By Paul Amery
IndexUniverse [IU]: Axel, how did you get into the ETF market?
Axel Lomholt (Lomholt): I started life as an active fund manager, managing global equity funds. We had trouble outperforming in the U.S., and as this made up 50% of the benchmark, we decided to index this portion of the portfolio and try to add value elsewhere. We didn't have any indexing software and I thought, "Let's do this in-house; I can do it easily." Then I found out it wasn't quite as easy as I'd thought!
We started to see big flows into index funds—beta products—in 1997/98, and I devoted myself full time to it. Then, a couple of years ago I moved into ETFs from the more institutional fund sector, as I realised that, in the long run, it will be very difficult to beat ETFs—from the point of view of cost efficiency, ease of use, transparency, liquidity.
IU: Average expense ratios across the European ETF market are still higher than in the U.S. Do you see this continuing, or will they converge?
Lomholt: I think some difference will remain—a lot of the expense ratio is made up of third-party costs, which are still higher in Europe than in the U.S. These could be licensing fees, some bespoke index fees, local taxes, for example. Having said that, I still think ETFs are a very competitive deal for investors—there are no front-end or exit fees, and the management fees are low when compared to other fund options.
IU: What other considerations do you feel are important in the active vs. passive debate, ETFs vs. other beta products?
Lomholt: One area that I think doesn't get talked about as much as it should be is operational costs. The debate about overall management fees, active versus passive management has been going on for a long time, but relatively few people talk about the back- and middle-office cost efficiency of using ETFs. Compare this with using swaps or futures, managing margin and collateral, or even a traditional index fund, buying 500 or so stocks, incurring custody and transaction fees. The operational savings from using ETFs are more difficult to quantify, but just focussing on expense ratios is definitely to miss one of their key attractions. In effect, a lot of the fund management role can simply be outsourced—very cheaply and effectively.
It's also important to take into consideration other factors, such as the potential stock-lending revenue from ETFs. I'm often surprised at how few European institutional ETF owners have made their funds available to borrow, as this is a very easy way to earn some extra return. Only a few percent of the available ETF stock is lent out in Europe, which amazes me, as investors are missing out on revenue—it's as close to a free lunch as you can get. The demand from the sell side—for example, from structured product teams in banks—to borrow ETFs is huge, for example, so it makes sense to meet it if you're a holder.
IU: Are these considerations filtering through to senior management in the funds industry?
Lomholt: I think slowly, but yes. But there are lots of cultural hurdles to overcome in big organisations. Lots of people don't know, for example, whether an ETF is booked like a stock or a mutual fund—it's a stock and settles like a stock. In some firms, accounting and risk systems need to be modified to handle ETFs.
Of course we can point this out, but one of the challenges we face when marketing or selling ETFs, or as an ETF provider, is that we have limited knowledge of the end user, since we don't see the fund manager's purchase of the ETF from the market-maker—only the creation or redemption if it's a large deal.
This complicates our life when we want to analyse who's using ETFs, and what the investor's objectives are. For us it becomes more an art than a science in determining this.
IU: Why are equity industry sector funds less developed in Europe than in the U.S.?
Lomholt: They certainly haven't been the biggest success - investors are still focused largely on other ways of putting together an equity portfolio; for example, by using country equity funds. From our point of view as an ETF provider, we have to cover all the sectors, even though we know that only a few will be popular at any given time. We still support this product range and hope that over time investors will come to use them more.
IU: What areas for new product development is iShares currently looking at? Are there any areas you feel are missing?
Lomholt: I think it's fair to say that there are many new concepts out there that we find of interest, but we like to reflect whether we as a company want to throw our weight behind them. Once we decide that there's a long-run investment theme that makes sense—take, for example, our infrastructure ETF—then we will launch funds accordingly.
Another way to look at it is to look at the average institutional or private portfolio. Let's say that 50-60% is in some core asset class; for example, large-cap equities or fixed income, then, say, another 15-20% in emerging markets and 5-10% in niche areas. If we take this typical portfolio profile and superimpose it onto our flows into iShares, then we find that things are very similar, in that we still see the biggest flows into the large, traditional ETFs—for example the EURO STOXX 50, the DAX, the FTSE 100—then healthy flows into emerging market funds and then some uptake of the more niche areas: infrastructure, clean energy, water, etc. So we see these funds as quite long-run asset gatherers.
We also want to make sure that our funds deliver what they promise. Some of the newer products on the European market—take inverse and leveraged funds—can have quite unpredictable payoff profiles. I'm not saying we won't get involved there, but there may be other areas where we prefer to commit our resources. Recently, for example, we launched the JPMorgan Emerging Market Bond Index ETF. It might seem like quite a boring product, but we raised almost a quarter billion dollars in a few weeks.
Is anything missing from our product range? Generally speaking, I think we have a very well-diversified range of products, and the only possible gaps that we would like to fill are in the fixed income space, where we sometimes run into supply constraints; and in emerging markets, where we may face liquidity and regulatory problems.
IU: How then would you compare the attractiveness of an inverse ETF to going short directly (physically) or via a futures contract?
Lomholt: Assuming that the ETF delivers more or less the inverse of the index return, then it comes back to the point I was making earlier, about operational simplicity. It's a retail product—retail investors are going to be less concerned with whether they receive, say -0.8 or -1.2 times the EURO STOXX 50 index return (to use hypothetical figures), whereas for an institutional investor, such a large tracking difference would create a problem. You need to get this balance right when designing the product. There have been some big issues, in the U.S. particularly, with the performance of funds of this type.