germany (under-represented) and Italy (overrepresented), the breakdown by country in our sample is very close to that of the population. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 14

Methodology of the European Survey A highly representative sample: breakdown by category Breakdown of respondents by category Our survey mainly covered asset management companies and pension funds, accounting for 64% and 21% respectively; Many other actors participated in the survey: banks, insurance companies, funds of hedge funds, etc. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 15

Methodology of the European Survey A highly representative sample: breakdown by category Breakdown of respondents by category In terms of the size of the asset management company or the investor, we cover respondents representing assets under management of their institution between 2.7 million to 70 billion Euros, with an average size of 6.985 billion Euros. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 16

The role of ETFs in the asset allocation ETFs and core-satellite portfolio management The core-satellite strategy is widely regarded as an effective way of organizing asset allocation; As highlighted by recent research ETFs can be a desirable instrument not only in the core portfolio (for strategic allocation purposes) but also in the satellite in order to make tactical bets; Nevertheless, according to the responses provided, only 48% of European investors have implemented a core-satellite approach to construct their portfolios. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 18

The role of ETFs in the asset allocation ETFs and core-satellite portfolio management Have you implemented (or are you going to implement?) a "core-satellite"-type organization of your allocation? 9% of respondents are to implement a core-satellite - type organization in the near future; But while only 7% respond they are not familiar with the approach, a significant proportion of respondents (36%) are not considering using the core-satellite approach at all. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 19

The role of ETFs in the asset allocation ETFs and core-satellite portfolio management What role do ETFs play in your allocation? While 28% of respondents used ETFs in the core portfolio, almost as many (24%) traded them for the satellite; A notable bulk (37%) of respondents do not clearly include ETFs in their asset allocation, as they stated that they were not using ETFs in the core portfolios or in the satellite portfolios or for the purpose of representing a geographical zone or asset class. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 20

The role of ETFs in the asset allocation ETFs and core-satellite portfolio management Breakdown of the 37% of respondents that appear in the category other according to their response to the question: Have you implemented (or are you going to implement?) a "core-satellite"-type organization of your allocation? Among those respondents who responded other, 46% had implemented the C-S strategy, which means that only 17% of all 112 respondents that applied it were actually using ETFs in ways other than that mentioned; As 48% of all respondents had employed a C-S strategy, we can deduce that 65% of investors who had applied a C- S strategy were using ETFs in the specific ways mentioned. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 21

The role of ETFs in the asset allocation ETFs and core-satellite portfolio management equity investments When evaluating the usefulness of different types of equity ETFs, European investors appeared to have a particular preference for geographic ETFs (83% of respondents considered them a useful tool); Sector ETFs were perceived as beneficial by 74% of investors, and most of them stressed their usefulness in core portfolios; Regarding style (growth/value) ETFs, as many as 40% of investors did not think they were useful in equity investment. But interestingly, style ETFs are regarded as a useful tool in the satellite portfolio by as many as 21% of respondents, which is the highest percentage among the three categories. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 22

The role of ETFs in the asset allocation ETFs and core-satellite portfolio management equity investments Do you think the following types of ETF are useful in equity investment? One can observe that style ETFs are clearly less popular than sector or geographic ETFs, especially for use in the core portfolio. Only 18% of respondents consider style ETFs to be useful in both the core and the satellite; This seems surprising given that the academic literature has widely agreed on the importance of style factors. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 23

The role of ETFs in the asset allocation ETFs and core-satellite portfolio management fixed income investments Compared to equity investment, respondents to the survey are less convinced of the role of ETFs in bond portfolio management; Regarding government bond investments, our respondents showed surprisingly uniform opinion on the usefulness of country ETFs and maturity segment ETFs; The bulk of respondents (over 40%), however, did not think either of them was useful in the field of government bond investing; Responses for corporate bond ETFs are broadly in line with those for government bond ETFs, showing again that bond ETFs are considered less useful than equity ETFs. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 24

The role of ETFs in the asset allocation ETFs and core-satellite portfolio management fixed income investments Do you think the following types of ETF are useful in government bond investment? The weak score for government bond ETFs may reflect that respondents do not fully realize the potential benefits of active investment strategies in the field of government bond investing: For example, different maturity segments are natural supports for tactical timing strategies (in the satellite); In addition, the different time-series behavior of such instruments, due to their differing exposure to interest rate changes, also makes them a useful vehicle for constructing an efficient core portfolio. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 25

The role of ETFs in the asset allocation ETFs and core-satellite portfolio management fixed income investments Do you think the following types of ETF are useful in corporate bond investment? The responses given in the survey may be explained by the fact that only a minority of investors engage in active asset allocation between subcategories for their bond portfolio; This view contrasts with the findings of academic studies that derive significant benefits from active allocation between narrower categories of the bond market such as maturity segments (see e.g. Amenc, Malaise and Martellini, 2004). EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 26

ETFs in practice In this section, we examine how European asset managers and institutional investors use ETFs in practice and whether the users were satisfied with the performance of ETFs or not. Furthermore, we give considerable attention to exploring how investors perceive ETFs or similar vehicles in the area of alternative investments; After having reviewed the usefulness of ETFs for equity, bond and other underlyings, we will discuss more advanced uses of ETFs, such as short selling and derivatives. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 28

ETFs in practice Usefulness of ETFs for equity investments Do you use ETFs for your equity investments? 45% of respondents are using ETFs at present, and 16% stated that they would start using ETFs soon; However, there were still as many as 37% of respondents who were not using ETFs, and not considering the use of them any time soon, which means that there remains considerable room for ETFs to develop. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 29

ETFs in practice Satisfaction with ETFs for equity investments Are you satisfied by the use of ETFs in equity investment? 4% No, because of the poor level of quality 4% Yes, because of the reduction in fees/expenses 21% Yes, because of the good level of liquidity 4% No for a different reason 45% Yes, because of the reliability of the t racking error 23% Yes, because of their good performance Among those that use ETFs, 92% were satisfied; For 45% of responses, the most distinct reason for satisfaction was the reliability of the tracking error. 23% were satisfied with the good performance of ETFs, while 21% were pleased with the good level of liquidity, and only 4% cited the reduced expense of ETFs. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 30

ETFs in practice Usefulness of ETFs for fixed income investments 6% Yes Corporate bonds 7% No answer Do you use ETFs for your fixed income investments? 8% No answer 13% No, but we will soon 13% Yes Government bonds 13% No, but we will soon 66% No In line with the judgment on their usefulness above - only 13% of respondents were trading ETFs as of the end of August 2006 and another 13% were considering the use of ETFs in the near future; This statement by practitioners comes despite the potential benefits of active allocation between bond ETFs, as documented in the literature. 73% No EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 31

ETFs in practice Satisfaction with ETFs for fixed income investments Are you satisfied by the use of ETFs in fixed income investment? Government bonds Corporate bonds Among the respondents who are users of government bond ETFs, 80% found ETFs to be satisfying. 35% named the reliability of the tracking error, 30% the reduction in expenses and 15% the good level of liquidity; Consistent with the fact that over 40% of respondents do not perceive corporate bond ETFs as a useful tool, there were as many as 73% that do not use such ETFs. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 32

ETFs in practice Usefulness of investable indices for hedge fund investments Do you use investable index products in your alternative investments (hedge funds)? 7% Yes 16% No, but we will soon Investable index products are 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; 9% No answer 68% No However there were 15% of respondents who were planning to use such instruments in the near future. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 33

ETFs in practice Satisfaction with investable indices for hedge fund investments Are you satisfied with investable index products in your alternative investments (hedge funds)? 27% No, for a different reason 7% No, because of the lack of reliability of he tracking error 13% No, because of their poor performance 7% Yes, because of the reliability of the tracking error 7% Yes, because of the reduction in fees/expenses 13% Yes, because of the good level of liquidity 13% No, because of the difference in returns between investable indices and non-investable indices 13% Yes, because of the poor level of liquidity Among the small group of users, only 27% were actually satisfied with the product they use; The problems with investable index products in the area of alternative investments are well known and ways of addressing these problems have been proposed in the literature (see Goltz, Martellini and Vaissié (2006)). EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 34

ETFs in practice Usefulness of ETFs for real estate investments Do you use ETFs in your real estate investments? 6% Yes 11% No, but we will soon 9% No answer In the area of real estate investment, only 6% of respondents were trading ETFs and 11% were planning to try soon; This is consistent with the fact that real estate ETFs are newly invented instruments. 74% No EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 35

ETFs in practice Satisfaction with ETFs for real estate investments Are you satisfied with ETFs in your real estate investments? Half of the users stated that real estate ETFs were satisfactory because of the good level of liquidity they provided, the reliability of the tracking error and their good performance; Among the other half, 20% of total users ascribed their dissatisfaction to the poor level of liquidity and another 10% complained of a lack of reliability in the tracking error. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 36

ETFs in practice Usefulness of ETFs for commodity investments Do you use ETFs in your commodity investments? Although, like real estate exchange-traded funds, commodity ETFs have only been introduced recently, they were more popular among respondents; 15% of respondents are trading commodity ETFs and another 20% showed their interest in stepping in soon. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 37

ETFs in practice Satisfaction with ETFs for commodity investments Are you satisfied with ETFs in your commodity investments? The percentage of satisfied users is also greater than that of the alternative investment classes above; Among the 65% of satisfied users, 30% appreciated the good performance of commodity ETFs, 20% cited the reliability of the tracking error and another 15% said they benefited from a good level of liquidity. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 38

ETFs in practice Benefiting from ETFs distinct features ETFs distinguish themselves from other indexing instruments by a number of features: Possibility of shorting an ETF Possibility of borrowing/lending an ETF Derivatives on ETFs There is a considerable share of respondents who were actually not familiar with these features of ETFs, showing a potential need for investor education on these issues; The following pages show how these features are perceived by European investors and asset managers. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 39

ETFs in practice Shorting ETFs Do you short ETFs? EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 40

ETFs in practice Borrowing/Lending ETFs Do you do securities lending with ETFs? EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 41

ETFs in practice Derivatives on ETFs Do you use options on ETFs? 7% No answer 4% Yes 9% Not familiar with it 6% No, but we will soon 9% No, unlikely to in the futu re 65% No EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 42

Pros & Cons of various investment vehicles In this section, we will compare four investment instruments: ETFs, futures, total return swaps (TRS) and traditional index funds. All these instruments allow the simple execution of trades in large baskets of stocks; Our evaluation criteria are loosely based on Rubinstein s (1989) early examination of such instruments. We look at the advantages and drawbacks of each instrument and then emphasize specific issues concerning total return swaps, futures and ETFs; We also assess the future use of these instruments by European institutional investors and asset managers in order to identify certain trends. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 44

Pros & Cons of various investment vehicles Liquidity Rating with regard to the level of liquidity Results show that respondents do value the ability to trade immediately with futures and ETFs, unlike standard index funds; This is in accordance with the academic literature that finds a value of immediacy in exchange-traded funds (see Comer et al., 2002). EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 45

Pros & Cons of various investment vehicles Cost of liquidity Rating with regard to the cost of liquidity Concerning the cost of liquidity, respondents' preferences are quite similar to those for liquidity; Responses show that futures still got the best rank, followed by ETFs. Index funds and, even more so, TRS were rated as weak. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 46

Pros & Cons of various investment vehicles Cost Rating with regard to cost Concerning cost, most respondents voted in favour of futures; 61% classified exchangetraded funds as good, but only 21% voted for them as very good and 13% considered they were poor with regard to this criterion; Index funds did not fare well either when compared to ETFs and futures. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 47

Pros & Cons of various investment vehicles Reliability of Tracking Error Rating with regard to the reliability of tracking error Exchange-traded funds obtained the best evaluation from respondents; Futures and index funds can be ranked second as 54% classified them as good or very good at providing reliability of tracking error; Total return swaps were evaluated as good as well, but it must be taken into account that almost half of the respondents did not express their opinion on them. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 48

Pros & Cons of various investment vehicles Available range Rating with regard to the available range On the available range, exchange-traded funds were ranked first. This is consistent with the recent developments in the ETF industry and has been stated as an advantage of ETFs in the literature (see e.g. Demaine (2002)); ETFs now offer exposure to a wide range of indices; this is a notable difference to futures, which have less of a diversified product range. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 49

Pros & Cons of various investment vehicles Minimal subscriptions Rating with regard to the minimal subscriptions Concerning the minimal trading subscription, ETFs gained overwhelming favour from European investors with 71% advocating them and only 1% objecting to them; Index funds were also considered to accommodate small subscriptions well by 55% respondents; Surprisingly, futures were ranked only slightly behind index funds, with 51% of respondents rating them as good or very good. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 50

Pros & Cons of various investment vehicles Operational constraints Rating with regard to the operational constraints Exchange-traded funds and index funds were perceived to be suffering less from operational constraints than the other two instruments; These results confirm that dealing with derivatives is still subject to considerable implementation problems; What is more, there appears to be a very pronounced difference between exchange-traded (futures) and over-the-counter derivatives (swaps). EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 51

Pros & Cons of various investment vehicles Regulatory regime Rating with regard to the regulatory regime Respondents preferred ETFs, with 65% ranking them as good and only 3% ranking them as poor; Interestingly, ETFs were also the category with the least nonresponses suggesting high familiarity among respondents with the regulatory regime that applies; Likewise, index funds and futures were mostly regarded as good; However, there existed considerable dissatisfaction with the regulatory framework for total return swaps. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 52

Pros & Cons of various investment vehicles Tax regime Rating with regard to the tax regime Concerning the tax regime, respondents to the survey agreed with academic research papers (e.g. Poterba and Shoven 2002) that stress the tax efficiency of exchange-traded funds; In fact, the majority of respondents (55%) ranked ETFs as very good and fairly good in terms of the applicable tax regime; However, index funds and futures are also considered to be good by only slightly fewer respondents (47% and 44% respectively). EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 53

Pros & Cons of various investment vehicles Specific issue: Total Return Swaps Is the fact that they are traded over the counter good or bad for you? Is the counterparty risk a problem for you? EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 54

Pros & Cons of various investment vehicles Specific issue: Futures Is the fact that they are derivative instruments a problem for you? EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 55

Pros & Cons of various investment vehicles Specific issue: Futures Is the requirement to roll over positions a problem for you? Are the margin calls a problem for you? EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 56

Pros & Cons of various investment vehicles Specific issue: Exchange Traded Funds Is mispricing with regard to the Net Asset Value a problem for you? Responses are rather surprising given that an empirical study by Engle and Sarkar (2004) for the US finds that domestic ETFs have highly efficient prices, though their finding is different for international ETFs; In fact, these authors find that premiums or discount with respect to the funds NAV are typically small and disappear very quickly, supporting the view that the creation and redemption mechanism of ETFs effectively limits arbitrage opportunities. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 57

Pros & Cons of various investment vehicles Specific issue: Exchange Traded Funds What type of ETF do you prefer? If the answer is Passive ETFs, which of the following do you prefer? EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 58

Pros & Cons of various investment vehicles Measuring TE and liquidity qualities How do you assess the tracking quality of the different investment supports? How do you assess the liquidity of the different investment supports? EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 59

Concluding thoughts Looking forward What type of products would you like to see developed in the future? EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 61

Concluding thoughts Overall, the results of the survey reveal that asset managers and investors are well aware of the advantages of ETFs; However, it seems to be the case that the full potential of these instruments for asset allocation is not currently being explored by the majority of investment management professionals; Given that our results suggest that the use of ETFs and the organisation of portfolio management into a core-satellite approach are bound to increase, we may expect a significant impact on investment management practices and on the development of the ETF industry in the future, as these tendencies can be expected to be mutually reinforcing. EDHEC European ETF Survey - presentation at the ETF Summit - Paris, November 22nd 2006 62