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ETFs Are Booming
Institutional use of exchange-traded funds has grown dramatically over the past 12 months, and it’s expected to continue apace. A greater number of institutions are adopting them for both strategic and tactical uses.
The ETF space is booming,” says Dan Dolan, director of wealth management strategies at Sector SPDRs. Inflows have been massive. “We went from $50 billion to $97 billion in two years,” he says. Indeed, the statistics speak for themselves. Globally, the ETF and ETP (exchange-traded product) industry in 2014 reached a new record of $2.8 trillion in assets, growth of 16 percent, with a record $338.3 billion in new asset inflows. “This dramatic growth demonstrates that ETFs have become a preferred tool for many types of investors,” says Deborah Fuhr, managing partner of ETFGI.
Comparing ETF assets with $23 trillion in traditional mutual fund assets, Daniel Gamba, managing director and head of BlackRock’s iShares Americas Institutional Business, says, “ETFs are an underrepresented investment vehicle compared with less-efficient mutual funds.” More institutions are using ETFs more broadly and more deeply with increased adoption among the largest pension plans, especially in the U.S. Now, foundations and endowments are embracing them as well. Roughly 25 percent of the largest corporate defined-benefit funds employ ETFs in their portfolios, as do one-third of the largest public defined-benefit pension funds and 40 percent of U.S. endowments, according to Greenwich Associates’ 2014 ETF study. The burgeoning growth is expected to continue by $200-$300 billion per year by some estimates.
“There’s a growing acceptance of ETF products among investors who haven’t chosen to use them before,” says Ian Schaad, managing director at Jane Street. Currently, ETFs represent a small percentage of total U.S. institutional assets, some institutions have begun to build sizable ETF allocations. According to Greenwich Associates, 46 percent of institutional ETF users allocate 10 percent or more of their total assets to ETFs, with almost 33 percent reporting ETF allocations from 10 to 25 percent. Nearly one in five institutions make even greater allocations. ETF growth is expected to continue in the coming year. Among institutions currently using ETFs in their portfolios, nearly half say they expect to expand use in the next 12 months. One-third expect to grow allocations by one to 10 percent, while nearly 15 percent plan increases of 10 percent or more.
It’s easy to see why. Lower fees and ease of trading and, in some cases, tax advantages are well known reasons. Investment performance is another one. Less than 10 percent of active managers beat the S&P 500, and it’s difficult to add alpha by picking stocks, bonds and commodities. “It’s hard to find active managers that add alpha and beat market benchmarks,” says Fuhr. Even hedge funds have lagged lately, especially when factoring in fees. “Investors want easier access to a greater number of markets and asset classes,” she says. They also want to be treated fairly, and ETFs are transparent and very democratic. “I can’t think of another way to invest in which all investors receive the same product at the same cost with the same ease of trading,” she says. Institutions and individuals achieve the same net results. “It’s a compelling proposition,” she says. “This is a tool to help people do their jobs.”
There are three main uses for ETFs: core exposures, precision exposures, and as a substitute for financial instruments. “We see major new client segments and significant new uses,” says Gamba. The main use of ETFs among institutional investors is to achieve core exposures, such as that of a broad index like the S&P 500, reflecting ETF growth over the past several years. However, most of the action is in utilizing precision exposures to drive alpha. “Contrary to the spirit of ETFs, they are being used to create multi-asset strategies that outperform market benchmarks,” he says. “This represents a majority of our book of business.”
ETFs are a competitive alternative to holding large baskets of equities and fixed-income. “They’re like building blocks,” says Fuhr. Money flowing into these types of strategic products has grown nearly 30 percent last year. Sectors are more popular, factor indices can help to generate alpha, and ETFs allow you to go long and go short. “Some markets don’t allow you to go short,” she says.
Indeed, one major segment of growth is active asset managers who are using specialty ETFs for multi-strategy solutions. “The third-party segment is growing significantly,” says Dolan. Asset managers are using ETFs to model and optimize their own portfolios, construct portfolios with specific profiles and achieve a broader diversity of returns. “Using sector ETFs, investors are customizing portfolios,” he says. Depending on an investor’s objective, it could generate growth by overweighting with a technology ETF and providing supplementary income with a utility ETF. Interest in utility ETFs has spiked in recent years. “It’s the best-performing sector in the market, with 28 percent growth last year,” he says. As investors continue their search for yield with persistent low interest rates, a utility ETF has done well compared with 10-year bonds. Overall, there has been tremendous investor interest in sectors. Health care has been a steady one. “With aging demographics, it’s been a long-term theme,” he says.
Reducing Volatility
In the heady markets of 10 or 15 years ago, investors were more aggressive, with many expecting double-digit growth from their stocks. Today, investor sentiment is more focused on reducing volatility. “They’re saying, ‘Don’t lose my money,’” says Dolan. A diversified basket of equities can reduce volatility. “And you can buy that basket—something that looks and trades like a stock—without having to decide between Chevron versus Texaco or Apple versus Microsoft,” he says. With a low expense ratio, and an easy trade, a sector ETF functions as a stock substitute. Energy has been the focus over the last six months, and the volatility has created an environment in which investors can play the ETF. “It’s a popular topic with varying opinions,” he notes. “Investors say, ‘I have an opinion about oil. I’m going long or short.’” The short side has been popular, and when you aren’t certain exactly where to place a bet, an ETF works efficiently. “Why take single stock risk when oil is so volatile,” he asks.
Other investors using precision exposures are regional and country allocators. “Japanese equity and currency ETFs have been big, both hedged and unhedged,” says Gamba, as the markets strengthened on the prime minister securing support for economic policies, sending stocks higher. “People have specific views on the country separate from the yen,” he says. Europe was an active arena as well, especially in the second half. “The euro is going in one direction currently, so the popular trade we’ve seen is hedged,” he says. Within Europe, the economic strengthening of Spain and Portugal has generated interest in those ETFs. Lower oil prices have encouraged investors too look at emerging Asia. Investors can gain exposure through ETFs used like building blocks and deployed much like financial instruments. The third key category of ETFs is financial instruments. “Compared to mutual funds and derivative products, ETFs are much more liquid and efficient,” says Gamba. The net cost of futures has risen due to new regulation. “ETFs are fully collateralized and function as replacement trades,” he says.
Last year was also a record year for ETFs in asset classes other than U.S. equities, particularly fixed-income. “Investors are turning to fixed-income ETFs to replace bonds,” says Gamba. Investment grade corporate debt contributed significantly, gathering $22.3 billion. Credit, high yield and emerging market ETFs grew as well. BlackRock’s report describes a number of factors. Interest rates remained low and investors favored safer, longer-duration bond categories, unlike the rush to short duration in anticipation of Fed tapering in 2013. European flows were the best ever in 2014, accelerating late in the year as high yield fell out of favor and the ECB revealed it was considering corporate bond purchases to help stimulate the Eurozone economy. Fixed income returns approached being competitive with equities, which were more moderate and volatile than in 2013.
As new ETFs are launched in ever more specific asset classes, concerns about liquidity can arise. Jane Street has been a market maker in the ETF industry for nearly 15 years, providing liquidity to exchanges, banks and broker-dealers. “Now our business is evolving and we’re offering institutional clients direct access to our liquidity,” says Schaad. Operating in all of the ETF asset classes, Jane Street has developed a specialty in parts of the market that are less widely traded, such as corporate bonds, thinly traded commodities and emerging market securities. “The advantage of our offering is scale,” he says. “We have more than 60 ETF traders in the US, Asia and Europe pricing continuously, 24 hours a day, and we can offer block prices for nearly all ETFs globally.”
Another significant use of ETFs supports so-called smart beta investing, also known as advanced beta, strategic beta, or factor investing. These are based on indices that are not weighted by the market capitalization of the underlying components, but by investment factors. “There is increasing demand for smart beta strategies,” says Gamba. The four most used are quality, value, size, and volatility, and as with the sector ETFs, they are often combined to achieve specific investment objectives.
Increasing Allocations
“Institutions have projected increasing ETF allocations for all five years we have conducted the study, and we have seen a steady increase in use and allocations throughout the subsequent periods,” says Greenwich Associates consultant Andrew McCollum. “These results suggest that institutions are not using ETFs on a one-off basis. Instead, they experiment with ETFs in a specific function, discover their utility and broaden their usage to other portfolio applications.”
“The biggest challenge is getting people to try them,” says Fuhr. “Investing in something you can’t buy easily is usually what tips people over.” Once they do, they invest more and use them more broadly. Institutions often adopt ETFs through experimenting for a specific portfolio function, usually cash management, then quickly expand into strategic uses. “We first began implementing ETFs as a way to streamline transitions between managers and to expedite portfolio rebalancing,” says one in the Greenwich Associates report. Now they use ETFs to maintain strategic allocation targets and expects to increase usage in the future. “Our use started as a short-term way to maintain exposure while harvesting losses and has evolved into long-term holdings for asset allocation,” says another who now uses ETFs as a means of obtaining cost-effective exposures in a variety of asset classes, including international bonds.
There are more ETFs in more categories, and more are being launched. In December 2014, BlackRock launched CRBN, a low carbon target ETF. Developed along with the United Nations Joint Staff Pension Fund and University System of Maryland Foundation, it is relevant to pensions, foundations and endowments that wish to pursue environmental sustainability strategies without divestment. “We see a growing demand from global investors who are seeking to invest in way that can have a positive impact on the broader economy without sacrificing potential returns,” says Gamba, “and to be able to do so with the ease, access and efficiency of an ETF.”
Going forward, ETFs face the same challenges for any investment—what will happen in the market. Forecast to grow are actively managed non-transparent ETFs, an increase in factor investing and more ETFs in more markets. Other trends are increased inclusion in 401(k) plans and more distribution through online brokers. “ETFs are maturing but not matured,” says Fuhr.
Growth Potential in Brazil
In Brazil, Latin America’s largest financial market, ETFs and the concept of passive investing in this kind of instrument is still catching on. The first was launched in 2006, and the market grew to a high of $45 million in daily trading volume in 2012 during Brazil’s high growth years before pulling back to $40.4 million at the end of 2014. “The ETF product is just becoming familiar to Brazilian investors,” says Claudio Jacob, managing director for client business development at BM&FBovespa. “ETF product is not very well known compared with other fund management.” Part of the reason is cultural, as Brazilians are used to human interaction. Part of the reason is regulatory. “Until 2014, ETFs in Brazil were legally restricted to in-kind, equity-based funds,” says Tatiana Grecco, head of index funds and portfolio solutions, Brazil at Itaú Unibanco. Demand and growth are encouraging. “Turnover has reached 1.5 percent of trading volume on the exchange,” says Jacob.
CVM, the Brazilian regulator, has been liberalizing regulations and a new generation of ETFs is expected to launch over the course of 2015. Highly anticipated is the fixed income ETF. “We expect it to launch in May,” says André Demarco, managing director, products and services engineering at BM&FBovespa. Brazilian investors hold most of their portfolios in fixed income. “Because of yields, we expect new investment from hedge funds and foreign investors,” says Jacob. There will be tax benefits as well. Also expected are new ETFs that provide investors with foreign exposure. “There is still a scarcity of such instruments in Brazil because it is costly to hold assets offshore and the cross-listing of foreign funds is not allowed,” explains Grecco.
In the past, most ETF holders in Brazil were retail investors. “In the last few years, large institutional investors have increased their use of ETFs by combining them with other strategies in their portfolios,” says Grecco. However, their investments have been concentrated in the largest ETFs because regulators ban investors from owning more than 25 percent of any ETF. “As the market develops, assets grow, and as smaller investors increase their use of ETFs, this constraint should become less important,” she says.
There are two main uses for ETFs among institutional investors and asset managers in Brazil. The first is for core long-term holdings, taking advantage of their low cost. This approach is quite commonly employed by institutional investors as a way to maintain performance benchmarks. The second is to take short-term positions in ETFs to time the market. Although this approach is more common among asset managers, some institutional investors actively trade ETFs to increase or reduce their overall positions in equities and thereby take advantage of short-term market trends. By Howard Moore