Institutional Investors Need to View ETFs Differently

“ETFs [exchange-traded funds] were initially designed to provide retail investors with easier and cheaper access to mutual funds. Over the years, their utility has been shown to be so much more than that. ETFs help institutions to hedge risk, manage their cash flow needs, gain quick exposures to illiquid market segments, and more. But in order for institutional use of ETFs to grow and mature, long-held structures for managing clients and trading products need to change,” concludes a report written by Greenwich Associates Managing Director Kevin McPartland, who is head of research for the firm’s Market Structure and Technology practice.

Investors and broker/dealers should start treating ETFs as an asset class all their own, the report suggests.  Doing so would help improve execution quality and ramp up client commissions and overall profitability.

Trading practices on both the sell side and buy side are leading to suboptimal executions, limiting ETF growth. For example, according to Greenwich Associates, many equity broker/dealers and market makers treat ETFs as equities, given they trade on equity exchanges. Many investors take the same approach, trading ETFs with algorithms and using transaction cost analysis (TCA) systems designed for single stocks, rather than ETFs. Further, while fixed-income ETFs trade on equity exchanges, they move like the bond market, putting equity traders far out of their comfort zone. 

According to the report, market leaders are starting to break away from these long-held beliefs.  For clients that need credit market exposure, traders and portfolio managers must explore all of the products at their disposal, and not just those with which they are most comfortable. Similarly, broker/dealer sales teams should be willing and able to offer clients access to the right instrument, and not just those that they cover or the one the client requested.

Equities are for growth, fixed income is for capital preservation, other asset classes are used for liquidity or to hedge risk—what should ETFs, as a separate asset class be used for? “For the most part ETFs are indexes, and so need to be treated as such. You can’t trade an index the same as a single stock or a single bond. It is important to understand the dynamics of the index constituents, and take those market dynamics into account when trading the ETF. For instance, does the ETF share price reflect the NAV [net asset value] of the portfolio?” McPartland tells PLANSPONSOR.

“Fixed income ETFs should be traded by fixed income traders,” he adds. “Commodity ETFs by the commodity desk. Over time, investors should care about getting the needed exposure at the best price, regardless of the instrument used to get there. The sell side should service them the same way, not keeping instruments siloed based on where or how they trade.”

According to McPartland’s report, there’s a negative stigma regarding ETFs among many institutional investors. “For instance, when a major sovereign wealth fund allocates $1 billion to an asset manager to achieve defined investment objectives, they are doing so with the belief that the asset manager can obtain the expected return at the right price and level of risk. If that asset manager then turns around and puts some of that $1 billion into ETFs—even if those ETFs provide the lowest cost exposure—some believe the manager is thereby skirting its duties and outsourcing the work to the ETF provider.”

The report notes that index futures have been used to gain exposure and hedge portfolios for decades. Beyond the technical differences between the product constructs, index-tracking ETFs can provide the same service.

According to the Greenwich Associates 2018 North American Fixed-Income Investors Study, only 12% of U.S. investment-grade credit investors are using ETFs. According to Greenwich Associates 2017 North American Fixed-Income Investors Study, the purposes for which the few investment-grade investors are using ETFs are:

• Hedge undesired portfolio risk – 53%;
• Maintain exposure to a liquid investment – 41%;
• Park cash positions in ETF to minimize cash drag – 35%;
• Meet potential cash flow needs – 29%; and
• Gain exposure to a sector or region/country – 24%.

A change in mindset is clearly needed to increase ETF use among institutional investors, according to the report.

Information about how to obtain a copy of the report, “Letting ETFs Stand on Their Own,” is here.