The vast majority of exchange-traded funds (ETFs) are unattractive long-term investments for most institutional investors, says investment consultancy Watson Wyatt.

Institutional investors should consider ETFs in conjunction with other types of investments, says the firm, for a number of reasons. First, they generally carry higher fees than many institutional index products. They may also have tax implications that require specialist advice. And they often contain counterparty risks for which investors may not be compensated.

Some institutional investors take a similar view. An investment manager at Thailand's Government Pension Fund tells AsianInvestor he does not use ETFs, as he feels they are too expensive. And other firms, such as research house Cerulli Associates, have suggested that relatively high management fees have hindered the take-up of the products in Asia. Charges aside, there are also concerns over more complex ETFs, such as those incorporating leverage or inverse structures.

Watson Wyatt concedes that the development of the ETF sector has driven product innovation, but the firm also says there is a great deal of development within indexation which is likely to offer passive investors a broader range of options and better risk-adjusted returns than those currently available. 

The case for including ETFs in institutional investment portfolios is not yet obvious, says Peter Ryan-Kane, Asia-Pacific head of portfolio advisory at Watson Wyatt in Hong Kong. He anticipates more competitive fees and transparent structures, adding: "In the meantime, they may be useful tools for transition and shorter-term exposure management."

Whereas the ETF industry has engaged in product proliferation, Ryan-Kane says he wants to see genuine innovation in the investment content of index products. "If investors are looking for more efficient market exposure," he adds, "their first step should be to review the indices underlying their existing investments, with a view to seeing if there are better alternatives." 

There are a good range of institutional passive products available in most markets, which are cheaper than many ETFs, adds Ryan-Kane. In addition, in many markets, passive funds have been structured with clearly defined tax positions for institutional investors, while the treatment of ETFs is much more variable, which typically necessitates tax advice.

A further issue is that there is a significant counterparty risk embedded in ETFs, whether through stock lending or the way in which swaps are used, he says, and it is not clear that investors are adequately compensated for taking these risks.

Despite the fanfare around the surplus of ETFs now available, Ryan-Kane says, "the real story is investors' realisation that capitalisation-weighted portfolios are not necessarily optimal". This has led them to contemplate shifting significant assets into alternative weighting approaches, he adds.