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November 6th, 2011 by

ETFs flourish as alpha stay elusive By David Ricketts

ETFs flourish as alpha stays elusive

By David Ricketts

It is no secret that active managers have received considerable flak for often failing to outperform benchmark indices and generate returns in line with their handsome fees.

Investors remain convinced that those with superior investment clout should be best placed to navigate market turbulence in search of the highest possible returns.

Figures suggest performance among active managers has been lacklustre, to say the least. A report by Standard & Poor’s earlier this year revealed that in 2010, with the exception of emerging market debt, more than half of US active managers failed to beat various benchmarks.

The most underperforming mutual fund categories over the past five years, according to S&P, were mid-cap stock and small cap growth funds, where 78.2 per cent and 72.7 per cent, respectively, of all actively managed funds underperformed their peer index.

In comparison, exchange traded funds (ETFs) linked to the S&P MidCap 400 Index and the S&P SmallCap 600 Growth Index beat corresponding professional stock pickers.

It should come as little surprise, then, that growing demand for ETFs, coupled with investor appetite for stable returns in a low interest rate environment, has created the ideal landscape for fixed income ETFs.

Appetite for the products has grown steadily, and fixed income ETFs have become the second largest category of ETFs in Europe with a total market share of around 20 per cent and assets under management of around €43.5bn ($60bn).

Nizam Hamid, head of ETF strategy at Lyxor, says the trend towards using ETFs to gain exposure to fixed income “is not just a shunning of active management” by investors, but a move to transparency of asset class exposure, returns and pricing.

“It is true that active managers have failed to deliver consistent alpha in the fixed income space, but the main attraction of ETFs has been choice of exposure and ability to use ETFs to manage portfolio risk,” he says.

Historically, during periods of high market volatility, fixed income ETFs have benefited from positive inflows. But with risk being mainly focused on sovereign credit, this has not been the case this year, adds Mr Hamid.

“However, investors continue to use fixed income ETFs to address issues such as a search for income in a low interest rate environment, together with tactical positioning with respect to inflation.”

S&P and MSCI remain the dominant index providers for the ETF industry, while Barclays Capital is considered the market leader in fixed income indices.

However, established index providers could see competition. In August, BlackRock filed with the US Securities and Exchange Commission to establish its own indices, rather than rely on those developed by third parties.

Alex Claringbull, managing director and fixed income portfolio manager at iShares, says the next five years in Europe “will very much be a fixed income story as the ETF market matures to match what investors are investing in.”

“ETFs did start with an equity flavour, and it has been predominantly an equity story so far,” he says.

Others are sceptical about what is truly driving demand.

José Garcia-Zarate, European ETF analyst at Morningstar, says the rise in fixed income appetite is nothing more than an effect of the financial crisis and “classic safe-haven flows”.

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