Institutional investors are moving in increasing numbers into fixed-income exchange-traded funds (ETFs), according to a recently released Greenwich Associates study, ETFs: Valuable Versatility in a Newly Volatile Market. The heightened demand for these products is derived from insufficient liquidity in the fixed-income market as well as institutional portfolios adjusting to an environment of rising interest rates, according to Andrew McCollum, managing director at Greenwich Associates and author of the report. “With the roll-out of increasingly granular and sophisticated fund structures, fixed income may be emerging as the next great growth frontier for ETFs,” the report speculated.
Close to 20% of the Greenwich study participants who are not currently investing in fixed income ETFs said that they are somewhat likely to start using them in the next 12 months. Among current fixed income ETF investors, one quarter plan to boost bond ETF allocations by more than 10%, and more than two-thirds are targeting increases of 5% or more.
Fixed-income ETFs are becoming increasingly prevalent in institutional portfolios, according to Bobby Eng, head of SPDR ETF business development-Canada, at State Street Global Advisors. “Approximately, eighty percent of our conversations gravitate toward fixed-income ETFs, and we expect that is where the majority of the growth will come from over the next three to five years,” he said. “Fixed-income ETFs provide a liquid, transparent and tradeable way to manage yield, credit and duration, and as an alternative to cash bonds and derivatives vehicles like CDX (credit default swap index), TRS (total return swap) and futures,” Eng said. “A rising rate environment makes it even more challenging to manage fixed income, so ETFs provide another tool that fixed income portfolio managers can use.”
A rising rate environment makes it even more challenging to manage fixed income, so ETFs provide another tool that fixed income portfolio managers can use.
Source of liquidity
For the past two to three years, there has been a demand for fixed-income ETFs as a source of liquidity, given the poor liquidity in the global bond markets, said McCollum. “We’ve seen big ETF trades—trades of $50 million or more—which shows that investors feel comfortable that they will find the liquidity they are looking for using ETFs,” he asserted. These recent moves into fixed-income ETFs represent a change in vehicles, as opposed to a change in portfolio allocation by investors, he noted.
The Juneau-based Alaska Permanent Fund Corporation (APFC), is an example of one fund that has increased its position in fixed-income ETFs in recent years. The approximately $65 billion fund uses the class “to gain temporary exposure to less liquid asset classes, where buying the individual constituents can take longer than we would like,” according to Jim Parise, APFC’s director of fixed income. “Currently, we are using high-yield ETFs to gain exposure to the sector, while we build an internally managed high yield portfolio,” he said. “ETF’s do allow us flexibility to put cash to work and are easily liquidated when the cash is needed. We had explored buying high-yield ETFs and taking delivery of the underlying securities, but found that strategy to be expensive and required us to give up too much control of our final portfolio,” Parise added.
Increased use to continue
Observers who have seen the growth in use of ETF over the past few years say there is no sign of it abating going forward. “Since the inception of the first fixed-income ETF, the growth rate has been 42% per year. There is now over $600 billion in fixed-income ETFs assets globally, with approximately half of those assets coming in during the last three years,” Eng noted. He expects that growth trajectory to continue for the next three to five years.
Emerging market exposure
APFC also uses ETFs to gain exposure to emerging market debt, in both local and hard currencies. “They allow us to express our bias toward both currencies, while staying relatively liquid versus our active managers,” Parise said. “They suffer the same tracking error and high fee problem as high yield, but the liquidity advantage serves our immediate needs,” he added.
The Ontario-based Technion Canada endowment fund, which takes a global approach to investing, also gains exposure to emerging markets through ETFs, in addition to direct equities. “ETFs are a low-cost and liquid vehicle to gain exposure to a broad group of securities while controlling for risk,” said Jack Bensimon, Chair of the Technion Canada endowment fund. “Our interest in investing in less developed countries reflects the growing global market cap of these countries and regions. Investing in emerging market ETFs provides direct exposure to these markets with less volatility and enhanced relative returns, while allowing for reasonable liquidity levels,” he said. “The key is to be top-down selective in emerging markets as risk profiles can differ dramatically from one emerging market to the next.”
Investing in emerging market ETFs provides direct exposure to these markets with less volatility and enhanced relative returns, while allowing for reasonable liquidity levels.
Ease of access and trading
Pension plans’ keen interest in ETFs has also grown as these institutions have become more knowledgeable about and comfortable with the product, according to Eng. “Since the global financial crisis, regulation and policy changes have led to higher capital charges and restrictions on proprietary trading. Dealer inventory has decreased, making it more challenging for institutional investors to source cash bonds,” he said. “As they look for alternative sources of liquidity, ETFs have become a go-to solution.”
Many investors have also commented on the operational ease of trading in the class along with speedy execution, facilitating access to fixed-income markets otherwise unavailable to them through individual securities, said McCullom. “That’s one of the key points around the bond story: liquidly, ease-of-use, and the quick access they provide. That’s what jumped up as key take-a-way around the bond ETF story,” he said. The ability to trade ETFs on the secondary market is another appealing factor, Eng noted.
Smart-beta ETF investing on the rise
Institutional investors are also increasing their allocation to smart-beta ETFs as a direct response to the volatility in the markets, according to the Greenwich report. The study showed that of the 180 investors surveyed, the share of participants investing in non-market-cap-weighted/smart beta ETFs increased to 44% in 2017, up from 37% in 2016. “Many people talked about how they used nimble smart-beta ETFs over the course of the past year, and volatility was part of the drive,” said McCollum. Eighty percent of institutional funds that participated in the study and that currently invest in smart beta ETFs said they expect to increase their allocations to these products this year.
“These figures are aligned with a broader industry trend of an increased focus on factor-based investing,” McCollum said. “That’s the place that we saw the biggest jump this year, on a year-over-year basis. The focus has bled over into the ETF market, as people are looking at new ways of investing, beyond just market-cap weighted,” he said. “Driving that growth in demand has been institutions’ concerns about the prospects of a spike in volatility—a fear that became all too real in February 2018,” the report stated. Sixty two percent of institutions that participated in the study and are investing in smart-beta ETFs are using minimum-volatility ETFs, making these funds by far the most popular in the category.
“We’ve seen real growth in more niche areas in equity ETFs–in smart beta, or factor based ETFs, rather than in broad market indices, said Zev Frishman, chief investment officer at Toronto, Canada-based Morneau Shepell Asset and Risk Management. “In the past, there was immense growth in ETFs based on broad market indices; over the last decade and particularly in the last few years, there is more and more interest in algorithm driven ETFs,” he said.
The study’s participants
The Greenwich study’s participants included institutional asset managers (48%), endowments, foundations, corporate defined-benefit plans, public pension funds, insurance companies and insurance asset managers, along with representation from family offices, investment consultants, and other segments. Approximately 45% of the institutions in the study have assets under management of $5 billion or more, and more than 1 in 5 have AUM topping $50 billion.
Most of the participants in the study are large institutions. Forty-five percent have assets under management (AUM) of more than $20 billion (up from 33% in 2016) and approximately 1 in 5 have AUM in excess of $100 billion (up from 14%). Together, the study participants represent a sizable slice of the U.S. institutional market, with a combined AUM of $11.16 trillion, up from $6.67 trillion in 2016.