Institutional strategies

April 01, 2001

'Hedge fund managers are one of the keenest users of ETFs'

Institutional investor interest in exchange-traded funds generally goes beyond that of the average retail investor. All ETF investors are interested in assessing the different levels of tracking error and liquidity, of course, but more and more institutions are discovering the treasure trove of advantages ETFs can offer.

While most retail investors look at ETFs as a buy-and-hold instrument, the time horizon for institutional investors is relatively short in comparison. Many institutions, if they do not use ETFs as a core strategy, use them as a satellite strategy around a core of actively managed products. According to industry sources, such institutions include hedge funds, mutual funds, pension funds, banks, insurance companies, foundations and public funds.

Hedge fund managers are one of the keenest users of ETFs, says Brad Zigler, head of iShares education at Barclays Global Investors. They are attracted by ETFs' inherent liquidity and the fact that they can get in and out of exposures very quickly with one trade. And because many hedge funds are quantitatively driven, the potential diversity of exposures offered by ETFs allows them to fine-tune these exposures relatively easily.

Most industry analysts agree that the potential benefits ETFs offer to institutions fall into six categories.

Basic index exposure

At their simplest level, ETFs allow institutions to gain market exposure to a particular sector or combinations of market sectors, capitalization levels and investment styles such as growth or value. In instances where institutions have used index futures to hold index exposures for some time, the process of selling expiring index futures contracts to buy contracts with a longer expiration period can be costly. As a result, one of the appeals ETFs hold for institutional clients is the ability to maintain a core position with a particular index exposure at a lower cost than with an index future.

Risk management

When institutions are unable to liquidate a position for either tax reasons or market impact reasons, they can use ETFs as an alternative to index derivatives to manage weak spots in their portfolio mix.

'For example, if an institution has an exposure to US markets with a broad market exposure and they are not confident regarding the future performance of technology stocks which may drag returns down, ETFs allow them to sell short a technology sector index fund,' says Zigler. 'This way, the potential pitfalls of owning a broad index portfolio can be negated, with the weakness in technology stocks cancelled out.'

According to another source, this was a popular trade at the end of last year, when traders were going long value, short growth. Institutions can also use this method to hedge more broadly against an entire market sector or style. Furthermore, the exposures available in the ETF world in many cases are broader than those available in index futures.

Transition management

ETFs provide institutions with an effective parking place for their money in the event they need to reposition their portfolios. If a fund needs to change managers while positions are being unwound and reinvested, institutions can maintain exposures to their desired securities in the form of an ETF. This allows portfolio managers to fulfil their market exposure mandate.

Cash equitization

When institutions receive an inflow of cash for which an asset allocation decision is yet to be made, an ETF allows them to invest in their target market represented by an index. As a result, the institution does not have to rush into making an asset allocation decision, but can gradually move into an active position all the while maintaining equity exposure. For example, a small cap manager may buy a Russell 2000 ETF in order to stay fully invested.

Institutions also use ETFs in lieu of futures that are not correlated to their benchmark in order to eliminate basis risk. 'So if you are a small cap manager and you are using S&P 500 futures to equitize cash, yes you would have equity type exposure, but you would actually have the wrong benchmark,' says Zigler.

Arbitrage

The difference between buying the securities from their source at a given price and buying an ETF with the equivalent securities may provide institutional investors with arbitrage opportunities, says Zigler. For example, a foreign country ETF can be bought in the US, and is traded in US dollars, allowing the institutional investor the opportunity to gain some alpha or profit.

Asset allocation

If an institution needs to increase or reduce the size of an existing asset allocation, moving the actual securities in the portfolio to meet the new asset allocation guidelines could be disruptive from both a tax and a market impact standpoint. By using ETFs as a proxy for those asset reallocations, an institution can buy the ETF that corresponds with the exposure in which it desires a long position and simultaneously sell short the ETF exposure in which it desires to reduce its weighting. This allows the institution to transition out of the former portfolio allocation model to the new one.

According to one ETF institutional business development officer, the knowledge level in institutions is definitely on the rise. He describes their current level of understanding as 'moderate,' and sees the need to provide this audience with more education.