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Nearly 20 years ago, the first players in the novel market for exchange-traded funds (ETFs) were institutional investors. Today, the retail investor crowd owns a greater share, but institutions rely heavily on ETFs for tactical investing moves, hedging, and maintaining market exposures during times of change—ETFs saw a big jump in volume during the financial crisis, for instance. They’re not always the lowest cost option, but they’re simple, quick, and convenient.
Having grown at 20% annually over five years, worldwide assets in exchange-traded products reached $1.4 trillion in March 2011, of which 80% was in equities, reports BlackRock Managing Director and ETF research maven Deborah Fuhr. Their contribution to trading volumes, however, has been far higher: ETFs have accounted for about 15% of total volume, and about 25% of trading value, in the U.S. equity markets since mid-2009. During the worst of the financial crisis, the need for ETFs’ liquidity sent their share of U.S. trading even higher, to 20% to 25% of volume.
Within those large numbers, the extent of institutional investors’ application of ETFs is known only indirectly. Greenwich Associates has surveyed U.S. institutions since 2009, and concluded that about 15% rely on ETFs, with greater participation—more than 20%—among endowments, foundations, and larger pension plans. As to ownership, BlackRock estimates that institutional hands hold about 40% of ETF value, and that breadth of ETF ownership has steadily increased with asset growth.
“Institutions didn’t find ETFs all of a sudden—they were the early adopters,” says Vanguard Group ETF head Rick Genoni. “What’s more sudden is the evolution of a more complete set of products that trade in sufficient volume.” At year end 2010, 141 ETFs had assets of more than $1 billion; options on ETFs, long and short trading of hedge funds, and position hedging by ETF marketmakers all have served to deepen the markets.
Institutions’ deployment of ETFs differs among asset owners and asset managers, and falls into four categories: portfolio tactics, liquidity management, equitization, and transition management. In the first instance, taking on exposure to market, “An asset owner doing the ‘delta-one tango,’ simply looking for a return stream, has the choice of a swap, a future, an ETF, and other instruments,” remarks Kevin Quigg, director of SSgA’s ETF Global Capital Markets Group. Sponsors have to be mindful of management fees and commission in their choices, Quigg says, but adds: “In some cases, an ETF might be the most attractive option because of greater liquidity, and there’s no counterparty risk.”
The betas available through ETFs are becoming increasingly granular, serving tactical investors on both the long and short sides. “In the Japan crisis, we saw many institutions using iShares to access that market quickly,” says Liz Tennican, Head of Institutional Sales for BlackRock’s iShares group, which today offers 20 country ETFs.
The head of a long-short equity hedge fund notes: “We use ETFs for hedging industry exposures. We prefer hedges that are company-specific but, when we have residual exposure to a company, we can use an industry ETF that provides a better hedge than, say, puts on the S&P 500.”
Institutions also have turned to ETFs to enhance the liquidity of traditional portfolios. “Since 2008, liquidity has been a governance concern with many institutions, and ETFs can be a solution,” notes Tennican. “One big application we have seen is investing a layer of 3% to 5% of a portfolio in ETFs, enabling the institution to maintain its strategic policy, but still have a high degree of liquidity.” In more mechanical applications, mutual funds rely on ETFs to stay fully invested in the face of purchases and redemptions. Cash arrives toward the end of a trading day, and ETFs enable managers to invest quickly in their benchmarks or sectors, and minimize cash drag.
Transitions managers also rely on ETFs. “Transition management has evolved into a business of risk management, and we use hedging vehicles, whether futures, currency forwards, or ETFs, in about half of our transactions,” says Steve Kirschner, Head of Transition Management for the Americas at Russell Investments, Seattle. “ETFs play their largest role in global equity transitions where smaller markets are not covered by futures. In India, for instance, there’s not really a futures market, but you can get access through an ETF that trades in Singapore, or an exchange-traded note in the U.S. ETFs have evolved to a point where they’re a scalpel for that sort of application.” Home-country ETFs also allow sponsors to work around difficulties in setting up new operations infrastructure in far-flung markets.
“You have more and more ETF sponsors entering the market and, to some extent, costs coming down,” observes Rick Genoni of Vanguard. “There’s more choice, both in multiple products on the same index, and more finely cut slices of markets that are difficult to trade otherwise.” While some in the business think the next leg of growth will come from incorporation into 401k plans, he says, “I think ETF asset growth still will be led by institutions.” —John Keefe
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