The ETF market has grown significantly in recent decades, particularly in the US and Europe, both in terms of the volume of money invested and the number of products available.
On the face of it these low-cost, flexible investments look ideal for DC pension funds, allowing managers to diversify investments across asset classes and geographies. So the question remains: why are these investments still largely overlooked by DC schemes in the UK?
Globally, many asset owners, including pension schemes, have started to invest in ETFs. BlackRock head of institutional iShares sales EMEA, Kirst Kuipers, says: “In recent years we have seen rapid growth in ETF adoption by asset owners, including pension schemes.
“Asset owners are becoming increasingly aware of the benefits ETFs offer – either through strategic asset allocation or more tactically. Improvements in technology are revolutionising the way investors access markets, creating efficiencies and more granular exposures to express their investment views.”
He adds: “In addition, the growth of new defined contribution retirement plans is fuelling ETF usage. These schemes start from scratch, with participants needing diversified exposure from day one with a requirement to manage inflows and outflows. The daily liquidity, transparency, and convenience of ETFs can provide a flexible solution.”
Integration
In the UK DC market, ETFs are mostly used by big master trust providers to help schemes align investment strategies with climate targets and can aid with more precise portfolio design.
Alison Leslie, head of DC investment at Hymans Robertson, says: “In the UK DC market ETFs tend to be used by larger schemes like master trusts, where there is a bigger budget and a more sophisticated investment strategy.”
She says ETFs have “come to the fore” due to the focus on net zero goals and climate targets. ETFs have to report holdings on a daily basis, so can help schemes have a more accurate gauge of their carbon liabilities, for example.
She adds: “Asset managers are increasingly speaking to asset owners about possible use cases in glidepaths or target date funds and using ETFs to help with precision portfolio design and completion.”
But ETF adoption in the UK is lagging behind Europe and the US, partly because UK DC platforms, which are designed for daily pricing, have difficulty handling ETFs that trade throughout the day.
Barnett Waddingham partner Sonia Kataora says: “These platforms have historically been slow to adopt ETFs due to the complexity of integrating ETF trading and settlement systems. In particular, ETFs are essentially securities that trade intra-day on an exchange. This presents practical difficulties for a DC platform, which is typically designed to handle funds that are priced once a day.”
However, Kataora points out that traditional pooled funds are subject to trading restrictions, which might limit the flexibility for investors who want to quickly adjust their allocations. But this has not been seen as a major drawback for DC, where people are typically investing over longer time frames.
“There is less of a recognised need for intra-day trading among pension schemes, particularly in DC schemes where investment horizons are long-term. Therefore, the liquidity advantages of
ETFs are not always fully appreciated or capitalised upon by pension funds,” she adds.
Additionally, achieving scale is challenging, since DC schemes rely on aggregating small cash flows for efficient trades, which is difficult with ETFs trading at varying times throughout the day and at different prices, according to Kataora.
Tax challenges
There may also be potential tax drawbacks for UK DC schemes. Many ETFs are domiciled outside the UK, with a significant number being based in the US.
These ETFs often distribute dividends that are subject to withholding tax in the country of domicile before the dividends are paid out to investors. For example, US-domiciled ETFs typically have a 15 per cent withholding tax on dividends paid to UK investors, including pension schemes.
This can be seen as a potential issue for DC schemes, as not being able to reclaim this withholding tax will reduce the overall return on the investment when compared to other pooled funds.
Tax considerations for ETFs vary by domicile and will depend on tax treaties signed between individual countries. So a scheme investing in an ETF holding S&P 500 stocks but domiciled in Luxembourg would face a 30 per cent US withholding tax due to the tax treaty between Luxembourg and the US.
As a result, pension schemes investing in foreign ETFs face more complex tax reporting and may incur higher management fees and unexpected costs.
The picture is more complicated with ETFs investing in commodities, including oil and gold, and currency ETFs. Precious metals ETFs face higher taxes on gains (up to 31.8 per cent), and currency ETFs have different tax treatments depending on their structure.
However, such withholding charges won’t apply to UK-based ETFs, but there may be other tax charges. Pension schemes don’t typically pay stamp duty on ETF purchases, but there may be other transaction costs associated with ETFs which can impact returns. In addition, if the ETF is holding UK shares, the underlying purchases of these shares may incur this charge, indirectly affecting the net asset value of the ETF.
However, Kataora says the ability to trade ETFs directly on the exchange helps manage “redemption requests” – which are withdrawals or sales – without selling underlying assets, therefore avoiding additional taxes and maintaining market exposure.
Flexibility and liquidity
ETFs can offer a number of advantages for DC schemes, particularly when it comes to flexibility and liquidity, allowing for quick adjustments to portfolios throughout the trading day, which isn’t possible with traditional mutual funds.
This enables pension funds to respond quickly to market changes, manage transitions between fund managers, and implement tactical asset allocation strategies effectively, according to Kataora.
Leslie agrees that the ability to trade ETFs throughout the day improves liquidity, particularly during times of market stress.
“Care has to be taken with cost as, whilst ETFs may on the face of things appear cheaper compared to institutional versions, they often do not carry any sales load in the price quoted. They can, however, still be attractive from a fee perspective.
“In terms of transparency, most ETFs will disclose their holdings daily, meaning that you do not have to wait until the quarter end to see details of underlying holdings.”
Counterparty risk
There are some additional risks to potentially bear in mind when investing in ETFs. Kataora mentions that synthetic ETFs, which use derivatives to mimic index performance instead of directly owning the underlying securities, carry higher counterparty risk.
However, synthetic ETFs often enable DC schemes to get exposure to markets or asset classes that would be difficult to obtain through physical ETFs or potentially other fund structures. Although there is obviously the risk that the derivatives provider, often an investment bank, is unable to meet its financial obligations, which could result in significant losses.
Kataora explains: “Pension funds assess the risk that the counterparty could default on its obligations, leading to losses.”
Voting rights
Another challenge with ETFs is that voting rights on investments are often managed by the ETF issuer, which limits individual investors’ influence on corporate decisions related to those assets. ETFs are traded like shares on an exchange and pension funds may struggle with this aspect unless they can directly buy and sell individual stocks.
Deborah Fuhr, managing director of research firm Exchange Traded Fund Global Insights (ETFGI), explains: “Only the largest pension plans have the ability to buy and sell shares and therefore buy and sell ETFs. So that makes their use of ETFs less than you might see in other jurisdictions because of the way ETFs work.
“There are cases where pension funds in the UK will outsource to an asset manager and at times those asset managers will actually hold ETFs, some of them on behalf of the pension funds.
“But ETFs may not be the best solution for pension funds depending on the size of the investment, the time horizon, and the benchmark.”
According to Fuhr, for significant longer-term investments, pension funds often prefer segregated accounts where they hold the securities directly, allowing them to exercise voting rights, especially on important issues like ESG concerns.
Consultant perspective
Pension funds often rely on investment consultants, who typically focus on selecting actively-managed investments and have not widely embraced or recommended ETFs.
As a result, ETFs are often overlooked as a potential tool for pension funds. She adds: “Often consultants tend to be paid to do manager selection for actively managed mandates and have tended not to encourage or advise on the use of ETFs. In general, you see that the consultants have not really embraced the idea that it makes sense for pension funds to use ETFs.”
Meanwhile, Kataora observes that for DC schemes, accessing ETFs can often involve working with investment brokers or custodians, which can incur additional costs, potentially outweighing the benefits of opting for these lower-cost investments.
ETFs can have a role to play in DC investment strategy, giving schemes more flexibility during times of market turbulence and helping them diversify more effectively. But there are still some technical hurdles that mean they will not be right for all schemes. Scheme managers and their investment consultants need to be aware of all complexities and costs.