The impact costs have on investment returns is finally sinking in, and smart-beta ETFs will allow institutional investors the better performance promised by active management, but at a cheaper price point.

With low investment returns forecast for the next several years and institutions’ need to outperform the Standard & Poor’s 500 Index, these investors are reviewing their options.

Cheaper & Tax Efficient
Compared to active managers, smart-beta ETFs offer the same outperformance opportunities, but do it inexpensively and with better tax efficiency, says Eric Balchunas, ETF analyst at Bloomberg and author of the book, “The Institutional ETF Toolbox.”

Smart-beta ETFs “use an active manager’s secret sauce and turn it into a rules-based index. That truly is the replacement for the active manager,” he said.

Beyond costs, smart-beta ETFs offer institutions flexibility they haven’t had before. Balchunas says institutional investors find comfort in the fact that most ETFs are approved by the Securities and Exchange Commission under the 1940 Investment Act, plus ETFs offer liquidity and anonymity they didn’t have before. ETFs can also be lent out, which lets institutions take in some money and cover the expense ratio.

“ETFs bring [institutions] freedom and liquidity. They don’t have to call somebody if they want to get out of [their position], somebody who might try to talk them out of it,” he said.

And the room for growth is evident in the accompanying table showing the breakdown of institutional usage when it comes to ETFs. Institutions have just scratched the surface.

Pensions Turning To ETFs
Balchunas says several types of institutions could benefit from using smart-beta ETFs. Pensions are already starting to replace pricey hedge funds with smart-beta ETFs.

“Hedge funds make up a disproportional amount of the cost. Pensions are underfunded, and one way to help get more of the market return is to go low cost,” he added.

Endowments are another area for smart-beta ETF use. For the past few years, endowments tried to match Yale’s returns, but interest in that model seems to be waning, notes Balchunas.

“If you use smart beta right, it can be just as powerful in terms of creating alpha as picking hedge funds or using private equity,” he said.

The insurance industry also offers “huge potential,” Balchunas notes. Insurance companies have a fairly small amount of exposure to ETFs, in part because of previous rules set by the National Association of Insurance Commissioners, the U.S. insurance standard-setting and regulatory support organization, regarding ETF use, Balchunas says. With those rules lifted, and more ETFs covering fixed income—smart beta or otherwise—insurance companies are now offered substantial potential for more investment.

Balchunas says the beauty of smart-beta ETFs, unlike passive ETFs, is they can be fine-tuned to overweight or underweight factors like momentum or volatility to get a chance to outperform the larger market.

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