The current market environment, marked by uncertainty over the timing of rate cuts and ongoing market volatility, presents unique challenges. Effective duration-related decisions about term exposure and curve positioning are critical in response to changing actuarial tables and liability profiles.

However, duration management can be time-consuming, complex and costly. Christopher Huemmer, director of ETF and fund strategy at Northern Trust Asset Management, believes ETFs can do a lot of the heavy lifting.

The Rise of ETFs for Institutional Investors

ETFs have been around since the early 1990s. The most notable is the S&P 500 ETF, which entered the market in 1993 and is represented by the ticker symbol SPY. The first fixed income ETF was not introduced until almost 10 years later. Bond ETFs only represent 1.5% of the total investible fixed income market and 3.3% of the U.S. high yield market. Despite this low number, institutional usage is surprisingly high.

About 80% of institutional investor respondents use ETFs in their respective portfolios, according to a 2024 Cerulli Associates survey. Of those respondents, 78% of insurance companies are invested in passive fixed income ETFs while 67% of are invested in active fixed income ETFs.

According to the survey, institutional investors use ETFs to gain or maintain exposure to certain bonds, to manage liquidity, for tactical positioning, to reduce costs and for higher yields. An important question that should be considered is: Are they being used for duration management?

Duration Management with ETFs

ETFs have emerged as a powerful solution for institutional investors seeking efficiency, transparency and flexibility in duration management. Once viewed primarily as tactical tools for transitions, ETFs are now strategic holdings, with institutions extending their holding periods well beyond the short-term horizons of the past.

Key advantages of ETFs include:

  • Ease of Access: Institutions can quickly enter asset classes and adjust exposures an duration.
  • Transparency: Daily publication of holdings enables rigorous due diligence.
  • Cost Efficiency: The creation/redemption process often avoids tax events and reduces transaction costs.
  • Liquidity: Market makers facilitate access to underlying bonds, even in less liquid asset classes such as high yield.
  • Broad Exposure: ETFs can hold a wide array of securities, providing diversification that may be difficult to achieve through direct purchases.

Fixed income ETFs have some significant advantages over direct bond investing. For starters, they can offer broader diversification with less capital. They can also provide easy exits and constant liquidity, due to their high trading volume. And because of this, the time to enter and exit a position is far quicker than through traditional bond trading, supporting more precise duration management.

Though bond ETFs represent a sliver of the entire fixed income universe, there are passive and active varieties that managers can choose from. And, most critically, the expense ratio of bond ETFs are significantly lower than through traditional bond trading. All of these factors make the case for expanded use of fixed income ETFs among institutional investors for duration management.

The Advantage for Insurance Companies

Insurance companies, which owned approximately $5.4 trillion in bonds at the end of 2024, have even more motivation to use ETFs for duration management. Insurance balance sheets are heavily regulated by the National Association of Insurance Commissioners (NAIC), which determines risk-based capital charges for securities that they own. Huemmer explains how the NAIC views ETFs: “Typically, they are rated like equities and tend to have a higher capital charge. However, fixed income ETFs that are rated and hold high quality, liquid assets tend to get a more favorable capital charge.”

Bond ETFs are very useful for tactical positions, but institutional investors such as insurers can use them for duration management. In addition to the advantages already mentioned, Huemmer explains that ETFs’ use of in-kind securities and do not trigger tax events for investors, as bonds held in separate accounts may do. And given the volumes of trades that an institutional investor can make in a year, those tax liabilities can add up when using an inefficient vehicle.

An Efficient Choice

Huemmer sees the active bond ETF market expanding over the coming years as institutional investors search for more efficient ways to manage duration in their fixed income portfolios. According to the Cerulli survey, 37% of institutional investors expect to increase their allocations to ETFs over the next two years. Perhaps they are recognizing the efficiencies of using these vehicles for duration management. And with the incoming rate-cutting cycle, it couldn’t be any more timely.

Explore how ETFs can fit into your portfolio.

IMPORTANT INFORMATION

Duration measures the sensitivity of a security or portfolio to changes in interest rates. It often is used as a measure of risk to interest rate moves for fixed income securities and funds.

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