EDHEC May-2010

An EDHEC-Risk Institute Publication
The EDHEC European ETF

Survey 2010
May 2010
with the support of
Institute
Table of Contents
Executive Summary ............................................................................................... 5
1. Introduction .....................................................................................................19
2. Background........................................................................................................23
3. Methodology and Data....................................................................................65
4. Results ................................................................................................................69
5. Conclusion ...................................................................................................... 103
References ............................................................................................................107
About EDHEC-Risk Institute .............................................................................113
About Amundi ETF ..............................................................................................117
EDHEC-Risk Institute Publications and Position Papers (2007-2010) ...... 121
We thank Amundi ETF for its support for our research.
Printed in France, May 2010. Copyright© EDHEC 2010.

2 The opinions expressed in this study are those of the authors and do not necessarily reflect those of EDHEC Business School.
The authors can be contacted at research@edhec-risk.com.
The EDHEC European ETF Survey 2010 — May 2010
Foreword
This survey has been taken as part of survey respondents see a need for new
the second year of the Amundi ETF products on, say, emerging markets and
"Core-Satellite and ETF Investment" alternative asset classes. Likewise, ETFs are
research chair. At EDHEC-Risk Institute, still used mostly in static strategies and
the objective of this research chair is to on broad market indices; their potential
provide research insights into the recent contribution to dynamic asset allocation
development of ETFs (exchange-traded and to allocation strategies in precisely
funds) and the ways they are used in core- defined market segments or styles is not
satellite asset management. For EDHEC- yet fully exploited.
Risk Institute, it is only natural to devote
significant resources to this research topic; As part of this document, we also provide
after all, both indexing and dynamic asset a background section with examples
allocation are a main focus of our asset that show how dynamic risk-budgeting
management research. strategies can be used with ETFs. This
section provides risk-controlled exposure
In the past decade, ETFs have stood out to the outperformance of specific asset
for their fast growth. Last year’s survey classes by implementing dynamic core-
results suggested that ETFs were one of satellite investments with ETFs. We thus
the few financial product innovations to hope to provide food for thought on how
weather the 2008 financial crisis without the liquidity of ETFs can be brought to its
undue pain, probably because, at the time, full benefit.
investors valued liquidity and transparency
above all. We would particularly like to thank our
partners at Amundi ETF for their support
This year’s results of our pan-European of our research and the publishing team
survey suggest that, as a consequence of led by Laurent Ringelstein.
strong growth, the industry has entered
a phase of increased maturity: ETFs are
now very widely used, and investors are
embracing innovative ETF products and
more advanced ways of trading them.
As the ETF market grows, so does the Noël Amenc
relevance of the impact of ETFs on the Professor of Finance
Director of EDHEC-Risk Institute
market as a whole. Both academic studies
and comments from survey respondents
suggest improvements in liquidity and
efficiency of markets in the underlying
securities as well as in related instruments.
Despite the increasing maturity of the ETF
business, the survey suggests that there is
still room for development. In particular,
An EDHEC-Risk Institute Publication 3

About the Authors
Felix Goltz is head of applied research at EDHEC-Risk Institute. He does

research in empirical finance and asset allocation, with a focus on alternative
investments and indexing strategies. His work has appeared in various
international academic and practitioner journals and handbooks. He obtained
a PhD in finance from the University of Nice Sophia-Antipolis after studying
economics and business administration at the University of Bayreuth and
EDHEC Business School.
Adina Grigoriu is head of asset allocation at AM International Consulting,

where she advises asset managers on constructing their hedge fund of fund
portfolios as well as dynamic core-satellite portfolios. She has an actuarial
degree and extensive experience in finance, including quantitative modelling.
She started her career as a derivatives trader. She then joined a multinational
asset management company where she held several positions, ranging from
product manager to fund manager and head of ALM.
Lin Tang is a research analyst at EDHEC-Risk Institute. She has a master’s

in risk and asset management from EDHEC Business School. Lin worked
as a product engineer for one year after receiving her bachelor’s in
engineering, with first-class honours, from Nanyang Technological University
in Singapore.
4 An EDHEC-Risk Institute Publication

2. Implementing
Executive Efficient
Summary
Indexation

Executive Summary
This study analyses the possible uses of an overview of the main survey results
ETFs (exchange-traded funds) in investment for current and future uses of ETFs in
management and gives a detailed account Europe.
of current perceptions and practices of
European investors in ETFs. ETFs have
experienced tremendous growth in the New Risk-Budgeting Techniques:
past decade: the first European ETF was Dynamic Asset Allocation Based on
launched in 2000, and by late 2009 there ETFs
were 829 ETFs in Europe and ETF assets
under management amounted to around The core-satellite approach
€227 billion (Fuhr and Kelly 2009b). We provide various illustrations of how ETFs
can be used in the dynamic core-satellite
An oft-mentioned advantage of ETFs approach. The timing of this study allows
is their liquidity. This attribute can be us to include a particularly volatile time
exploited in dynamic asset allocation period in financial markets: the aftermath
strategies that use frequent changes of the Lehman failure at the end of 2008,
in portfolio weights to keep risk under the sharp drop in stock prices in early 2009,
control. The background section of this and the pronounced recovery for the rest
document describes in detail how ETFs are of the year. Including such a period with
designed and how they may be used for the recent extreme market conditions may
such dynamic risk-budgeting techniques. provide a good test of the robustness of the
Our aim here is to provide investors with asset allocation methods analysed.
useful background information on ETFs
and with conceptual and methodological The core-satellite approach allows
ideas on how ETFs may be used to their full investors to separate their portfolio
advantage in asset allocation decisions. management into the construction of a
strategic benchmark and the generation
As the ETF market has gotten bigger and of outperformance of that benchmark. The
more sophisticated, it is essential for ETF benchmark is constructed in the core and
investors to be informed of the views and outperformance is sought in the satellite.
practices of their peers. The second part Core portfolios may be made up of an
of this document focuses on the results allocation to broad market indices or indices
of a survey of 192 European ETF users, for specific segments. Satellite portfolios
who provided us with information on may try to generate outperformance by
their current use of ETFs and their views deviating from the core portfolio, either
of various issues with ETFs and competing with exposure to other asset classes or
indexing products. segments or with exposure to actively
managed funds. Indexing vehicles such
To summarise the main findings of the as ETFs may thus be used in both the core
study, we will first look into dynamic and the satellite.
risk-budgeting techniques using ETFs
and highlight specific examples from the The separation of portfolio management
background section. We will then provide into benchmark construction and

Executive Summary
outperformance generation allows Dynamic core-satellite portfolio

investors to structure their portfolio management
management tasks in a coherent manner. The dynamic core-satellite approach is a
Moreover, it allows straightforward new concept that builds on the principle
tracking error management. Since the of constant proportion portfolio insurance
core portfolio is, by definition, free of (CPPI). This procedure enables asymmetric
any tracking error with respect to the return profiles through systematic dynamic
benchmark, the satellite portfolio is the allocation rules. Dynamic core-satellite
only source of tracking error. The tracking management extends this approach to
error of the overall portfolio is thus asymmetric tracking error management.
determined by the weights attributed to Investors will thus be certain that any
the core and the satellite. By fixing the underperformance of the benchmark will
weights of a satellite with a tracking error be capped. Dynamic shifts in allocation are
of 20%, for example, at 10%, 20%, or 30%, made not to a risky and a risk-free asset
the tracking error of the overall portfolio in the absolute sense, but to the satellite
is 2%, 4%, or 6%. portfolio and the core portfolio. The core,
of course, is free of tracking error risk; the
However, such static allocation, in which satellite is not.
the proportions invested in the core and the
Exhibit 2: This table compares the traditional CPPI and the
satellite are constant, does not distinguish relative CPPI approaches
between “bad” (underperformance of the Traditional CPPI Relative CPPI approach
benchmark) and “good” tracking error Risky asset Satellite portfolio
(outperformance of the benchmark). The Risk-free asset Core portfolio
full potential of core-satellite portfolio
management is reached only when the The advantage of the dynamic core-satellite
allocation to the core and to the satellite approach is that it allows an investor to
is adjusted dynamically. The dynamic truncate the relative return distribution
core-satellite approach of Amenc, Malaise so as to shift the probability weights from
et Martellini (2004) is a method for such severe relative underperformance to more
asymmetric management of tracking potential for outperformance.
error; the idea is to benefit from satellite
outperformance while limiting the risk of
downside tracking error.
Exhibit 1: Allocation to core and satellite allows control of tracking error risk
Static core-satellite approach
symmetric management of tracking error by fixing allocations to core and satellite
Dynamic core-satellite approach

asymmetric management of tracking error by using a dynamic strategy to limit underperformance of the core while
benefiting from the upside potential of the satellite
Core Satellite
Defines the investor’s long-term choices in terms of risk/return profile through Seeks to outperform the core while
• exposure to standard commercial indices introducing tracking error through
• improved allocation to sub-segments (such as sectors, styles, etc.) or asset • exposure to additional risk premia
classes • alpha obtained by an active strategy
• improved allocation to constituents of commercial indices (new forms of
indexing)

Executive Summary
In the dynamic core-satellite approach, a incorporate so-called investment goals.

floor determines the investor’s risk budget. Instead of imposing a lower limit on total
If the difference between the floor and portfolio value, an investment goal (or cap)
the total portfolio value increases, i.e., if restricts the upside potential of the portfolio.
the cushion becomes larger, the investor’s Although they may seem counterintuitive
risk budget increases and more assets are at first glance, goal-directed strategies
allocated to the riskier satellite. By contrast, reflect the possible failure of an investor
if the cushion becomes smaller—that is, if to gain additional utility once some level
there is less room in the risk budget—the of wealth is reached. In other words, once
share of investment in the satellite falls. this wealth is reached the hope of realising
more gains becomes the fear of losing
In standard dynamic core-satellite the accumulated wealth. By forgoing this
investment, this floor is a constant possible extra wealth, investors benefit
fraction of a given benchmark value; it from a decrease in the cost of downside
protects the portfolio from severe relative protection. These investment goals may be
losses. Depending on the investment constant or they may be a deterministic or
purpose, however, different floors stochastic function of time.
might be used to exploit more fully the
benefits of core-satellite management. We use several examples to illustrate the
Indeed, core-satellite management can benefits of the dynamic core-satellite
accommodate more complex or even investment strategy. In several of these
multiple floors. examples, we take dynamic allocation to
a defensive bond core (government bond
The most commonly used alternative ETFs) and a risky equity satellite (Euro Stoxx
floors are the capital guarantee floor, 50 ETFs). We provide an overview of this set
the maximum drawdown floor, and the of examples in the next two sections.
trailing performance floor. The capital
guarantee floor, usually used in CPPI, Dynamic core-satellite portfolio
attempts to preserve the initial invested management with ETFs: absolute
wealth. Maximum drawdown floors are return funds
designed to prevent the total portfolio In the first example, we look at the
value from falling more than a specified management of a portfolio with an absolute
fraction of the highest asset value it has return objective. Investors interested in
ever attained. So this particular floor is absolute return strategies expect market
suitable for absolute return funds. Finally, conditions not to have a great negative
the trailing performance floor is meant to impact on portfolio performance; they
prevent a portfolio from posting negative expect drawdown not to be substantial.
performance over a twelve-month trailing So, in our example, we rely on a dynamic
horizon, regardless of the performance of core-satellite investment with a maximum
equity markets. drawdown floor. Moreover, the twelve-
month trailing performance of the
Besides imposing different floors, dynamic portfolio shall not be negative, and we
core-satellite management can also define an investment goal to limit the

Executive Summary
risky upside potential of the investment. the satellite are tremendous, with a sharp
The core consists of a broad government increase in value before 2000, steep falls
bond ETF, the satellite of a broad equity from 2000 to 2002 and in 2008, and a spike
ETF. Furthermore, to limit overall risk the in March 2009. The dynamic core-satellite
maximum allocation to the satellite is arrangement combines the advantages
restricted to 50%.1 of each of its ingredients: the smooth
performance of the bond core and the
Exhibit 3 shows the cumulative returns of upside potential of the equity satellite. As
this strategy, as well as those of the core a result, performance is smooth over the
and the satellite. In addition, to highlight entire period, and cumulative returns at the
the built-in protection of this investment end of the period are actually higher than
strategy, the floor is displayed as well. those of both the core and the satellite.
The graph also shows the dynamics of the
We can draw a number of conclusions floor. It is instructive to look at portfolio
from this figure. The dynamics of the performance during the stock market
core portfolio confirm the conservative downturn beginning in 2000. In fact, the
character of the core investment. However, dynamic core-satellite portfolio is little
1 - The bond ETF for the core
consists of medium-term
we also see that the performance of the affected. As the portfolio value approaches
government bonds with bond core was quite flat for extended the floor, the allocation shifts to the core.
terms to maturity of three to
five years. The equity satellite periods, such as from 1998 to 2000, or from A similar pattern can be observed starting
is made up of blue-chip
European stocks (Euro Stoxx
2004 to 2006. The returns of the equity ETF in the second half of 2008. This shift is
50). Please refer to the main in the satellite portfolio were lower than also shown in the following graph, which
document (section 2.2.2) for
further explanation of the those on the core portfolio when seen over shows the weight of the satellite.
exact implementation of the
example.
the entire period. More importantly, the
fluctuations of the large cap equity ETF in
Exhibit 3: Absolute return fund: cumulative returns of the core, the satellite, and the dynamic core-satellite portfolio

Executive Summary
Exhibit 4: Absolute return fund: changes in the allocation to the satellite
Controlling the risk of tactical bets ratios from 7/12 to 11/12. Our scenarios
with dynamic core-satellite portfolios also assume that the manager will allocate
of ETFs 0% of the portfolio to the satellite if he
The previous example shows that dynamic thinks the satellite will underperform the
risk budgeting can provide sound absolute core the following month and 50% if he
return management and that it is easily thinks that it will outperform.
implemented with ETFs for traditional
asset classes (equity ETFs and bond ETFs). The resulting scenarios show that though
What makes it remarkable is the absence they obviously have attractive average
of reliance on forecasts. The systematic returns such strategies suffer from severe
allocation based on past values of the bond drawdown. Even with extremely high
core and the equity satellite portfolio means and clearly unrealistic hit ratios of 11/12
that the investor takes on no forecasting maximum drawdown is considerably higher
risk. than in the absolute return portfolio based
on the dynamic core-satellite approach we
Of course, investment houses may have described above.
access to proprietary forecasts that they
may wish to use to shift the allocation It is natural to wonder whether it is
from the core to the satellite or from the possible to combine the return potential of
satellite to the core. To test the ability of forecasting and downside risk management
such a strategy to obtain absolute return that would mitigate the high maximum
properties similar to those of the dynamic drawdown. We thus integrate the active
core-satellite approach described above, we manager’s forecasting ability into the
run simulations in which we assume that a dynamic core-satellite investment concept.
tactical manager has positive forecasting Since the main objective is to reduce the
skill; that is, that he correctly forecasts drawdown statistics that result from the
monthly satellite outperformance seven errors of skilled forecasters, we define the
times out twelve (his hit ratio, in other floor so as to impose a maximum drawdown
words, is at least 7/12). We assume hit of 10%. If the manager expects the satellite

Executive Summary
to outperform the core, the multiplier is tracked by ETFs makes it possible to further
set to m=5. customise the core and the satellite. These
examples, then, are some of the possible
But if he expects the satellite to applications of ETFs. We turn now to the
underperform, the multiplier is set to survey responses.
m=0. In such situations, the portfolio is
fully protected from the expected negative
performance of the satellite. Current Use of Exchange-Traded
Funds by European Investment
Exhibit 5 shows the percentage by which Professionals
combining the dynamic core-satellite The responses we obtained from European
(DCS) framework and forecasts reduces investment professionals reveal an
the maximum drawdown found in standard increasingly mature ETF market. Despite
tactical allocation (forecasts alone). this increasing maturity, the respondents’
views indicate that ETF products still have
The table shows that risk control leads to ample room for further development. For a
significant benefits, especially when the hit longer-term perspective on the results, we
ratio is comparatively low. In short, dynamic also indicate corresponding results from the
risk budgeting makes it possible to limit the ETF surveys we have taken since 2006.
severe drawdown resulting from forecast
errors in the standard tactical allocation The maturing
strategy. The same forecasting ability was of the ETF market and ETF users
used for both strategies. The survey results show that the frequency
of ETF use—the percentage of respondents
The two examples summarised here show who use ETFs in a given asset class that
that the DCS approach provides a coherent they generally invest in—is starting to
framework with which to structure portfolios level off, but that the intensity of use—the
that allow investors to gain exposure percentage of total investment a given asset
to the upside potential of certain asset class accounted for by ETF-like products—
classes and to keep risk, either absolute has grown significantly over the past
or relative to a benchmark, under control. year. Moreover, our results suggest th at
It is kept under control by rebalancing advanced products such as inverse and
the positions in keeping with the leveraged ETFs have become major
investor’s dynamic risk budget. Since components of the ETF markets and that
ETFs are easily traded, they are a investors are more likely to trade ETFs over
natural medium for such strategies. the counter or to trade options on ETFs.
In addition, the wide range of indices
Exhibit 5: Reduction of the maximum drawdown when forecast-based tactical asset allocation is made part of the dynamic core-
satellite framework.
Hit ratio of prediction of outperformance of the satellite 7/12 8/12 9/12 10/12 11/12
Risk reduction through DCS (reduction in magnitude of 44% 34% 23% 13% 1.3%
avg. max. drawdown) compared to the standard tactical
allocation approach

Executive Summary
Exhibit 6 shows that the frequency of Intensity of use, however, has increased
ETF use is much the same as that of last sharply. For the respondents who do invest
year, though there is growth in certain in the particular asset class, exhibit 7
asset classes. In short, ETFs for fixed- shows the share of their portfolios accounted
income products are used with increasing for by ETFs. Other than equity ETFs, whose
frequency this year (from 61% to 68% for share has fallen, ETFs have gained a significant
government bond ETFs and from 55% to share of assets over the past twelve months.
60% for corporate bond ETFs). Hedge fund Hedge fund ETFs now account for one-fifth
ETFs are also seeing increasingly frequent of the hedge fund investments of the
use (34% to 38%). On the whole, increases respondents who use ETFs for this particular
in the frequency of use are much flatter asset class.
than in years past.
Exhibit 6: Use of ETFs or ETF-like products over time
Exhibit 7: Percentage of total investment accounted for by ETFs or ETF-like products

Executive Summary
Advanced uses of ETFs, such as securities Post-crisis rebound

lending, trading options on ETFs, and short and satisfaction with ETFs
selling ETFs, are used by only a small fraction As the 2010 survey was taken after a severe
of respondents (less than 15%). financial crisis had given way to general
easing, satisfaction with ETFs rebounds.
But options on ETFs have progressed well, Dissatisfaction, especially with the liquidity
as they are now used by 8% of investors, and performance of ETFs for alternative
up from 6% the year before (see exhibit asset classes, had been expressed in the
8).2 The use of inverse and leveraged ETFs 2009 survey. It is now back at 2008
is now relatively common and these product levels.
innovations are now firmly established.
Exhibit 8 shows these results. For example, exhibit 9 shows that
satisfaction with real estate ETFs, hedge
Exhibit 8: Advanced uses and forms of ETFs
2 - We have no numbers for

2006 as inverse ETFs were
launched only after 2006.
The question for the use of
leveraged ETF has been asked
since the 2010 survey.
Exhibit 9: Satisfaction with ETFs or ETF-like products over time

Executive Summary
fund ETFs, and corporate bond ETFs has Impact of ETFs on the broader market
increased in the past year. As the ETF market is maturing and as these
instruments are ever-more widely used,
These high degrees of satisfaction are one naturally wonders what impact ETFs
consistent with survey respondents’ views make on the broader markets. Academic
of ETFs, views often more favourable than studies have shown that there is a
those of competing indexing vehicles. significant improvement in the liquidity
When it comes to comparing ETFs, futures, of underlying markets as well as in the
total return swaps, and traditional index price efficiency of the futures market
funds, our survey confirms that ETFs, along after the introduction of ETFs (Hegde and
with futures, are the preferred indexing McDermott 2004; Madura and Richie 2007;
vehicles. Ackert and Tian 2001; Deville 2005; and
Deville and Riva 2007). Exhibit 11 shows
The table below indicates the average ratings that many respondents have themselves
received by each instrument on a range observed that ETFs have improved the price
of criteria and on a scale of one (poor) to efficiency of the spot and future markets.
three (very good). Overall, ETFs and futures Moreover, many respondents have observed
receive the highest scores, while total return increased liquidity in the underlying market
swaps receive the lowest. ETFs are rated after the introduction of an ETF.
outstanding for ease of use (minimum
subscription and operational constraints) Other academic studies find that futures
and range of products. ETFs also outscore lag ETFs in incorporating information on
traditional index funds on all ten criteria; financial markets. Hasbrouck (2003) and
overall, index funds have a score of 2.15, Tse, Bandyopadhyay, and shen (2006), for
as compared to 2.37 for ETFs. These ratings example, show a clear price leadership
suggest that total return swaps (TRSs) are of the ETF market over the spot market.
particularly poor in the sense that they are This leadership suggests that ETFs process
less liquid, costlier, and harder to use than information faster than the spot market.
the three other products. Exhibit 12 shows that about half of
Exhibit 10: Summary of the ratings for ETFs, futures, TRSs, and index funds
ETFs Futures TRS Index Funds
QUALITY
Liquidity 2.42 2.82 1.73 2.15
Cost of liquidity 2.16 2.70 1.78 2.08
Other costs 2.25 2.70 1.83 1.89
Tracking error 2.28 2.51 2.47 2.19
Product range 2.52 2.07 2.10 1.99
Transparency 2.27 2.75 1.93 2.20
Minimum subscription 2.76 2.13 1.55 2.28
Operational constraints 2.53 2.15 1.60 2.24
Regulatory regime 2.39 2.42 1.80 2.36
Tax regime 2.12 2.19 2.02 2.09
Average score 2.37 2.44 1.88 2.15

Executive Summary
Exhibit 11: Concerning price efficiency, have you observed...
Exhibit 12: Do you watch information on ETFs to gain access to information about the underlying securities?
respondents frequently monitor information It is clear that ETFs are still used mainly in
on ETFs rather than on the underlying market. static strategies and that the focus is on
In other words, practitioners rely heavily on broad market indices. The use of ETFs for
the price leadership of ETFs and thus exploit dynamic strategies and on clearly defined
ETFs not just as investment vehicles but also sub-segments of the market is far from
as sources of information. reaching its peak. Exhibit 13 provides an
overview of the purposes for which—and
Room for further innovation and the frequency at which—ETFs are used by
improvement our survey respondents.
The significant impact that ETFs now have
even on related and underlying markets, Exhibit 14 confirms that the dominance
as well as the high rates at which they of broad market ETFs is particularly
are used, shows that the market has pronounced in core portfolios. This exhibit
attained a considerable degree of maturity. summarises the use of different ETFs in the
At the same time, patterns of use and core-satellite allocation. The results show
survey responses suggest that there is that, although ETFs on finer segments of
considerable room for further development the respective markets are used relatively
of ETF products and for new ways of using often as satellite vehicles, the dominance
them. of broad market ETFs in the core is clear.

Executive Summary
Exhibit 13: How often do you use ETFs for the following purposes?
This dominance is not limited to managers focus on using broad market

equities, as these ETFs also account for indices.
the bulk, though to a somewhat lesser
degree, of the demand for government When asked what they would like to see
bond ETFs and corporate bond ETFs. developed, survey respondents emphasise
On the whole, perhaps the most telling emerging market ETFs, high yield bond ETFs,
information from exhibit 14 is that, and alternative asset class ETFs, as shown
instead of actively managing their in exhibit 15. So, despite the hundreds of
long-term beta exposure to obtain the ETFs already made available to investors in
most efficient risk/return tradeoff in their Europe, there is considerable room for new
core portfolios, European investment product development.
Exhibit 14: Summary of the use of different instruments in the core-satellite allocation
In the core In the satellite In both
Equity ETFs
Broad market ETFs 73% 12% 8%
Style ETFs 18% 47% 3%
Sector ETFs 10% 52% 5%
Government bond ETFs
Maturity-segment ETFs 32% 32% 0%
Inflation-protected bond ETFs 48% 16% 4%
Corporate bond ETFs
ETFs by credit rating segment 7% 37% 4%
Alternative asset ETFs
Real estate 16% 32% 0%
Commodities 18% 55% 7%
Hedge funds 14% 27% 4%
Infrastructure 4% 36% 0%

Executive Summary
Exhibit 15: What type of ETF products would you like to see developed further in the future?
Conclusion satellite investments. In addition, maximum

The objective of the EDHEC European ETF drawdown, i.e., extreme risk, is limited.
Survey 2010 is to provide insight into
current and potential uses of ETFs. To reach The uses to which European investors put
this objective, we analyse the uses to which ETFs provide interesting insight. First, the
European investors and asset managers results of our survey show that ETFs are
put ETFs as well as their perceptions of widely used and that they are becoming
these instruments. We also provide an even more important to investors. ETFs
introduction to dynamic core-satellite satisfy practitioners across all asset
portfolio management and show how classes. As the market has matured, the
investors can structure risk-controlled percentage of investors using ETFs is
portfolios of ETFs to meet particular increasing at a much slower rate than
risk-budgeting objectives. in the past. However, ETFs account for
a still-growing share of portfolio assets.
Taken together, our illustrations of Second, our survey results show that
dynamic core-satellite portfolios highlight ETFs, as they have grown into a large and
the potential benefits of combining the liquid market, may have a positive
tradability of ETFs and dynamic risk impact on the broader market; ETFs
management. Although core-satellite now provide investors with information
investments can be static, the illustrations and increase market efficiency.
show that their full potential is reached Third, our survey sheds light on possible
when the allocation to the satellite future developments in the ETF industry.
and the core is adjusted dynamically. Investors would like to have a broader
The main benefit of this dynamic choice of relatively risky products for
adjustment is that it allows investors to traditional asset classes and more new
take advantage of rising markets and, at products for alternative asset classes.
the same time, limits their risk. As a result, When it comes to their role in asset
dynamic core-satellite strategies often offer allocation, the EDHEC survey shows that
a better risk/return tradeoff than core or ETFs are used mainly as static vehicles.

Executive Summary
And the large majority of investors who

take a core-satellite approach to portfolio
management report that they rely mainly
on broad market indices, especially in
the core. But the wide range of ETFs for
sub-categories and styles is left partly
unused. On the whole, it seems that there
is still room for innovation in the ETF
market: new ways of using ETFs and new
ETF products would both be welcome.

2. Implementing Efficient
1. Introduction
Indexation

1. Introduction
Exchange-traded funds (ETFs), investment survey sheds light on developments in the

vehicles that track a given index or ETF market in the last few years.
benchmark, are perhaps one of the greatest
financial innovations of recent years. Unlike In addition to their intrinsic appeal, ETFs
conventional index funds, however, ETF provide a very convenient means of
units trade on stock exchanges at market- improving asset allocation in portfolio
determined prices, thereby combining the management. Indeed, this survey also
advantages of mutual funds and common illustrates how ETFs can be used in
stocks. conjunction with core-satellite portfolio
construction. This dynamic risk-budgeting
Although the first European ETF came technique, which has attracted growing
on the market only in 2000, assets under investor interest in recent years, splits the
management of ETFs amounted to $227 portfolio into a core, which fully replicates
billion as of late December 2009 (Fuhr and the investor’s specifically designated
Kelly 2009b). In less than ten years, ETFs benchmark, and a return-generating
have become a serious alternative to other satellite (or satellites), which is allowed
financial products, such as futures or index a greater tracking error. This survey
funds, that allow participation in broad demonstrates the main benefits of this
market movements. In addition, ETFs are asset allocation strategy: benefiting from
one of the few products that seem not the upside while keeping overall risk low.
to have been hit by the financial crisis.
European mutual funds suffered outflows The EDHEC European ETF Survey 2010
of $570 billion over the course of 2008; began with an online questionnaire
ETFs, by contrast, collected $74 billion (Fuhr of European professionals in the asset
2009). management industry. For a read on the
possibly diverging views and opinions
And the ETF market is still growing: whereas across the industry, this survey targeted
the first ETFs attempted to replicate the institutional investors as well as asset
performance of broad equity markets, newer management firms and private wealth
products are venturing into more exotic managers. The questionnaire consists
markets and asset classes, such as emerging of sections covering the role played by
markets and alternative investments, real ETFs in the survey respondents’ asset
estate, infrastructure, private equity, allocation decisions, practical aspects of
and even hedge funds. As the market is ETF investments, as well as the applications
maturing, being aware of the views and of ETFs for portfolio construction.
practices of ETF investors is essential. The In addition, the questionnaire asks
aim of this survey is to contribute to this respondents to compare ETFs and other
awareness by analysing the current uses and investment instruments that can be
perceptions of ETFs in Europe. It is our hope considered close substitutes: total return
that this survey will provide insight into swaps, futures, and index funds. Finally,
how ETFs could further benefit investors. we invited survey respondents to express
Finally, as it compares results with the their views on future developments in the
results of past EDHEC ETF surveys, this ETF market.

1. Introduction
On the whole, our results suggest that markets and high yield debt and new forms
the ETF industry, though in a phase of of indices for traditional classes as well as
increasing maturity, is still experiencing more options for alternative asset classes.
strong growth. As a result of this growing
maturity, ETF users are taking advantage However, the use of ETFs is somewhat
of more advanced uses of ETFs: over-the- limited to passive holdings of broad
counter trading, leveraged and short ETFs, market indices. The wide range of ETFs for
and others. ETF users also have clearer views sub-segments and styles is not used to its
of the construction methods they prefer; full potential. Likewise, most practitioners
passive ETFs are clearly preferred to active do not benefit from the possibilities of
products, and an emerging consensus on trading options on ETFs, selling ETFs short,
replication sees physical and synthetic or lending them out.
replication preferred to statistical sampling.
ETF users, however, are still demanding more ETFs and futures are the preferred indexing
product development and most intend to instrument. Most of all, ETFs are perceived
increase their exposure to ETFs. to have an edge over other products, such
as total return swaps and index funds,
Survey results show that ETFs are widely in terms of liquidity, transparency, and cost.
used and that they are becoming even more Respondents also appreciate the wide range
important to investors. Satisfaction with ETFs of products and asset classes available with
in all asset classes is very high. In addition, ETFs. So it would come as no surprise if ETFs
the share of total investment accounted and futures were to take market share from
for by ETFs is growing significantly. The index funds and total return swaps.
percentage of those who use ETFs in the
relevant asset classes shows that ETFs are This survey proceeds as follows. In the
very popular with investors, especially next section, we review the European ETF
in equity (96%) and commodity (80%) market and explain this financial product
sectors. in more detail. We then illustrate how ETFs
can be used in core-satellite investment.
The results also show that there are some The method used to take the survey is
emerging trends in the ETF industry and described in section 3. European investors’
that new products are being developed. views of ETFs, the uses of ETFs, and
Investment in OTC markets has grown comparisons of ETFs and other indexing
considerably in the last year. About products are presented in section 4. Section
one-third of investors have adopted the 5 draws conclusions from the survey
advanced form of ETFs—leveraged ETFs. results.
Although investors prefer pure replication
ETFs, interest in synthetic replication
ETFs is growing. Furthermore, investors
observe improvements in markets through
the introduction of ETFs. As for future
developments, investors expect to see more
products providing exposure to emerging

1. Introduction

2. Background

2. Background
2.1. Overview of Exchange-Traded in April 2000. Although the European ETF

Funds industry started late and the US accounts
An exchange-traded fund (ETF) is for over 68% of the global ETF market
an investment vehicle whose shares (Fuhr and Kelly 2009b), Europe is catching
(units) are traded on stock exchanges up. Total ETF assets increased by 45.7%
at market-determined prices. Most ETFs over the year 2009; European ETF assets
are index funds that consist of a basket grew by 59% (Deutsche Bank 2010).
of securities and attempt to track, as
closely as possible, the performance of Growth of the European ETF market
market indices or benchmarks. Unlike Exhibit 2.1 shows that the European ETF
traditional index funds, however, they are market has expanded enormously since its
distinct investment vehicles with stock- 2000 kick-off. Assets under management
like characteristics: they are listed on had risen to $227 billion by the end of
exchange and, like normal stocks, they December 2009. More than 800 ETFs were
can be bought and sold at market prices available, almost double the 423 available
during trading hours. They can also be just two years earlier. ETFs on alternative
traded in the same ways as other stocks asset classes grew faster than any other
are traded (they can be bought on margin, ETF product segment. Hedge fund ETFs
sold short, and so on). As such, an ETF grew to €684mn over the last twelve
is a hybrid of a stock and a fund. With months from zero at the end of 2008
these new instruments, investors can gain (Deutsche Bank 2010). Commodity ETFs
broad exposure to equity, fixed income, grew 176% to €10.18bn; currency ETFs
and alternative asset markets with much 196% to €170mn.
less effort and at lower cost than they
Exhibit 2.1: European ETF market growth
could before. ETFs, then, can be regarded
as an innovative financial instrument that
widens the range of options available to
investors. Müller and Weber (2009) have
shown that more sophisticated investors
would be more likely to invest in such
low-cost investment products than less
sophisticated investors. Despite their
simplicity, ETFs may thus be a tool that
corresponds to the needs of the more
sophisticated investors.
Source: Fuhr and Kelly (2009), data as of the end of December
2009
2.1.1. The European ETF Market
Launched on the Toronto Stock Exchange
(TSX) in 1990, ETFs have since flourished Market segmentation
worldwide. At the end of 2009, worldwide According to Fuhr and Kelly (2009b), at
ETF assets surpassed the US $1 trillion the end of 2009, Europe had surpassed the
milestone. In Europe, the first ETF, meant United States (where there are 772 ETFs)
to track the Euro Stoxx 50 index, appeared and was offering the largest total number

2. Background
of ETFs (829) in the world. Taken together, 2.1.2. Understanding ETFs

equity ETFs account for the majority As a combination of an index fund and a
of ETFs; nearly 70% of all ETF assets are stock, an ETF should be analysed from both
invested in this asset class (see exhibit 2.2). standpoints. Like traditional index funds,
ETFs tracking national indices are the most ETFs usually attempt to track or replicate
popular equity ETFs: seventy-one ETFs are a particular index of equities, debts or
pegged to domestic indices; they account other securities, a broad sector, or a group
for 16.22% of the European ETF market in of international stocks. Like mutual funds,
terms of asset under management. With ETFs are registered as open-end funds,
15.46% of the market, those covering continuously offering new fund shares
regional euro-zone indices rank second. to the public and required to buy back
Another 14.74% are international equity outstanding shares on request and at a
ETFs. Fixed-income ETFs are also popular; price based on the current value of the
they account for 22.64% of the total fund's net assets. Although the designs
European ETF market. Commodity ETFs, in of ETFs and mutual funds are similar,
third place, account for 6.7% of European investors can treat ETFs as normal stocks,
ETF assets. buying or selling ETF shares through a
1 - Sometimes ETFs are
wrongly classified as
broker or in a brokerage account, just as
Exhibit 2.2: Types of European ETFs by assets under
closed-end funds, since both
management (USD)
they would buy the shares of any publicly
exhibit similar features,
such as holding multiple traded company.1
securities and asset classes.
Furthermore, both can be
traded on exchange. The Physical replication ETFs, statistical
most important difference
from closed-end funds replication ETFs, and swap-based ETFs
is that ETFs always trade
very closely to their NAV,
An ETF’s replication mechanism is one of
since any deviation can be its defining features. Indeed, ETFs come in
exploited by arbitrageurs’
redeeming and then buying three flavours: physical index replication
new units. Closed-end funds,
by contrast, rarely trade at
funds, statistical replication, and swap-
their NAV. based replication. An ETF is considered a
physical replicating index fund (sometimes
also cash-based replication) if the ETF
manager holds all the constituents of the
22.64% Fixed income underlying index in the same proportion
16.22% Country exposure Europe - equity as the constituent securities of the
15.46% Regional exposure euro-zone - equity
14.74% International emerging markets - equity index. This approach offers a natural
5.30% Country exposure United States - equity replication of the target index. The main
6.69% Commodities
5.28% Regional exposure europe - equity advantage of this form of replication is its
4.49% European sector exposure - equity straightforwardness. The drawback is that
3.58% Global exposure - equity
2.41% Inverse/leverage/leveraged inverse it is difficult to implement when the index
2.07% Style - equity to be replicated is a broad index with a
0.87% Euro-zone sector exposure - equity
0.15% Currency large number of securities. This difficulty
0.03% Alternative arises from liquidity problems with index
0.01% US sector exposure - equity
0.05% Other constituents, clearing and settlement
Source: Fuhr and Kelly (2009b), data as of end 2009
problems, and the high cost of executing

2. Background
the basket of securities. So, even physical risk. This risk, of course, is realised only
replication will lead to tracking error. when the index outperforms the basket of
securities, since this difference obliges the
ETFs can also use statistical sampling counterparty to make cash payments. In
strategies to replicate the chosen index. addition, this risk is limited to 10% of the
Instead of fully replicating the index, fund’s value and before reaching this limit
the fund invests in only a fraction of the of 10% the swap position will reset. This
total index constituents. The aim is to limit is imposed by UCITS III regulation in
replicate the index by focusing on highly the European Union.
liquid underlying instruments. This form
is generally used for very broad indices, To manage counterparty risk rigorously,
where it is less costly than full replication. exposure to this risk is assessed and
But it necessarily leads to tracking error, monitored by the fund providers on a
the magnitude of which depends on the daily basis (Amery 2008b). As a result of
accuracy of the statistical replication the 2008 credit crunch, the fund providers
model. In addition, statistical replication usually set a lower limit than the UCITS
may lead to counterparty credit risk. requirement to ensure that exposure to
Counterparty risk arises when the manager the counterparty not exceed the limit
of the ETF tries to enhance performance (Amery 2008b; Cheng 2009). At the same
by lending or selling securities to buy time, fund providers are also seeking other
financial products that reduce the tax means of shedding counterparty risk.
burden. Over-collateralisation, a commonly used
form for hedging credit risk, has been
Finally, there are swap-based ETFs. The basic made part of the replication process of
idea of these funds is to outsource tracking swap-based ETFs. In over-collateralisation
error management to a counterparty: the the collateral assets will have a higher
fund itself invests in a broad basket that value than the net asset value of the ETF.
does not fully replicate the index. The In the event of counterparty default, the
replication itself is provided by the swap collateral will thus provide investors a
counterparty, and any differences in the comfortable margin of protection. Some
performance of the basket and that of the ETFs cover counterparty risk by buying
index are counterbalanced by the swap credit protection in the form of credit
payments. An ETF usually has a single swap default swaps.
counterparty, often the parent bank of the
fund provider. Some providers, however, Dividend distribution
use multiple counterparties for the swaps Like conventional index funds, ETFs can
held by their ETFs. Swap counterparties are deal with dividend payments in two ways.
indicated by the provider and their identity They may, for example, pay dividends to
is thus known to investors. The advantages their shareholders. Dividend payments on
of this third replication technique are that the securities held in the fund remain in
the ETF does not bear tracking error risk the fund in the form of cash until they are
and that swap-based replication comes at paid out at fixed time intervals. This leaves
low cost. However, it leads to counterparty the investor with the task of managing the

2. Background
reinvestment of these dividends, but also Primary and secondary markets

allows him to obtain periodic cash flows. Although ETFs are registered as open-
In between the fund’s dividend payment end funds, there are significant structural
dates, the accumulation of cash in the differences between ETFs and traditional
fund due to stock dividends may lead to mutual funds both in how their shares
small deviations of performance from the are issued and redeemed and in how their
index. ETFs may also reinvest dividends. shares or units are traded. Exhibits 2.3 and
These ETFs track the total return (including 2.4 explain the operational structure and
reinvested dividends) on the underlying activities along the ETF transaction chain
index. The only cash flows the investor in the primary and secondary markets.
has to deal with are those occurring when
he buys and when he sells the ETF; for the An ETF, as a registered fund company, is
investor, management of dividends is thus supported by a custodian holding its assets,
simplified. an administrator producing daily net asset
value, and a management company looking
after operations. The fund is created when
Exhibit 2.3: The graph lays out the process of creating and redeeming an ETF in the primary market and trading it in the secondary
market, indicating participants involved in this transaction flow.
Primary market (creation)
ETF administrator ETF custodian ETF manager
Procedures Manage
daily NAV Fund the fund
company
Redemption:
(reverse process of creation)
ETF market makers swap
ETF units with the ETF
custodian for the underlying
Basket of securities ETF creation units basket of securities
Securities can be traded in
Capital markets for cash
ETF market makers; Capital

liquidity providers;
markets
(Securities lending,
Secondary market (buy) Authorised market
borrowing & trading
activities)
participants
EXCHANGE
Cash ETF
Sell: (Reverse process
of buying)
Broker ETFs are exchanged for cash
Cash ETF
Investor

2. Background
authorised market participants such as buy ETF shares through their intermediary
institutional investors commit capital to at the quoted ask price or sell shares at
seed a fund that will attempt to replicate the quoted bid price. Intraday buy or sell
an index. Unlike traditional mutual funds prices depend on supply and demand and
or unit investment trusts, shares in the on the prices of the underlying securities.
ETF are created by the authorised market If the price of the ETF shares fluctuates and
participant’s depositing a specified block deviates from its NAV, market participants
of securities with the ETF. The authorised can step in and make an arbitrage profit
market participant purchases the block on the differences. An indicative NAV
of the underlying securities directly on (iNAV) is published every fifteen seconds
the markets, based on the information for ETFs, so the price can be compared
contained in the portfolio composition almost continuously to this iNAV. If ETFs
file (PCF), a file prepared by the ETF are undervalued compared to their NAV,
manager. In return for this deposit, the arbitrageurs buy ETF units and redeem
authorised market participant receives them at the custodial bank in exchange
a fixed amount of ETF shares with a net for the underlying securities. If ETFs are
asset value (NAV) that is the value of the overvalued, they buy the underlying
replicating index. ETF shares are usually securities, redeem them for creation units
created or redeemed in lots of 50,000 or and then sell the created ETF shares on
100,000 or some other pre-specified size, the markets. As a result, any mispricing of
known as creation units. Some or all of the the NAV of the fund and the underlying
ETF shares may then be sold on exchange. security will be short-lived, and the price
of the ETF is unlikely to deviate from
On the exchange, ETF market makers look the value of the underlying portfolio
at inventories and start quoting bid and (Mussavian and Hirsch 2002; Kalaycioglu
ask prices for the ETF shares. Investors can 2004).
Figure 2.4: Typical activities during an ETF transaction in primary and secondary markets
1 Liquidity providers authorised market participants commit capital to seed a fund aiming at replicating an index.
2 Liquidity providers and authorised market participants purchase a basket of the underlying securities, based
on the portfolio composition file (PCF) prepared by the fund company.
3 The market makers then exchange the basket of the underlying securities with the fund company (ETF custodian)
for a set number of ETF units with an NAV, that is, the value of the replicating index.
4
On the exchange, ETF market makers start market making and quote bid and ask prices of the ETF units based
on their inventory.
5 Investors can buy ETF units through their retail brokers at the quoted "ask"price, in exchange of cash.
Due to continuous intraday trading, the price of the ETF may fluctuate and deviate from its NAV. Moreover,
6 the underlying index value may also go up or down during the trading day. These events create arbitrage
opportunities for the market makers.
7
ETF units are created or redeemed on a daily basis, which enables the market makers to keep ETF prices close
to the NAV.
The market makers can swap a set numer of ETF units with the ETF custodian for the underlying basket of securities,
8
which can then be sold for cash in the secondary market.

2. Background
Trading ETFs off exchange equity markets. They are thus a shortcut
ETFs are frequently traded off exchange, for investors seeking to hold a part of the
especially for very large orders. The first market (Stock 2006).
possibility is to engage in over-the-
counter trading of ETF shares. These so- The aim of style ETFs is to replicate the
called block trades may allow investors to returns on a particular investment style.
benefit from tighter bid/ask spreads than In equity markets, firm size (large cap,
they would on the exchange. The second small cap) and investment style (growth,
possibility is to buy an ETF at unknown NAV. value) have been shown by Fama and
An order at unknown NAV that is emitted French (1992, 1993, 1996) to be important
during the day will be executed at the determinants for the cross-sectional
closing NAV of the fund. These orders lead variation in expected stock returns. Style
to a creation (buy order) or redemption ETFs build on these findings and replicate
(sell order) of ETF units, similar to what the returns of such investment strategies.
happens in a traditional mutual fund that Sector ETFs focus on industry sectors, which
is not traded on exchange. This means of they attempt to replicate. The motivation
buying an ETF does not lead to any bid/ask for relying on sector exposure to construct
2 - Actively managed ETFs
are meant, like mutual funds,
spread since the order is executed at the an equity portfolio is provided in a study by
to deliver above-average NAV; the investor does bear creation and Ibbotson Associates (2002) that highlights
returns. They charge more
than traditional ETFs but, in redemption costs. the low correlation of different sectors
general, less than mutual
funds. They are supposed to
and the low correlation of sectors and the
have some of the advantages 2.1.3. Exchange-Traded Funds from market. Another study (Hamelink, Harasty,
of ETFs, such as transparency,
tax efficiency, and liquidity, Different Asset Classes and Hillion 2001) shows that the benefits
all while being actively
managed. However, since
In this description, we will mention only of sector diversification outweigh those of
managers are paid for their ETFs that allow access to the normal country diversification. Further evidence
stock selection, frequent
disclosure of the underlying returns of an asset class or segment of the importance of sector and style
stock holdings would
encourage investors to buy
of assets. We do not look at ETFs that diversification is provided by Vardharaj
the underlying securities on are actively managed or ETFs that use and Fabozzi (2007). Finally, ETF providers
their own instead of trading
ETFs. On the other hand, structured forms of investment strategies. have moved from providing exposure to
if transparency is low, the
price of ETFs would suffer
We describe the asset classes now covered mature markets to providing exposure
significant deviation from by ETFs. In addition to the standard equity to emerging market equity, either in the
the NAV of the underlying
holdings. and fixed-income ETFs, we mention ETFs form of global emerging market indices or
on a range of alternative asset classes. in the form of specific country exposures.
Equity ETFs Fixed-income ETFs

ETFs that replicate stock market indices In addition to equity markets, ETFs provide
were first on the market and are still the cheap exposure to fixed-income markets
most important type.2 Broad market ETFs by replicating the returns of government
attempt to replicate the returns of the bonds. These ETFs can, of course, provide
entire stock market as reflected by a broad exposure to broad market government
index such as the S&P 500 for the US or bonds as well as to more specific segments.
the Stoxx 600 for Europe. Such broad Maturity-segment ETFs reflect the returns
ETFs offer diversified exposure to general on investments in government debt with

2. Background
terms to maturity ranging from short to simply borrow the low-yield currency and
long. Inflation-protected bond ETFs invest buy the high-yield currency. The academic
only in inflation-protected bonds. literature has identified the carry trade as
a source of a risk premium similar to the
The corporate debt ETF market is less risk premia for value or small-cap stocks.3
well developed, at least in Europe. For The momentum strategy reflects the view
now, only broad market corporate bonds that currencies will continue performing
are available. With the growth of the ETF as they have been. Taking long positions
market, new products specifically designed in the currencies with the highest returns,
for sub-segments of the corporate bond short positions in the currencies with the
market may well be in the works. lowest returns, or both positions will lead
to returns higher than those of a buy-
Money market ETFs and-hold strategy. Currency ETFs have
There are also ETFs designed to replicate the attracted investors as they can be used
returns of short-term cash instruments. for hedging or diversification (Jagerson
These funds offer investors a way to 2007).
invest in various cash-like short-term
3 - See Brunnermeier, Nagel,
and Petersen (2008) or Jurek
securities, including commercial paper, Alternative asset class ETFs
(2007) for an analysis of repurchase agreements, Treasury bills, and Finally, the concept of ETFs has been
these strategies.
certificates of deposit. These funds have extended to alternative investments.
drawn investor attention for the interest Although not in all cases pure ETFs, but
rates they pay, usually higher than those sometimes slightly more complicated
of certificates of deposit, and for their financial constructions, these investment
total expense ratios lower than those of products enable investors to gain
money market mutual funds (Johnson simple access to alternative investment
2010). Moreover, money market ETFs opportunities such as hedge funds,
usually provide a degree of diversification commodities, real estate, or infrastructure.
not easily achieved by individual investors ETFs on alternative asset classes allow
and are seen as safer than bank deposits investors to diversify portfolios but do
(Amery 2008a). not require the infrastructure needed for
direct investments and manager selection
Currency ETFs in alternative asset classes, infrastructure
Currency ETFs invest in a single currency they may be unfamiliar with. The benefits
or basket of currencies. There are two main of using alternative index ETFs in a global
investment strategies for currency ETFs. portfolio have been analysed by Pezier
In the first, passive tracking, movements (2008).
in a particular currency or a basket of
currencies are replicated. In the second, ETFs in the alternative investment universe
systematic currency trading, long/short must deal with illiquid underlying assets,
positions in various currencies are taken. an obligation at odds with one of the main
Examples of currency trading strategies objectives of ETFs, that is, to provide high
are the carry trade and the momentum liquidity. As a result, ETFs must usually
strategy. ETFs relying on the carry trade rely on proxies of the asset class, proxies

2. Background
that can only approximate the price funds, futures, and total return swaps
movements in these asset classes. (TRs). Because of their similar features,
they can be regarded—depending on the
Hedge fund ETFs, for example, can rely investment purpose—as alternatives to
on hedge fund factor models that make ETFs.
it possible to replicate the performance
of broad hedge fund indices by investing The closest of these alternatives are
in more standard and thus more liquid traditional index funds, which are in fact
assets. ETFs relying on these models the predecessors of ETFs. Index funds
have recently been launched. Hedge can be viewed as unlisted ETFs, to which
fund ETFs can also be set up with the they are very similar, except that they
help of managed account platforms: can be bought from and sold only to the
these ETFs enable investors to invest managing company of the mutual fund
directly in hedge funds via so-called (primary market). As ETFs are growing
parallel managed accounts of hedge fund rapidly, the academic literature has
managers. To ensure the liquidity of the addressed the question of whether ETFs
ETFs, only hedge fund managers who are replacing index funds. Agapova (2009)
are active in strategies known for their shows that the asset inflows to ETFs do not
liquidity are selected. Commodity ETFs reflect asset outflows from conventional
are based mostly on commodity futures, index funds. Guedj and Huang (2008), on
although some funds also invest directly the other hand, show that ETFs can be
in such precious metals as gold. Illiquid substitutes for index funds tracking the
underlying holdings are also a problem main equity indices. Thus, there is some
for real estate ETFs. Real estate ETFs debate in the academic literature as to
usually replicate real estate indices that whether the growth of ETFs is coming at
are based on real estate investment trusts the expense of index funds.
(REITs), listed collective equity investment
vehicles that provide relatively high Investors can also opt for derivative
liquidity. They may also invest in a basket instruments (futures and total return
of real estate stocks. Infrastructure ETFs swaps) to trade large baskets of assets.
invest in stocks or indices from three Futures are standardised forward
clusters: energy (oil and gas storage and contracts that make it possible to trade
transportation), transportation (airport baskets of assets (bonds, equities, or
services, highways and railroads, marine commodities) at a certain date in the
ports and services) and utilities (electric, future. Since these derivatives are traded
gas, water, multi-utilities) (Fuhr and Kelly on exchange, they are highly liquid. Total
2009b). return swaps, by contrast, are not traded
on exchange; they are over-the-counter
2.1.4. Alternatives to Exchange- (OTC) contracts. Here, the total return of
Traded Funds an index or a single security is swapped
In addition to ETFs, there is a variety of for fixed regular cash flows. A TRS is
financial products that allow simple trades similar to a standard swap except that
of large baskets of assets: traditional index the total return (cash flows plus capital

2. Background
depreciation/appreciation), not cash flows Transparency

alone, is swapped. As with any swap, the ETFs are considered more transparent than
parties do not transfer actual ownership mutual funds. The detailed composition of
of the assets. Total return swaps expose the fund is published on a daily basis, and
investors to counterparty credit risk the net asset value is frequently computed
because they are traded OTC, whereas and made available to the market during
futures are exchange-traded instruments trading hours. Investors are able to see
and thus benefit from clearing-house what exactly goes into the ETF, and the
mechanisms that mitigate counterparty investment fees are clearly laid out. In
credit risk. the light of pricing scandals that have
affected the mutual fund industry, the
2.1.5. Benefits and Use of ETFs transparency of ETFs has become quite a
Because they are hybrids of stocks draw; indeed, at the outset, it served as an
and funds, ETFs provide institutional impetus for the growth of the market.
and private investors with a number
of combined benefits and, as a result, Cost
improve the ways they invest. ETFs are One of the primary advantages of ETFs
much easier to trade than funds. And a is that they offer all of the benefits
single ETF trade can provide much broader associated with index funds at much
exposure than a single stock trade. They lower cost. Because of the essence of
are also tax efficient. index tracking, ETFs obviously charge less
than actively managed funds. Moreover,
Ease of trading even though, like stocks, they involve
The ease of trading ETFs is the result of commissions, their lower costs may make
their liquidity and transparency. The them more attractive than traditional
advantage of highly liquid markets such index funds. It is useful to distinguish two
as the ETF market is that large amounts aspects of costs, total expense ratios and
of assets can be traded without making transaction costs.
a large impact on the market. The
liquidity of ETFs stems from their listing First, ETFs charge management fees and
on exchange and from direct provision of other operating fees. The total expense
ETFs by authorised participants. Investors ratio (TER) offers a fair standard by which
can enter or exit at any time. Small trades to compare such costs, since management
can be executed whenever the exchange fees alone might lead to misconceptions.
is open and at market prices that change As reported by Euronext (2009), total
from moment to moment, which shows a expense ratios for many standard
higher degree of liquidity than traditional European equity and government bond
index funds, priced once a day at the close. indices are now between fifteen and
Any type of order used in trading stocks can forty basis points. More exotic ETFs in
be used in trading ETFs. For larger trades, emerging markets, short ETFs, or ETFs in
ETF shares can be handled efficiently by specific strategies, with expense ratios
authorised participants under the in-kind ranging from fifty to one hundred basis
creation and redemption process. points, are more expensive. These costs

2. Background
are significantly lower than those of and frequency of trading determine

traditional equity index funds, which the relative merits of each instrument.
usually have expense ratios of around one Kostovetsky (2003), for example, finds that
hundred basis points, even when they are for large investments ETFs are preferable
simply tracking standard indices. In 2009, to index funds, while for small amounts,
Fuhr and Kelly reported that the average the high transaction costs make ETFs less
TER for equity ETFs in Europe was thirty- attractive unless the holding period is
seven basis points a year. long. Gastineau (2001) notes the reasons
that make ETFs more cost efficient than
Second, ETF shares must be bought by index funds. First, ETFs are usually very
investors, either on or off exchange, and large funds, allowing economies of scale
the investor incurs transaction costs. If and, second, expenses for the transfer
ETF shares are bought or sold on exchange agency function of mutual funds are not
or over-the-counter, the investor incurred with ETFs.
incurs transaction costs that amount to
brokerage fees, as well as half the bid/ Obtaining broad and diversified market
ask spread. If ETFs are bought at unknown exposure
4 - SGAMCAC40 FLEXIBLM
has a TER of 1.00%, and
NAV, the investor does not bear costs in Benefiting from the quality of index funds,
ISHARES PFANDBRIEF has form of bid/ask spreads but in the form of investors can gain instant and diversified
a TER of 0.10% (Euronext
2009). creation/redemption costs. access to various markets by trading ETFs.
5 - For example, ISHARES
NASDAQ 100 and PS EQQQ
Once an investor buys an ETF, he gets
track the same NASDAQ 100 Costs differ significantly from one ETF to exposure to the entire market for the
index. The TER for iShares
is 0.33% but 0.20% for another. Differences are found in both underlying assets and diversification of
PowerShares (Euronext 2009).
total expense ratios and transaction systematic risk. Moran (2003) has argued
costs (either bid/ask spreads or creation/ that ETFs are a useful means of achieving
redemption fees). An ETF can have a TER diversification. In addition, the portfolio
as high as 1.00% or as low as of 0.10% of ETFs can provide more customised
(Euronext 2009).4 These differences are diversification. A cautious investor who
not merely a result of the different index wants to invest in real estate and fixed
or asset class tracked by the ETF; indeed, income, for example, could easily form
the costs of ETFs tracking similar segments a portfolio by trading ETFs tracking real
or even the same index may differ.5 estate indices and fixed-income ETFs,
and he could structure the fixed-income
The cost advantage of ETFs over other portion by splitting it into medium-term
indexing instruments obviously depends and short-term bonds or government
on the benchmark. For large institutional bonds and corporate bonds. Miffre (2006)
investors, mandates to replicate an index has shown that the ability to construct
are usually less costly but also less liquid portfolios of country-specific ETFs makes
than an ETF. But ETFs usually charge less it possible for the equity investor to
than other open-ended index funds. obtain risk-adjusted performance better
Moreover, the costs are specific to the than that obtained by holding a global
context in which the index products index fund.
are used. In particular, the position size

2. Background
Trading with high tax efficiency over problems and margin maintenance,
Tax-conscious investors have lately begun and they can cover more benchmarks
to prefer ETFs to mutual funds. The special than futures (Fuhr 2001).
tax rules on conventional mutual funds
require that realised capital gains be 2.1.6. Advanced ETF Products and
passed on to shareholders, a requirement Portfolio Practices
widely regarded as increasing the tax We now turn to more specific ways of
burden on buy-and-hold investors using ETFs. These strategies offer more
(Dickson and Shoven 1995; Shoven, flexible approaches to investors than
Dickson, and Sialm 2000). Although simple long positions in a given asset class
ETFs are subject to the same tax rules as or segment. We provide below an overview
mutual funds, their distinct “redemption of advanced types of ETF products, as
in-kind” mechanism, allowing an investor well as of advanced ways of using ETFs in
to redeem a large number of ETF shares by portfolio practice.
swapping ETFs for the underlying stock,
does not incur capital gains. Poterba and Inverse ETFs
Shoven (2002) compared the before- and Inverse ETFs, also called short ETFs, are
6 - A wash-sale is the sale of
a security at a loss followed
after-tax returns of SPDR (an ETF that supposed to provide investors with the
by the immediate repurchase holds the securities in the S&P500) and inverse of the performance of an index,
of the identical security.
Wash-sales are used to the Vanguard Index 500 fund from 1994 which is achieved through short selling.
reduce the tax burden, since
other capital gains can often
to 2000 and they find that tax effects are In addition, these ETFs provide investors
be offset by these capital favourable for the ETF. Some investors with the money market interest on the
losses and thereby reduce
total taxable gains. even use ETFs for such tax manoeuvring amount invested and interest earned on
as realising capital losses and getting the short position.
around restrictions on wash-sales (Bansal
and Somani 2002).6 Leveraged ETFs
Leveraged ETFs provide investors more
Immediacy of exposure aggressive exposure to the underlying
A basic use of ETFs is to equitise cash index, without the operational hassles of
and manage cash flows. As a kind of easy making leveraged investments themselves.
trading vehicle, ETFs are useful for cash Leveraged ETFs usually attempt to provide
management. A fund manager could constant leverage in such a way that the
invest cash inflows in ETFs as a temporary excess returns of the index are magnified
investment that minimises cash drag or by, say, a factor of two for the holder of
benchmark risk. By contrast, if the fund a leveraged ETF. There are also leveraged
manager needs to raise cash immediately, versions of inverse ETFs, so investors can
he could buy time by first liquidating ETF magnify their inverse exposure in a simple
holdings on the market and then other trade.
positions. Although futures have been
used for the same purpose, ETFs can be Options on ETFs
a good alternative, as small trades can be Options on ETFs began trading on
made, they require no special documents derivatives exchanges shortly after the
and accounts, they are not subject to roll- introduction of ETFs. These instruments

2. Background
are limited to a relatively narrow range to market risk. As a temporary way to

of the most successful ETFs. The possible become defensive without incurring
advantages of these options include precise transaction costs and undesirable capital
exposure to the underlying fund, minimum gains, this mechanism can be used in
investments lower than those required by various ways, including more sophisticated
index options, as well as physical delivery trading strategies involving shorting some
of the underlying asset if the option is combination of several indices. In addition,
exercised (index options, by contrast, are ETFs can be sold short, as part of a purely
settled in cash). speculative trade, to take advantage of
market downturns.
Shorting ETFs
Unlike traditional index funds, ETFs may Lending ETF units
be sold short. Since ETFs can be borrowed ETF units held by an investor may be lent
and sold short, long/short strategies are out to generate additional income for the
possible. With these strategies, long/ portfolio. Interest paid by the borrower of
short exposure to different style or sector the ETF may compensate for management
indices can be used to capitalise on fees and generate income above the
return differentials between categories management fees in the ETF.
while maintaining low or zero exposure
Leveraged and inverse ETFs

Inverse and leveraged ETFs have attracted a lot of attention since their launch in 2005.
With these ETFs, investors can easily magnify returns, hedge portfolios, and manage
risk without any operational hassles about margin accounts or margin calls. By late
2009, there were 113 leveraged and inverse ETFs in US and fifty-three in Europe.
Assets under management have exceeded $28 billion in the US and $5 billion in
Europe (Fuhr and Kelly 2009b).
Despite the popularity of these instruments, the mechanics of leverage create more
risk for investors than do traditional ETF structures. First, leveraged and inverse ETFs
must be re-balanced on a daily basis to keep their returns on a multiple of the returns
of the underlying index. This re-balancing may have an impact on the liquidity and
volatility of the underlying index during the closing period of the market. If Atn is the
fund’s NAV at time tn , the exposure of the ETF needs to be adjusted on day tn+1. This
adjustment, denoted by Δtn+1, is given as follows (Cheng and Madhavan 2009):
Δtn+1 = Atn (x 2 − x )rtn ,tn+1

where x is the multiple of the performance and rtn, tn+1 the return of the underlying
index from calendar time tn to time tn+1. According to the formula, the more highly
leveraged the ETF is, the greater the amount it needs to adjust at the end of the
day. Furthermore, the adjustment for inverse ETFs would be even larger than that
for long leveraged ETFs. For example, if comparing the value of (x2-x) at x=-2 and

2. Background
x=2, it is apparent that the double inversed ETF will have a much greater adjustment
than a double leveraged ETF. Cheng and Madhavan (2009) also study the relationship
between the changes in the aggregate hedge demand near the market close and the
return of the underlying index. They find that a 1% move in the US equity market
would lead to a 16.8% change in the aggregate hedge demand, whereas a 5% move
would cause 50% more aggregate hedge demand.
It has also been shown that the returns of leveraged ETFs are path dependent. Cheng
and Madhavan (2009) and Avellaneda and Zhang (2009) have shown that the change
in asset values over time depends on the volatility of the underlying index. In general,
the lower the volatility of the underlying index, the smaller the change in the asset
value of the ETF.
Finally, empirical results imply that the long-term performance of leveraged and
inverse ETFs would deviate from the promised returns (Lu, Wang, and Zhang 2009).7
This suggests that leveraged and inverse ETFs are suitable for short holding periods
8 - Leveraged and inverse rather than for long-term buy-and-hold strategies.
ETFs are pre-packaged
margin products. When they
are first designed the margin
Recent complaints in the United States about the long-term underperformance of
requirements for going long leveraged and inverse ETFs have come to the attention of regulators. In June 2009,
on and shorting ETFs must be
taken into account. the Financial Industry Regulatory Authority (FINRA) underscored the problems with
leveraged and inverse ETFs. In August, FINRA, together with the Securities and Exchange
Commission (SEC), stated that inverse and leveraged ETFs were not suitable for buy-
and-hold investors. Following these warnings, Edward Jones and UBS announced they
would suspend sales of leveraged and inverse ETFs to their clients; Morgan Stanley
and Wells Fargo later announced they would put leveraged and inverse ETFs under
review; the state of Massachusetts stepped in to examine the sales practices of big
leveraged ETF providers (Johnson 2009). The large providers of leveraged and inverse
ETFs have defended their products. The objective of leveraged and inverse ETFs is to
achieve promised return on a daily basis (ProFunds Group 2009). The products should
be monitored by investors rigorously every day, or even rebalanced frequently so
that the target return will not be missed. It is not suitable for simple buy-and-hold
investors.
FINRA has put in place a new margin requirement, in effect as of 1 December 2009,
for leveraged ETFs. Under the old rules, the maintenance margin for any long ETF
was 25% of its market value and the margin for any short ETF was 30% of its market
value. Therefore, the maintenance margin requirements8 for leveraged and inverse
ETFs were unrelated to the promised leverage. Under the new rules, these margin
requirements will increase by a percentage commensurate with the leverage of the
ETF, not to exceed 100% of the value of the fund (FINRA 2009). In this case, a leveraged
ETF which promises a return three times that of the underlying index must maintain
75% of the margin.

2. Background
Although leveraged and inverse ETFs came under intense scrutiny in 2009, investor
interest in these instruments did not wane. Gabriel (2010) estimates net inflow to
leveraged and inverse ETF of $12.16 billion over the year 2009. In the same year, more
than thirty new ETFs were launched in the US alone.
In short, the liquidity advantage of leveraged and inverse ETFs, which have attracted
growing attention in recent years, makes them suitable for short-term trading.
Indeed, both academic research and regulatory investigations have suggested that
these ETFs are more suitable for short-term investment than for long-term buy-and-
hold strategies.
2.1.7. Tracking Error and Liquidity methodology. Practitioners, for example,

Tracking error and liquidity are the two have long used a number of liquidity
most crucial criteria for evaluating the measures, but academic articles continue
quality of an ETF. So it is important to to debate their merits. Popular liquidity
know how to assess them. indicators are market spreads, turnover, and
assets under management. Several authors
Tracking error in the finance literature have proposed
There are many ways to assess the tracking more advanced liquidity measures. One
quality of an ETF. First, and quite evidently, recently advocated measure, as proposed by
it is possible to analyse the difference Acharya and Pedersen (2005), is explained
between the returns on the ETF and those in more detail in the box below.
on the index. Second, the correlation of
the two assets can be used to determine Of course, the number of transactions in
the tracking quality. Another simple ETF shares is not necessarily indicative
method of analysing tracking error is to of the liquidity of an ETF. For several
compare the mean returns of both assets. reasons, in fact, ETFs may be classified
There are, however, more sophisticated as highly liquid even if relatively few ETF
means of evaluating tracking error. These shares change hands. The first is that the
means include asymmetric or downside market maker has a contractual obligation
tracking error (which is the relative return towards the stock exchange and towards
equivalent to downside risk measures such the ETF provider to fulfil its role as market
as semi-variance in an absolute return maker for a given transaction size and with
context) or co-integration analysis (see a determined maximum spread. Therefore,
Engle and Sarkar 2006 for an application even if trading volume is low on a given
to the tracking quality of ETFs). day, ETF investors can trade at any time of
the day. The second reason is that in Europe
Liquidity most ETF transaction volume actually takes
The second key issue with indexing place off exchange, either by trading ETF
instruments is liquidity. Practitioners, of shares over the counter or at unknown
course, are highly familiar with liquidity, NAV. The volume traded on exchange is
but the finance literature has yet to come thus not a reliable indicator of the actual
to a consensus on theory and on empirical transaction volume.

2. Background
The true liquidity of an ETF is the liquidity depends only on the liquidity of the
of the underlying securities. After all, any underlying securities. As described above,
deviation of the price of the ETF from the the market maker swaps ETF units with the
price of the basket of securities is easily ETF custodian for the basket of securities
arbitraged away through the creation and of the ETF, so it is the liquidity of securities
redemption mechanism. This arbitrage in this basket that matters.
The Acharya and Pedersen (2005) liquidity measure

The Acharya and Pedersen (2005) liquidity measure is derived from the so-called
liquidity-adjusted CAPM. This is a multifactor model for expected excess stock returns
of the following form:
E[rt i − rt f ] = E[cti ] + λβ 1i + λβ 2i − λβ 3i − λβ 4i

The various beta terms in the regression equation correspond to covariance terms
of returns and illiquidity. β1i is the traditional CAPM beta (covariance of the stock
return and market return), β2i is the covariance of the stock’s illiquidity and market
illiquidity, β3i is the covariance of stock returns and market illiquidity, and β4i is the
covariance of stock illiquidity and the market return.
The illiquidity measure for a given stock i in the month t is computed as

Daysti
1 Rtdi
ILLIQti = ∑
Daysti d =1 Vtdi
where Rtdi is the absolute return of the i-the stock on day d of month t, and Vtdi is
the volume of the stock. The illiquidity measure reflects the idea that the price of an
illiquid stock will display large movements in response to a given volume of trading.
The authors find that of the four terms in the asset pricing model the co-movement of
stock illiquidity and market returns has the greatest influence. This liquidity measure
has been constructed to evaluate the liquidity of stocks. It would not be helpful to
apply this measure directly to the ETF shares, for the reasons cited above. However, it
may be a means of measuring the liquidity of underlying securities.
Pricing and performance drift

Although index ETFs are designed to track an index passively and provide exposure to
its risk and performance features, ETFs that for legal reasons cannot fully replicate an
index need to be managed more actively. Any deviation of an ETF’s returns from the
underlying index returns results in a performance gap. Unlike index funds, which can
be bought and sold only at their daily NAV, ETFs can be exchanged in secondary markets
at ask/bid prices that may differ from their NAV. Figure 2.5 provides a description of
the sources of deviation that ETFs may encounter.

2. Background
Figure 2.5: Performance shortfall of an ETF
Secondary market Primary market
Market controlled Manager controlled
Investor's buy/sell NAV of the exchange Underlying

price of the ETF traded fund index value
Pricing efficiency Management efficiency
Total performance shortfall, from an investor's perspective
For an investor, the total performance shortfall (or gain) is the right measure with
which to identify the gap between the performance of the ETF and that of its underlying
index. This gap should be measured as the return difference between the underlying
index and the ETF—taking into account the investor’s actual buying price. This price,
however, is not easy to obtain, and might require studying specific transactions to
take into consideration the specific market impact of such trades.
The total performance shortfall can be conceived as the sum of the ETF management
inefficiencies and market inefficiencies. Since the former lie within the ETF
management itself, they can be controlled by the fund management company. The
latter are beyond the control of the ETF company, since they depend on the market
makers, supply and demand, and transaction costs.
Net asset value versus market price

An ETF has an NAV calculated with reference to the market value of the securities held.
NAV is the total value of the fund after netting the market value of each underlying
share in its holdings, cash, accruals, fees, operating costs, and other liabilities and
divided by the number of issued shares. For fully replicated index trackers, the NAV
should be exactly the same as or very close to the fund’s underlying index value
(taking into consideration a multiplier if required).
On exchange, however, the market price of an ETF, like that of a stock, is determined
by supply and demand. ETFs are bought and sold at their market prices, which may
be at a premium or discount to their NAVs. When the market price of an ETF is not
equal to its NAV, arbitrage opportunities are created and the creation and redemption
process brings the fund’s market price back to its NAV.

2. Background
The intraday NAVs of ETFs are also usually calculated every fifteen seconds by third-
party vendors; the market prices of the underlying index constituents are taken into
account so that investors can tell whether the ETF is fairly priced. This intraday NAV,
also known as indicative net asset value (iNAV) or indicative optimised portfolio value
(IOPV), is different from the daily NAV of the fund, which is computed after the
market closes for the day.
In an empirical study, Engle and Sarkar (2006) find that in the US ETFs have highly
efficient prices, though their conclusions for international ETFs are different. In
fact, the authors find that the premiums or discounts on fund NAVs are usually
small and disappear very quickly, a disappearance that confirms the view that the
creation and redemption mechanism of ETFs effectively limits and destroys arbitrage
opportunities.
Performance drift
Ideally, ETFs should derive their value and volatility only from the market movements
of the underlying index or market prices of the constituent securities of this index.
But perfect replication is not always possible; in fact, performance drift is inevitable.
An index portfolio is only a paper portfolio and requires virtually no management,
administration, asset buying or selling, custody, and so on. An ETF, by contrast, holds
assets physically, manages them, distributes dividends and handles a relationship with
investors. These operations incur costs. So to keep costs down and make sure they are
consistent it is necessary to understand the components of these costs. Several costs
can be a drag on ETF performance, some related to the direct costs of implementing
the strategy, others to the way the index is replicated and exceptions handled.
• Implementation: ETFs need not replicate indices by buying or selling the underlying
securities. They are paper portfolios calculated on the basis of market prices and
weightings of their underlying securities. The underlying securities may not be very
liquid and, given the large size of an ETF portfolio, the price of a constituent security
may go up as a result of high demand during implementation. This cost, also known
as portfolio construction/rebalancing cost or transition cost, which also includes the
actual transaction costs, results in a performance drag on the ETF portfolio.
• Management fees and other operational expenses: unlike ETF portfolios, indices do
not incur management fees, administrative costs and other operating expenses. Often
expressed in terms of total expense ratio as a percentage of the NAV, these costs are
deducted from the ETF assets and the daily NAV is affected accordingly (daily accrual).
When dividends and interest income are paid, usually every quarter or twice a year,
total management expenses are deducted from the payment and the NAV of the ETF
returns to the index value.
• Transaction costs in the secondary market: investors buying or selling ETFs on
exchange through their broker must shoulder brokerage commissions, bid/ask

2. Background
spreads, the market impact of a large transaction, stamp duty, transaction levies
charged by the exchange, and so on. These costs make ETF returns lower than those
of the underlying index.
• Cash drag: if ETFs pay dividends they usually do so every quarter or twice a year.
However, the underlying securities pay dividends sporadically throughout the year.
While the index value reflects full dividend reinvestment, an ETF portfolio holds extra
cash that has no capital appreciation, no returns. This generates a minor disparity
between the ETF portfolio value and the underlying index value. Tracking error caused
by this phenomenon is called “cash drag” because the ETF portfolio holds extra cash
that drags its performance down.
• Mispricing costs in secondary markets: an ETF may trade at lower than (at a discount
to) its NAV or higher than (at a premium to) its NAV. Factors such as unmatched
supply and demand, illiquid underlying securities, and market inefficiency may
contribute to the move of trading prices away from NAV. Since ETF shares can be
created/redeemed anytime during trading hours by authorised market participants or
arbitrageurs, this disparity does not last long.
On the other hand, there are also several benefits that may allow an ETF to compensate
for replication costs. In some cases an ETF can yield higher returns than the index to
be replicated.
• Securities lending: ETF providers can lend their securities to other market participants
and thereby earn lending fees.
• Tax benefits: in some countries it is possible to partly recover withholding taxes
through the purchase of single stocks during the period of dividend payments.
• Management of index events: intelligent management of index component changes
and other events can generate additional returns for the ETF. However, if done
unsuccessfully, such management may also lead to underperformance of the index.
The Impact of ETFs on price efficiency

Before the introduction of ETFs, index futures were one of the major means of
replicating index performance. Futures markets may show slight deviations of
the futures price from the fair price reflected by the underlying index value, and
these deviations may be caused by transaction costs or market illiquidity. This
price discrepancy results in arbitrage opportunities. As arbitrageurs observe such
opportunities and execute the orders immediately, the mispricing will disappear
quickly if the market is liquid (Roll, Schwartz, and Subrahmanyam 2008).
Empirical studies have observed that significant price discrepancies exist in index
futures markets (Modest and Sundaresan 1983; Figlewski 1984; MacKinlay and
Ramaswamy 1988; Yadav and Pope 1994). Neal (1996) also argues that mispricing

2. Background
could lead to arbitrage trades. On the other hand, studies have shown that it
is precisely this arbitrage trading activity that constitutes one of the factors
resulting in reversions to the theoretical value (Garrett and Taylor 2001; Tse 2001;
Alphonse 2007).
The difficulties of tracking an index were greatly reduced by the introduction of ETFs.
These new instruments are traded on exchange like stocks, all while replicating indices
in cost- and tax-efficient ways. With the in-kind creation and redemption process,
arbitraging trades are much easier to execute and, as a result, the price discrepancy in
ETF markets is short-lived. As ETFs offer another means of index tracking, a vast body
of academic research has looked at the influence of ETFs on the price efficiency in the
index spot-futures market. Hasbrouck (2003) and Tse, Bandyopadhyay, and Shen (2006)
show a clear price leadership of the ETF market over the spot market, a demonstration
that suggests that ETFs process information faster than the spot market. Evidence from
the Diamonds and the QQQ funds (Hegde and McDermott 2004; Madura and Richie
2007) suggests that the liquidity of the underlying index market increases after ETFs
were introduced. This increased liquidity stems largely from the lower cost of trading.
Furthermore, Ackert and Tian (2001), Deville (2005), and Deville and Riva (2007) show
that the introduction of ETFs significantly improved price efficiency in the index spot-
futures market. Market responses to observed price deviations are also swifter in periods
during which there is an ETF on an index than they are in periods before the existence
of the EFT (Kurov and Lasser 2002). In a recent paper by Deville, Gresse, and de Séverac
(2009), a strong two-way causality between futures price efficiency and index stock
liquidity appears after the introduction of the ETF.
In summary, the empirical literature finds that the introduction of ETFs offers better
opportunities to perform arbitrage. Moreover, it improves the liquidity of the underlying
index and reduces price discrepancies in the index spot-futures market.
2.2. Asset Allocation with ETFs management, has received increasing

We turn now to the uses to which ETFs attention from investors. The objective of
can be put in portfolio management. this section is to give a short introduction
First, we provide an introduction to core- to the core-satellite approach. We first
satellite portfolio management. We then present static core-satellite management
provide examples of how ETFs may be techniques. We then turn to dynamic
used to do the risk budgeting required by portfolio strategies based on the core-
this portfolio management technique. satellite approach.
2.2.1. Core-Satellite Portfolio Introduction to core-satellite

Management management
Core-satellite management, a different The core-satellite approach divides the
paradigm from conventional investment portfolio into a core component, which

2. Background
is passively managed and fully replicates In the satellite, the investor seeks to
the investor’s specifically designated outperform the core. The counterpart of
benchmark, and an outperformance- the potential for outperformance is the
seeking component, made up of one or risk of deviating from the investor's long-
more satellites, that is allowed higher term risk exposure as defined in the core.
tracking error. This satellite can be active Satellites are often actively managed and
or passive, depending on the preferences usually invested in markets that require
of the investor. more specialised managers. However,
outperformance of the benchmark may
The core portfolio exists to provide the stem not only from active management
best possible risk/return tradeoff while but also—and perhaps more consistently—
respecting the constraints—with respect from passive investment products that
to long-term risk exposures—to which track asset classes or sub-segments whose
the investor may be subject. The core can longer-term performance is significantly
be made up of a pure index fund or an better than those in the benchmark.
ETF. However, any long-term allocation
to different indices can constitute the The separation of funds into a core and a
9 - For an analytical
derivation of this separation
benchmark, which is not necessarily satellite is not done for practical reasons
in asset/liability management limited to market indices, but can also alone; indeed, this separation is grounded
context, see Martellini (2008)
or Martellini and Milhau be made up of an allocation to a variety on economic theory. It is optimal for
(2009).
of sectors or styles and to new forms of investors who benchmark to a specific
indexing. The important point is that this external benchmark.9
allocation is the long-term benchmark
representing the investor’s risk/return Core-satellite management has become
preferences. the standard means of designing
portfolios. A detailed analytical derivation
The satellite is not subject to the of the core-satellite portfolio design is
constraints to which the core is subject. presented in the box below.
The Arithmetic of core-satellite investing

In this box, we set the problem in a simple mean-variance analysis to show how to
derive the optimal proportions to invest in the satellite and the core.
We first take a core-satellite construction with a single satellite. The mathematics is

then straightforward. The overall portfolio P, a combination of the core portfolio and
the satellite portfolio, can be expressed as follows:
P = wS + ( 1− w )C
where w is the fraction invested in the satellite S, and 1-w is the fraction invested in
the core C. The difference between the portfolio and its benchmark B is computed as
follows:
P − B = wS + ( 1− w )C − B = w ( S − B ) + ( 1− w )( C − B )

2. Background
Assuming for the sake of simplicity that the core replicates the benchmark perfectly,
we get C = B; we then have: P − B = w ( S − B ) .
Using this formulation, we can now calculate the tracking error of the portfolio TE(P)
with respect to its benchmark B. It is given as a function of the tracking error of the
satellite TE(S):
TE ( P ) = var ( P − B ) = w var ( S − B ) = wTE ( S )
This formulation makes it possible to assess the efficiency of a core-satellite portfolio

with respect to tracking error management. Consider, for example, an active investor
who is allowed a 2.5% tracking error budget. The investor either hires one manager
with a tracking error equal to 2.5% for the entire portfolio or forms a passive core,
consisting of 80% of his overall portfolio, and leaves 20% in an aggressively managed
satellite with a tracking error chosen so that the overall portfolio tracking error does
not break his risk budget; here, the satellite is permitted a 12.5% tracking error, as
given by the following computation:
TE ( P ) 2.5%
TE (S) = = = 12.5%
w 20%
The next step consists of deriving the optimal proportion w* to invest in the satellite
and in the core. This problem can be solved by simple mean-variance analysis, using
the following utility function U(x):
U(x ) = E[x ] − λσ 2(x )

where E[x] is the expectation operator, σ2(x) its variance, and λ the investor’s risk
aversion. Hence, we have
U(P − B) = E[P − B] − λσ 2(P − B) = IR ( P ) × TE ( P ) − λTE 2 ( P ) (A1)

where IR(P) is the information ratio of the portfolio P with respect to the benchmark
(Grinold and Kahn 2000). Hence:
E[P − B] E[P − B]
IR ( P ) = =
σ(P − B) TE ( P )
When the core perfectly replicates the benchmark, the information ratio of the overall
portfolio IR(P) is actually independent of the proportions in the core and the satellite
and equal to the information ratio of the satellite IR(S) (as long as the proportion w
invested in the satellite is strictly positive). This relationship can be easily seen from
the following:
E[wS + ( 1− w )C − B] wE[S − B]
IR ( P ) = = = IR ( S )
σ(wS + ( 1− w )C − B) wTE ( S )
Replacing TE(P) by its expression as a function of TE(S) in equation (A1), we may
rewrite the optimisation program as follows:
U ( w ) = IR × w × TE (S) − λw 2TE 2(S)

2. Background
The first-order condition, enabling us to obtain the optimal value of the proportion w*
to be invested in the satellite portfolio, reads:
∂U * IR
∂w
( )
w = 0 ⇒w* =
2λTE ( S )
For example, let us assume that the tracking error of the active fund is 5%, that the
information ratio IR is 0.5, and that the coefficient of risk-aversion with respect to
relative risk λ is 20. Then, the optimal proportion invested in the active portfolio is:
IR 0.5
w* = = = 25%
2λTE ( S ) 2 × 20 × 5%
The tracking error resulting from this allocation is: TE ((P)

P ) = 25% × 5% = 1.25%
So far we have assumed that the satellite is made up of a single portfolio. As suggested
before, the satellite investment might again consist of several components, each with
a different manager. The point is then to find the optimal allocation to the active
managers. Extending the analysis to the case of a satellite S invested in a number n of
active portfolio managers Si according to the proportions wi is straightforward.
n
If S = ∑wi Si , the excess return on the satellite portfolio is then:
i =1 n
S − B = ∑ wi ( Si − B )
i =1
and the tracking error of the satellite portfolio reads:

1
⎛ N N
⎞ 2
TE ( S ) = ⎜ ∑ wiw j σ ij − 2∑wi σ iB + σ B2 ⎟
⎝ i , j =1 i =1 ⎠
where σij is the covariance of portfolio managers Si and S j , and σB the volatility of
the benchmark.
One can then find the optimal fraction invested in each active manager so as to
achieve the highest possible information ratio. One can show (Scherer 2002) that the
optimal condition is that the ratio of return to risk contribution is the same for all
managers:
wk α k wl α l
=
⎛ 2 2 ⎞ ⎛ 2 2 ⎞
⎜ wk σ αk + ∑wkw j σ kj ⎟ ⎜ wl σ αl + ∑wlw j σ kj ⎟
⎝ j ⎠ ⎝ j ⎠
TE (S) TE (S)
where αi is the alpha that portfolio manager i can generate with respect to the core
portfolio.

2. Background
Benefits of the core-satellite approach Finally, if the investor uses active managers,
The core-satellite approach has many the separation into a core and a satellite
advantages over conventional portfolio may help reduce fees: high management
management, especially when relying fees will be paid only for this actively
on actively managed satellites. First, it managed satellite; the passively managed
makes it possible to control the portfolio’s core usually involves much lower fees.10
overall tracking error. The core portfolio
simply tracks the long-term benchmark; To show the possible cost advantages of
it does not deviate from that benchmark using an active manager in the framework
and therefore has no tracking error. of the core-satellite approach, consider
The performance-seeking satellite, by the following example. Assume that
contrast, is allowed significant tracking an investor has a relative risk tracking
error. But as the satellite is only a fraction error budget equal to 5% and wishes to
of the total investment, overall tracking use the skills of an active manager. The
error is of course much lower. To maintain first solution is to allocate 100% of the
the tracking error required for the overall portfolio to an active manager who will
portfolio, one needs only strike the proper commit to respecting the 5% tracking
10 - In fact, the origins
of core-satellite portfolio
balance between the tracking error of error constraint. We assume that the
management are linked to the satellite and its weight in the overall management fees charged by this active
an attempt to optimise the
costs of active portfolio portfolio. Hence, rather than imposing manager are equal to forty basis points.
management.
a direct tracking error constraint on The second solution consists of allocating
the overall portfolio, the core-satellite 75% of the portfolio to a purely passive
approach limits tracking error by product, e.g., an ETF, or to a strategy
controlling the weights of the satellites. based on an efficient benchmark, and the
remaining 25% of the portfolio to a 20%
Since the satellite allows substantial tracking error manager. We assume that
deviation from the benchmark, the fund the management fees of a core portfolio
manager is freer to use his personal skills passively invested in ETFs are equal to
and thus perhaps to outperform the sixteen basis points.
benchmark; he need not be fixated on
maintaining low tracking error. To see this The second option, consistent with a
more clearly, consider an active manager core-satellite approach to active asset
with a 5% tracking error constraint. In management, offers two benefits. First,
fact, such a manager is 95% passive, and allowing the active manager to deviate
the active portfolio choices he can make significantly from the benchmark leads to
are thus relatively few. At the same time, better use of the manager’s skills. If the
the restriction of the weight attributed manager has reliable views of the market,
to the satellite in the overall portfolio a 5% tracking error constraint leaves him
keeps risks under control. In short, the with too little room to implement active
skills of asset and fund managers can be decisions consistent with these views.
exploited much more efficiently and in a Beating the market is notoriously tough.
risk-controlled manner. Starting out with a hand tied behind your
back is unlikely to make things any easier.

2. Background
The second benefit of the core-satellite described by Black and Jones (1987)
approach is that it makes it possible to and Black and Perold (1992), allows
differentiate the value added by the core the production of option-like positions
(the benchmark) and the outperformance through systematic trading rules. CPPI
generated by deviation from that dynamically allocates total assets to a
benchmark. Finally, the core-satellite risky asset in proportion to a multiple
approach keeps management fees under of a cushion defined as the difference
control. With these assumptions, i.e., forty between current portfolio value and a
basis points for the active manager and desired protective floor. The result is an
sixteen basis points for the core—and effect similar to that of owning a put
these are realistic assumptions—one option. In such a strategy, the portfolio’s
gets total fees for the portfolio equal exposure falls to zero as the cushion
to twenty-two basis points, lower than approaches zero; when the cushion is
the fees usually charged by active zero, the portfolio is completely invested
managers with the same tracking error in cash. Thus, in theory, the guarantee is
constraints (5%). Asset managers must perfect: the strategy of exposure ensures
compete for business, of course, and that the portfolio never descends below
such a difference in fees may be decisive. the floor; in the event that it touches the
Figure 2.6 illustrates the benefits provided floor, the fund is “dead”, i.e., it can deliver
by the core-satellite approach in terms of no performance beyond the guarantee.
tracking error control and management
fees in the case of an actively managed This CPPI procedure can be transferred to
satellite. a relative return context. Amenc, Malaise,
and Martellini (2004) show that an
Dynamic Core-Satellite Investing approach similar to standard CPPI
The core-satellite investment concept can can be taken to offer the investor
also be extended to a dynamic context, a relative-performance guarantee
in which the proportion invested in the (underperformance of the benchmark is
performance-seeking portfolio (i.e., the capped). Conventional CPPI techniques
satellite) can vary as a function of the still apply, as long as the risky asset is
current cumulative outperformance of re-interpreted as the satellite portfolio,
the overall portfolio. which contains risk with respect to the
benchmark, and the risk-free asset is re-
The dynamic core-satellite concept builds interpreted as the core portfolio, which
on the principle of constant proportion contains no risk with respect to the
portfolio insurance (CPPI). This principle, benchmark. The key difference from CPPI
Figure 2.6: This table illustrates how the core-satellite approach provides benefits to asset managers in terms of tracking error
control and management fees if the investor uses an active manager.
Core Satellite Overall
Weight 75% 25% 100%
Tracking error 0% 20% 5%(0%×0.75+20%×0.25)
Management fees 16bps 40bps 22bps(16×0.75+40×0.25)

2. Background
is that the core or benchmark portfolio As it happens, investor expectations

can itself be risky. In a relative-risk context, are rarely symmetric. In other words,
the dynamic core-satellite investment can when stock market indices perform
be used to improve the performance of a well, investors are happy to be engaged
broad equity portfolio by adding riskier in relative return strategies. On the
asset classes to the satellite. Dynamic other hand, when stock market indices
core-satellite investing may also be of perform poorly, they express a strong
interest to pension funds, which must desire for absolute return strategies.
manage their liabilities: the core is then Value-at-Risk minimisation and volatility
made up of a liability-hedging portfolio, minimisation allow only symmetric risk
and the satellite is expected to deliver management. For example, the minimum-
outperformance. variance process leads to forgoing
upside potential in the performance
Figure 2.7: This table compares the traditional CPPI and the
relative CPPI approaches
of commercial indices in exchange
Traditional CPPI Relative CPPI approach
for lower exposure to downside risk.
Risky asset Satellite portfolio Although this strategy allows long-term
Risk-free asset Core portfolio outperformance, it can lead to significant
short-term underperformance. It also
This dynamic version of a core-satellite makes it very hard to recover from severe
approach, which can be seen as a market drawdowns. The dynamic core-
structured form of portfolio management, satellite technique, by contrast, focuses
is hence a natural extension of CPPI on asymmetric risk management.
techniques. The advantage of the
approach is that it allows an investor to From an absolute-return perspective, it
truncate the relative return distribution is possible to propose a tradeoff between
so as to allocate the probability the performance of the core and satellite.
weights away from severe relative This tradeoff is not symmetric, as it
underperformance and towards greater involves maximising the investment in
potential outperformance. the satellite when it is outperforming the
core and, conversely, minimising it when
Core-satellite portfolios are usually it is underperforming. The aim of this
constructed by putting assets that are dynamic allocation is to produce greater
supposed to outperform the core in the risk-adjusted returns than those produced
satellite. But if economic conditions by static core-satellite management.
become temporarily unfavourable the Like standard CPPI, this dynamic
satellite may in fact underperform the allocation first requires the imposition
core. The dynamic core-satellite approach of a lower limit on underperformance
makes it possible to reduce a satellite’s of the benchmark at the terminal date.
impact on performance during a period This so-called floor is usually a fraction
of relative underperformance, while of the benchmark portfolio, say 90%.
maximising the benefits of the periods of Investment in the satellite then provides
outperformance. access to potential outperformance of the
benchmark.

2. Background
This method, derived analytically in the outperformance for the satellite. Using
box below, leads to an increase in the these components, the investor may
fraction allocated to the satellite when manage his tracking error by defining,
the satellite outperforms the benchmark. statically or dynamically, the allocations
An accumulation of past outperformance to the two.
results in an increase in the cushion
and therefore in the potential for a Core-satellite portfolios may be
more aggressive strategy in the future. constructed either across asset classes
If the satellite has underperformed the or for individual asset classes. An equity
benchmark, however, the fraction invested portfolio that invests in a standard index
in the satellite decreases in an attempt in the core and in an index for emerging
to ensure the guarantee of the relative market small caps in the satellite, for
performance objective. example, is a single-class core-satellite
portfolio. A core portfolio made up of
At this point, it may be useful to summarise equity, real estate and bond indices, and a
the various possibilities (see figure 2.8). satellite portfolio of active equity-market-
The investor must first choose his long- neutral hedge funds is a multi-asset class
term benchmark, the core portfolio. He portfolio.
must then identify attractive sources of
Figure 2.8: Allocation to the core and satellite keeps tracking error under control
Static core-satellite approach
Symmetric management of tracking error by fixing allocation to the core and satellite
Dynamic core-satellite approach
Asymmetric management of tracking error by using a strategy to limit the underperformance of the core
while benefiting from the upside potential of the satellite
Core Satellite
Defines the investor’s long-term choices in terms of risk/return profile through Seeks to outperform the core while
• exposure to standard commercial indices inducing tracking error through
• improved allocation to sub-segments (such as sectors, styles, and so on) or asset classes • exposure to additional risk premia
• improved allocation to constituents of commercial indices (new forms of indexing) • abnormal returns (alpha) obtained
by an active strategy
The arithmetic of the dynamic core-satellite process

The dynamic core-satellite investment process has two objectives: to increase the
fraction allocated to the satellite when the satellite has outperformed the benchmark
and to reduce this fraction invested when the satellite has underperformed the
benchmark.
This dual objective can be met with a suitable extension of CPPI to relative risk
management. Let Pt be the value of the portfolio at date t. The portfolio Pt can
be broken down into a floor Ft and a cushion Ct, according to the relation Pt = Ft
+ Ct. Note this slightly abusive notation compared to the derivation of the static
core-satellite investment approach, in which Ct was the core portfolio. We use Bt to
denote both the core and the benchmark. The floor is given by Ft = kBt, where k is a

2. Background
constant less than 1. Finally, let the investment in the satellite be Et = wSt= mCt = m(Pt
- Ft), with m a constant multiplier greater than 1 and w the fraction invested in the
satellite. The remainder of the portfolio Pt-Et = (1-w)Bt is invested in the benchmark.
In a relative investment context, the core will contain some assets that closely track
a given benchmark, whereas the satellite will have assets that ought to outperform
this benchmark. For example, the B for the core investment can be thought of as
investments in a bond portfolio, whereas the investment in the satellite S is made
up of stocks. In the following, dSt/St can then be thought of as the continuous-time
stock process, and dBt/Bt as the respective bond process. By the same token, Et can be
thought of as the total invested in equities.
We assume the following dynamics for the assets and the portfolio value:
dSt
= μdt + σdWt
St
dBt
= rdt
Bt
dSt dB
dPt = Et × + ( Pt − Et ) × t
St Bt
where Wt is a standard Brownian motion, and r the continuously compounded interest

rate.
The process for cushion growth tells us about the upside potential and allows us to
calibrate an optimal value for m:
dS dB
dCt = dPt − dFt = Et × t + (Pt − Et ) × t − dFt
St Bt
dSt dB dB
dCt = mCt × + (Ct + Ft − mCt ) × t − Ft × t
St Bt Bt
⎛ dS dB ⎞
dCt = Ct ⎜ m t + (1− m) t ⎟
⎝ St Bt ⎠
It is useful to derive explicitly the final value of the portfolio PT as well as the cushion
CT. The floor is given as Ft = exp(-r(T-t))Ft, where Ft corresponds to the guaranteed
capital at the terminal date. The value of the portfolio at terminal date is then PT = FT
+ CT. To estimate CT, note that
dCt ⎛ dSt dB ⎞ dB ⎛ dS dB ⎞
=⎜m + (1− m) t ⎟ = t + m ⎜ t − t ⎟
Ct ⎝ St Bt ⎠ Bt ⎝ St Bt ⎠

2. Background
One can solve the previous stochastic differential equation to obtain the expected
value of the cushion at the terminal date CT, as well as the expected total portfolio
value PT:
m
⎛S ⎞ 1
CT = C0 ⎜ T ⎟ exp ⎢⎡( 1− m )(r + mσ 2)T ⎥⎤
⎝ S0 ⎠ ⎣ 2 ⎦
m
⎛S ⎞ 1
PT = FT + C0 ⎜ T ⎟ exp ⎢⎡( 1− m )(r + mσ 2)T ⎥⎤
⎝ S0 ⎠ ⎣ 2 ⎦

When no leverage is allowed, the exposure is limited to total assets PT. In this case,
ET = min(Pt, m(Pt - Ft)), and there is no closed-form solution for the payoff PT in terms
of the level of the stock market ST (Sharpe and Perold 1988).
Dynamic management of the tracking Dynamic management of tracking error, on

error the other hand, offers investors full access
Static core-satellite management makes to good tracking error, while keeping bad
it easy to manage overall tracking error. If tracking error to an acceptable minimum,
the investor has a particular tracking error and it does so by adjusting the fractions
budget, fixing the proportions invested in invested in the core and the satellite.
the core and in the satellite ensures that Relative risk control is thus made more
he will stay within this budget. efficient.
Illustrative example
Assume that the benchmark is a passive investment, e.g., a bond index. The guarantee
is set at 90% of the benchmark value and we assume that the multiplier is equal to
four (further details can be found in the box on the arithmetic of the dynamic core-
satellite process).
On date T0, the initial portfolio value and benchmark value are set at 100, with a
floor of 90% of the benchmark value. The floor is thus 0.9×100 = 90. The cushion
is therefore equal to 100 – 90 = 10. The investment in the satellite is then 10 × 4 =
40, which results in 100 – 40 = 60 in the core. Assume that at date T1 the difference
between the satellite and the benchmark is +10% (as it would be if, for example,
the satellite returned 0% and the core returned -10%). In this case, the investment
in the core has fallen by 10% (from 60 to 54). The value of the satellite portfolio
has remained at 40, while the benchmark has also decreased by 10% (from 100 to
90). The difference between the fund value (94 = 54 + 40) and the benchmark value
(90) is now equal to 4. The floor has dropped from 0.9 × 100 to 0.9 × 90 = 81. Thus
the cushion is now 94-81=13. The new optimal fraction to invest in the satellite is

2. Background
13 × 4 = 52, which leaves 94 – 52 = 42 in the core. On date T1 the resulting allocation

is therefore 52/94 = 55% to the satellite and 42/94 = 45% to the core.
Let us assume, on the other hand, that the difference between the satellite and the
benchmark is -10% (as it would be, for example, if the satellite remained unchanged
and the core returned +10%). In this case, the value of the core has increased by 10%
(from 60 to 66). The value of the satellite has remained at 40, while the benchmark has
increased by 10% (from 100 to 110). The floor is now at 0.9×110 = 99. The difference
between the fund value (106 = 66 + 40) and the floor (99) is now equal to 7, meaning
that the cushion has decreased from its initial value of 10. The new optimal fraction
to invest in the satellite is 7 × 4 = 28, which leaves 106 – 28 = 78 in the core. On date
T1 the resulting allocation is therefore 28/106 = 26% to the satellite and 78/106 =
74% to the core.
As can be seen from this example, the method leads to an increase in the fraction
allocated to the satellite (from 40% to 55% in the example) when the satellite has
outperformed the benchmark. The accumulation of past outperformance has resulted
in an increase in the cushion, and thus in greater potential for a more aggressive
(higher tracking error) strategy in the future. If, on the other hand, the satellite has
underperformed the benchmark, the method leads to a tighter tracking error strategy
(through a decrease of the fraction invested in the satellite portfolio) in an attempt to
ensure that the relative performance objective is met.
Extensions to dynamic core-satellite core-satellite approach can be extended

analysis in a number of directions, allowing the
Setting the floor is the key to dynamic introduction of more complex floors or
core-satellite management, since it ensures of so-called investment goals. Instead
asymmetric risk management of the of imposing a lower limit for the total
overall portfolio. If the difference between portfolio value, a goal (or cap) restricts
the floor and the total portfolio value the upside potential of the portfolio. It can
increases, that is, if the cushion becomes also be extended to account for a state-
larger, more of the assets are allocated dependent risk budget, as opposed to the
to the risky satellite. By contrast, if the constant expenditure of the risk budget
cushion becomes smaller, the fraction of implied by the basic dynamic core-satellite
investments in the satellite decreases. strategy. We list below several possible
floor designs, and we then discuss the
In the standard case presented above, the option of making a goal part of the
floor is a constant fraction of the benchmark investment process.
value: Ft = kBt. However, depending on the
investment purpose, different floors might Capital guarantee floor: this is the most
be used to better exploit the benefits of basic expression of a risk budget, and it is
core-satellite management. Indeed, the given by Ft = ke −r ( T −t )A0 , where r is the risk-

2. Background
free rate (here assumed to be a constant), k where At-12 is the portfolio value twelve
is a constant <1, and A0 the initial amount months earlier. Again, this constraint can
of wealth. The capital guarantee floor is be extended to relative risk budgets by
what is usually used in CPPI. taking, for example: Ft = Bt-12.
Benchmark protection floor: this is the Conventional strategies consider the floor
basic dynamic core-satellite structure; but ignore investment goals. Goal-directed
it protects k% of the value of any given strategies recognise that an investor might
stochastic benchmark: Ft = kBt. In asset have no additional utility gain once a total
management, the benchmark can be any wealth Gt beyond a given goal is reached.
given target (e.g., a stock index). In asset/ This goal, or investment cap, may be
liability management, the benchmark constant; it may also be a deterministic or a
will be given by the liability value, so A1 stochastic function of time. Goal-directed
≥ Ft = kBt is a minimum funding ratio strategies involve optimal switching at
constraint.11 some suitably defined threshold above
which hope becomes fear (Browne 2000).
Maximum drawdown (maxDD) floor:
11 - On this subject we refer extensions of the standard dynamic asset It is not immediately clear why any investor
the reader to Martellini and
Milhau (2009). allocation strategy can accommodate would want to impose a strict limit on
various forms of time-varying multipliers upside potential. But the intuition is that
and floors. In particular, Grossman and by forgoing performance beyond a certain
Zhou (1993) have considered a “drawdown threshold, where the relative utility of
constraint” that requires the asset value At greater wealth is lower, investors benefit
to satisfy at all times At > Ft =αMt, where from a decrease in the cost of downside
Mt is the maximum asset value reached protection. In other words, without a
between date 0 and date t: max(As)s<t. In performance cap or goal, investors run a
other words, only portfolios that never higher risk of missing an already almost
fall below 100α% of their maximum-to- reached investment goal.
date value are admitted, for some given
constant α. The interpretation is that any The presence of a goal can be
drawdown must always be less than 1-α. accommodated by a strategy in which
This maxDD floor was originally introduced the fraction invested in the performance-
to absolute risk management but can be seeking satellite is a multiple m2 of the
extended to relative risk management by distance to the goal, while the presence
taking: At/Bt >αmax(As/Bs)s<t, where Bt is of the floor can be accommodated by a
the value of any benchmark. strategy in which the fraction invested
in the performance-seeking satellite is a
Trailing performance floor: this floor multiple m1 of the distance to the floor.
imposes a constraint that a portfolio If, in addition, one defines the threshold
shall avoid negative performance over a wealth (denoted by Tt) above which the
twelve-month trailing horizon, regardless investor shifts from a goal-oriented focus
of the performance of equity markets. to a risk-management focus, one obtains
More formally, it is given by Ft = At-12, a piece-wise dynamic allocation strategy,

2. Background
with the threshold Tt to ensure smooth at different times. The trailing performance
pasting. The aforementioned floors floor is particularly useful for absolute
(capital guarantee, benchmark protection, return products, in which the investor
maxDD, trailing performance, etc.) have expects the probability of losing money
equivalents in goals. over any one-year period to be extremely
low. In addition, this dynamic risk
In this section, our aim was to show that management can be applied to absolute
core-satellite portfolio management wealth risk or relative performance
allows a coherent structure of investment risk, reflecting liabilities or investor
decisions. The core portfolio makes it objectives.
possible to meet the investor’s long-term
risk/return objectives, while the satellite 2.2.2. Examples of Core-Satellite
portfolio provides access to upside Asset Allocation Based on ETFs
potential. Dynamic allocation will then We now turn to applications of core-
allow a systematic increase in exposure satellite allocation using equity and
to the satellite portfolio when it does fixed-income ETFs. The first example deals
well, while controlling risks by shifting with relative risk management, while the
to the core when the satellite does second extends the approach to the design
poorly. As a result, the approach allows and management of absolute return
asymmetric tracking error management: funds. The third compares the dynamic
underperformance of the benchmark core-satellite approach and an actively
will be limited and the investor will have managed portfolio strategy, and presents
access to the excess returns potentially ways to combine both approaches. Finally,
generated by the satellite, which can be the fourth example shows how investors
managed actively or invested in a market can use the dynamic core-satellite
segment that tends to have higher technique in an opportunistic way to
average returns than the benchmark. benefit from the return to “normal” values
Finally, we have provided a list of possible of credit spreads, while keeping risk under
extensions of the basic version of the control.
dynamic core-satellite approach.
Managing relative risk: optimal
This approach, of course, has a wide packaging of small-cap exposure
variety of applications. Different kinds In this first example, we consider a core-
of floors or the inclusion of goals make satellite portfolio in which the core is
possible strategies that meet particular made up of the Euro Stoxx 50 index and
requirements. The inclusion of a maximum the satellite of the Euro Stoxx small-cap
drawdown constraint, for example, is of index. This configuration allows us to
particular interest to open-ended funds, illustrate how to manage the risk that
since it reduces the extent to which the small-cap stocks will underperform
performance depends on the entry point. the large-cap Euro Stoxx 50. Since small-
Thus, asset managers can use maximum cap stocks have historically outperformed
drawdown constraints to satisfy the needs large stocks over long periods (albeit at
of investors who enter and exit the fund higher risk), periods of underperformance

2. Background
of small-cap stocks may be characterised Our objective is to see how the dynamic
as an anomaly in the small-cap/large-cap risk budgeting described above fares in
spread. such market conditions. The parameters we
use are a multiplier of m=5 and a relative
We take monthly returns data from guarantee of k=0.90. Consequently, the
January 1994 to December 2009 for these initial allocation to the satellite is 50%
two equity indices. The starting date is of the overall portfolio. Instead of using
limited by the availability of the data for the simple rule for the floor Ft = kBt (Bt
the small-cap index. Figure 2.9 shows that denoting the benchmark), we rely on the
small-cap stocks did not outperform their dynamic rule for the floor Ft=kPt-12 Bt/
large-cap counterparts over the period Bt-12, as presented in the insert on the
we examine. A portfolio that is long small relevant floors. This specific floor makes
caps and short large caps would have it possible to decrease the dependence of
almost constant value at the end of 2009 the results on the entry point, as discussed
for €100 invested at the start of 1994. above. Figure 2.10 shows the risk and
In other words, any static overweighting return statistics for the two ETFs and for
of small caps over that period would not the dynamic risk budgeting approach for
have yielded a risk premium. Looking at the period. In addition, the table shows
the change of the value of this long- the same statistics for a static 50-50 mix
short portfolio, we see that small caps of the core and the satellite.
underperformed until 2000, then kept
pace with large caps and finally rallied
in 2002. This rally ended in 2007, when
small-cap stocks again underperformed
until December 2008, followed again by a
period of outperformance in 2009.
Figure 2.9: Small-cap minus large-cap spread, cumulative returns, 1994-2009

2. Background
Figure 2.10: Risk and return statistics for different portfolios in the small-cap example
Jan. 1993 – Dec. 2009 Average return* Maximum drawdown Volatility* Sharpe ratio*/**
Large-cap core 4.65% -62.74% 19.57% 0.14
Small-cap satellite 5.17% -63.47% 19.09% 0.17
Static core-satellite 5.06% -59.82% 18.57% 0.16
Dynamic core-satellite 7.04% -60.09% 18.62% 0.27
* annualised statistics - ** risk-free rate fixed at 2%
As figure 2.10 shows, the fixed-mix performance of the small-cap satellite.

portfolio that at each period invests 50% Most active managers would be envious
in the core and 50% in the satellite yields of outperformance of this magnitude.
an annualised rate of return of 5.06%. In addition, the average performance
This performance is similar to that of the of the DCS is better than that of either
large-cap core, and it suggests that the the core or the satellite, and risk is lower.
decision to include small caps did not This outperformance is achieved with
add much value over the period. With sophisticated packaging of small-cap
the dynamic core-satellite technique, the exposure, which adds value to a naïve
investor obtains an annualised average static exposure.
return of 7.04%, thus reaping almost 200
basis points per annum more than in the Figure 2.11 shows the changes in the
static allocation. This outperformance of allocation to the core (a large-cap ETF)
the static mix of the large-cap core and and the satellite (a small-cap ETF) in the
the small-cap satellite is the result of dynamic core-satellite strategy. Over the
reliance on dynamic risk budgeting to first half of the period, the allocation to
keep the dynamic core-satellite portfolio small caps gradually decreases, as small-
from suffering from the periods of poor cap stocks underperform the large-
Figure 2.11: Changes in allocation in the small-cap example

2. Background
cap benchmark. Starting in 1998, the the investor also expects the probability of
dynamic core-satellite strategy increases losing money over any one-year period to
the allocation to small-cap stocks, as the be extremely low. Our assumption is that
satellite outperforms and the cushion on twelve-month trailing performance, an
increases. In 2006, the allocation to the absolute return product will avoid posting
satellite decreases again, reflecting poor negative performance, however the equity
small-cap performance. In early 2008, the market performs. This constraint can be
allocation to the satellite portfolio starts accommodated with a twelve-month
to grow very fast and, as a result of the trailing performance floor.
swift recovery of small-cap stocks, reaches
almost 100% by late 2009. This increased We take the following ingredients. First,
allocation in times of outperformance, we specify a maximum drawdown equal to
combined with downside protection in 10%, a twelve-month trailing performance
times of underperformance, accounts for floor, and a soft landing objective with
the good performance of this strategy. respect to a performance cap (investment
goal) set at 2.5 times the cash rate.12
Managing absolute risk: designing Second, we implement a dynamic core-
12 - For a detailed discussion
of this floor and the various
absolute return funds with ETFs satellite allocation process with the core
investment goals, please refer Absolute return funds have seen invested in a bond ETF and the satellite
to the end of section 2.2.1
13 - These strategies widespread growth in the asset in a large-cap stock ETF (both in the euro
were introduced by Estep
and Kritzman (1988),
management industry in recent years. zone), with a maximum allocation set at
who labelled them “time These funds claim to provide relatively 50%.
invariant portfolio protection
strategies” (TIPP), and later smooth returns with limited risk. Not
formalised by Grossman and
Zhou (1993) and Cvitanic and
unlike hedge funds, absolute return funds, More precisely, we combine a core that
Karatzas (1995). as their name suggests, seek absolute invests in medium-term bonds (EuroMTS
returns; they are not benchmarked to a for bonds with three to five years to
market index or peer group. maturity) and a satellite that invests in
an ETF on the Euro Stoxx 50 index. The
Although there is no unique definition objective of the proposed strategy is
of the concept, most investors interested to optimise returns while limiting the
in so-called absolute return strategies drawdown risk of the portfolio to 10%.
have two main expectations, one having The intuition behind the maximum-
to do with performance management drawdown constraint is that the
and the other with risk management. investment in the risky asset depends
In other words, investors interested in not only on the risk aversion but also
these strategies have a performance on the margin for error.13 When the risk
target (usually expressed as a multiple of budget is spent, one should be prepared
a cash rate or as a constant target) that to move away from the risky asset. The
they expect to hit regardless of market idea is to benefit from the returns on the
conditions, and these investors expect to stock market ETF if stocks outperform
avoid large drawdowns (with a maximum bonds, while securing protection from the
drawdown set at 10% in the example that downside risk of the equity investment.
follows). In an absolute return product,

2. Background
The data used consists of monthly core portfolio confirm the conservative
returns including reinvestment of coupon character of the core investment.
or dividend payments for the period However, we also see that performance
from January 1999 to December 2009. of the bond core was quite flat over the
The starting period is different from some extended time periods, such as from
the application above because bond 1998 to 2000 or from 2004 to 2006. The
data is available starting only with the returns of the equity ETF in the satellite
introduction of the euro, as is usual for portfolio were lower than those on the
euro-denominated bond indices. core portfolio when seen over the entire
period.The fluctuations in the value of
The strategy for this form of absolute the large-cap equity ETF in the satellite
return fund is, of course, one of many are tremendous, with a sharp increase
possible means of meeting the objectives before 2000 and steep falls from 2000
of absolute return investors. The dynamic to 2002 and in 2008. The dynamic core-
core-satellite strategy, in short, is flexible satellite combines the advantages of each
enough to design a broad variety of of its ingredients, namely the smooth
investment strategies. performance of the bond core and the
upside potential of the equity satellite.
Figure 2.12 shows the cumulative returns As a result, performance is smooth over
of the strategy we implemented, as well the entire period, and cumulative returns
as of the core and the satellite portfolios. at the end of the period are actually
In addition, to highlight the built-in higher than those of both the core and
protection of this investment strategy, the satellite. The graph also shows the
the floor is displayed as well. dynamics of the floor, which reflects the
degree of protection. It is also instructive
We can draw a number of conclusions to look at the performance in the stock
from this figure. The dynamics of the market downturn beginning in the year
Figure 2.12: Absolute return fund: change in the core, the satellite, the floor, and the dynamic core-satellite portfolio

2. Background
2000. In fact, the dynamic core-satellite in smooth returns. Figure 2.14 shows the
portfolio is largely unaffected. As the returns over rolling periods of one year.
portfolio value approaches the floor, the We see that the dynamic core-satellite
allocation shifts to the core. A similar portfolio achieves positive returns over
pattern can also be observed starting in most rolling windows of one year. Even for
the second half of 2008. This behaviour the most recent observations of trailing
is illustrated in figure 2.13, which shows returns, the strategy generates positive
the weights held in the satellite portfolio numbers, unlike the satellite, which, for
over time. the same periods, posts returns worse
than -40%. In fact, the behaviour of the
The objective of the strategy analysed here dynamic core-satellite portfolio is similar
should be kept in mind. The conservative to that of the defensive bond portfolio
nature of the core and the dynamic risk that makes up the core.
management process are meant to result
Figure 2.13: Absolute return fund: changes in allocation to the satellite
Figure 2.14: Absolute return fund: performance of the core, the satellite, and the DCS over one-year rolling periods.

2. Background
Risk and return statistics for the dynamic portfolio will increase when the satellite
core-satellite strategy confirm the is expected to outperform the core. We
conclusions from the figures analysed consider two ways of translating these
above. In particular, figure 2.15 shows forecasts into action. We look first at
that the average return exceeds that of forecasts used in a standard tactical asset
the core by more than 250 basis points, allocation approach that simply increases
while keeping risk (maximum drawdown the allocation to the satellite to a fixed
and volatility) at lows similar to those of weight when it is expected to outperform
the defensive core. and resets it to the lower weight when it is
expected to underperform. We then look
Structuring portfolios to benefit from at whether the manager could actually
predictive skills of active managers benefit from using such forecasts of the
We have seen that dynamic risk outperformance of the satellite in the
budgeting can ensure sound absolute dynamic core-satellite approach. We turn
return management. What is remarkable now to these two examples.
is the absence of reliance on prediction.
Systematic allocation based on past values The performance of forecast-based
of the core and satellite portfolios means investment depends, of course, on the
that the investor bears no forecasting risk. accuracy of the forecasts. If the forecast
Of course, investment houses may have is right most of the time, the portfolio
access to proprietary forecasts that they should perform well. In this section, we
may wish to use to move the allocation assess the performance of a manager with
between risk-free and risky assets. In fact, varying degrees of positive prediction
an asset manager may well wish to benefit skill.
from his forecasting skill.
The detailed setup of the analysis
Forecasts may be generated in many is as follows: we simulate an active
different ways, including econometric manager’s approach with the following
models and qualitative analysis. It is assumptions:
not our objective here to consider how • If the manager thinks the core will
forecasts are best generated. But once outperform the satellite in the following
they are, a crucial question is how to month he will allocate 100% of the
translate them into portfolio decisions. portfolio to the core.
Obviously, the weight of the satellite • If the manager thinks the satellite will
in any forecast-based core-satellite outperform the core in the following
Figure 2.15: Absolute return fund: risk and return statistics for the core, the satellite and both static and dynamic core-satellite
investments
December 1998 – December 2009 Average return* Maximum Volatility* Sharpe ratio*/**
drawdown
Core 4.55% -3.08% 2.52% 1.01
Satellite 1.18% -59.90% 20.18% -0.04
Static core-satellite 3.45% -27.92% 9.64% 0.15
DCS 7.27% -3.11% 4.26% 1.24
* annualised statistics - ** risk-free rate fixed at 2%

2. Background
month he will allocate 50% of his portfolio An obvious result from figure 2.16 is
to the satellite. The remaining 50% is that higher hit ratios lead to higher
allocated to the core. average expected returns. But the table
• The manager rebalances his holdings also shows that the average for the
monthly. maximum drawdown statistic computed
• We assume that the manager has positive across the 1,000 hypothetical managers
forecasting skill, that is, that he correctly is relatively high even in the presence of
forecasts satellite outperformance over positive forecasting skill. For a hit ratio of
a month at least seven times a year. In 7/12 maximum drawdown is, on average,
other words, we assume a hit ratio of at approximately -14%. This average shows
least 7/12. We look at hit ratios ranging the impact of poor forecasts. In fact, even
from 7/12 to 11/12. though these managers are right most
of the time, they err five months a year,
To assess the performance of this approach, thus exposing the investor to significant
we simulate 1,000 scenarios for the period downside risk.
from January 1999 to December 2009. The
investments used in the core and satellite The average value of risk and return
correspond to the previous example, i.e., statistics across 1,000 scenarios does not
we use a defensive euro government show the impact of manager-selection
bond portfolio in the core and a large-cap risk. Using a single manager leads to
equity satellite. Each scenario corresponds uncertainty, as results may be much
to a time series of returns for the active better or much worse than the average
manager, given his bets. Thus the 1,000 across 1,000 managers. First, the results
scenarios represent the returns obtained obtained by a single manager depend on
by 1,000 hypothetical active managers the actual hit ratio displayed over the
who have a given hit ratio. sample period as opposed to his true long-
term forecasting ability. Second, given a
Figure 2.16 shows risk and return statistics realised hit ratio, portfolio performance
for these scenarios. Since every scenario depends on the consequences of his
represents the returns of a hypothetical predictions. Predicting outperformance
manager, the average for expected return over a month during which the satellite
and for maximum drawdown over all underperforms by 1% is not the same as
scenarios corresponds to the result for the predicting outperformance over a month
average active manager according to our during which it underperforms by 10%,
hypothetical hit ratios. even though both are instances of forecast
Figure 2.16: Forecast-based standard tactical allocation: this table shows results for the tactical asset allocation strategy allocations
are adjusted in keeping with forecasts of satellite outperformance. Results are shown for different hit ratios of forecasts; 1,000
scenarios are simulated.
Hit ratio 7/12 8/12 9/12 10/12 11/12
Average expected return 6.35% 8.93% 11.52% 14.11% 16.78%
Average maximum drawdown -14.23% -11.40% -8.92% -6.99% -4.68%
Worst maximum drawdown -29.98% -25.31% -25.43% -21.40% -15.81%
Worst performance over a rolling one-year period -24.81% -23.03% -22.12% -21.40% -13.46%

2. Background
error. Likewise, predicting outperformance forecasting and downside risk

over a month during which the satellite management that would mitigate the
outperforms by 10% is more valuable high figures for maximum drawdown.
than predicting outperformance over a As it happens, it may be possible by making
month during which it outperforms by the active manager’s forecasting ability
1%, though both are instances of forecast an integral part of the dynamic core-
accuracy. satellite investment. We will thus condition
the dynamic core-satellite strategy on the
The worst performing manager (or return forecasts for the satellite, all while
scenario) draws down a maximum of respecting the dynamic risk budget used
between -30% to -16% (figure 2.16) in the examples above.
depending on the hit ratio we assume.
Likewise, the worst return over a one-year Since the main objective is to reduce the
rolling period ranges from -25% to -13% drawdown statistics that result from the
depending on the hit ratio. So it is clear errors made by skilled forecasters, we
that relying on active forecasting leads impose a maximum drawdown of 10%.
to additional risk, even if the manager is Next, we incorporate the manager’s
known to have positive forecasting skill. forecasting ability by introducing a
time-varying multiplier m. If the manager
The severe drawdowns shown even for expects the satellite to outperform the
managers with positive forecasting skill core, the multiplier is set to m=5, thus
underscore the inability of these tactical allowing a considerable fraction to
allocation strategies to provide absolute be invested in the equity satellite. If
return portfolios with smooth return the manager expects the satellite to
profiles. Even with extremely high and underperform the core, the multiplier
clearly unrealistic hit ratios of 11/12 is set to m=0. So the portfolio is fully
maximum drawdowns are considerably protected from the expected negative
higher than in the absolute-return performance of the satellite.
portfolio based on the dynamic core-
satellite approach we described above. As before, we simulate 1,000 scenarios to
So risk control can reduce risk more than assess the average performance of this
forecasting ability can. risk-controlled strategy. The results (figure
2.17) show the benefits of using dynamic
One naturally wonders if it is possible core-satellite manage to limit the extreme
to combine the return potential of drawdown induced by forecast error.
Figure 2.17: Forecast-based strategy made part of DCS management: the table shows the performance and maximum drawdown
of the strategy that integrates forecasts into a DCS framework. Forecasts are based on a simulation of 1,000 scenarios with various
hit ratios.
Hit ratio 7/12 8/12 9/12 10/12 11/12
Average return 6.49% 8.62% 11.01% 13.47% 16.27%
Average maximum drawdown -7.97% -7.49% -6.84% -6.05% -4.62%
Worst maximum drawdown -9.65% -9.68% -9.47% -9.47% -9.04%
Worst performance over a rolling one-year period -8.57% -8.57% -8.57% -8.17% -7.43%

2. Background
Again, active management provides several asset classes and the advantages
high returns that evidently increase as of the core-satellite approach.
forecasting ability (the hit ratio) improves.
However, making forecasts part of a DCS Although core-satellite investments can
approach manages downside risk much made statically, the illustrations clearly
better; for a hit ratio of 7/12 the average show that they reach their full potential
maximum drawdown is only -7.97%. In when the allocation to the satellite and the
the simple tactical allocation strategy, core are adjusted dynamically. The main
by comparison, the average maximum benefit of this asset allocation strategy
drawdown is -14.23%. This dynamic is the combination of participation in
risk budgeting makes it possible to limit upside market movements and limited
the severe drawdown in the standard risk exposure. As a result, in many cases
tactical allocation. This reduction is more dynamic core-satellite strategies offer
pronounced for relatively low ratios. But better risk/return tradeoffs than either
even with the higher hit ratios it leads core or satellite investments. In addition,
to considerable risk reduction. Figure maximum drawdown—extreme risk—is
2.18 shows the reduction in maximum limited.
drawdown for each hit ratio. Risk control,
then, clearly has significant benefits. We proceed now to the presentation of
the survey methodology and data. The
The two strategies assume identical main results of the survey—European
forecasting ability. The results demonstrate investors’ views of ETFs, the use of ETFs,
that the dynamic core-satellite approach and their comparative advantages and
reduces the risk of tactical bets based on disadvantages—are found in section 4.
return forecasts.
This example underscores the benefits of

dynamic core-satellite investment even
for managers who prefer to rely, as it
were, on their crystal balls. Dynamic core-
satellite management may also improve
the downside risk management of
portfolios when an asset manager wishes
to use forecasts to make tactical bets.
Taken together, the examples presented

in this section highlight the potential
benefits of using ETFs to gain exposure to
Figure 2.18: Risk reduction: risk controlled forecast-based strategy versus standard tactical allocation strategy. This figure shows
the reduction of the average drawdown obtained by using the DCS approach to implement portfolios based on predictions of
outperformance of the satellite portfolio over a one-month horizon.
Hit ratio 7/12 8/12 9/12 10/12 11/12
Risk reduction (reduction in magnitude of avg. max. drawdown) 44% 34% 23% 13% 1.3%

2. Background

2.
3. Implementing
Methodology and
Efficient
Data
Indexation

3. Methodology and Data
3.1. Methodology These numbers show that our sample

The EDHEC European ETF survey 2010 is a fair representation of the European
was taken with an online questionnaire investment market by geography. We also
of European professionals in the asset asked respondents about the main activity
management industry. This survey targets of their institution, allowing us to divide
professional asset managers with experience them into professionals in institutional
of ETF instruments, including institutional asset management and those in private
investors, asset management firms, and wealth management. With 68% of the
private wealth managers. The questionnaire survey respondents, institutional asset
consisted of three sections. In the first, managers are the largest professional group
survey respondents are asked about the represented in this study (see exhibit 3.2).
role ETFs play in their asset allocation About 27% of respondents work in private
decisions. The next set of questions turned wealth management. The remaining 5%
to practical aspects of ETF investment, are other professionals such as investment
such as satisfaction with ETF products, as bankers or brokers. Investment and asset
well as applications of ETFs for portfolio management firms account for the largest
optimisation. In the final set of questions, share of institutional investment managers
respondents are asked to compare ETFs and covered in this survey (see exhibit 3.3).
other investment instruments that can be Pension funds and insurance companies
considered close substitutes: index funds, account for another 21% of the institutional
futures, and total return swaps. Finally, we investment management companies. Such
invited the survey respondents to express asset owners thus make up a significant
their views of future developments in the share of survey respondents.
ETF market.
Exhibit 3.1: Country distribution of respondents
This exhibit indicates the percentage of respondents who exercise
in each of the mentioned countries. Percentages are based on
the 192 replies to the survey.
3.2. Data
The email containing a link to the
questionnaire was sent in January 2010. The
first response was received on 13 January,
the last on 1 March. In all, we received 272
answers to our survey. However, about 29%
of respondents reported that they have
never invested in ETFs. Since our aim is to
include only experienced ETF investors in this
survey, we excluded these respondents.
Our survey is aimed at European investment

professionals. Thus, the 192 respondents to
the survey are based in Europe, many from 18% France 4% Spain
18% UK 3% Luxembourg
France, the UK, and Switzerland. The exact 15% Switzerland 1% Ireland
breakdown of the respondents’ geographic 10% Italy 13% Other EU
7% Netherlands 5% Non-EU
distribution can be seen in exhibit 3.1. 6% Germany

Exhibit 3.2: Main activity of respondents assets under management may reflect the
This exhibit indicates the distribution of respondents by
professional activity. Percentages are based on the 192 replies greater popularity of ETFs with medium-
to the survey. sized companies, a phenomenon noted by
Fuhr and Kelly (2009a).
Taken together, we believe that this regional

diversity and fair balance of different asset
management professionals make the
survey largely representative of European
ETF investors. We now turn to the analysis
of the responses.
Exhibit 3.3: Type of institutional investment management
companies
This exhibit indicates the breakdown of 132 institutional
investment managers by professional activity. The “other” group
includes respondents from hedge funds, market makers, pension
68% Institutional investor
reserve funds, and securities services.
(pension fund, asset management
company, insurance company),
institutional investment consultant
27% Private wealth management
5% Investment banker and broker
In view of the importance of choosing

investment instruments such as ETFs or
competing index products, we would
expect fairly high-ranking executives or
portfolio management specialists to be
most well placed to respond to our survey.
Many of the respondents indeed occupy
high-ranking positions: 13% are CEOs, 77% Investment/asset management
and roughly 23% are directly responsible for 4% Life insurance
2% Non-life insurance
the overall investments of their company. 15% Pension fund
Another third of the survey respondents 3% Other
are portfolio or fund managers (see exhibit
3.4).
Finally, exhibit 3.5 shows the assets under

management of the companies for which
the survey respondents work. Nearly 11%
are large firms with more than €100bn
in assets under management, but, in the
main, the EDHEC ETF Survey 2010 reflects
the views of medium-sized companies,
with assets under management of between
€100mn and €10bn. Nearly 20% manage
than €100mn of assets. The breakdown of
Exhibit 3.4: Position of survey respondents

This exhibit indicates the breakdown of respondents by position
held in the company. Percentages are based on the 192 replies to
the survey. Non-responses are reported as “no answer” so that
the percentages for all categories add up to 100%.
3% Supervisory board member

13% CEO/managing director/president
6% CIO/CFO/treasurer
4% CRO/head of risk management
13% Head of asset allocation/head of
portfolio management
33% Portfolio manager/fund manager
7% Vice president
9% Associate/analyst
2% Marketing position
5% Independent private wealth manager
5% No answer
Exhibit 3.5: Asset under management (€)

This exhibit indicates the breakdown by assets under
management. Percentages are normalised by excluding the
twenty-four non-responses.
30
24.40 24.40
20.83
20
13.10
10.71
10
6.559
0
<10mn
10-100mn
100mn-1bn
1-10bn
10-100bn
>100bn

4. Results

4. Results
In this section, we present the main industry investors. We begin by analysing

results of this survey and discuss possible the use of ETFs in different asset classes;
explanations for the respondents’ answers. we also look at satisfaction with ETFs.
In section 4.1, we take a close look at the We then move to the ETF replication
use of and satisfaction with ETFs. In addition methods preferred by investors and the
we invite those surveyed to express their trading strategies used in the industry.
views of future developments in the ETF Section 4.1.5 illustrates the advanced uses
market. In section 4.2, we compare the of ETF products and section 4.1.6 assesses
practitioners’ views of ETFs and their the means by which investors measure
views of investment instruments that tracking error and liquidity. Finally, we
can be considered close substitutes: index invite survey respondents to express their
funds, futures, and total return swaps. views of the future developments in the
Finally, we examine the role played by ETFs ETF markets.
in asset allocation decisions. This section
focuses on the reasons for investing in 4.1.1. Use of ETFs
ETFs and the uses of ETF instruments in the in Different Asset Classes
core-satellite approach. In the last section, First, we look into the relative importance
we compare the results of this year’s survey accorded ETFs and other investment
and those of previous EDHEC ETF surveys instruments in each asset class. In a
for further insight into the development preliminary step, exhibit 4.1 summarises
of the ETF market. the use of ETFs or ETF-like products by those
investors who invest in the relevant asset
classes. For instance, 96.4% of respondents
4.1. Use of and Satisfaction with reported that they have invested in equity.
Exchange-Traded Funds Ninety-six percent of these respondents
As ETF products have been gaining more have used ETFs or ETF-like products for
attention in recent years, it would be equity investments. More than 40% of
of use to highlight perspectives from investors who invest in bonds use ETFs to
Exhibit 4.1: Use of ETFs and ETF-like products

This exhibit indicates the percentage of respondents who report that they use ETFs or ETF-like products for asset classes they have
already invested in. The percentages have been normalised by excluding the non-responses.

4. Results
invest in this asset class. By the same token, corporate bonds of those who invest
a large fraction (80%) of investors who in this asset class is done through ETFs.
invest in commodities use ETFs to do so. Equity ETFs account for one-fourth
Infrastructure ETFs are used by 50% of those of the amount invested in the equity
who hold infrastructure assets and by 40% universe by those who use equity ETFs.
of those who hold real estate. Hedge funds Hedge fund ETFs, money market fund
and currencies are the two asset classes for ETFs, and infrastructure ETFs account for
which ETFs are least likely to be used. Only one-fifth of average investment in these
30% of investors who invest in these asset asset classes. Institutional investment
classes use such ETFs. managers are much more reluctant to invest
large fractions of their wealth in equity
For each asset class, exhibit 4.2 shows the ETFs than are private wealth managers.
percentages of amounts invested accounted For example, fewer than 40% of institutional
for by ETFs or ETF-like products. Exhibit 4.2 is investment managers report that
different from the questions asked in exhibit they make more than 20% of their equity
4.1: exhibit 4.1 shows the percentage of investments through ETFs, whereas around
respondents who use ETFs for asset classes 60% of private wealth managers invest
they have invested in, whereas exhibit more than a fifth in equity ETFs. Furthermore,
4.2 reflects the intensity of use by those this difference is statistically significant
investors who use ETFs. ETFs are now a (p<0.05, Fisher’s exact test).
sizeable share of overall assets across asset
classes. Indeed, for the average respondent 4.1.2. Satisfaction with ETFs
to this question, they account for 38% We continue our analysis with a general
of total commodity investment and for a assessment of the satisfaction with ETF
broadly comparable (35%, 34%, and 32%) products by asset class. Evidently, only
share of government bond, real estate, those who use ETFs in the respective asset
and currency investments respectively. class are asked to report their degree of
Twenty-nine percent of investment in satisfaction. Exhibit 4.3 shows that, over all
Exhibit 4.2: The percentage of total investment accounted for by ETFs or ETF-like products
This exhibit indicates the average percentage of total investment accounted for by ETFs or ETF-like products for each asset class. We
consider only respondents who do use ETFs for the given asset class. Thus, the percentage indicates the share of all investment in
the asset class, for those respondents who do use ETFs, accounted for by ETFs. The percentages have been normalised by excluding
the non-responses.

4. Results
asset classes, a large majority of respondents The reasons for satisfaction or dissatisfaction
are satisfied with their ETFs. Except for may be manifold. With corporate bonds,
hedge fund ETFs, satisfaction is very high liquidity is naturally an issue and may pose
(above 70%) for all types of ETFs; in many a challenge to ETF providers. In alternative
cases, for ETFs in equity, government investment classes, hedge funds, for instance,
bonds, and infrastructure, for instance, it liquidity problems may also resurface. In
exceeds 90%. For currency and commodity addition, constructing truly representative
ETFs, satisfaction rates are on the order indices in alternative asset classes may
of 70 to 77%. Private wealth managers, be a challenge, especially when doing so
however, 0% of whom report satisfaction involves attempts to attain the liquidity
with currency ETFs and 59.3% of whom necessary to construct an instrument
report satisfaction with commodity ETFs, are such as an ETF (see Goltz, Martellini,
much less satisfied with these two products and Vaissié 2007 for a description of the
than are institutional investment managers challenges of constructing liquid indices
(92.3%1 of whom report satisfaction on alternative strategies).
with currency ETFs and 82.4%2 of whom
1 - The p-value of Fisher’s report satisfaction with commodity ETFs). 4.1.3. Replication Methods for
exact test is 0.0071, which is
significant at the 1% level. These differing degrees of satisfaction Exchange-Traded Funds
2 - The p-value of Fisher’s
exact tests is 0.0326, which is
may be the result of private wealth Most ETFs are passively managed and
significant at the 5% level. management’s tendency to invest in replicate indices. More recently, actively
currency or commodity ETFs for exposure managed ETFs have been launched as well. As
to the market and to make tactical bets, exhibit 4.4 shows, however, the majority of
whereas institutional investment managers respondents prefer passive ETFs. Active ETFs
may use currency and commodity ETFs to fly in the face of the investment philosophy
diversify their portfolios. Hedge fund ETFs that would have the manager eschew
also obtain relatively low satisfaction scores, stock-picking and concentrate on asset
with less than two-thirds of users stating allocation. They allow immediate trading
that they are satisfied. in actively managed funds. Therefore, the
Exhibit 4.3: If you use ETFs or ETF-like products, are you satisfied with them?
This exhibit indicates the percentage of investors who are satisfied with ETFs or ETF-like products they have used for each asset
class. The percentages have been normalised by excluding the non-responses.

4. Results
logical application of such funds would be A large majority (77%) of those who
short-term manager selection, not asset favour passive ETFs express a preference
allocation. Active ETFs are supposed to have for conventional pure replication ETFs
some of the advantages of ETFs, such as (see exhibit 4.5). Synthetic replication
transparency, tax efficiency, and liquidity, and statistical replication are still seen
all while being actively managed, but, since as less attractive than full replication.
managers are paid for their stock selection, Synthetic replication through derivatives
frequent disclosure of the underlying stock is, however, significantly more popular
holdings would encourage other investors (preferred by 19% of respondents) than
to buy the underlying securities on their statistical replication (preferred by 4%).
own instead of trading ETFs. On the other
hand, if transparency is low, the price of The dominance of pure and synthetic
ETFs would deviate greatly from the NAV replication could be explained by the
of the underlying holdings. This dilemma fact that pure replication ETFs may be
may make active ETFs less attractive to preferred by investors looking at narrow
investors. indices, whereas synthetic replication may
Exhibit 4.4: What types of ETFs do you prefer?
be preferred by investors looking to use
3 - Two exchange-traded
products on S&P500 volatility
This exhibit indicates the breakdown of respondents by preferred broader indices in which pure replication is
type of ETF. Non-responses are reported as “no answer” so that
index futures were launched
the percentages for all categories add up to 100%.
difficult. Synthetic or statistical replication
in January 2009.
usually costs less than pure replication.
We did not assess whether these benefits
outweigh investors’ preference for pure
replication. Moreover, the relatively low
acceptance of statistical replication may
be a potential obstacle to the expansion of
ETFs in asset classes with low liquidity, in
which full replication may not be feasible
and liquid derivatives are not available.
On the other hand, that investors prefer
synthetic replication to statistical replication
may give markets an incentive to develop
2% No answer liquid derivatives in various asset classes,
13% Active ETFs
85% Passive ETFs
since ETF providers could exploit the
presence of these products to launch new
ETFs. The launch of the exchange-traded
In fact, as explained in the background to products on volatility indices that has been
this survey, besides pure replication, passive made possible by the nascent market for
ETFs may rely on synthetic replication volatility derivatives3 and ETFs that use
(derivatives written on the index) or credit derivatives to obtain credit exposure,
statistical replication (using an optimisation for example, show how new derivatives
procedure to match the returns on the index facilitate the creation of innovative index
with a selection of securities that may differ tracking funds. The ability to replicate
from that of the index). indices, such as a volatility index, is also

4. Results
an advantage of synthetic replication over the entire cost of this liquidity in the form
pure replication, as it is often impossible to of bid/ask spreads.
offer such products by pure replication.
Exhibit 4.6: How much of your ETF trading is done OTC rather
than on exchange
Exhibit 4.5: Which replication method do you prefer?
This exhibit indicates breakdown of respondents by percentage
This exhibit indicates the breakdown of respondents by preferred
of total trading volume done OTC. Non-responses are reported
replication method. The percentages in this exhibit are for
as “no answer” so that the percentages for all categories add
respondents who prefer passive ETFs only.
up to 100%.
4 - The percentage is taken

from EDHEC-Risk European
ETF Survey 2009
5 - The difference between
the percentage of 77% Pure replication
respondents in the 2009 and 6% No answer
19% Synthetic replication 58% <10%
2010 surveys is statistically
(i.e., using derivatives) 4% 10% to 25%
significant at the 5% level
4% Statiscal replication (i.e., sampling) 11% 25% to 50%
(Fisher’s exact test).
6 - Roughly 50% of 5% 50% to 75%
respondents had up to two 4% 75% to 90%
counterparties; only 5% had 4.1.4. Trading Exchange-Traded Funds 12% >90%
more than five.
One of the great advantages of ETFs is that
they are easily traded on conventional Next, we turn to the number of counterparties
exchanges. So we ask the respondents used when trading ETFs. On average,
how much of their ETF trading is done over respondents use about three counterparties,
the counter rather than on exchange (see with the mean at 3.29 and the median at
exhibit 4.6). Although 58% of respondents 3. Exhibit 4.7 shows the exact breakdown.
do not trade a significant share of their Roughly 40% of respondents have up to
ETF investments over the counter, more two counterparties, and another 54% use
than 20% of respondents do more than three to five. Only 8% rely on more than five.
half of their ETF trading on OTC markets. This year, respondents are more likely to
The percentage of respondents who report have more than two counterparties than
that they trade more than 90% of their ETF they were last year (Amenc et al. 2009),6
investments on OTC markets has grown possibly as a result of the 2008 financial
from 6%4 in 2009 to 12% in 2010.5 This crisis—investors prefer to diversify their
growth reflects the greater willingness counterparty risk.
of ETF users to use such more advanced
trading mechanisms, which can lead to
lower transaction costs; they thus benefit
from the liquidity of ETFs without bearing

4. Results
Exhibit 4.7: How many counterparties do you have when trading reluctance to use these products: indeed,
ETFs?
This exhibit indicates the breakdown of respondents by number only between 4% and 11% of respondents
of counterparties they deal with. The percentages are normalised report that they are unfamiliar with them.
by excluding the non-responses.
The greater popularity of inverse
and leveraged ETFs may be the
result of their operational simplicity.
Inverse and leveraged ETFs are pre-packaged
margin products (see section 2.1.6). It is
not necessary for investors to manage
the margin account on their own as they
must when they short ETFs by themselves.
Moreover, the recent criticism of short
selling in general may raise obstacles to
shorting or lending ETFs (Uchimoto et al.
2005).
19% Fewer than 2
19% 2 We also ask whether those respondents
30% 3
7 - Only 16.3% of
institutional investors use 24% From 4 to 5 who do not make use of ETFs for these
leveraged ETFs compared 3% From 6 to 7 advanced purposes intend to do so in the
to 43.1% of private wealth 5% 8 of more
managers. This difference future. The results show that some 10%
is statistically significant
of respondents do indeed intend to do so
(p<0.01, fisher’s exact test). 4.1.5. Advanced Exchange-Traded
Furthermore, private wealth in the near future, results that suggest
managers are more likely Fund Products and Use of ETFs
to use inverse ETFs (29.4%) a coming increase in the advanced use
and short ETFs (19.6%) than
As mentioned in the background to this
of ETFs. For instance, 11% of respondents
institutional investors (17.8% survey (section 2.1.6), ETFs stand out for a
and 8.5% respectively). are currently lending ETFs, and 10% report
number of more advanced features. Exhibit
that they plan to lend them in the future,
4.8 summarises how these features are
growth of nearly 100% not even taking into
used by European investors and asset
account that possibly spurred by educating
managers. We ask about the use of inverse
the investors who are unfamiliar with the
and leveraged ETFs, options written on ETFs,
strategy.
the short selling of ETFs, and the use of ETF
shares in securities lending.
4.1.6. Measuring Tracking Error
One can draw several conclusions from this and Liquidity
chart. First, ETFs packaged with advanced As noted in section 2.1.7, tracking error
trading strategies (inverse or leveraged ETFs) and liquidity are the two essential criteria
are very widely used (by about one quarter by which to evaluate the quality of ETFs
of respondents),7 in spite of their recent and other indexing vehicles. The primary
appearance (see section 2.1.6). By contrast, goal of an ETF is to track the performance
only some 10% of respondents write options of an underlying index. Thus, tracking error
on standard ETFs, sell them short, use them in is a straightforward indicator of the quality
securities lending, or make other advanced of the ETF. Furthermore, for investors, the
uses of them. Insufficient knowledge of greatest advantage of ETFs is that they can
advanced uses of ETFs is not a reason for the be traded on exchange; hence ETFs are very

4. Results
liquid, and liquidity is another criterion by comparison of mean returns (27%). That
which to evaluate an ETF. In this section, 10% of respondents express no opinion
then, we look at the means respondents may be the result of the assumption that
use to assess these criteria. the tracking quality of these instruments
is good (exhibit 4.19 shows that 89% of
Exhibit 4.9 shows that respondents generally respondents believe that ETFs have good
use standard measures of tracking quality, tracking quality). Some respondents use
such as the error with which the returns such advanced measures of tracking error
of the instrument track those of the index as the asymmetric or downside tracking
(73% of respondents), the correlation error (see Amenc, Malaise, and Martellini
of the two assets (40%), or simply the 2004 for an explanation of why investors
Exhibit 4.8: Advanced use of ETFs

This exhibit indicates the adoption of advanced use of ETFs. Non-responses are reported as “no answer” so that the percentages for
all categories in each advanced use of ETFs add up to 100%.
Exhibit 4.9: Which method do you use to assess the tracking quality?
This exhibit indicates the percentages of respondents who reported that they use particular methods to assess tracking quality.
Respondents were able to select more than one method. Non-responses are reported as “no answer” to show the response rate.

4. Results
should be concerned with such asymmetric Pedersen (2005) model, which is described
risk measures) or co-integration analysis.8 in section 2.1.7.
In addition, the percentage of respondents
using more advanced measures has grown Survey respondents rely largely on market
since 2009,9 growth that suggests that spreads (71%), turnover (53%), and
investors are paying closer attention to ETF AUM (47%) as measures of liquidity (see
tracking quality. exhibit 4.10). A significant percentage of
respondents (16%), however, rely on the
The second key issue with indexing co-movement of liquidity in the instrument
instruments is liquidity. Although and the returns on the index, as proposed
practitioners are highly familiar with by Acharya and Pedersen (2005).10 There
liquidity measures, the finance literature are also respondents who mention that the
has yet to come to a consensus on theory liquidity of underlying holdings and the
and on empirical methodology. In the cost of ETFs could be good indicators of the
following exhibit, we list four methods liquidity of ETFs. These answers are found
for liquidity measures. The bid ask spread is among the 3% of respondents choosing
the most common. The narrower the market “other” answers.
8 - See Engle and Sarkar
(2006) for an application to
spread is, the more liquid the product is.
the tracking quality of ETFs Assets under management of the ETF show 4.1.7. The Impact of ETFs on the Spot
9 - In 2009, 13% of
respondents used more the size of the ETF and may proxy for the and Futures Market
advanced measures
of tracking error (the
liquidity of the product. The turnover rate As ETF markets become more mature, it is
asymmetric tracking error is an indicator of trading volume. The final reasonable to evaluate the impact of ETFs on
analysis or co-integration
analysis); in 2010, 21% of method, about the co-movement of liquidity the broader market. The academic literature
respondents do so. This
difference is statistically
and returns, represents the Acharya and described in the background (see section
significant, using Fisher’s
exact test (p<0.05).
Exhibit 4.10: Which method do you use to assess liquidity?
10 - See box in section 2 for
This exhibit indicates the percentages of respondents that reported to use particular method to assess liquidity. Respondents are
more detail.
able to select more than one method. Non-responses are reported as “no answer” to show the response rate.

4. Results
2.1.7) has found evidence that ETFs have then, seem to share the views of academics–
a positive impact on the related futures that is, that the liquidity of underlying
markets or on underlying securities. So we markets and the price efficiency of the
ask respondents for their views of price futures market improves significantly
efficiency in the spot/futures market after after the introduction of ETFs (Hegde
the introduction of ETFs. and McDermott 2004; Madura and
Richie 2007; Ackert and Tian 2001;
Exhibit 4.11 shows that 13% of respondents Deville 2005; Deville and Riva 2007).
have themselves observed that ETFs have The high non-response rate indicates
improved price efficiency in spot and that many investors are not yet aware of
futures markets. And 31% of respondents the impact of ETFs on spot and futures
have observed the improved liquidity in markets.
the underlying market. Many practitioners,
Exhibit 4.11: Concerning price efficiency, have you observed...

This exhibit indicates the percentages of respondents who expressed their opinions on the two arguments about price efficiency.
Non-responses are reported as “no answer” so that the percentages for all categories in each argument add up to 100%.
Exhibit 4.12: Do you watch information on ETFs to gain access to information about the underlying securities?
This exhibit indicates how frequently respondents watch information on ETFs to gain access to information about the underlying
securities. Non-responses are reported as “no answer” so that the percentages for all categories add up to 100%.

4. Results
Exhibit 4.12 shows that about half of hedging and risk management with ETFs,
respondents frequently monitor information and cash equitising with ETFs. Exhibit 4.13
on ETFs rather than on the underlying shows that the greatest increase (chosen
markets. This finding suggests that by 54.2% of respondents) is expected
practitioners have found relationships to come in accessing new asset classes.
between ETFs and underlying markets ETF providers’ strategies of covering new
similar to those found by academic research. asset classes such as listed real estate, listed
Hasbrouck (2003) and Tse, Bandyopadhyay, private equity, commodities, and even more
and Shen (2006) show a clear price specific alternative asset class segments
leadership of the ETF market over the spot would seem justified. Slightly more than
market, which suggests that ETFs process 23.4% of respondents would like to increase
information faster than the spot market. the use of ETFs for optimal portfolio
Thus, in accordance with the increased construction. By implication, respondents
frequency and intensity with which they are not only see ETFs as purely passive means
being used, it seems that ETFs have entered a of covering broad market segments
phase in which they actually have an impact but also want to exploit diversification
on their underlying baskets of securities benefits from optimally constructed
and on related futures markets. In general, portfolios combining ETFs. In recent years, as
both the observations of practitioners, as it turns out, asset managers have launched
reflected in the responses to our survey, and funds of ETFs whose sole focus is asset
the empirical academic literature suggest allocation. There is ample evidence that
that ETFs have a positive impact on price asset allocation strategies with ETFs may
efficiency in financial markets. provide significant value-added (Amenc,
Goltz, and Grigoriu 2010; Miffre 2007).
4.1.8. Future Development of ETFs Respondents seem to share this view and
Our questions have hitherto focused mainly thus see optimal portfolio construction as
on current uses of ETFs. A clear advantage a major area in which future use of ETFs
of our survey methodology, which gives may increase. The other main area seeing
us access to a sample of investment growing use (23.4%) is risk management/
management professionals, is that, rather hedging (13%). An increase in using ETFs
than merely note what is being done, we for cash equitisation is predicted by only
can also analyse plans for the future. In 5.7% of respondents.
a final set of questions in this section on
ETFs, we seek survey respondents’ views of
the ways they are likely to use ETFs in the
future and of the products they would like
to see developed.
First, we ask those surveyed to identify the

area in which they predict the greatest
increase in the use of ETFs. These areas include
exposure to new asset classes through ETFs,
constructing optimal portfolios of ETFs,

4. Results
Exhibit 4.13: In which area do you predict the greatest future there are now more than eight hundred
increase in your use of ETFs?
This exhibit indicates the breakdown by area in which investors products on the market (Fuhr and Kelly
expect the heaviest growth. Non-responses are reported as 2009b). Are investors interested in seeing
“no answer” so that the percentages for all categories add
up to 100%. still more products developed and, if
so, of what kind? As exhibit 4.14 shows,
emerging markets equity ETFs (52%) are
of greatest interest to respondents. About
one-third of the respondents would like
to see new products for alternative asset
classes, especially for commodities (39%),
currencies (28%), and hedge funds (27%).
With 29% of respondents, ETFs based on
new forms of indices also rank high on the
wish-list. Unlike standard capitalisation-
weighted indices, these indices are equally
weighted or based on fundamental company
1% No answer
54.2% Exposure to new asset classes
characteristics (Arnott, Hsu, and Moore
through ETFs 2005; Amenc, Goltz, and Le Sourd 2009),
23.4% Construction of optimal portfolios
of ETFS
or on weights derived from portfolio
13% Hedging and risk management optimisation (Amenc et al. 2010). Emerging
with ETFs
5.7% Cash equitisation with ETFs
market bond ETFs are also of interest to
investors (37%). By contrast, new products
It has now been ten years since the first in ethical investment (14%) and actively
ETF appeared in the European market. Over managed equity (10%) are not in high
this period, the industry has matured and demand.
Exhibit 4.14: What type of ETF products would you like to see developed further in the future?
This exhibit indicates how many respondents would like to see further development for different ETF products. Respondents are
able to choose more than one product.

4. Results
On the whole, investment management alternative is considered to have a range

professionals are thus requesting access to of indices and asset classes greater than
non-standard beta (emerging markets and that of ETFs. In other words, European
alternative asset classes) or to traditional investors and asset managers are well aware
equity beta through new weighting of the diversity of ETFs, which has grown
schemes. On the other hand, investment swiftly in recent years. Third, futures are
managers are far less interested in ETFs the most serious alternative to ETFs, but
that select securities either through ethical ETFs are preferred for their lower minimum
screening or through active stock-picking subscription, fewer operational constraints,
by a manager. and more advantageous tax and regulatory
regimes. It would seem that implementation
problems (such as margin calls, and applying
4.2. The Pros and Cons of ETFs, exact allocations even for small portfolios)
Futures, Total Return Swaps, and give ETFs an advantage over futures. Fourth,
Index Funds respondents believe that ETFs generally
In this section, we compare four investment perform much better than TRSs.11
instruments–ETFs, futures, total return
11 - This belief seemingly
conflicts with that expressed
swaps (TRSs), and traditional index funds— When interpreting the results, one should
by Lhabitant, Mirlesse, that allow easy trading of large baskets of bear in mind that a high percentage of
and Chardon (2006), who
concluded that indexation stocks. The criteria by which we evaluate those surveyed do not answer all questions.
with derivatives provides
better performance than ETFs
these instruments are based loosely on That some respondents do not invest in a
and that, when considering those of Rubinstein’s (1989) early study. We specific product or are unfamiliar with it
both costs and tracking error,
swaps are the most efficient look at the advantages and disadvantages may account for the high non-response
means of tracking an index.
These conflicting beliefs may
of each instrument and then emphasise rate. Rather than adjusting the rankings
be explained, to some extent, specific issues concerning total return for non-responses, we indicate the use
by a lack of familiarity with
TRSs, as a considerable share swaps, futures, index funds, and ETFs. In of alternatives to ETFs separately; we also
of respondents do not answer
this particular question.
addition, we highlight developing trends in indicate the percentage of non-responses,
Even among those who the ways European institutional investment since we can then draw conclusions as to
do, however, TRSs are not
considered superior. managers and asset managers use these the familiarity of survey respondents with
instruments. each instrument or evaluation criterion.
4.2.1. Comparing ETFs and Their Exhibit 4.15 shows the use of alternatives
Alternatives to ETFs. About half of respondents invest
We ask survey respondents whether they in futures and index funds in addition to
invest in alternatives to ETFs such as futures, ETFs. By contrast, only 20% have allocated
TRSs, and index funds and to rate ETFs to TRSs. Futures and index funds, then, are
and their alternatives on several criteria. the most popular alternatives to ETFs. Only
The responses—analysed in greater detail 17% of respondents use none of these
below—permit a few broad conclusions. alternatives, a figure that suggests that, on
First, in terms of liquidity, transparency, the whole, our respondents are well placed
and cost, ETFs are considered advantageous, to compare indexing instruments.
although on some criteria they are less
well regarded than futures. Second, no

4. Results
Exhibit 4.15: Use of substitutes for ETFs

This exhibit indicates the percentages of respondents who report they use alternatives to ETFs. Respondents are able to choose more
than one alternative. Non-responses are reported as “no answer” to show the response rate.
As exhibit 4.16 shows, 67% of respondents When it comes to fees and expenses,
believe that futures are very good in terms exhibit 4.18 shows that most respondents
of liquidity and almost no respondents think that ETFs are the best instrument.
state that liquidity is “poor”. The liquidity Eighty-four percent consider ETFs either
of ETFs ranks second, being viewed as very good or fairly good in terms of
very good by 44% of respondents and costs; only 10% consider them poor.
poor by 4%. Only 24% of respondents, by Still, the cost advantage of futures is
contrast, view index funds as very liquid. considered superior (56%). Total return
The liquidity of TRSs, viewed as the least swaps and index funds are viewed as very
liquid of these instruments, is considered good by only 10% to 15% of respondents,
very good by a mere 8% of respondents. but a sizeable fraction of investors (21% to
These results show that respondents 23%) think they are poor on this score.
value the ability to trade immediately
with futures and ETFs, unavailable with The evaluation of the costs of these
standard index funds. instruments is, of course, specific to the
context in which they are used. The large
Survey respondents’ views of the cost of position sizes of our respondents, as
liquidity are broadly similar to their views indicated by the AUM they report, may
of liquidity itself. Exhibit 4.17 shows that, account for the preference for ETFs and
by this criterion, futures are held in highest futures.
esteem (55% judging them very good),
followed by ETFs (24%) and index funds
(21%). On the whole, ETFs and futures are
viewed positively by similar percentages of
respondents (82% and 75% respectively).
Only 9% view TRSs as very good on this
score. Twenty-three percent view them
as poor.

4. Results
Exhibit 4.16: Respondent views of liquidity

This exhibit indicates respondent views of liquidity for each of the mentioned products. Non-responses are reported as “no answer”
so that the sum of percentages of opinions for each product is 100%.
Exhibit 4.17: Respondent views of the cost of liquidity

This exhibit indicates respondent views of the cost of liquidity for each of the mentioned products. Non-responses are reported as
“no answer” so that the sum of percentages of opinions for each product is 100%.
Exhibit 4.18: Respondent views of other costs (fees, expenses)

This exhibit indicates respondent views of other cost (fees, expenses) for each of the mentioned products. Non-responses are
reported as “no answer” so that the sum of percentages of opinions for each product is 100%.

4. Results
Only a marginal percentage of respondents The survey suggests that the range of
believe that the tracking error of these four products available for ETFs (considered
instruments is unreliable (see exhibit 4.19). very good by 52% of respondents) is
Futures obtain the highest percentages superior to that of the competition (see
of very good responses, followed by TRSs. exhibit 4.20). This finding is consistent
The tracking error quality of index funds with recent developments in the ETF
is considered fairly good. However, taking industry, which is offering exposure to
respondents who indicate that these a wide range of indices (Demaine 2002).
products are either very good or fairly good Although the product range of futures
together, ETFs have a clear edge on futures is less well diversified, they come in
and TRSs. Furthermore, few respondents second, followed by TRSs and index funds.
consider the tracking error quality of any Only 14% to 19% of the respondents believe
of these instruments poor. The weakest are that these two instruments have a very good
index funds, seen as poor by 8%. product range. Furthermore, about 15% of
Exhibit 4.19: Respondent views of tracking error quality

This exhibit indicates respondent views of the tracking error quality for each of the mentioned products. Non-responses are reported
as “no answer” so that the sum of percentages of opinions for each product is 100%.
Exhibit 4.20: Respondent views of the available product range

This exhibit indicates respondent views of the available product range for each of the mentioned products. Non-responses are

4. Results
respondents believe that the product range a very good opinion of futures, and ETFs
for each of the three competitors to ETFs (considered very good by 37%) are preferred
is poor; only 4% believe the same of the to index funds (26%) and TRSs (17%
ETF product range. positive). Taking positive opinions together,
ETFs and futures are viewed most favourably
As 4.21 shows, very few respondents (3%) (84% for ETFs and 77% for futures).
believe that futures are poor in terms of
transparency. A similarly low percentage ETFs are clearly the preferred instrument
(roughly 10%) find the transparency of when it comes to the minimum subscription
ETFs and index funds wanting. Total requirement (see exhibit 4.22). Seventy-
return swaps, on the other hand, are three percent of respondents consider ETFs
considered poor by 21% of respondents. very good by this criterion and only 3%
Sixty-two percent of respondents have consider them poor. The positive views of
Exhibit 4.21: Respondent views of transparency

This exhibit indicates respondent views of the transparency for each of the mentioned products. Non-responses are reported as “no
answer” so that the sum of percentages of opinions for each product is 100%.
Exhibit 4.22: Respondent views of the minimum subscription

This exhibit indicates respondent views of the minimum subscription for each of the mentioned products. Non-responses are

4. Results
ETFs are to be compared with the views of more than half of our respondents believe
futures, which are considered very good that ETFs are very good in terms of such
by only 23% of respondents but poor by constraints and 36% consider them fairly
14%. Hence, futures rank even slightly good. Traditional index funds and futures
behind traditional index funds (31% have are ranked behind ETFs, with about 23%
very good opinions of them). The highest to 28% of respondents seeing them as
percentage of respondents (36%) to express very good, and 38% to 41% seeing them
the greatest degree of dissatisfaction as fairly good. Here again, then, index
(poor) with the minimum subscription funds have a slight edge on futures.
went to TRSs. Total return swaps are clearly perceived
as the instrument most susceptible to
As exhibit 4.23 shows, ETFs are considered operational constraints, with 31% of
less susceptible to operational constraints respondents taking a dim view of them.
than the other three instruments. Indeed, Hence, the answers to this question confirm
Exhibit 4.23: Respondent views of operational constraints

This exhibit indicates respondent views of the operational constraints for each of the mentioned products. Non-responses are
Exhibit 4.24: Respondent views of the regulatory regime

This exhibit indicates respondent views of the regulatory regime for each of the mentioned products. Non-responses are reported
as “no answer” so that the sum of percentages of opinions for each product is 100%.

4. Results
the existence of a pronounced difference may be linked to respondents’ relative

between exchange-traded (futures) and unfamiliarity with these instruments. The
over-the-counter derivatives (swaps). percentage of respondents who view the
corresponding tax regimes with a jaundiced
Exhibit 4.24 indicates that respondents prefer eye is, at around 10%, constant from one
ETFs (44% consider them very good) when instrument to the next.
it comes to the regulatory regime to which
they are subject. Only 7% deem them poor We have summarised the rankings for these
by this criterion. Index funds and futures four products on these ten criteria in the
are, for the most part, viewed positively. table below. For each particular question, we
There is considerable discontent with the assign a grade of one to three for answers of
regulatory framework for TRSs. Seven poor to very good and calculate the average
percent of respondents rate them very good, score based on the number of respondents
40% fairly good, 20% poor. who have answered that question. The row
“average score” shows the average for the
Lastly, the majority of respondents (78%) ten evaluation criteria for each type of
consider ETFs either very good or fairly instrument.
good in terms of their tax efficiency, which
compares to 62% for futures and 67% On the whole, ETFs and futures get the
for index funds (exhibit 4.25). Roughly highest scores and TRSs the lowest (less
equal shares of respondents (20% to than two, or fairly good, in fact). For
24%) report that they are very satisfied individual criteria, futures have good
with the tax regimes to which ETFs and scores for liquidity, cost, tracking error,
futures are subject. Total return swaps and transparency, whereas ETFs, the
receive fewer positive responses than all strongest rivals to futures, stand out for
other instruments (49%). This difference ease of use (minimum subscription and
is affected by the varying fraction of operational constraints) and range of
non-responses across instruments, which products. ETFs also dominate traditional
Exhibit 4.25: Respondent views of the tax regime

This exhibit indicates respondent views of the tax regime for each of the mentioned products. Non-responses are reported as “no
answer” so that the sum of percentages of opinions for each product is 100%.

4. Results
index funds, as they receive better average problems with TRSs: the requirement for
ratings on all ten criteria; overall, index over-the-counter trading and the associated
funds have a score of 2.15 as compared counterparty credit risk.
to 2.37 for ETFs. As for TRSs, the tracking
error is very good (2.47 out of 3) and the As exhibit 4.26 shows, trading over the
product range is comparable to that of counter is problematic for the majority of
futures (2.10 for TRSs and 2.07 for futures). respondents (55%). Counterparty risk is
On all other criteria, however, they have the even more problematic (70%). In view of
lowest ratings of the four index tracking the recent financial crisis and the prominent
vehicles. These ratings suggest that TRSs failures of 2008, this fear of counterparty
are particularly poor in the sense that they risk is understandable.
are less liquid, more costly, and harder to use
than the three other types of products. The rate of responses (roughly 86%) to
these particular questions is significantly
4.2.2. Specific Problems with higher than the percentage of respondents
Investment in Total Return Swaps, who report that they have invested in
Futures, and ETFs TRSs (20.3%).12 These exhibits suggest
12 - Similar results are found
for these specific questions
that respondents do not use TRSs because
among the respondents who Total Return Swaps counterparty risk and OTC transactions
invest in TRSs. Fifty-four
percent consider trading OTC Considering responses across all criteria, dissuade them from using them in the
problematic for TRSs and
79% regard counterparty
we find, broadly, that respondents take a first place.
risk as a more severe issue dimmer view of TRSs than of the other three
for TRSs.
instruments. In addition, fewer respondents Futures
invest in TRSs than in the other instruments, In direct comparison of all four instruments,
a circumstance that suggests that futures fared remarkably well; when it
respondents are relatively unfamiliar with comes to indexing strategies, they are
them. Our survey addresses two particular the greatest rivals to ETFs. Unlike ETFs,
Table 1: Summary of the ratings for ETFs, futures, TRSs, and index funds
This table indicates the average scores which the four products received from respondents based on the ten criteria. For each
criterion a score from one to three was assigned for answers of poor to very good and the average score was calculated based on
the number of responses to the question. The familiarity percentages were obtained by using (1-non-responses).
ETFs Futures TRSs Index funds
QUALITY
Liquidity 2.42 2.82 1.73 2.15
Cost of liquidity 2.16 2.70 1.78 2.08
Other cost 2.25 2.70 1.83 1.89
Tracking error 2.28 2.51 2.47 2.19
Product range 2.52 2.07 2.10 1.99
Transparency 2.27 2.75 1.93 2.20
Minimum subscription 2.76 2.13 1.55 2.28
Operational constraints 2.53 2.15 1.60 2.24
Regulatory regime 2.39 2.42 1.80 2.36
Tax regime 2.12 2.19 2.02 2.09
Average score 2.37 2.44 1.88 2.15

4. Results
Exhibit 4.26: Concerning total return swaps...

This exhibit indicates respondents’ opinions of the two arguments concerning total return swaps. Non-responses to this question
are reported as “no answer” so that the percentages for all categories in each argument add up to 100%.
Exhibit 4.27: Concerning futures...

This exhibit indicates respondents’ opinions of the two arguments concerning futures. Non-responses to this question are reported
as “no answer” so that the percentages for all categories in each argument add up to 100%.
futures, as derivative instruments, require position-rolling as problems, a finding that

rollover transactions and involve margin strengthens the perception of futures as a
calls. Moreover, as exhibit 4.23 shows, the possible alternative to ETFs.
operational constraints associated with
futures are viewed with greater disfavour Still, it is interesting that investors consider
than are those associated with ETFs. margin calls the main problem of futures.
When asked directly, respondents Once again the financial crisis may be the
report that margin calls (45%) and reason: the combination of high market
the rollover of positions (33%) are volatility and dried up liquidity makes it
problematic for them (exhibit 4.27). harder than it normally would be suddenly
That futures are derivatives is seen as to provide enough cash to meet margin
problematic by only 28% of respondents. requirements.
On the whole, the significant percentage
of respondents seeing margin calls Exchange-Traded Funds
and position-rolling as problems jibes with Turning to ETFs, we ask questionnaire
the relatively sceptical view of futures respondents for their opinions of pricing
when it comes to the operational constraints errors with respect to the net asset value
they face. On the other hand, many (NAV) of the ETF, and of the advantages of
respondents do not see margin calls and ETFs for securities lending.

4. Results
Exhibit 4.28: Concerning ETFs...

This exhibit indicates respondents’ opinions of the two arguments concerning ETFs. Non-responses to this question are reported as
“no answer” so that the percentages for all categories in each argument add up to 100%.
Possible mispricing with respect to the NAV As exhibit 4.29 shows, respondents expect
was of concern to 61% of respondents to increase their use of both futures and
(see exhibit 4.28). This finding is somewhat ETFs. In fact, the number of respondents
surprising, as Engle and Sarkar (2006) find who plan to increase their use of these two
that the premiums or discounts on fund instruments is far greater than the number
NAVs are usually small and disappear very of respondents who plan to decrease it.
quickly (see section 2). It may be that the This positive outlook is especially striking for
respondents to our survey associate the ETFs. Seventy-three percent of respondents
problem of non-synchronous observations plan to use ETFs more heavily, whereas only
of fund prices and fund NAVs with the 6% plan to dial back. Thirty-one percent
problem of mispricing, which is in fact of respondents plan to use futures more
another problem altogether. heavily, whereas 4% plan to cut back. Since
this survey elicits responses only from those
Thirty-five percent of the respondents who are already ETF investors, this expected
view securities lending as an advantage, increase is even more remarkable.
possibly to generate additional returns to
compensate for the replication costs. Total return swaps and traditional index
funds, by contrast, are likely to play a minor
4.2.3. Looking Ahead role in the future: the number of asset
Finally, we venture a glimpse into the future managers who expect to rely less heavily
by asking survey respondents for their on these instruments is greater than that
views of their future use of ETF and other of those who expect to rely more heavily on
financial instruments. In section 4.1.8, we them. Only 14% plan to rely more heavily
have already established some plans for on TRSs; 17% plan to rely on them less
future use of ETFs and priorities for new heavily. For index funds the situation is
product development. In this section of the similar: 21% plan to use them less and
survey, we ask respondents to comment on 24% to use them more. On the whole, the
their plans for all four indexing vehicles. As anticipated growth in ETF use will come at
a complement to the evaluation of these the expense of indexing vehicles such as
instruments on the quality criteria above, TRSs and index funds.
this question makes it possible to assess the
likely development of the market share of
each instrument.

4. Results
Exhibit 4.29: How do you predict your future use of the following instruments?
This exhibit indicates respondents’ forecast of the future use of each of the mentioned products. Non-responses are reported as “no
answer” so that the percentages for all categories in each product add up to 100%.
4.3 The Role of ETFs or less; scores above three are considered
in the Asset Allocation Process characteristic of frequent users (see exhibit
As ETFs offer liquidity, cost efficiency, 4.30).
and product variety, they have become
important to asset allocation strategies. The results show that more than 60% of
In this section we analyse the purpose of respondents use ETFs frequently either for
ETF investments and the role of ETFs in long-term (buy-and-hold) investments or
core-satellite investing. In fact, one of the for broad market exposure (or for both
benefits of taking a survey of ETF users is purposes). ETFs are less often used for
that we get information not only on the tactical bets (50%), short-term (dynamic)
frequency and intensity with which ETFs investments (49%), or specific sub-segment
are used but also on the reasons they are exposure (44%). ETFs are even more rarely
used and on views of their role in asset used for management of cash flows (19%),
allocation. neutralisation of factor exposures related to
other investments (15%), dynamic portfolio
4.3.1. Purpose of ETF Investments insurance strategies (11%), or arbitrage
We begin with the investors’ reasons for opportunities (9%).
using ETFs. Investment in ETFs may be for
the longer or the shorter term; it may be These results show that investment in
for broad market exposure or for access ETFs is associated mainly with long-term
to specific segments. In addition to such exposure to broad market indices. All the
broad categorisations, we assess how same, that up to 50% of respondents use
often ETFs are used for specific purposes ETFs for short-term exposure to specific
such as neutralising factor exposures or market sub-segments and for tactical bets
arbitraging related assets. We ask how indicates that other investment purposes
often the survey respondents use ETFs for are increasingly important as well.
different investment purposes on a scale
from never (score zero) to always (score
six on the scale). Respondents fall into two
groups: rare users are those who score three

4. Results
Exhibit 4.30: How often do you use ETFs for the following purposes?
This exhibit indicates the frequency at which respondents use ETFs for each of the mentioned purposes. Respondents were asked
to rate the frequency from one to six. “Frequently” includes ratings from four to six and “Rarely” ratings from one to three and
non-responses.
4.3.2. Exchange-Traded Funds in the Exhibit 4.31: Have you implemented a core-satellite
allocation?
Core-Satellite Allocation This exhibit indicates the percentages of respondents using a
In this section, our survey addresses the core-satellite-type allocation. The percentages are based on
192 responses.
application of ETFs in core-satellite methods
of asset allocation. The core-satellite
strategy, as discussed in section 2.2, is
widely regarded as an effective means
of organising asset allocation. First, we
look into the popularity of this investment
approach. Despite its advantages,
only 45% of ETF investors have taken
a core-satellite approach to portfolio
construction (exhibit 4.31). About 11% of
respondents in this survey report that they
are not familiar with this approach.
45% Yes
44% No
11% Not familiar with it
Forty-four percent of respondents have not

taken a core-satellite investment approach.
As exhibit 4.32 shows, however, 19% of
those who have not yet taken this approach
are planning to do so, whereas 81% state
that they are unlikely to.

4. Results
Exhibit 4.32: Will you implement a core-satellite allocation in and satellite. Moreover, different types
the future?
This exhibit indicates the percentage of respondents having not of ETFs may be used simultaneously;13
yet taken a core-satellite approach likely do so in the future. in other words, a user of broad market ETFs
may also use style ETFs. So the results merely
indicate the importance of a particular
ETF to the core or the satellite. They do
not enable conclusions on the overall use
of ETFs for a given asset class. In fact, this
question has already been dealt with in
section 4.1.1.
Equities
When evaluating the usefulness of equity
ETFs, core-satellite investors express
a preference for broad-based ETFs.
19% Unlikely in the future
81% We will soon Exhibit 4.33 shows that 73% of equity
ETF users use these vehicles in the core,
13 - The percentages
shown refer to the users of
whereas only 12% use them in the satellite.
particular ETFs out of all ETFs are convenient means of making Another 8% use broad market ETFs for both
users of ETFs for the given
asset class. For example,
core-satellite allocations. Although indexing core and satellite investments. Style and
the percentage of users of is sometimes perceived to be limited to sector ETFs are clearly less popular than
style ETFs in the satellite
refers to the percentage of the core portfolio (for strategic allocation broad-based ETFs, especially for use in the
respondents who use style
ETFs in the satellite of those
purposes), ETFs can also be beneficial in the core. In the satellite, however, style ETFs
respondents who invest in satellite (for tactical bets), as highlighted are used by 47% of respondents, whereas
equity ETFs. This presentation
ensures that we assess the in section 2.2. In the next questions, then, sector ETFs are used by 52%. Again, very
relative importance of the
types of ETFs in the asset
we assess the role of ETFs in different few investors use style and sector ETFs in
class, as opposed to the asset classes for the construction of the both core and satellite. As the literature has
overall importance of the
asset class itself. core-satellite portfolio. stressed the importance of style factors,
our finding is surprising. Investment
We ask survey respondents to identify the styles are not highly correlated, and this
ETFs they use in each asset class, i.e., what correlation is remarkably stable, so equity
types of ETFs they prefer for allocation style diversification is one of the most
to equity, fixed income, and alternative promising ways of building a diversified
asset classes in both core and satellite core portfolio.
portfolios or in one or the other. Responses
are non-exclusive, as a given ETF may be
used in both the core and the satellite.
We then present results for particular ETFs
in order to separate responses into exclusive
categories; that is, we report the percentages
of respondents using a particular ETF (a
broad market ETF, for example) in the core
alone, in the satellite alone, or in both core

4. Results
Exhibit 4.33: If you use equity ETFs, please indicate whether you use them in the core, in the satellite, or in both.
This exhibit indicates the use of equity ETFs in the core-satellite approach for each of the mentioned categories. The percentages
are based on the investors who report that they invest in equity ETFs and make core-satellite allocations.
Exhibit 4.34: If you use government bond ETFs, please indicate whether you use them in the core, in the satellite, or in both.
This exhibit indicates the use of government bond ETFs in the core-satellite approach for each of the mentioned categories.
The percentages are based on the investors who reported that they invest in government bond ETFs and make core-satellite
allocations.
Government bonds differing exposure to interest rate changes,

For government bond investments, again also makes them a useful vehicle for
broad-based ETFs (84%) are preferred constructing an efficient core portfolio. Very
in the core portfolio (see exhibit 4.34). few investors (0% to 4%) use government
Maturity-segment ETFs (32%) and bond ETFs in both core and satellite.
inflation-protected bond ETFs (48%) are
less popular for the core portfolio. However, Corporate bonds
they are also relatively more common Exhibit 4.35 shows, again, that, in the
for the satellite portfolio (16% to 31%). core portfolio, broad market ETFs are the
This finding is interesting, since different most widely used. ETFs on indices that
maturity segments are natural media for subdivide corporate bonds into finer
tactical timing strategies in the satellite. categories, such as sectors, maturity, or
In addition, the time-series behaviour of rating segments, are used less frequently in
these instruments, which differs with their the core. However, compared to government

4. Results
bonds, corporate bonds are generally more decisions involving bond markets include
widely used and investors make wider use Shiller (1979), Fama (1981), Ilmanen (1995,
of specific sub-segment ETFs in the satellite. 1997), and Ilmanen and Sayood (2002).
In the satellite portfolio, the most popular
ETFs are rating-segment and sector ETFs Alternative asset classes
(37% of those who use corporate bond Finally, we look at how European
ETFs), followed by maturity-segment ETFs core-satellite investors use ETFs or ETF-like
(30%). These results show that practitioners index products for alternative investments.
seem to agree with academic research The predominance of commodity ETFs or
that points to the significant benefits of ETF-like products is clear. These products
active allocation to such finer categories are used mainly in the satellite. Indeed,
of the bond market as maturity segments. some 55% of ETF investors in the alternative
Example of papers on tactical asset allocation investment universe use such products
Exhibit 4.35: If you use corporate bond ETFs, please indicate whether you use them in the core, in the satellite, or in both.
This exhibit indicates the use of corporate bond ETFs in the core-satellite approach for each of the mentioned categories. The
percentages are based on the investors who reported that they invest in corporate bond ETFs and make core-satellite allocations.
Exhibit 4.36: If you use alternative asset ETFs or ETF-like products, please indicate whether you use them in the core, in the satellite,
or in both.
This exhibit indicates the use of alternatives asset ETFs in the core-satellite approach for each of the mentioned categories. The
percentages are based on the percentages of investors who reported that they invest in alternative asset ETFs and make core-
satellite allocations.

4. Results
for commodities investing in the satellite. dominance is not confined to equities

Investable index products are not as popular alone, as these ETFs also account for
in hedge fund investments, possibly as a the bulk, though to a somewhat lesser
result of their relatively recent appearance. degree, of demand for government bond
Only 27% of all users of ETFs for alternative ETFs and corporate bond ETFs. Likewise,
asset classes use them for the satellite. In alternative asset class ETFs are used more
the satellite, real estate ETF users accounts heavily in the satellite than in the core,
for 32% of all users of alternative ETFs and a somewhat surprising development in
infrastructure ETF users 36%. In the core, view of the inflation-hedging properties of
these percentages are considerably lower alternative asset classes (Amenc, Martellini,
than percentages for the satellite for all and Ziemann 2009) and the improvements
four alternative asset classes. Again, very they make to the long-term risk/return
few ETF users rely on alternative ETFs in tradeoff in the core, attributes that make
both core and satellite. them suitable for allocation to the core
portfolio.
Table 2 summarises the use of different
instruments in the core-satellite allocation. On the whole, perhaps the most important
The results suggest that the types of ETFs result of our analysis is that, instead of
used in the core are different from those actively managing their long-term beta
used in the satellite. Although ETFs on finer exposure to obtain the most efficient risk/
segments of the respective markets are return tradeoff in their core portfolio,
relatively widely used as satellite vehicles, European investment managers focus
the dominance of broad market ETFs for mainly on using broad market indices in
investments in the core is striking. This their core portfolios.
Table 2: Summary of the use of different instruments in the core-satellite allocation
This table shows the summary of the use of different instruments in the core-satellite allocation. Not all respondents answered
the questions, so the percentages in the rows do not add up to 100%.
In the core In the satellite In both
Equity ETFs
Style ETFs 18% 47% 3%
Government bond ETFs
Inflation-protected bond ETFs 48% 16% 4%
Corporate bond ETFs
ETFs by credit rating segment 7% 37% 4%
Alternative asset ETFs
Real estate 16% 32% 0%
Commodities 18% 55% 7%
Hedge funds 14% 27% 4%
Infrastructure 4% 36% 0%

4. Results
4.4. Trends: Use of and Satisfaction ETFs for fixed-income products are used by
with ETFs over Time a slightly greater percentage of respondents
In the past decade, investment in ETFs who use core-satellite strategy (from 61%
has increased significantly, but, since to 68% for government bond ETFs and
ETFs are still rather new, not all potential from 55% to 60% for corporate bond ETFs).
investors are aware of all the uses to which Hedge fund ETFs are likewise used by a
they can be put or of all the benefits to greater share of respondents (34% to
be derived from them. In short, the ETF 38%).14
industry is maturing, but, as our survey
suggests, investment in standard ETFs and The increase in the popularity of ETFs by
more sophisticated varieties is growing. share of investors who use them is not so
In this section, we compare the results obvious it was to that in 2009; however,
of the 2010 survey and those of the there is a substantial increase in the
surveys taken in 2006, 2008, and 2009. percentage of total investment accounted
This comparison may provide further for by ETF-like products for a given asset
insights into the dynamics of ongoing uses class. For those respondents who do use ETFs
of ETFs. in the asset class, exhibit 4.38 compares the
14 - The corresponding
question changed slightly
fractions of our respondents’ portfolios that
from one survey to the next, 4.4.1. Use and Satisfaction are invested in ETFs.15 Other than equity
such that the answers to the
question might be biased Comparisons show that the recent ETFs, whose share of total investment has
downwards in 2010. In 2006,
the question was: “Do you
tremendous growth of the frequency of ETF fallen, ETFs have gained significant ground
use ETFs for this type of asset use has stabilised in 2010. The use of most on investments in other instruments over
class?” In 2008, the question
was: “Concerning your ETF products in core-satellite investments is the past twelve months. Hedge fund ETFs
investment in the following
asset class, please indicate
much the same as it was last year (exhibit now account for one-fifth of the hedge
which of the following ETFs 4.37). By frequency of use we mean the fund investments of the respondents who
you use for the core and/
or satellite”. In 2009, the percentage of respondents who use ETFs in a use ETFs for this particular asset class.
question was identical to
the question asked the year
given asset class that they generally invest in.
before, but only to investors
who take a core-satellite
approach to investment. In
Exhibit 4.37: Use of ETFs or ETF-like products over time
2010, although we have a
This exhibit indicates the use of ETFs or ETF-like products for different asset classes over time. The percentages are based on the
specific question for the use
of ETFs in each asset class, results of EDHEC ETF surveys 2006, 2008, 2009, and 2010.
we obtained the use of ETFs
only for investors who take
a core-satellite approach;
in this way, this year’s and
last year’s results will be
comparable.
15 - Since this question
was not asked in the EDHEC
European ETF Survey 2006,
we can provide a comparison
only with last year’s answers.

4. Results
Exhibit 4.38: Percentage of total investment accounted for by ETFs or ETF-like products
This exhibit indicates the percentage of total investment accounted for by ETFs or ETF-like products for different asset classes over
time. The percentages are based on the results of EDHEC ETF surveys 2008, 2009, and 2010.
Exhibit 4.39: Satisfaction with ETFs or ETF-like products over time

This exhibit indicates the percentages of respondents satisfied with ETFs or ETF-like products for different asset classes over time.
The percentages are based on the results of EDHEC ETF surveys 2006, 2008, 2009, and 2010.
On the whole, these results suggest corporate bond ETFs do fairly well in terms
that, although ETFs are widely used and of investor satisfaction. Unlike the drop in
growth seems to be flattening, ETF users satisfaction with alternative asset ETFs in
are allocating ever-larger shares of their 2009, a significant rise in satisfaction is
investments in a given asset class to ETFs. observed in all alternative asset ETFs in 2010.
More than 80% of investors are satisfied
Satisfaction with standard equity and with real estate ETFs, and even hedge fund
government bond ETFs has remained ETFs have satisfied around two-thirds of
high. For each product, there are around investors. As it turns out, satisfaction
90% of respondents who are satisfied with ETFs is greater than it was in 2009;
with them. Similarly, commodity ETFs and it has made up ground and, in general,

4. Results
Exhibit 4.40: Preferred ETF type—active or passive?

This exhibit indicates the preferred ETF types over time. The percentages are based on the results of EDHEC ETF surveys 2006, 2008,
2009, and 2010.
Exhibit 4.41: Investors' preferred replication methods

This exhibit indicates replication methods preferred by passive ETF investors. The percentages are based on the results of EDHEC ETF
surveys 2006, 2008, 2009, and 2010.
it is even slightly higher than in 2008. maintain their dominance. The increased
The dissatisfaction with alternative asset use of ETFs is seemingly accompanied
class ETFs voiced in the 2009 survey thus by a desire to limit ETFs to indexing, as
seems to have been rather specific to the opposed to seeing them venture into active
post-crisis period during which the 2009 management.
survey was taken.
Exhibit 4.41 shows that, as in previous
Exhibit 4.40 clearly indicates that—for the years, investors in passive ETFs favour pure
time being—passive ETFs, preferred to active replication. In 2006, investors viewed both
ETFs by a margin that has grown even wider statistical and synthetic replication with
than it was in previous years, are likely to equal favour, but over the past four years

4. Results
they have viewed synthetic replication, are now firmly established, although the
now the preferred replication mechanism use of inverse ETFs has dropped to 24%
of 20% of respondents, with greater favour, from 2009. Our results do not make it
a shift that comes mainly at the expense possible to conclude whether this drop is
of statistical replication. the result of decreased interest in taking
short positions as the equity market has
These findings allow us to draw two main rallied or of increased interest in ways of
conclusions. First, although growth in the taking short positions other than short
frequency at which ETFs are used is levelling ETFs. Other advanced uses of ETFs, such as
off, the intensity is not. The share of overall a shorting ETFs directly (without buying
investment in the respective asset classes inverse ETFs) and securities lending, are
accounted for by ETFs has increased in adopted at much the same rates as they
the past year. Second, alternative asset were last year. Eight percent of investors
class ETFs and corporate bond ETFs are no used options on ETFs in 2010, 25% more
longer tainted by the effects of the crisis; than in 2009.
satisfaction with these products is as high
as it was before the crisis. The financial crisis in 2008/2009 influenced
investors’ views of TRSs as possible
4.4.2.Developments in Advanced Uses of alternatives to ETFs. That they are traded
ETFs, Challenges for Total Return Swaps, OTC and involve counterparty risk is a great
and Outlook on Indexing Products perceived drawback. As the 2009 survey
Exhibit 4.42 shows that advanced uses and showed, both OTC trading and counterparty
the adoption of sophisticated forms of ETFs risk were of far greater concern to investors
have increased in the course of the past than they were before the crisis—or,
year—albeit from a low base. The use of indeed, than they are now that financial
inverse and leveraged ETFs is now relatively markets are recovering. Yet they are still
common and these product innovations considered obstacles.
Exhibit 4.42: Advanced uses and forms of ETFs

This exhibit indicates the adoption of advanced forms of ETFs over time. The percentages are based on the results of EDHEC ETF
surveys 2006, 2008, 2009, and 2010. The use of inverse ETFs is not available for the year 2006 as these products were launched
only after 2006.

4. Results
Exhibit 4.43: Regarding total return swaps...

This exhibit indicates the respondents’ opinions of the two arguments concerning total return swaps over time. The percentages are
based on the results of EDHEC ETF surveys 2006, 2008, 2009, and 2010.
Exhibit 4.44: Will you increase your use of the following indexing products?
This exhibit indicates the percentages of investors who reported that they would use the mentioned products more heavily. The
percentages are based on the results of EDHEC ETF surveys 2006, 2008, 2009, and 2010.
Finally, we look at the expected developments of the strong growth of ETFs, a majority
of all four indexing products analysed in of investors still expect to rely even more
this survey, and examine expectations heavily on ETFs. The slight drop in this year’s
for these products by comparing the results may imply that, as ETFs mature,
findings of this year’s survey and those of the frequency at which they are used
previous years. Very clearly, exhibit 4.44 has stabilised. It is also possible that the
shows that investors expected to invest remaining growth of ETFs will come at the
increasingly in ETFs. The exhibits in this expense of other indexing products, most
survey (exhibit 4.35, for example) indicate of all TRSs and traditional index funds. In
that these expectations have materialised. fact, only a minority of investors plan to
Interestingly, even against the backdrop increase their use of these rivals to ETFs.

4. Results

Conclusion

Conclusion
The EDHEC European ETF Survey 2010 reported after the financial crisis and
presents the results of a comprehensive evident in last year’s survey, is much less
survey of 192 institutional investment in evidence. The percentages of survey
managers and private wealth managers. respondents' investing in particular asset
In addition to analysing ETF investment, classes who invest in ETFs show that ETFs
this survey sheds light on the role of ETFs are very popular with investors, especially
in asset allocation and compares ETFs and in the equity (96%) and commodity (80%)
other investment products traditionally sectors. As the market has matured, the
used as indexing vehicles: futures, index percentage of investors using ETFs is
funds, and total return swaps. increasing at a much slower rate than in the
past, but ETFs account for a fast-growing
On the whole, the results of the survey share of the portfolio assets of those
suggest that, as a consequence of strong who do use them. Indeed, assets in ETF
growth, the industry has entered a phase investment account for at least one-fifth
of increased maturity, as ETFs are now of total investment in each asset class.
very widely used, investors are embracing So, although the percentage of investors
more advanced ways of trading and using who use ETFs may have levelled off, the
ETFs, such as OTC trading and securities intensity has not, as shown by the significant
lending, and the positive impact of ETFs growth of the most recent year.
on the market as a whole, including
their underlying assets and other related New trends in the use of ETFs have also
instruments, is being felt by an increasing emerged. First, the number of investors who
number of market participants. Despite this reported that they trade more than 90%
maturity, there is still room for growth. In of their ETF investments on OTC markets
particular, survey respondents see a need rose from 6% in 2009 to 12% in 2010.
for new products on, say, emerging markets Our 2010 respondents also report an
and alternative asset classes. Likewise, ETFs increase in the number of their trading
are still used mostly in static strategies and counterparties.
on broad market indices; their potential
contribution to dynamic asset allocation In addition to these changes in the ways
and to allocation strategies in precisely ETFs are traded, the use of advanced
defined market segments or styles is not products such as options on ETFs has grown
yet fully exploited. in the last twelve months. In addition, there is
a broader consensus on the preferred means
In sum, the results of our survey show of replicating indices when constructing an
that ETFs are widely used and that they ETF. Pure replication ETFs are the favourite,
are becoming even more important to but interest in synthetic replication ETFs is
investors. Satisfaction rates have reached growing; statistical replication, on the other
astonishing highs of about 90% for equity, hand, is falling out of favour, a trend that,
government bond, and infrastructure despite the 2008 financial crisis, which led
ETFs, and above two-thirds for other ETF to a slight dip in the popularity of synthetic
products. Dissatisfaction with corporate replication, has been taking shape over the
bond, real estate, and hedge fund ETFs, last four years.

Conclusion
Our survey results also show that, as they predominantly long-term or buy-and-hold
have been growing into an important and investments. By contrast, fewer than 50% of
liquid market, ETFs may have a positive respondents state that they frequently rely
impact on the broader market; ETFs now on ETFs for short-term investments or for
provide investors with information and exposure to specific market sub-segments.
increase market efficiency. Indeed, as our And the large majority of investors who
survey shows, investors use ETFs as sources take a core-satellite approach to portfolio
of information on market developments management report that they rely mainly
and state that they observe improvements on broad market indices, especially in
in market efficiency after the introduction the core. But the wide range of ETFs for
of ETFs. These results dovetail with the sub-categories and styles is left partly
evidence found by much of the literature; unused.
that is, that the introduction of ETFs has
improved the price efficiency in the spot This year’s survey has also allowed us to
and future markets (Ackert and Tian 2001; compare investor views of ETFs and of
Deville 2005; Deville and Riva 2007). other indexing vehicles. Although futures
rival ETFs, ETFs are seen as clearly superior
Responses to our survey also shed light on to traditional index funds on all available
future developments in the ETF industry. For quality criteria. For investors, the main
traditional asset classes, investors would like advantages of ETFs are the ease with which
to have a broader choice of relatively risky they can be used and the wide product
products. For example, 52% of investors range they come in.
would like to see the development of
emerging market equity ETFs; 37% and Although there are more than eight
34% would like to see more emerging hundred ETFs or ETF-like products offered
market bond ETFs and high yield bond ETFs. in Europe (Fuhr and Kelly 2009) and growth
Although 80% of investors who invest in in the use of ETFs has stabilised, the ETF
commodities allocate to commodity ETFs, industry is still developing; investors see
39% of respondents, a higher percentage further demand for completing the product
than for any other ETF for alternative range. ETFs have entered the mainstream,
asset classes, would like to see these ETFs as the survey shows, but, as investors have
developed still further. New products such begun using ETFs in a more sophisticated
as currency ETFs and hedge fund ETFs are fashion (OTC trading of ETFs, for example)
also on investors’ wish-lists. and embraced innovative products (ETFs
on new asset classes, leveraged ETFs, and
The EDHEC survey shows that ETFs are mainly so on), it is clearly in the interests of the
used as static asset allocation vehicles. As it ETF industry to continue making available
happens, ETFs are used largely for passive new products and proposing innovative
holdings of broad market indices. Seventy ways to use them.
percent of all ETF users, for example, report
that they frequently rely on ETFs to obtain
broad market exposure; and for more
than 60% of the respondents ETFs are

Conclusion

References

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• Amenc, N., F. Goltz, A. Grigoriu, and D. Schroeder. 2009. The EDHEC European ETF survey
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• Amenc, N., F. Goltz, and A. Grigoriu. 2010. Risk control through dynamic core-satellite
portfolios of ETFs: Applications to absolute return funds and tactical asset allocation.
EDHEC-Risk Institute.
• Amenc, N., F. Goltz, and V. Le Sourd. 2009. The performance of characteristics-based
indices. European Financial Management 15(2): 241–78.
• Amenc, N., F. Goltz, L. Martellini, and P. Retkowsky. 2010. Efficient indexation: An
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About EDHEC-Risk Institute

Founded in 1906, EDHEC is The Choice of Asset Allocation An Applied Research Approach
one of the foremost French and Risk Management In an attempt to ensure that the research
business schools. Accredited by
the three main international
EDHEC-Risk structures all of its research it carries out is truly applicable, EDHEC
academic organisations, EQUIS, work around asset allocation and risk has implemented a dual validation
AACSB and Association of MBAs, management. This issue corresponds to system for the work of EDHEC-Risk.
EDHEC has for a number of a genuine expectation from the market. All research work must be part of a research
years been pursuing a strategy
for international excellence
On the one hand, the prevailing stock market programme, the relevance and goals of
that led it to set up situation in recent years has shown the which have been validated from both an
EDHEC-Risk in 2001. limitations of diversification alone as a risk academic and a business viewpoint by
With 47 professors, research management technique and the usefulness the centre's advisory board. This board
engineers and research
associates, this centre has the
of approaches based on dynamic portfolio is made up of internationally recognised
largest asset management allocation. On the other, the appearance researchers, the centre's business partners
research team in Europe. of new asset classes (hedge funds, private and representatives of major international
equity, real assets), with risk profiles institutional investors. The management of
that are very different from those of the the research programmes respects a rigorous
traditional investment universe, constitutes validation process, which guarantees the
a new opportunity and challenge for the scientific quality and the operational
implementation of allocation in an asset usefulness of the programmes.
management or asset-liability management
context. This strategic choice is applied to Six research programmes have been
all of the centre's research programmes, conducted by the centre to date:
whether they involve proposing new • Asset allocation and alternative
methods of strategic allocation, which diversification
integrate the alternative class; taking • Style and performance analysis
extreme risks into account in portfolio • Indices and benchmarking
construction; studying the usefulness of • Operational risks and performance
derivatives in implementing asset-liability • Asset allocation and derivative
management approaches; or orienting instruments
the concept of dynamic “core-satellite” • ALM and asset management
investment management in the framework
of absolute return or target-date funds. These programmes receive the support of
a large number of financial companies.
The results of the research programmes
are disseminated through the three
EDHEC-Risk locations in London, Nice and
Singapore.
In addition, EDHEC-Risk has developed a

close partnership with a small number of
40% Strategic Asset Allocation
sponsors within the framework of research
45.5% Tactical Asset Allocation
11% Stock Picking
chairs. These research chairs correspond
3.5% Fees
to a commitment over three years from
Source EDHEC (2002) and Ibbotson, Kaplan (2000)
the partner on research themes that are
agreed in common.
The following research chairs have been Each year, EDHEC Risk organises a major
endowed to date: international conference for institutional
• Regulation and Institutional Investment, investors and investment management
in partnership with AXA Investment professionals with a view to presenting
Managers (AXA IM) the results of its research: EDHEC Risk
• Asset-Liability Management and Institutional Days.
Institutional Investment Management,
in partnership with BNP Paribas Investment EDHEC also provides professionals with
Partners access to its website, www.edhec-
• Risk and Regulation in the European risk.com, which is entirely devoted to
Fund Management Industry, international asset management research.
in partnership with CACEIS The website, which has more than 35,000
• Structured Products and Derivative regular visitors, is aimed at professionals
Instruments, who wish to benefit from EDHEC’s analysis
sponsored by the French Banking and expertise in the area of applied
Federation (FBF) portfolio management research. Its
• Private Asset-Liability Management, monthly newsletter is distributed to more
in partnership with ORTEC Finance than 400,000 readers.
• Dynamic Allocation Models and New
Forms of Target-Date Funds, EDHEC-Risk Institute: Key Figures,
in partnership with UFG 2008-2009
Number of permanent staff 47
• Advanced Modelling for Alternative
Number of research associates 17
Investments,
Number of affiliate professors 5
in partnership with Newedge Prime
Overall budget €8,700,000
Brokerage
External financing €5,900,000
• Asset-Liability Management Techniques
Number of conference delegates 1,950
for Sovereign Wealth Fund Management,
Number of participants at
in partnership with Deutsche Bank EDHEC Risk Executive Education 371
• Core-Satellite and ETF Investment, seminars
in partnership with Amundi ETF
• The Case for Inflation-Linked Bonds:
Issuers’ and Investors’ Perspectives, Research for Business
in partnership with Rothschild & Cie The centre’s activities have also given rise
to executive education and research service
The philosophy of the centre is to validate offshoots.
its work by publication in international
journals, but also to make it available to EDHEC-Risk's executive education
the sector through its Position Papers, programmes help investment professionals
published studies and conferences. to upgrade their skills with advanced risk
and asset managementtraining across
traditional and alternative classes.

The EDHEC-Risk Institute PhD in FTSE EDHEC-Risk Efficient Indices

Finance FTSE Group, the award winning global
The EDHEC-Risk Institute PhD in Finance index provider, and EDHEC-Risk Institute
at EDHEC Business School is designed launched the first set of FTSE EDHEC
for professionals who aspire to higher Risk Efficient Indices at the beginning
intellectual levels and aim to redefine the of 2010. Initially offered for the UK, the
investment banking and asset management Eurobloc, the USA, Developed Asia-Pacific,
industries. It is offered in two tracks: a ex. Japan, and Japan, the index series aims
residential track for high-potential graduate to capture equity market returns with an
students, who hold part-time positions at improved risk/reward efficiency compared
EDHEC Business School, and an executive to cap-weighted indices. The weighting of
track for practitioners who keep their full- the portfolio of constituents achieves the
time jobs. Drawing its faculty from the highest possible return-to-risk efficiency
world’s best universities and enjoying the by maximising the Sharpe ratio (the reward
support of the research centre with the of an investment per unit of risk).
greatest impact on the European financial
industry, the EDHEC-Risk Institute PhD in
Finance creates an extraordinary platform EDHEC-Risk Alternative Indexes
for professional development and industry The different hedge fund indexes available
innovation. on the market are computed from different
data, according to diverse fund selection
The EDHEC-Risk Institute MSc in criteria and index construction methods;
Risk and Investment Management they unsurprisingly tell very different
The EDHEC-Risk Institute Executive MSc stories. Challenged by this heterogeneity,
in Risk and Investment Management is investors cannot rely on competing hedge
designed for professionals in the investment fund indexes to obtain a “true and fair”
management industry who wish to view of performance and are at a loss
progress, or maintain leadership in their when selecting benchmarks. To address
field, and for other finance practitioners
this issue, EDHEC Risk was the first to
who are contemplating lateral moves. It
launch composite hedge fund strategy
appeals to senior executives, investment
indexes as early as 2003.
and risk managers or advisors, and analysts.
This postgraduate programme is designed
to be completed in seventeen months of The thirteen EDHEC-Risk Alternative
part-time study and is formatted to be Indexes are published monthly on www.
compatible with professional schedules. edhec-risk.com and are freely available
to managers and investors.
The programme has two tracks: an executive
track for practitioners with significant
investment management experience and
an apprenticeship track for selected high-
potential graduate students who have
recently joined the industry. The programme
is offered in Asia—from Singapore—and in
Europe—from London and Nice.

About Amundi ETF

About Amundi ETF
Since 2009 Amundi ETF has been Money Market range) and Société Générale
strategically increasing its product range (Fixed Income range).
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As of today, there are over 200 listings allocation:
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• Sector diversification through a large
Amundi ETF is committed to offering selection of World and European sector-
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to management fees, Amundi ETF works Contacts :
carefully with market makers to keep bid/
ask spreads as tight as possible.
+33 (0)1 43 23 84 44
• High-quality info@amundietf.com
To ensure optimal management, the Amundi amundietf.com
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replication method* that aims to keep
the tracking error to a minimum while
replicating the benchmark index as closely
as possible. Moreover, Amundi ETF can rely
on the good credit rating of its counterparts,
Crédit Agricole (Equity, Commodity and *except for the 3 historical ETFs

About Amundi ETF
ETF Sales About Amundi

The Amundi ETF range is distributed by Amundi ranks third in Europe1 and
dedicated sales teams at Amundi and CA among the top ten global players in asset
Cheuvreux (the European stock broker of management2 with around €670 billion
Crédit Agricole Group). under management3.
Located at the heart of the main investment

• Germany regions in more than 30 countries, Amundi
Werner Jürgens : +49 (0) 69 47 897 241 offers a comprehensive range of products
• Italy covering all asset classes and major
Vincenzo Sagone: +39 02 8062 8020 currencies.
• France and Other Countries
Laetitia Roche-Hintzy: +33 (0)1 41 89 75 96 Amundi develops savings solutions to
Fannie Wurtz: +33 (0)1 41 89 75 95 meet the needs of more than 100 million
retail customers worldwide and designs
innovative, high-performing products for
institutional clients which are tailored
• Benelux specifically to their requirements and risk
Eric Van Eyken: +32 (0) 2 541 18 17 profile.
• Germany
Bettina May: +49 (0) 69 47 897 241 Benefiting from the support of two powerful
• Italy banking groups, Crédit Agricole and Société
Antonio Volpe: +39 02 0065 2964 Générale, Amundi aims to establish itself
• Switzerland as the undisputed leader in asset
Benoit Garcia: +41 (0)22 31 60 1 51 management in Europe, recognized for:
• UK • the quality of its products, their financial
Ian Milton: +44 (0)20 7074 9330 performance and transparency
• its close relations with customers, partner
networks and institutions
• the efficiency of its organisation, resulting
Market Maker from the individual and collective talents
of its teams
• a commitment to integrate sustainability
ETF Trading: +33 (0)1 41 89 74 70 and social purpose criteria into its
Or your usual sales or sales-trading investment policies, going beyond financial
contact. criteria alone.
www.amundi.com
1 - IPE Top 400 survey published July 2009, data at 31

December 2008
2 - GI 100 ranking published September 2008, data at June
2008
3 - Amundi Group pro forma figures as at 31 December
2009

About Amundi ETF

EDHEC-Risk Institute
Publications and Position
Papers (2007-2010)

EDHEC-Risk Institute Publications

(2007-2010)
2010
• Amenc, N., and S. Sender. Are Hedge-Fund UCITS the Cure-All? (March)
• Amenc, N., F. Goltz, and A. Grigoriu. Risk control through dynamic core-satellite portfolios
of ETFs: Applications to absolute return funds and tactical asset allocation (January).
• Amenc, N., F. Goltz, and P. Retkowsky. Efficient indexation: An alternative to cap-weighted
indices (January).
• Goltz, F., and V. Le Sourd. Does finance theory make the case for capitalisation-weighted
indexing? (January)
2009
• Sender, S. Reactions to an EDHEC study on the impact of regulatory constraints on the
ALM of pension funds (October).
• Amenc, N., L. Martellini, V. Milhau, and V. Ziemann. Asset-liability management in
private wealth management (September).
• Amenc, N., F. Goltz, A. Grigoriu, and D. Schroeder. The EDHEC European ETF survey
(May).
• Sender, S. The European pension fund industry again beset by deficits (May).
• Martellini, L., and V. Milhau. Measuring the benefits of dynamic asset allocation strategies
in the presence of liability constraints (March).
• Le Sourd, V. Hedge fund performance in 2008 (February).
• La gestion indicielle dans l'immobilier et l'indice EDHEC IEIF Immobilier d'Entreprise
France (February).
• Real estate indexing and the EDHEC IEIF Commercial Property (France) Index
(February).
• Amenc, N., L. Martellini, and S. Sender. Impact of regulations on the ALM of European
pension funds (January).
• Goltz, F. A long road ahead for portfolio construction: Practitioners' views of an EDHEC
survey. (January).
2008
• Amenc, N., L. Martellini, and V. Ziemann. Alternative investments for institutional
investors: Risk budgeting techniques in asset management and asset-liability management
(December).
• Goltz, F., and D. Schroeder. Hedge fund reporting survey (November).
• D’Hondt, C., and J.-R. Giraud. Transaction cost analysis A-Z: A step towards best execution
in the post-MiFID landscape (November).
• Amenc, N., and D. Schroeder. The pros and cons of passive hedge fund replication
(October).

EDHEC-Risk Institute Publications

(2007-2010)
• Amenc, N., F. Goltz, and D. Schroeder. Reactions to an EDHEC study on asset-liability

management decisions in wealth management (September).
• Amenc, N., F. Goltz, A. Grigoriu, V. Le Sourd, and L. Martellini. The EDHEC European ETF
survey 2008 (June).
• Amenc, N., F. Goltz, and V. Le Sourd. Fundamental differences? Comparing alternative
index weighting mechanisms (April).
• Le Sourd, V. Hedge fund performance in 2007 (February).
• Amenc, N., F. Goltz, V. Le Sourd, and L. Martellini. The EDHEC European investment
practices survey 2008 (January).
2007
• Ducoulombier, F. Etude EDHEC sur l'investissement et la gestion du risque immobiliers
en Europe (November/December).
• Ducoulombier, F. EDHEC European real estate investment and risk management survey
(November).
• Goltz, F., and G. Feng. Reactions to the EDHEC study "Assessing the quality of stock
market indices" (September).
• Le Sourd, V. Hedge fund performance in 2006: A vintage year for hedge funds?
(March).
• Amenc, N., L. Martellini, and V. Ziemann. Asset-liability management decisions in private
banking (February).
• Le Sourd, V. Performance measurement for traditional investment (literature survey)
(January).

EDHEC-Risk Institute Position Papers

(2007-2010)
2010
• Lioui, A. Spillover Effects of Counter-cyclical Market Regulation: Evidence from the
2008 Ban on Short Sales (March).
• Amenc, N., P. Schoefler and P.Lasserre. Organisation optimale de la liquidité des fonds
d’investissement (March).
2009
• Till, H. Has there been excessive speculation in the US oil futures markets?
(November).
• Amenc, N., and S. Sender. A welcome European Commission consultation on the UCITS
depositary function, a hastily considered proposal (September).
• Sender, S. IAS 19: Penalising changes ahead (September).
• Amenc, N. Quelques réflexions sur la régulation de la gestion d'actifs (June).
• Giraud, J.-R. MiFID: One year on (May).
• Lioui, A. The undesirable effects of banning short sales (April).
• Gregoriou, G., and F.-S. Lhabitant. Madoff: A riot of red flags (January).
2008
• Amenc, N., and S. Sender. Assessing the European banking sector bailout plans
(December).
• Amenc, N., and S. Sender. Les mesures de recapitalisation et de soutien à la liquidité
du secteur bancaire européen (December).
• Amenc, N., F. Ducoulombier, and P. Foulquier. Reactions to an EDHEC study on the
fair value controversy (December). With the EDHEC Financial Analysis and Accounting
Research Centre.
• Amenc, N., F. Ducoulombier, and P. Foulquier. Réactions après l’étude. Juste valeur ou
non : un débat mal posé (December). With the EDHEC Financial Analysis and Accounting
Research Centre.
• Amenc, N., and V. Le Sourd. Les performances de l’investissement socialement responsable
en France (December).
• Amenc, N., and V. Le Sourd. Socially responsible investment performance in France
(December).
• Amenc, N., B. Maffei, and H. Till. Les causes structurelles du troisième choc pétrolier
(November).
• Amenc, N., B. Maffei, and H. Till. Oil prices: The true role of speculation (November).
• Sender, S. Banking: Why does regulation alone not suffice? Why must governments
intervene? (November).
• Till, H. The oil markets: Let the data speak for itself (October).

EDHEC-Risk Institute Position Papers

(2007-2010)
• Amenc, N., F. Goltz, and V. Le Sourd. A comparison of fundamentally weighted indices:

Overview and performance analysis (March).
• Sender, S. QIS4: Significant improvements, but the main risk for life insurance is not
taken into account in the standard formula (February). With the EDHEC Financial Analysis
and Accounting Research Centre.
2007
• Amenc, N. Trois premières leçons de la crise des crédits « subprime » (August).
• Amenc, N. Three early lessons from the subprime lending crisis (August).
• Amenc, N., W. Géhin, L. Martellini, and J.-C. Meyfredi. The myths and limits of passive
hedge fund replication (June).
• Sender, S., and P. Foulquier. QIS3: Meaningful progress towards the implementation of
Solvency II, but ground remains to be covered (June). With the EDHEC Financial Analysis
and Accounting Research Centre.
• D’Hondt, C., and J.-R. Giraud. MiFID: The (in)famous European directive (February).
• Hedge fund indices for the purpose of UCITS: Answers to the CESR issues paper
(January).
• Foulquier, P., and S. Sender. CP 20: Significant improvements in the Solvency II
framework but grave incoherencies remain. EDHEC response to consultation paper n°
20 (January).
• Géhin, W. The Challenge of hedge fund measurement: A toolbox rather than a Pandora's
box (January).
• Christory, C., S. Daul, and J.-R. Giraud. Quantification of hedge fund default risk
(January).

Notes
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For more information, please contact:
Carolyn Essid on +33 493 187 824
or by e-mail to: carolyn.essid@edhec-risk.com
EDHEC-Risk Institute
393-400 promenade des Anglais
BP 3116
06202 Nice Cedex 3 - France
EDHEC Risk Institute—Europe

New Broad Street House - 35 New Broad Street
London EC2M 1NH
United Kingdom
EDHEC Risk Institute—Asia

9 Raffles Place
#57-12 Republic Plaza
Singapore 048619
www.edhec-risk.com

EDHEC May-2010

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An EDHEC-Risk Institute Publication

The EDHEC European ETF

with the support of

Executive Summary ............................................................................................... 5

3. Methodology and Data....................................................................................65

5. Conclusion ...................................................................................................... 103

About EDHEC-Risk Institute .............................................................................113

About Amundi ETF ..............................................................................................117

EDHEC-Risk Institute Publications and Position Papers (2007-2010) ...... 121

We thank Amundi ETF for its support for our research.

Printed in France, May 2010. Copyright© EDHEC 2010.

An EDHEC-Risk Institute Publication 3

About the Authors

Felix Goltz is head of applied research at EDHEC-Risk Institute. He does

Adina Grigoriu is head of asset allocation at AM International Consulting,

Lin Tang is a research analyst at EDHEC-Risk Institute. She has a master’s

4 An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication 5

6 An EDHEC-Risk Institute Publication

outperformance generation allows Dynamic core-satellite portfolio

Dynamic core-satellite approach

An EDHEC-Risk Institute Publication 7

In the dynamic core-satellite approach, a incorporate so-called investment goals.

8 An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication 9

Exhibit 4: Absolute return fund: changes in the allocation to the satellite

10 An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication 11

Exhibit 6: Use of ETFs or ETF-like products over time

Exhibit 7: Percentage of total investment accounted for by ETFs or ETF-like products

12 An EDHEC-Risk Institute Publication

Advanced uses of ETFs, such as securities Post-crisis rebound

Exhibit 8: Advanced uses and forms of ETFs

2 - We have no numbers for

Exhibit 9: Satisfaction with ETFs or ETF-like products over time

An EDHEC-Risk Institute Publication 13

14 An EDHEC-Risk Institute Publication

Exhibit 11: Concerning price efficiency, have you observed...

An EDHEC-Risk Institute Publication 15

This dominance is not limited to managers focus on using broad market

16 An EDHEC-Risk Institute Publication

Conclusion satellite investments. In addition, maximum

An EDHEC-Risk Institute Publication 17

And the large majority of investors who

18 An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication 19

Exchange-traded funds (ETFs), investment survey sheds light on developments in the

20 An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication 21

22 An EDHEC-Risk Institute Publication

An EDHEC-Risk Institute Publication 23

2.1. Overview of Exchange-Traded in April 2000. Although the European ETF

24 An EDHEC-Risk Institute Publication

of ETFs (829) in the world. Taken together, 2.1.2. Understanding ETFs

An EDHEC-Risk Institute Publication 25

26 An EDHEC-Risk Institute Publication

reinvestment of these dividends, but also Primary and secondary markets

Primary market (creation)

ETF administrator ETF custodian ETF manager

ETF market makers; Capital

An EDHEC-Risk Institute Publication 27

28 An EDHEC-Risk Institute Publication