Investors Increasingly Embrace ETFs for Liquidity

Institutional assets are flowing into exchange-traded funds (ETFs) as U.S. institutions integrate ETFs into essential investment functions ranging from risk management and liquidity enhancement to the generation of income and yield in a challenging interest-rate environment.

In a new report, “ETFs: ‘Active’ Tools for Institutional Portfolios,” Greenwich Associates says it interviewed 187 institutional investors and found respondents invest an average 21.2% of total assets in ETFs—up from the 18.9% of total assets reported in 2015. Those allocations are likely to grow in 2017. Forty-seven percent of equity ETF investors and 38% of bond ETF investors expect to increase their allocations to the funds in the year ahead.

“Although institutions are using ETFs as a means of obtaining strategic investment exposures, for many institutions, ETFs also have taken on a central role in critical functions like risk and liquidity management,” says Greenwich Associates consultant Andrew McCollum. Approximately half the institutions in the study use ETFs for liquidity management and nearly the same number employs ETFs in risk management/overlay strategies.

The survey found institutional demand for ETFs is fueled by several powerful trends:

• Institutions are using ETFs alongside other investment vehicles. Thirty-eight percent of institutional ETF users are replacing other vehicles in their portfolios, including active mutual funds and derivatives positions.
• Institutions are using innovative ETF structures to address challenges in their portfolios. Growing numbers of institutions are turning to non-market-cap weighted/Smart Beta funds like Minimum-Volatility ETFs and Dividend/Equity Income ETFs to help navigate the challenges posed by low interest rates and increasing market volatility. The share of institutional ETF users investing in non-market-cap weighted/Smart Beta ETFs increased to 37% in 2016 from 31% in 2015, and 44% of these investors plan to increase their allocations to the funds in the next year.
• Demand for ETFs is being fueled by the roll-out of new multi-asset funds. Fifty-two percent of asset managers use ETFs as part of multi-asset funds operated for clients. That share is up sharply from the 35% of asset managers employing ETFs in these funds in 2015. Within these funds, asset managers allocate a full 55% of total assets to ETFs.
• Past impediments to institutional use are giving way. Fewer institutions are expressing concerns about ETF liquidity and expenses. In fact, many institutions are introducing the funds into their portfolios specifically to enhance liquidity and reduce costs. Meanwhile, explicit prohibitions or limitations against ETF investments are becoming less common in both equities and fixed income. In 2015, nearly one-quarter of non-users said they were prevented from investing in fixed-income ETFs by internal investment guideline restrictions. That share fell to 19% in 2016.

When conducting due diligence on a potential ETF investment, institutions consider four primary factors: the degree to which the ETF matches their exposure needs, liquidity/trading volume, the expense ratio of the fund and performance/tracking error. Insurance companies, of course, pay close attention to an ETF’s National Association of Insurance Commissioners (NAIC) rating, and institutions across the board also take into account the fund company and management behind the ETF.