The vast majority of Exchange Trade Funds (ETFs) are an unattractive long-term investment option for most institutional investors, according to global consultant Watson Wyatt.

The firm claimed while the development of the sector has driven a great deal of product innovation, institutional investors should consider ETFs in conjunction with alternative options because ETFs generally have higher fees than many institutional index products; may have tax implications that require specialist advice; and often contain counterparty risks which investors may not be compensated for.

The firm also suggested 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.

Chris Sutton, senior investment consultant at Watson Wyatt, said: "The ETF business is to be applauded for its substantial innovation and the way it has opened up a world of potentially interesting market exposures. However, the case for their inclusion in institutional investment portfolios is not yet obvious as we wait to see more competitive fees and transparent structures.

"In the meantime, they may be useful tools for transition and shorter-term exposure management. Where the ETF industry has engaged in product proliferation, we would rather press for genuine innovation in the investment content of index products. If investors are looking for more efficient market exposures their first step should be to review the indices underlying their existing investments, with a view to seeing if there are better alternatives."

According to the firm there is a good range of institutional passive products available in most markets, which would prove to be cheaper than many ETFs. 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.

Sutton said: "ETF sponsors have also embedded significant amounts of counterparty risk inside ETFs, whether through stock lending or the way in which swaps are used. It is not clear that investors are being adequately compensated for having to take these risks when holding an ETF."

The firm said ETFs could be useful tools for transition and exposure management but asserts that most investment strategies can also be implemented more cheaply and efficiently using index funds, index futures or swaps.