Israel's Version of Exchange-traded Funds Has Become a Major Factor in the Bourse

KSM is the segment’s dominant player.

KSM, Israel’s biggest manager of exchange-traded funds, is celebrating its 10th anniversary this month.

The company is so closely linked to ETFs, or as they are known in Israel index-linked certificates ‏(teudot sal in Hebrew‏), that for most investors KSM’s decade also marks the 10th anniversary of ILCs themselves.

That is an enviable place to be. Like Coca-Cola for cola-flavored fizzy drinks or Band-Aids for adhesive bandages, KSM is the name-brand player in ILCs, funds that track a diverse range of commodities, currencies and stock and bond indices in Israel and abroad. They are bought and sold like a closed-end mutual fund via the stock exchange, the manager structuring the product to mimic a particular index, so-called passive investing.

ILCs have become the Tel Aviv Stock Exchange’s single most successful investment channel. KSM, which is part of the Excellence financial services group, manages some NIS 27 billion in funds, as of the end of June, via 146 ICLs.

Roy Regev, a KSM director, attributes the company’s massive success to rethinking what ILC could be. “We related the ILC as the means for changing the way investment managers manage their investments,” he told TheMarker in an interview. “The minute we internalized this point, we understood that our job was to supply investment managers with an additional investment tool ? one that would replace stock-picking. Instead of a personal portfolio of securities they would have a system of investing via indices.”

KSM in fact joined the game three years after Psagot Investment House, then called Psagot Ofek, began offering the Tali 25 ILC, in 2000. But as a sign of KSM’s market dominance in the years since then, in February Psagot paid NIS 153 million for the ETF unit of Meitav Investment House. But even with that addition of some NIS 22 billion in funds under management at the time, Psagot remains only the third largest player in the segment.

Today KSM accounts for nearly a third of the total market, with Tachlit (an ILC manager that Mietav now controls through a merger with DS Apex) controlling 30%, Psagot 28.6% and Harel Insurance just under 9%.

“The unique quality of KSM is that we didn’t look at the ILC as just another investment tool,” says Regev, pointing back to those early days 13 years ago when Psagot didn’t see its pioneering ILC as an investment for the masses but for an elite of traders trading options on the Tel Aviv Stock Exchange’s Maof index. “They offered it as a tool for Maof traders, an alternative way for them to trade the index more easily. In other words the ILC served as a substitute for Maof trading in addition to trading options themselves.”

Psagot’s Tali 25 was benchmarked to the TA-25 index, in other words for Maof options players. By contrast, KSM’s first ILC was benchmarked to the broader TA-100 index. “That’s a benchmark for investors and investment managers,” he says.

What’s next for ILCs?

The global ETF industry has some $3 trillion under management, still only a fraction of the $20 trillion controlled by mutual funds. But in the past few years, more new money has gone into passively managed funds like ETFs than their actively managed peers. “The exponential growth for the ILC is still ahead of us,” predicts Regev.

What does he see coming next for the ILC segment?

“Research has shown that managing investments based on indices is preferable to active management. An investment manager has to make two critical decisions. The first and most important is allocation ? asset allocation ? that is, how much of the portfolio should be invested in what channels. Based on that breakdown, he can now go to the second level of decision-making ? in which securities to invest. That he can do by buying the relevant indices. More and more financial groups are moving to index-based investing.”

Avner Hadad, along with Regev a founder of KSM and today its CEO, points to the risks entailed in actively managed portfolios.

“You can find years in which there were no special movements in the indices and that in those years that without a specific stock, for instance Mellanox, an investment manager who hadn’t bought it would not have produced any return. This illustrates something deeply fundamental in the understanding of the passive versus the active approach. In 2010-2011, the share indices didn’t rise, but the indices had better returns than active investments.”

Boaz Nagar, KSM’s chairman, warns there is a risk to the success of ILCs. ILCs are already the dominant player in the equities market, where the high-risk element is mitigated by investing via indices.

“With new money for equity investments, if 90% is invested through ICLs and 10% in equity mutual funds, and that’s the trend, that all the market is going to indices, it could create a financial crisis. That’s one of the things being discussed by regulators in Europe.

“The bond market, both in Israel and throughout the world, is controlled by active managers. ICLs are trying to enter the fixed-income segment, that’s our next move in this game. But in Israel, the buying and selling fees for ICLs don’t leave enough of a return for the investor.”

Ester Levanon, the CEO of the Tel Aviv Stock Exchange, has complained that trading volumes on the bourse have been falling. Has that been hurting the ILC industry?

“It’s unfortunate to see the decline in trading volume, but ICLs make up about 30% to 40% of the TASE’s turnover, which makes it an anchor that preserves [the level of] trading,” Hadad says. Nevertheless the pinch of thin liquidity is biting.

Thin liquidity

“If a client comes and asks me to buy or sell a certain index in the bourse whose liquidity if low, I adjust myself accordingly ? I don’t give him the same quantity I would have in the past,” says Hadad. “An ICL is a pipeline for an investor to invest in an index. If the market is suffering thin liquidity, the same happens to an ILC.”

Hadad says an investor can ask to convert his ICL into the underlying stocks, if he is unhappy for instance with the lack of liquidity. But the last time he received such a request was four years ago and swapping an index for the components won’t solve his problem. “I have the expertise to manage an ILC better. We have the trading systems ... Even if he were to decide to manage his ICL on his own, he would encounter the same [liquidity] problems,” he says.

Asked where they invest their private capital, all three say only in ICLs. Regev, however, admits that he puts 5% of his money in an actively managed account ? just to see whether it can outperform his ICLs. It hasn’t, he happily adds.

Ofer Vaknin