Institutional investors are looking to exchange-traded funds in higher numbers and are gradually exposing themselves to more asset classes in a hunt for easy market access and liquidity.
These money managers are seeking ETFs primarily for equity portfolios, but fixed income is slowly becoming more popular, as shown by a new report from Greenwich Associates sponsored by BlackRock Inc., owner of the iShares line of ETFs. The research found that 40 per cent of institutions using ETFs now intend to invest a greater portion of their total assets in the funds next year.
More than half of the asset managers polled that use ETFs have fixed-income funds in their portfolios now, and the category has seen major growth in the last two years. That compares to more than 80 per cent who use international and domestic equity funds in their investing.
"We were pleasantly surprised by how fixed income popped out of the report. Some of the equity numbers, we've been seeing those trends for several years where an ETF is an efficient way to access international markets. But the fixed-income growth was neat," said Greg Walker, head of iShares Institutional Business BlackRock Canada.
Mr. Walker attributes this to regulatory changes making traditional markets more expensive, as well as the maturity and size of the ETF market with secondary markets now available on larger funds.
The bigger the funds get, the more popular they will become. "Fixed income is one of those markets where it's over the counter. There can be less transparency than the equity market, and the ETF, especially as they grow larger and mature over time, is becoming a really efficient tool to access that less transparent market," Mr. Walker said.
Retail investors are drawn to ETFs for their low fees, but larger institutional asset managers can often get index exposure for a lower management fee than those charged on ETFs. Respondents to the study highlighted ease of use and access, as well as liquidity, as the facets that appealed to them. "We very quickly get into a situation where if we're not adding extra value they're not going to buy the ETF," Mr. Walker said.
ETFs, particularly smaller funds, have recently come under fire for providing less liquidity than some investors imagine, especially in more complicated asset categories such as high-yield bonds and futures where trading has become complicated with wider spreads.
But iShares isn't concerned with these issues. Its ETFs aren't leveraged or synthetic – they hold physical bonds – so Mr. Walker argues that investors wouldn't be taking on any undue risk by investing in them. That is, other than having an outlook for the performance of the asset class, which is always important.
And the flows of capital in and out of ETFs are proof of their liquidity, Mr. Walker said. "What happened during the credit crunch was that if you held cash bonds you weren't trading anything – you couldn't trade your bonds," he said. At least the ETFs could be sold, even if it was at a discount. And that helped boost the profile of ETFs in the market.
But there are still hurdles ahead for ETF providers hoping to reach those larger clients.
Institutional funds and asset managers that use ETFs are still among the minority and the study found "investment guidelines" and "internal limits" were the biggest barriers to respondents allocating more funds to ETFs.
Mr. Walker says conversations with new buyers are happening all the time, as portfolio managers and traders that have only traded single bonds look at the ETFs for better pricing or liquidity. The study found that 14 per cent of endowments and foundations that aren't using ETFs now plan to start in the coming year, up from 4 per cent in 2012.