Growth in the use of ETFs and Indexing

 In Europe, as well as globally, retail and institutional investors have been steadily embracing the use of exchange-traded funds. Last year, ETFs in Europe received net inflows of US$22bn, according to ETF Global Insight, while according to EFAMA, Ucits funds registered net outflows of US$119bn.

The move to ETFs and indexing is being driven by several factors, including investors increasingly embracing the benefits of being diversified within and across asset classes. It is also fuelled by the recognition it is difficult to pick stocks or bonds that perform better than the benchmark.

On top of this, it is hard to find active funds that consistently beat their benchmarks, while the costs associated with stock-picking also play a role.

It is also the case that more investors are developing financial plans based on when and how much money they will need.

Once you have decided on your asset allocation, which forms the building blocks of your portfolio, you look at which investments will best fulfil those allocations. Many money managers prefer to pick individual stocks and bonds in their home country or region but use ETFs, funds or derivative products to invest in markets where they lack expertise, access to research or the ability to invest directly.

Let us assume that one of the target allocations the investor wants to implement is exposure to the US stock market, as represented by the S&P 500 index. Performance is one of the key considerations for investors and most would like to find active funds that consistently deliver returns that are above the index – the S&P 500 in this example. But finding funds or a fund that consistently delivers on this goal is a significant challenge for both retail and institutional investors.

Standard and Poors, Lipper and Morningstar published three new studies last week on the performance of active funds versus their benchmarks which again found that consistently a majority of active managers in most categories lag their benchmark.

The Lipper study looked at how well actively managed mutual funds in Europe performed over the past twenty years. The study found that 26.7% of equity funds beat their benchmark in 2011, 40% over 3 years and 34.9% over the past 10 years. In 2011 only 23.7% of active bond funds beat their benchmark, 45.4% over 3 years and 16.2% over 10 years.

There are considerable variations in the number of funds that did well in each year and by region. Funds investing in the UK and European equities have performed better than global equity funds. Funds investing in North American equities have had consistently fewer managers beating their benchmarks than the other categories.

Lipper estimates that active equity fund market in Europe is approx. euro 1.5 trillion while index funds and ETFs account for euro 299 or 17 percent of the overall equity assets.

The best performing area for bond funds was global emerging market bonds where 23.1 percent beat their benchmark.

Finding the time and information to select active funds in Europe is made more challenging by the large number of funds to select from currently around 35,000 funds. Fund turnover is also very significant with typically 3,400 new funds launched and 2,400 closed each year on average over the past 10 years.

In Europe typically four out of ten active funds beat their benchmarks. The challenge for the retail investor is do they have the skill, time and information to select the right funds.

Morningstar research analysed over 1,300 long only international equity distributed in Europe with at least ten years of history. The study found that an average of 6.8 percent of these funds have outperformed the market index, i.e. MSCI World index.

The tenth annual S+P indices versus active funds (SPIVS) scorecard found that over a five-year period most active equity and bond managers in most categories lag their benchmarks. In calendar 2011, 81 percent of active large cap managers underperformed the S&P 500. Changing the time horizon or the asset class makes little difference to the results.

The challenge of finding professional managers who consistently beat their benchmark – as measured by the S&P 500 index - and delivered alpha by picking individual stocks has not changed much in the past nearly forty years.

Numerous studies have shown that it is hard for professional active investors to consistently beat their benchmark. What’s more, the annual costs associated with investing in active funds is significantly more than investing in an index fund designed to track the same benchmark.

These higher costs are another important factor accelerating the move to index investing. Since the recent financial crisis, investors have become more aware of the impact these expenses can have on active fund performance. An active fund that delivers returns below the benchmark prior to costs being deducted looks like a faulty choice for a building block after deducting the typical annual 1.50% expenses for active funds.

An index fund may not offer the potential to outperform a benchmark, but you do know you will get the benchmark minus fees and any tracking error, which should be very small - typically less than 0.50 percentage points for an S&P 500 index fund.

Over the past few years we have seen growth in the use of index investing by both retail and institutional investors through futures, structured products, equity-linked notes, index funds and ETFs.

Investors need to be diligent in determining how they might implement index exposure to their selected benchmark. Futures tend to cover less than 80 benchmarks. Also, many investors aren’t allowed to use futures, while others are limited in their use and others prefer not to use them.

Structured products and equity-linked notes are investment vehicles, which are created by banks and brokers on a bespoke basis. They typically require an initial investment of $20 million to $100 million, depending on the index.

Meanwhile, index mutual funds tend to exist only on well-known indices while ETFs cover an ever-expanding array of indices and asset classes. ETFs offer a number of benefits over many of the other alternatives mentioned above: small minimum investment, typically less than $80; liquidity; diversification; low cost; exchange-traded; and real-time access to a wide range of indices and asset classes around the world.

At the end of February 2012, the European ETF industry had 1,270 ETFs with 4,485 listings, assets of $302.3bn from 37 providers listed on 21 exchanges, according to ETF Global Insight. Measured by the number of funds, synthetic ETFs comprise 63% of the total, or 801 funds, in Europe. In contrast, physical ETFs account for $184.3bn, or 61%, of ETF assets in Europe. In the year to the end of February, physical ETFs received 65.4% of the $4.7bn of net new assets invested into ETFs listed in Europe. In 2011, synthetic ETFs suffered net outflows of $3.7bn while physical ETFs gained $28.9bn.

Deborah Fuhr is a partner of the recently founded ETF Global Insight, independent analysis and consulting firm aimed at providing services to the ETF industry worldwide.