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Institutional Investors Taking a Longer View on ETFs

The percentage of institutional investors using exchange-traded funds for long-term strategic purposes rather than short-term tactical ones has risen sharply during the past year.

Institutional investors are taking a much longer-term approach to exchange-traded funds, according to a third annual study on how institutional investors and asset managers use ETFs by Greenwich Associates of Stamford, Connecticut.

A much higher percentage are now using ETFs for what Greenwich describes as “strategic purposes” — holding them for at least a year or longer — rather than using them as short-term, “tactical” portfolio management tools for one to three months, the study found.

The percentage of institutional investors holding ETFs for a year or longer rose to 51 percent in 2012, up from 36 percent in 2011, while the percentage of asset managers holding ETFs for that long rose to 33 percent from 18 percent, according to the study.

“Institutions are often first drawn to ETFs for help with two basic functions: manager transitions and cash equitization/interim beta,” the authors of the study wrote.

Short-term uses are still very significant, however, especially within the asset manager group, with 61 percent reporting that they used ETFs during manager transitions and 78 percent saying they do so for cash equitization/interim beta. With institutional funds, the corresponding numbers were 55 percent and 44 percent.

“When someone has an underperforming manager they’d like to replace, in the interim, they don’t want to leave the money with the manager, and they don’t want to lose access to that asset class; and ETFs allow them to maintain their allocations,” says Greenwich consultant, Andrew McCollum. Parking the cash in a money-market fund for a couple of months would throw their asset allocation models out of whack, he notes.

The study group included 80 institutional investors who currently use ETFs — corporate and public pension funds, foundations and endowments — and 18 asset managers with discretion for institutional assets. Greenwich did the survey on its own the first year, but this year and last year it was underwritten by BlackRock, which sponsors iShares, McCollum says.

Last summer, when Greenwich did its big annual U.S. Investment Management Study, it found that about 14 percent of U.S. institutional investors use ETFs, and “that really hasn’t changed much over the past couple of years,” McCollum says. “It’s still a relatively small proportion of large institutional investors who are using them in their portfolios,” he says. “What changed is that they’re using them for broader purposes,” and that includes using them as “liquidity vehicles,” he says.

“What we started noticing after the financial crisis was that a lot of funds — primarily, endowments and foundations — increased their cash holdings,” McCollum says. In a zero-rate environment, holding cash became “a drag on portfolio returns,” and therefore, Greenwich has noticed an “emerging” trend towards substituting ETFs for some of that cash because ETFs can be liquidated quickly should the need arise. But they also have “stronger returns” than cash instruments, he says.

The study also found a significant difference between the U.S. entities that were surveyed and their European counterparts. In this study, which was strictly U.S.-based, “two thirds of institutional funds and more than three quarters of asset managers that employ exchange-traded funds prefer to invest in ETFs that use physical methods of benchmark replication, or ETFs made up of actual securities, as opposed to those that use derivatives,” the study says.

In that regard, they are unlike their European counterparts who “are quite comfortable using swap-based ETFs,” says Jennifer Litwin, a senior director at Greenwich, who was quoted in the report. But this study found that in the U.S., 66 percent of the institutional funds and 61 percent of the asset managers surveyed viewed the “counterparty risk associated with swap-based ETFs as a substantial risk” that “introduces a new and largely unnecessary layer of complexity to the product that can be easily eliminated through physical exposure,” the study says.

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