ETFs hit a few important new milestones this year. They turned 25 (the first ETF was born in Toronto in 1989), their assets surpassed those of hedge funds (US$2.97 trillion) and, as of June, more ETF shares had traded hands in one year than the entire U.S. GDP.
And institutional investors are on board. Year after year, firms like Greenwich Associates publish new research that trumpets big gains in ETF assets among the world’s largest and most sophisticated investors. Last year, for example, it reported 21% of U.S. institutions are using ETFs—and, among those, nearly half allocated 10% or more of their total assets to ETFs.
But, as U.S. institutional investors boost their ETF allocations, how are Canadian plan sponsors using them? Are Canadian plan sponsors integrating them into portfolios? And, after years of education on the part of ETF providers, are Canadian plan sponsors and institutions boosting their ETF use?
Som Seif, president and CEO of Purpose Investments, says the question really isn’t about whether Canadian plan sponsors are using ETFs but how they’ve evolved in their portfolios.
“Early on, pension plans were using ETFs for specific quick access in a certain sector or asset class—as tools to equitize exposure,” he explains. That’s changing. “What has evolved is a broader acceptance among plan sponsors of the ETF structure to gain access to long-term investment portfolios and as a core part of a pension portfolio.”
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For some, that means finding a permanent home in their portfolios, says Robert Trumbull, head of asset owner ETF sales with State Street Global Advisors. “Many clients are starting small and expanding their use, starting off with shorter hold periods and growing from there,” Trumbull explains.
ETFs are also a growing part of portfolio construction for institutional managers that pension funds invest in.
“Right now, we’re using ETFs to provide inexpensive broad market exposure in several different asset classes,” says Marlene Puffer, a partner with Alignvest Investment Management. She notes ETF holdings provide exposure to global fixed income, global equities and liquid alternatives.
Since some of the firm’s portfolios are relatively new, ETFs have played the placeholder role as the firm builds out its strategies and continues to grow its asset base.
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“For us, the use of ETFs is just one part of a tool kit as our business evolves,” says Puffer. And then there’s the question of whether the education work by ETF providers has led to Canadian institutions and plan sponsors truly using ETFs to their full potential. Possibly not, says Howard Atkinson, president of Horizons ETFs, who admits pension funds here in Canada still don’t hold that many ETFs.
“We seem to be quite a bit behind the U.S., where institutional use of ETFs has accelerated,” he explains. “Furthermore, most of the ETFs held in Canada are concentrated in the top 10 funds, with pension plans holding the largest ETFs.”
Part of the problem could be the costs, he says. For pension fund clients, active management here is still relatively cheap by global standards—that puts pressure on ETF providers to do the job even more cheaply. That can be challenging, says Atkinson. “Anything north of 35 basis points and the larger pension plans can get their asset allocation strategies by hiring managers or doing it themselves.”
MORE THAN US$5 TRILLION
ETF assets under management expected by 2020
— 2015 PwC survey
Investors like Puffer, however, note ETF costs can be competitive. She says ETF providers in Canada are focused on bringing in institutional clients— they’re talking directly with plan sponsors to try to meet their needs in terms of product design, including lower costs.
“People focus on costs with ETFs, but, in reality, it’s not always as much of a barrier as you think once you do detailed research,” she adds. And, she explains, regulatory changes have also made derivatives less appealing relative to ETFs in many markets. Competition among ETF providers, coupled with securities lending revenues, also makes ETFs competitive with some institutional index funds, and they offer much more flexibility to shift allocations across funds.
The rise of bond ETFs
Greg Walker, managing director and head of iShares Business Development, Canada, says smaller pension plans in Canada are already well into the ETF space thanks to active managers, who are using them. For Canada’s largest plans, ETFs are becoming a growing part of their day-to-day investment process as a way to manage cash and liquidity.
Where Walker does see growth is in fixed income ETFs. They could come to take a prominent place in pension portfolios as higher-yielding corporate bonds get harder to find and trade.
“Canadian plans are using bond ETFs to gain exposure to areas of the credit curve they could not previously access in a precise way, or didn’t want to manage internally—high yield, for example,” he explains. He adds ETFs are solving a big problem for plans seeking additional liquidity in their fixed income exposure. Bond ETFs offer easy access to an asset class that’s become harder and harder to manage post-2008.
$42.6 BILLION
Total assets under management of the top 25 ETFs in Canada as of Aug. 31, 2015
— Canadian ETF Association
One of the big conversations happening now, however, involves the liquidity of bond ETFs. Can they deliver what they promise? Asif Haque, director of investments for the Colleges of Applied Arts and Technology Pension Plan, says the plan doesn’t use bond ETFs right now but may do so in the future. “We’d like to get more comfortable with the liquidity profile of these ETFs, and understand better how they might track underlying indices in times of crisis.”
Puffer believes bond ETFs aren’t the problem— and that they can, in fact, improve liquidity. “ETFs provide daily liquidity,” she says. “And ETFs focused on credit have tighter bid-ask spreads than on the underlying individual securities.” All of that is good for investors in normal two-way market conditions. But, if investors decide to stampede for the exit from credit products, ETFs will suffer the same price moves and lack of liquidity as the underlying securities.
Still, she says, many investors—including sophisticated ones—don’t yet understand everything about how ETFs are created. “There’s a whole marketplace that is not well understood outside the ETF space where creation units are made—that’s how dealers create liquidity that is not seen in the market quotes,” Puffer adds.
Mike Hunnicutt, head of institutional ETF sales with Invesco PowerShares, agrees plan sponsors want to learn more about “ETF mechanics and how they trade. They are also interested in better understanding implementation. How does it fit into the existing portfolio?”
Plan sponsors want to know how other institutions are using ETFs—and they want to know how the underlying indexes are constructed, he says. In part, that means working directly with investors to help them match the right ETF or combination of ETFs with their needs, and to determine all the factors that go into making that decision. So far, according to Puffer, ETF providers have been extremely good at sitting down with institutions, even if that means providing analysis on a competitor’s product.
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As Trumbull points out, “We’re only in the early stages of growth of ETFs—it’s not a story that will play out overnight. There are more large liquid exposures covering a variety of asset classes than there have ever been—that helps solve more challenges than we have been able to [solve] in the past.
“I still think rate of use is increasing—and so I think there’s a long way to go in terms of education and increase in utilization.” As providers work hard to show plan sponsors how and where to use ETFs, it’s clear they’re making headway—and that there’s still a long way to go. As the ETF industry continues to create new products and to cover different asset classes (there are currently 5,823 ETFs listed globally, reports ETFGI), institutional investors will need to continue the conversation and education.
Caroline Cakebread is a freelance writer based in Toronto.
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