EDHEC-Risk’s annual European ETF Survey reveals investor attitudes to risk, replication and asset allocation

Written on 30 March 2012.

• In relation to the issues raised by financial authorities and international organisations on ETF risks, the survey suggests that investors have a differentiated view on different replication methods, taking several dimensions into account such as cost, tracking error, and accessibility of broad indices, among others, when making choices on the preferred replication mechanism. Depending on the objectives at hand, different replication mechanisms are perceived to have different types of benefits.

• Industry communication on the risks of ETFs has led to the counterparty risk of physical ETFs being underestimated. As a result, investors think that full physical replication (a positive score of 2.28 out of 3) is less risky than synthetic replication (1.41 out of 3) in terms of counterparty risk. Even though almost all physical replication ETFs engage in securities lending, investors fail to appreciate the risk of this activity, giving full replication a score of 2.11 out of 3 for operational risk caused by securities lending, compared to 1.55 out of 3 for synthetic replication, even though synthetic replication ETFs do not use securities lending directly.

• In general, respondents prefer full replication over either sampling replication (where the index is replicated physically with a limited number of securities) or synthetic replication, but there is a clear preference for synthetic ETFs to replicate indices in challenging universes, such as illiquid alternative asset classes and broad indices with more than 1,000 constituents.

• Overall, in terms of reliability, coverage, cost and risk, though all three approaches are comparable, synthetic replication receives a slightly higher average score (2.12 out of a possible 3.00) compared to full replication (2.01) and sampling replication (2.01).

• Investors acknowledge that the current education on the differences between highly regulated ETFs and largely unregulated ETPs needs to improve in order to avoid confusion.

• While investors are using ETFs more heavily for dynamic strategies and specific sub-segment exposure than in the past, the main use of ETFs remains long-term buy-and-hold investing in broad market indices.

• Investors are also moving towards applying ETFs for portfolio optimisation and risk management, and continue to see ETFs mainly as index-replicating products, rather than active funds.

• ETFs are mainly used as beta or asset allocation tools, thus allowing investors to focus on the first-order issue of beta management, rather than on stock picking issues, which are only of third-order importance.

• There has been increasing demand for ETFs based on new forms of indices, from 29% to 39% over the past year, which indicates growing interest in alternative-weighted indices.

• ETFs remain very popular for passive investment. In terms of future use, a majority of respondents (63%) indicate that they intend to increase their allocation to ETFs in the future.

• Respondents also intend to increase their investment in futures, while they expect their use of traditional index funds to stay stable on average and that of total return swaps to decrease.

A copy of the EDHEC-Risk Institute survey can be found here:

EDHEC-Risk European ETF Survey 2011

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