Small and medium-size institutional investors are increasingly utilizing exchange-traded funds (ETFs) to efficiently implement investment strategies that used to be the exclusive domain of large institutional investment funds.
Most discussions about the use of ETFs tend to focus on the benefits they offer to retail investors. Indeed, most passively managed index tracking ETFs are a fraction of the cost of mutual funds with similar investment mandates. Typically, what investors save in fees results in outperformance over the funds, since the vast majority of equity mutual funds underperform their benchmark, according to the quarterly Standard & Poor’s Indices Versus Active Funds Scorecard.
The concept of switching from a mutual fund to an ETF is very much akin to what has driven generic drug usage—it’s cheaper and is designed to achieve the same results. According to BlackRock’s latest ETF Landscape report, this has helped the Canadian ETF market grow from $10 billion in assets in 2005 to nearly $36 billion currently. Globally, ETF assets are now more than $1 trillion. Despite this phenomenal growth, ETF usage among institutional investors remains relatively low.
Probably the most cited study of institutional ETF usage is one conducted by New York-based Greenwich Associates in April 2010. It looked at more than 70 institutional investors and found that about 14% of the surveyed institutional funds in the U.S. use ETFs. These investors account for nearly half of the ETF assets in the world. No similar study exists for Canada, but the usage is likely substantially lower among Canadian institutions.
Interestingly, more than half of the respondents said they intend to increase their usage of ETFs over the next three years. In the U.S., the ETF discussion is happening, and uptake by institutions is anticipated to create further explosion in ETF assets there. In Canada, however, ETF uptake has been much slower.
The lack of penetration of ETFs into the institutional space may have to do with the fact that ETFs have been largely marketed on the cost-savings argument rather than the actual benefit they bring to portfolio management.
For retail investors, the cost savings offered by ETFs are a huge advantage. This isn’t always the case for institutional investors, however, as institutional pricing on mutual funds is far cheaper. And for large institutional investment funds, total return swap strategies, for example, can be created to replicate an index strategy at a cost lower than anything available in the ETF market.
The advantage for institutions in using ETFs is their flexibility as a tactical portfolio tool. Most institutional funds don’t have the robust derivatives or commodity trading desks enjoyed by larger pension plans or financial institutions, so an ETF offers the next best alternative for investors to get quick and precise exposure to an asset class without having to go through the expensive process of developing their own in-house expertise.
Particular to the pension and endowment space, ETFs allow all types of investors—regardless of their level of assets—to implement the broad-based asset allocation strategies influenced by the work of Gary P. Brinson, L. Randolph Hood and SEI’s Gilbert L. Beebower. They argue that the greatest variability of returns comes from the appropriate asset allocation of simple asset classes.
If you look at the asset allocation of large pension plans such as the Ontario Teachers’ Pension Plan (Teachers’) or the California Public Employees’ Retirement System (CalPERS), you see broad-based asset allocation to a huge range of asset classes. According to Teachers’ 2009 annual report, the fund had $41 billion in equities in both indexing and actively managed strategies, $6.4 billion in fixed income, $45.9 billion in inflation-sensitive securities, which includes $8 billion directly in infrastructure and timberland, and nearly $2 billion directly in commodities.
Teachers’ can invest directly in these asset classes and take partnership roles in real estate, infrastructure, etc. ETFs level the playing field for institutional funds with a similar investment objective but lacking the scale of a plan such as Teachers’. ETFs are a relatively cheap and easy way to enhance the asset allocation of an investment strategy, particularly while a more long-term solution is sought.
For example, commodity ETFs allow smaller institutional investors to essentially get pure exposure to the majority of the major commodity asset classes out there. Some of the largest ETFs in the world provide the investor with direct exposure to oil, natural gas and gold. Historically, direct investment into commodities was the exclusive domain of large commodity trading desks at financial institutions and large pension plans.
The Greenwich study found that 56% of U.S. money managers that use ETFs are, in fact, using them to make tactical adjustments to their portfolios’ asset allocations.
Similarly, 45% of plan sponsors use ETFs for the same reason. (See Figure 1)
The investment consultation process can be long, and, increasingly, sources of alpha are limited in many broad-based institutional strategies. ETFs quickly put money to work to take advantage of market conditions, and with their correlation to the underlying index or asset class being almost perfect, there is little concern about them undermining the correlations of the asset allocation strategy as can occur with external fund managers.
In this regard, ETFs fit nicely in being used in sector rotation strategies, where a portfolio manager is looking to rotate asset class exposure, with increasing correlation among single stock names within many equity indexes—the index tends to deliver similar if not identical performance to many of its underlying stocks. ETFs can be a cheaper and less risky way to get the same performance that used to occur by rotating single stock names.
ETFs represent a huge cross-section of the investment universe. ETF investment options are more diverse than the wide world of mutual funds. Investors get to buy well-known, broad-based equity index tracking ETFs and their sub-indexes, but there are also leveraged, inverse, leveraged inverse, commodity, single country, single sector and myriad specialty categories such as ETFs that track volatility or offer access to spread trading strategies between commodities such as gas and oil.
Equity ETF Investing
Equity ETFs represent the lion’s share of ETF assets. According to the Greenwich study, institutions use equity ETF strategies primarily as tactical tools—in particular, they are commonly used as so-called “cash equitization” strategies—essentially making sure cash assets are invested into the market while a longer-term investment solution is sought.
Greenwich found that approximately 63% of money managers that employ ETFs use them in cash equitization, and 30% use them for rebalancing and transition management. The numbers drop considerably when you start to look at ETFs being used as core long-term investment holdings.
Arguably, the poster child for using ETFs in its portfolio is the $26-billion Harvard Endowment Fund. As of November 2010, the fund’s top five equity holdings were all ETFs; the majority of these are emerging market equity ETFs.
Without in-house ability to find the appropriate stocks in these fairly exotic markets, having equity ETF exposure gives the investor the majority of that stock universe’s return, likely at a cost point that is better than most actively managed mutual funds.
Tactical investing also may partly explain the appeal of leveraged ETF usage among institutions. They can be used in many different ways: from capturing an investment trend to implementing a pair trading strategy or simple portfolio hedging, if they are inverse ETFs.
As the Greenwich study points out, institutional investors use ETFs as a tactical trading tool. It would make sense to deploy a leveraged ETF, which generally offers two times the daily performance of an index or commodity and, therefore, offers potential for larger profit in a shorter period. (Since these ETFs are reset on a daily basis, period returns can deviate from the performance of the underlying benchmark, particularly in volatile market conditions. This phenomenon has sometimes been erroneously referred to as tracking error.)
In fact, investors move between the bull and bear products and actually anticipate moves in the direction of the marketplace. During the highs of 2008, investors moved heavily into the bear ETFs and reversed the course at the bottom of 2009.
When thinking about leveraged ETFs, it is much better to conceptualize them as tactical portfolio tools used by the majority of their investors to magnify their returns in any given market condition or to potentially hedge long positions in the equity market with less capital.
Minimizing Tracking Error
Tracking error is the difference between the performance of an ETF and its ability to replicate the performance of an index, as stated in the ETF’s investment objective. Interestingly, problems in tracking error with single long equity index ETFs have led to a new evolution in the ETF space, where, if possible, many providers are launching new ETFs using a total return swap (TRS) to get exposure to equity indexes.
The majority of equity-tracking ETFs physically hold the constituent securities of the index they replicate or track. Trading expenses and rebalancing costs can make it difficult to precisely replicate the performance of the index, resulting in a potential tracking error to the index return.
TRS structures are growing in prominence because they are generally cheaper to run and provide the exact return of the index minus nominal costs. Large institutional investors usually get their indexing exposure from a TRS. In fact, in Europe, large providers have launched swap-based ETFs. The swap structure is also available in Canada.
In the world of institutional investing, every basis point counts; tracking error is a chief concern. Figure 2 highlights that a greater compounded return can be achieved with a smaller tracking error. (see PDF to view Figure 2) It compares four funds with varying degrees of negative tracking error that track the same benchmark index over a 10-year period and charts the difference in performance that occurs throughout that 10-year period.
Fixed Income ETF Investing
With rates at record lows, it would make sense that more investors would be looking to take advantage of the low-cost structure of ETFs to get fixed income exposure to ensure that the majority or their yield—effectively, their return—is realized.
In the Journal of Fixed Income, Naomi E. Boyd and Jeffery M. Mercer argue that excess returns in fixed income can be achieved by “correctly timing changes in yields and/or yield spreads” using pretty standard past information metrics on what types of factors influence the interest rate cycle.
“Overall, we find that the use of turning points in the interest rate cycle, requiring only past information, could have substantially enhanced risk-adjusted returns for fixed income investors, even after accounting for transaction costs,” the authors write.
In other words, indexing strategies in fixed income do not offer the same opportunities that certain equity indexing strategies do. Further hampering indexing strategies is the difficulty of trying to replicate the return of major fixed income indexes.
Unlike equities, corporate bonds trade over the counter rather than through an exchange, making efficient and cost-effective execution difficult. Corporate bonds do not always have the breadth, liquidity or efficiency that stocks do.
The DEX All Corporate Bond Index, the most widely used corporate bond benchmark in Canada, includes 600-plus issues. Many of these do not have the adequate liquidity required by an ETF to be traded on a daily basis. Using an actively managed income strategy within an ETF that delivers a beta similar to a popular fixed income benchmark may offer a solution to this. The combination of a low management fee and an actively managed portfolio can lead to outperformance over passively managed index tracking ETFs simply by avoiding some of the structural pitfalls of trying to replicate an index benchmark.
The world’s largest actively managed ETF, the PIMCO Enhanced Short Maturity Strategy Fund, is essentially a low-risk, short-term debt security ETF that offers a similar risk profile to a money market fund, but with a slightly higher yield. There’s no index that allows an investor to duplicate this strategy; having an experienced fixed income investment team and a low management fee are crucial to the success of the strategy, as is the ability to easily enter and exit positions in this investment vehicle—something only an exchange-listed security can provide.
Regardless of whether they are actively or passively managed, ETFs once again give smaller plans and funds the flexibility to enter in and out of the fixed income market at a relatively low cost. The addition of more advanced fixed income strategies will likely give investors access to the types of customized and innovative fixed income strategies that previously belonged exclusively to large-scale investors.
Increasing Usage
Given the structural advantages of ETFs, it is somewhat surprising that institutional uptake isn’t higher. Usage should increase simply as a result of the explosion in the number of ETF offerings readily available from passively managed equity ETFs and commodity tracking ETFs to newer actively managed ETFs. The breadth of choice in the ETF market has increased the size of the investment tool box available to all investors, regardless of how many assets they manage.
The combination of greater ETF choice with greater ETF education should help accelerate institutional usage over the coming years. Indeed, the Greenwich study found that nearly 30% of institutions lack familiarity with ETFs, which has led to a hesitation to use them. Greenwich Associates says it is imperative for providers to work with consultants to increase this familiarity. This should result in greater institutional uptake in the number of ETFs used in institutional portfolios in years ahead. BC
Howard J. Atkinson is the president of Horizons Exchange Traded Funds. hatkinson@horizonsetfs.com