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Unfulfilled Potential – The Results of the EDHEC European Survey 2008

The EDHEC European ETF Survey 2008  analysed the current use of ETFs by European investors and asset managers based on a questionnaire that was filled out by 111 European institutions. In addition, we provided an outlook on future usage 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 hoped to provide some insights into how ETFs could be employed to further benefit investors, in addition to what is currently done. The report also provides insights into some developments over time, as we can compare results with an earlier survey EDHEC conducted 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, current use of such 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% employ 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 seems to be widely ignored. This seems surprising as the wide range of available ETFs precisely offers the advantage to be able to design precise allocations that correspond to the investor’s long term risk/return objectives, as opposed to accepting an allocation inherent in a broad market index. The dominance of broad market ETFs in respondents’ core portfolios is not limited to equity investments, but is also found for 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 the satellite proportion of their portfolio, which corresponds exactly to the percentage of respondents using ETFs in the core. This result is interesting as the core-satellite approach initially advocated the use of very active instruments in the satellite portfolio. However, the outperformance of the satellite may of course be generated by exposure to different betas (small cap stocks, value stocks, credit risk etc.), as opposed to manager alpha. Our survet results suggest that current industry practice seem to acknowledge the role that such beta management plays in the satellite portfolios.

3. ETFs for alternative assets on the rise
Our survey results suggest a strong increase in the popularity of ETFs and ETF-like products investing in alternative assets. The percentage of respondents using ETFs for commodities, real estate or hedge funds has increased considerably compared to 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 percent of respondents used ETFs for a given alternative asset class. Thus, it seems that the 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 concerning future product development. Finally, when asked where they see the strongest increase in their future use of ETFs, 44% state it will be in accessing new types of asset classes via ETFs.

4. ETFs are still concentrated in the equity arena
The area where the use of ETFs is strongest, is still in equity investing. For the average respondents ETFs constitute more than 20% of their 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 only used by a fraction of respondents. Even if we count in the respondents who say thay may use the feature in the future, for each feature, only 10% of respondents are current or potential users. Moreover, for each of this feature, more than 70% of respondents are unfamiliar with it. This suggests that there seems to be a need for more investor education on these issues. An exception are inverse performance ETFs, which are used or will be used in the future by more than 30% of respondents. For all these features, the number of respondents who will use them in the feature is at least as high as the number of current users, suggesting that growth can be expected in ETF lending, ETF options trading, and short selling of ETFs.

6. ETFs and Futures are the preferred indexing instruments
We asked 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 were considered as advantageous by respondents although they were less well-ranked than futures with respect to some criteria. ETFs were ranked as the best in terms of available range of indices and asset classes. Therefore, European investors and asset managers seemed to be well aware of the product diversity of exchange-traded funds which has been dramatically enhanced in the past few years. Futures seemed to be the most serious challenger of ETFs, but ETFs were perceived as superior with regards to minimal subscription, operational constraints and the tax and regulatory regime. Therefore, it appears that implementational concerns with futures (such as margin calls, and applying exact allocations even for small-sized portfolios) put ETFs at an advantage.

7. Passive ETFs with full replication are the preferred choice of investors
The large majority of respondents preferred passive ETFs. Active ETFs are preferred by only about 10% of respondents. Likewise, only 16% of respondents say they would like to see more actively managed ETFs being developed. For the construction of passive ETFs, the majority of respondents prefers pure replication of the index by holding all components with the required weight. Synthetic replication and statistical replication are seen as less attractive than full replication. Synthetic replication through derivatives is however 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 asked which instrument respondents are most likely to use more in the future. Intentions of future use of ETFs, futures, total return swaps and index funds reveal that there is a tendency of increase 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 project an increase, versus 2% that project a decrease. For total return swaps, only 18% plan to increase their use, and 9% of respondents plan to decrease it. The only instrument where an increase in future use is not pronounced is index funds, where 23% intend an increase and 19% a decrease. Overall, it seems to be the case that the anticipated increase in ETF usage will not necessarily hinder the further development of other indexing vehicles.

New Risk Budgeting Techniques: Applications with ETFs

In addition to providing an analysis of the current use of ETFs in the industry, we also provide an overview of novel ways of applying ETFs within portfolio management. More precisely, we illustrate how various ETFs may be used in the context of dynamic risk budgeting.

In order to provide a feel for the results in the full document, we concentrate on an example where the investor chooses to add an ETF of value stocks to generate outperformance. 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 generally, 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.

It is usual to construct core-satellite portfolios by placing assets that are supposed to outperform the core in the satellites. However, it may happen during some periods that these assets underperform the core, for example if economic conditions become temporarily unfavourable for these assets. The dynamic core-satellite approach described in more detail in the full report makes it possible to reduce a satellite’s impact on performance during a period of relative underperformance, while maximising the benefits of the periods of outperformance.

In the present example, we implement the dynamic core satellite approach (Amenc, Malaise and Martellini (2004)). This method allows investors to achieve asymmetric tracking error management. It leads to an increase in the fraction allocated to the satellite when the satellite has outperformed the benchmark. Indeed such an accumulation of past outperformance has resulted 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.

The figure below indicates the cumulative outperformance of the value index over the large cap index. It can be seen that 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, i.e. he 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, so 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, where the weight of the satellite is readjusted so as to control tracking error in an asymmetric manner. 

Risk and return statistics for different investment strategies with ETFs

*annualized statistics are given.
**risk free rate and MAR are fixed at 2%.
***non-annualised 5%-quantiles are estimates. 

From the average returns in the first column of the table, it can be seen that 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 nonlinear risk management yields an annualised average return of 8.22%. Thus, comparable to the case of the small cap example, the dynamic core satellite approach adds an annual value of roughly 200 basis points over the static core satellite portfolio.

From this example, it can be seen that the dynamic packaging of beta exposures allows generating outperformance in the order of 2% per year over a naïve static allocation to such beta exposure. In the example, the dynamic core satellite technique allows to benefit from the outperformance of value stocks, even though that outperformance is not consistent over the entire time period. ETFs are an ideally suited vehicle to implement such dynamic strategies, since there is a wide range of ETFs available on potential satellite assets, and their easy tradability allows implementing such 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 mostly limited to passively holding broad market indices. The wide range of available 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 a stock. 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.