Exactly one year ago, a consultant warned CIO not to believe the hype about institutional exchange-traded funds (ETFs). Wishing to remain anonymous, he announced the ETF “boom” touted by providers had “yet to translate into the portfolios of true, long-term institutional investors.”

Fast forward to June 2015; the boom has arrived. Investor assets in ETFs and other products (ETPs) reached a record high of nearly $3 trillion—more than the $2.97 trillion invested in hedge funds, according to specialist consultancy ETFGI and Hedge Fund Research. A massive $152.3 billion flowed into ETPs in the first half of 2015 alone, compared to $39.7 billion entering hedge funds. “This is a significant achievement for the global ETF/ETP industry, which just celebrated its 25th anniversary while the hedge fund industry has existed for 66 years,” ETFGI reported in July.

The institutional pendulum seems to have swung in favor of passive strategies. Some large pension funds are publically rethinking their hedge fund allocations—the California Public Employees’ Retirement System dropped its entire $4 billion program last year—opting for potentially cheaper options. And nearly seven years of hot stock markets have made low-cost, high-performing equity beta products look good—very good.

“With the positive performance of equity markets, many investors have been happy with index returns and fees,” ETFGI said. “This situation has benefited ETFs/ETPs.” Trouble is, these investors may stick around only as long as the bull market. When their capital—sooner or later—chases performance elsewhere, the pronouncements of a sector “boom” may move on with it.

But beyond the flattering economic climate, cutting-edge ETP providers have another powerful factor working in their favor: They’re making products that major allocators actually want.

First-generation ETFs offered institutions run-of-the-mill exposures for retail prices—a challenging value proposition for nearly any CIO. Yet more and more, ETFs are going beyond traditional index exposures, offering baskets of securities filtered by risk factors rather than, say, region. And much like actively managed smart beta strategies, these ETF counterparts are popular. Morningstar reported 844 global smart beta ETPs representing nearly half a trillion dollars as of June 30, 2015. In addition, smart beta ETPs accounted for more than one-fifth of all US assets in exchange-traded funds.

“They are a cost-effective way to get very stylized exposures, allowing investors to get quite granular with underlying holdings,” says Lori Heinel, chief portfolio strategist for State Street Global Advisors. “The larger, more actively traded ETFs can also provide a lot of liquidity so even large investors can establish sizeable positions.”

ETFGI likewise characterized the product universe as “an enormous toolbox of index exposures to various markets and asset classes, including hedge fund indexes and some active and smart beta exposures.” Paying five basis points for Vanguard’s S&P 500-tracking ETF makes no sense when one can pay two basis points for the institutional-plus product. But paying 45 basis points for a value-tilted, momentum-chasing, low-volatility emerging-market ETF sounds like a bargain next to 2-and-20 for a hedge fund manager to do something similar.

Or at least, that’s the logic some asset management giants are banking on.

“Institutional ownership of ETFs really across the board continues to grow,” says Stephen Sachs, a Goldman Sachs Asset Management (GSAM) managing director. “We think that trend will certainly continue with most of the industry. Insurance companies have been big adopters—particularly in the last four or five years—using ETFs for their global asset allocations, versus other types of institutions that have been slower adopters.”

Research bears this out. As of 2013, roughly 40% of endowments and 31% of foundations used ETFs, according to a survey by consulting firm Greenwich Associates. Two pension funds led by Power 100 members—the New Jersey Division of Investment and Lockheed Martin Investment Management Company—held a combined $4.1 billion in ETFs in 2014, Deutsche Bank data show. That’s more than many institutions have dedicated to the liquid vehicles, but $4 billion out of the two funds’ aggregate $113 billion hardly counts as evidence of a “boom.”

GSAM’s confidence extends beyond lip service, however. On September 21, it launched its first smart beta ETF managing $50 million in institutional capital. Days later, JP Morgan announced the arrival of its fourth smart beta exchange-traded fund.

But what about those without any skin in the game: the asset owners? Institute for Advanced Study CIO Mark Baumgartner stands firmly in the ETF-optimist camp. “ETFs are growing and will continue to be a way to access the markets with greater liquidity and lower costs,” the investment chief argues. “The good news is as the market matures, institutions will have more choices: Invest with higher cost hedge fund managers seeking alpha, or invest with lower cost ETFs providing alternative beta.” The products can offer value “as soon as they are of the caliber, scale, and quality that institutional investors require,” Baumgartner says. As head of a $700 million endowment, he believes peers are able to access “heretofore inaccessible hedge fund strategies—call them ‘alternative betas’—using ETF structures.”

ETFs may be gaining believers, but some continue to doubt their usefulness for $1 billion-plus portfolios. One such skeptic is Ken Frier, who has managed portfolios for ETF providers’ current client base (high-net-worth individuals) and the one they aspire to: large institutions. Now partner at Atlas Capital Advisors, Frier previously served as CIO of the United Auto Workers Retiree Medical Benefits Trust ($60 billion) and the Stanford Management Company ($22 billion). Frier says he uses ETFs in his current role investing for wealthy clients, but saw no need for them as a large asset owner.

“If you’re an institutional chief investment officer with billions of dollars to your advantage, then you can target your asset allocation more efficiently in other ways, rather than using ETFs,” Frier says. While he acknowledges that ETFs can provide diversified market exposures, he believes asset owners have access to cheaper means of achieving the same effect. And like Baumgartner, Frier argues that ETFs still lack the “institutional class”—greater scale and lower costs—to make them attractive to most CIOs. For small funds with a few million dollars, however, he believes ETFs can serve as an effective tool to target exposures and diversify portfolios with flexibility.

Morningstar’s Director of Global ETF Research Ben Johnson agrees. The ETF “boom” has occurred predominantly with smaller institutions and, he says, “around the edges of portfolios for short-term exposures, cash management purposes, and liquidity sleeves.” Only recently are ETFs inching into the core of portfolios. “The very large funds don’t necessarily see any appeal because they have very specific needs and are able to leverage that size into purchasing power,” Johnson continues. “This gives them access to strategies that are custom-fit to their needs at prices lower than those ETFs are offered at.”

A large sovereign wealth fund, for example, with a sustainability mandate or particular industry concentration is not likely to seek out ETFs to manage these exposures. “The one-size-fits-all ETF cannot necessarily meet all of the nuanced needs of different institutions,” Johnson says. But with nearly $3 trillion under their control worldwide, the question is when—and at what price—ETFs will hit on the size that’s right for global institutions.

—Amy Whyte & Sage Um