Institutions Still Wary Of ETFs

ETFs have been embraced by retail investors, but the institutional market has a long way to go.

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Reviewed by: Heather Bell
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Edited by: Heather Bell

[This article appears in our August 2019 issue of ETF Report.]

For the second year in a row, Keefe, Bruyette & Woods (KBW) has surveyed institutional investors to see how and why they use ETFs, especially equity ETFs. The results are interesting, and we provide some key highlights.

KBW solicited data from 26 institutional investors, 64% of which were hedge funds or private equity firms. The mix also included responses from mutual fund/insurance and institutional wealth managers, banks and endowments/foundations. Overall, 60% of participants had less than $1 billion in assets under management, while 20% had more than $5 billion.

“If you think about the nature of the institutional business, they’re being paid for their stock picking,” said Melissa Roberts, a managing director and research analyst at KBW. ”Using an ETF is somewhat contrarian to their business.”

“The way in which they’re using ETFs is kind of creative,” she added. “But also because it’s creative and unique, it’s taken them longer to ramp up an acceptance of them.”

Blessing Or Curse?
More than half the respondents said they thought of ETFs as a game changer, a “useful tool/investment option,” but 31% chose a far darker option, labeling ETFs a “ticking time bomb” that’s a “temporary market disruption, with limited long-term use.” (See Figure 1.)

 

 

As an insight as to why they might think that, 100% of respondents said ETFs have an impact on the prices and volumes of their underlying stocks, with concentration risk seen as the biggest risk associated with the vehicles. Other top risks mentioned by the 19 respondents who answered the question included liquidity and tracking error (see Figure 2).

 

 

The concerns with concentration risk were based on the idea that ETFs were crowding into the same names, concentrating exposure in relatively illiquid securities and changing the fund-flow dynamic in individual stocktrading, Roberts said. She noted also that as stock pickers, institutional investors are likely more interested in the impact of ETFs on individual securities.

With quite a few participants seeing ETFs as ticking time bombs, it’s not surprising that roughly 46% said they weren’t invested in ETFs. However, of those that do  invest in them, 54% said they use them as trading tools or for risk management, while 46% said they use them for asset allocation purposes.

Of those institutions invested in ETFs, 38% have less than 10% of their assets allocated to ETFs, while 12% have 10-25% in ETFs, and just 4% have between a quarter and half of their assets in ETFs.

Using ETFs
Interestingly, of those currently using ETFs or planning to during 2019, 57% said they’d use the creation/redemption feature of ETFs in the primary market. That number has declined from 2018, when 67% of respondents said they’d use an ETF’s primary market.

Roberts believes that institutional investors using a broad market ETF as a placeholder in their portfolio would be most likely to take advantage of the primary market of the ETF, because it could be easier than trading on the secondary market with a large position.

The top reason for using ETFs based on respondents’ answers was risk management, with 81% of all respondents listing that as a factor supporting ETF usage. The percentage is similar to the results from 2018.

Cost Concerns Lessen
The second reason—with respondents allowed to select multiple answers—most cited was the low costs associated with ETFs, which was selected by 42% of all respondents. However, that’s down from 47% in 2018’s survey, and KBW attributes the change to the spreading cost compression in the ETF space, which has made cost less of a concern for investors.

Precision was notable because both third-place answers cited it. Not only did 35% of all respondents say that shorting a precise exposure was a reason to use ETFs (an increase from the prior year), 35% also chose getting precise exposure as a reason, almost doubling from the 19% that selected that answer the prior year.

Tax benefits and diversification were the least chosen factors.

KBW notes that the importance of precise exposure is further reflected by the fact that 88% of all respondents said they do or would use sector-specific ETFs, and 58% said they do or would use broad market index ETFs. Only one respondent chose actively managed ETFs.

“I think they’re more focused on things they can use as hedges for individual securities,” Roberts noted, suggesting broad market ETFs may be used for placeholder purposes.

Choosing ETFs
Participants were asked to select the top three factors they considered when selecting an ETF. The underlying index—and its construction and methodology—was the top choice, selected by 85% of the total number of survey participants, followed by secondary market trading liquidity (50%) and costs (46%) (see Figure 3).

Indeed, 59% of respondents said they’d rather use the ETF with the most precise exposure, compared with 41% who said they’d pick the one that trades the most. Accordingly, 59% said they were likely to switch to an ETF offering more precise exposure. Another 36% said precise exposure wasn’t their primary concern, and they’d likely continue using an ETF.

One of the most important questions asks participants what their plans are for ETF usage in 2019. Three-quarters said they’d maintain their current level of usage, while 17% said they’d increase usage. Another 4% said they’d start using ETFs for the first time, while an additional 4% said they’d use fewer ETFs.

“Institutions are kind of slow adopters,” Roberts observed, noting that retail investors have been much  quicker to accept ETFs.

Indeed, the survey represents a small slice of the vast institutional space, but it suggests ETFs have a lot more growth left to them in the space going forward. 

 

Heather Bell is a former managing editor of etf.com. She has also held editorial positions at Dow Jones Indexes and Lehman Brothers. Bell is a graduate of Dartmouth college and resides in the Denver area with her two dogs.