How Small Institutions Use ETFs

Small institutions use exchange-traded funds to control costs and access most parts of the markets, especially since smaller institutions usually don’t have the same leverage large institutions do to negotiate fees with fund providers.

Not surprisingly, many small institutions predominantly use U.S. large cap ETFs for that cheap market access, but some organizations also employ ETFs to reach fixed income markets, with a few embracing active ETFs.

Increased Choices
Johann Klaassen, chief investment officer of Horizons Sustainable Financial Services, notes it’s gotten easier in the past few years to use ETFs for his clients, which are mostly small nonprofit institutions that want socially responsible investment (SRI) portfolios. The portfolio sizes he manages for them range between $50,000 and $1 million in investment assets.

The three ETFs he uses most often are in the U.S. large cap space: the iShares MSCI KLD 400 Social ETF (DSI), the Change Finance U.S. Large Cap Fossil Fuel Free ETF (CHGX) and the Etho Climate Leadership U.S. ETF (ETHO). He also uses some ESG international large cap and fixed income ETFs.

ETFs are a great way to control costs, especially in the ESG space, Klaassen says: “Mutual funds tend to be a little more expensive than the ETFs, at least in the part of the industry I’m using them. I can’t use the 1 basis point Vanguard regular mutual funds because they don’t have any that are ESG or SRI.”

There are more ESG exchange-traded funds available now, particularly on the equities side. However, he points out his firm doesn’t have a full ESG portfolio using ETFs because there are still some parts that aren’t manageable using ETFs.

Klaassen notes in all there are about 23 ESG ETFs he uses in different strategies—some equity, some fixed income. Although new ETFs debut frequently, he still has to evaluate them to see if they’re a good fit. The biggest portfolio gaps he has are in the U.S. and international small and midcap equity asset classes and emerging markets. There may be a few ESG ETFs in those asset classes, but the pickings are slim.

The ESG ETF universe is expanding, but Klaassen says it takes time to get them rolling: “The folks who are setting these things up aren’t sure that there’s enough demand yet to meet their requirements for what they feel they need.”

More Than Cost Control
Tom Lee, chief investment officer of equities and derivatives at Parametric Portfolio Associates, whose firm manages portfolios for small institutions, suggests there are a few other reasons in addition to costs why small institutions use ETFs.

ETFs are popular in asset classes like U.S. large cap stocks where the institution may have low conviction that an active manager can outperform the index, or they may want access to certain factors, Lee explains. Institutions may invest in an ETF while they’re searching for a portfolio manager, such as looking for an active manager in emerging markets. Using the ETF gives them market exposure during the manager interview and onboarding process.

“What’s nice about it is that oftentimes they can fund the manager with the ETFs and the manager will then just transition out of the ETF to fund their specific portfolio so the client doesn’t lose exposure,” Lee explained. “I’m not saying that’s always the case, but in a lot of cases, institutions use the ETF as a funding instrument.”

It’s also easier for smaller institutions to use ETFs versus larger institutions because they don’t have to worry about liquidity or moving the market, he adds.

Small institutions generally use ETFs strategically, rather than tactically, Lee observes, although occasionally these organizations may trade ETFs because of market mispricing or have a change in philosophy, such as moving to value from a market-cap-weighted position.

Lee points out he’s noticing some small institutions using fixed income ETFs, but adds there’s still some reticence about ETFs properly tracking bond indexes, concerns that date back to the financial crisis. He notes that his firm has nuanced discussions with institutions about fixed income ETFs: “It doesn’t make the client feel a lot better when they see higher volatility in their portfolio versus if they were in an index.”

He notes that some firms like BlackRock have published papers arguing that true price discovery is occurring in the ETF, not the indexes, although he adds that he isn’t taking a position on that point of view.

Dipping A Toe Into Active ETFs
Low-cost, plain vanilla, passive ETFs are popular with small institutions just as they are with other investors: They’re cheap, transparent and easy to understand. Michael Skillman, CEO of Cadence Capital and CEO of Pacific Global ETF Trust, points out that some small institutions are also looking to active ETFs.

“Many managers are starting to launch active ETFs, a swath going the nontransparent route, because I think they see it as a more cost-effective vehicle to gain access to an investment strategy,” he said.

Larger institutions generally have access to the big custodial firms for their separately managed accounts, but Skillman observes that an increasing number of midsize and smaller institutions are looking at the active ETF route rather than using mutual funds. Active ETFs don’t come with the inside costs such as transfer agency fees that are found in mutual funds, he points out.

Active ETFs are a newer, smaller part of the ETF landscape, and for now not too many smaller institutions are using them, so it will mean educating both the asset owner and the consulting firms to understand how active ETFs fit.

“It really comes down to the fact that they just don’t know how to go about trading these vehicles,” said Skillman. “Obviously, the big sell-side firms would be happy to help them, but there are specialists out there too that really focus in this area.”

It may take more specialists working with institutions on how to use active ETFs, since specialists don’t solely focus on the expense ratio, but other costs, too, he adds: “If I get picked off in the bid/ask spread, then the cost advantage of using an ETF goes away.”