As the investment landscape evolves, defined contribution (DC) pension schemes are exploring new avenues to enhance returns, diversify and manage risk. Among the tools garnering attention are exchange-traded funds (ETFs), the diversity and scale of which have grown remarkably in recent years.
In July, assets invested in the global ETF industry reached an all-time high of $13.61 trillion, (£10.37 trillion) according to the independent research group ETFGI. This is up 17 per cent since the end of 2023 and nearly 400 per cent compared to a decade ago. This surge underscores ETFs’ transition from a niche innovation to a popular investment vehicle.
The flexibility and accessibility of ETFs have made them popular among institutional investors, with roughly two-thirds using ETFs heavily, according to State Street Global Advisors.
But while institutional investors use ETFs widely, their application in DC pension schemes in particular is difficult to gauge. This prompts important questions for advisers to these schemes: how suitable are ETFs for DC portfolios, and what factors should be considered when recommending them?
Types of ETFs: A broad universe
The ETF universe is diverse, offering investors a versatile tool for portfolio construction. With more than 10,000 ETFs available worldwide by the end of July this year, they provide a level of granularity and access often unmatched by other investment vehicles.
“ETFs allow instant access to baskets of stocks, bonds or commodities and are most commonly used to track an index, such as the S&P 500 or FTSE 100,” says Sam Benstead, fixed income lead at Interactive Investor.
Passive ETFs offer a cost-effective way to gain broad market exposure, while active ETFs provide a more hands-on approach, with portfolio managers aiming to outperform the market.
“Some ETFs might focus on a particular part of an index, such as technology shares,” Benstead adds.
“Some may track commodities, while others can identify companies that show certain characteristics, like value or growth – these are known as smart beta ETFs.”
The ongoing expansion of the global ETF market, with a record-breaking 1,063 products launched so far in 2024, underscores the growing opportunities available to DC pension schemes looking to diversify their portfolios.
Benefits for DC schemes
This broad universe of ETFs makes them ideal for portfolio diversification. Edward Malcolm, head of UK ETF distribution at JP Morgan Asset Management, describes them as “the ultimate tool” in this regard.
ETFs may be useful for investors wishing to gain quick exposure to specific markets, asset classes or sectors, given they have minimal set-up processes.
“If you believe this is a year where significant geopolitical changes will impact economic and regulatory outlooks, you can easily buy an ETF for that region,” explains Deborah Fuhr, managing partner and co-founder at ETFGI.
“That may be useful in the Latin American emerging markets, where a number of recent elections may pave the way for opportunities that investors wish to seize quickly.”
The diversifying powers of ETFs include their ability to provide access beyond traditional asset classes. Ben Lewis, head of investment proposition at Mercer, says: “One thing ETFs have some advantages in is accessing diversifying allocations that are not easily accessed within a traditional portfolio.”
For example, Mercer’s flagship DC solution uses exchange-traded commodities to gain exposure to gold, offering a straightforward way to include physical assets in a portfolio.
“The ETF toolbox has grown quite significantly,” says Fuhr.
“Still, it’s important to ensure each investment meets a scheme’s criteria in terms of size, time horizon and other factors.”
ETFs also offer high levels of transparency and liquidity.
“Regulation requires ETFs to disclose their portfolio positions daily,” Malcolm explains. This transparency allows investors to see exactly what they own at any given time, which is particularly valuable during periods of market volatility and may help reassure nervous DC members. They can be traded like stocks, without minimum investment requirements, making them accessible to large institutional investors and smaller schemes alike.
Another key advantage of ETFs is their cost-effectiveness, which is compelling for DC default investment options and their typically tight budgets. “ETFs are pretty attractive when it comes to pricing, especially for DC schemes, which are very cost-constrained,” Malcolm notes.
However, an ETF’s fees are set for all investor types, which should be a consideration for larger DC schemes, which tend to have high bargaining power when engaging with other investment vehicles such as segregated accounts.
The allure of active
While the ETF universe is vast, the binary between active and passive is crucial – and actively managed ETFs are rapidly gaining traction. Of the more than 1,000 new ETF products listed this year, 46 per cent were active.
Active ETFs allow DC schemes to access actively managed strategies that have the potential to outperform benchmarks, while maintaining the diversification and transparency benefits of passive ETFs.
“Historically, ETFs were mostly passive, but we’ve been leveraging our active investment capabilities and delivering that expertise through the ETF wrapper,” JPMAM’s Malcolm says.
“If a team has a strong track record of outperformance, that’s attractive to DC schemes. But it’s not just about outperformance; it’s also about risk management. In times of stress, it can be reassuring to know there’s a portfolio manager behind the scenes.”
Additionally, since ETFs are considered a low-cost investment vehicle, there is an expectation that even active ETFs be priced competitively. “In the DC pension space, the focus on cost is shifting from just fees to overall value for money,” Malcolm adds. “An active ETF may be a way for schemes to access high-quality active management at a reasonable price.”
The future landscape
With global ETF assets under management expected to surpass $19.2 trillion by 2028, according to PwC the landscape is set for significant growth. However, the future of ETFs within DC pensions is not without challenges.
One barrier is the operational complexity involved. As Lewis notes, the platform providers used by many DC schemes play a crucial role: “You can have the best ideas, but if your platform provider can’t make the ETF available within a reasonable timeframe, then it’s very difficult to bring it into your portfolio.”
ETFs can also introduce increased tracking error, particularly in less liquid markets, where there may be a divergence between the ETF’s market price and the price of the underlying assets. To reduce this risk, it’s crucial to evaluate the liquidity of an ETF’s underlying assets, the accuracy of its benchmark replication and overall market conditions before investing.
Despite these challenges, experts see potential for ETFs to play a bigger role in DC portfolios, particularly in niche areas such as commodities or tactical allocations. But as the DC landscape consolidates, with larger schemes tending to prefer segregated accounts for their negotiating power, ETFs may remain a complementary tool rather than a core holding.
Lewis says: “In instances when a DC investor wants to move quickly with a mandate, particularly for diversifying allocations, there may be a role for ETFs to play.”