It's that time of year again: The Greenwich Associates' 2017 U.S. Exchange-Traded Funds Study, conducted in collaboration with BlackRock, is hot off the presses.
The annual survey, which offers fascinating insights into how and why institutional investors are using ETFs in their portfolios, is must-read for ETF nerds like us.
But as we thumbed through this year's report, "ETFs: Valuable Versatility In A Newly Volatile Market," we realized that something feels different this year. And it's not just because ETFs are now commonplace at institutions (e.g., a whopping 90% of survey respondents said they used equity ETFs, and 77% said they used bond ETFs).
Rather, what's striking is the ways in which institutions are using ETFs. Whether it's swapping futures positions out for index ETFs or deploying multifactor and smart-beta bond products, institutions are moving beyond basic, core exposures and using ETFs to enact sophisticated, creative strategies that, years ago, only a handful of investors dared attempt.
Below we've highlighted the five results from this year's survey we found most intriguing:
Cost Isn't Investors' Top Concern
Expenses are a hot topic these days, and ETF issuers are racing to see who can offer the fund with the lowest fees. But respondents in the Greenwich survey said other factors mattered more than cost, such as liquidity, performance and fund exposure.
For 80% of institutions surveyed, the top concern when evaluating ETFs was whether that fund's particular exposure met their portfolio needs. Other primary concerns included liquidity and volume (76%) and fund performance, including tracking error (66%). ETF expense ratios were also a primary concern (66%), but they weren't the only consideration that mattered:
That result may sound counterintuitive, considering the massive inflows we've seen into low-cost ETFs in recent years. Bloomberg senior ETF Analyst Eric Balchunas recently reported that of the $107 billion that ETFs and index mutual funds took in year-to-date, 90% went to funds cheaper than 0.20%.
But perhaps it's just a happy accident, says Andrew McCollum, managing director of Greenwich Associates and author of the report.
"Fees are indeed an important decision driver with ETFs," said McCollum. "However, given that ETF fees are so low, the differential between providers is not as substantial as it is among active managers. As a result, other criteria—such as quick access, ease of use or liquidity—tend to rise above fees as decision drivers."
Fund liquidity is of particular importance, as institutions are increasingly using ETFs in "quick response" strategies, says Ravi Goutam, head of Pensions, Foundations and Endowments for iShares:
"These institutions are trading in size, and rapidly, based on moving markets. They may not hold their positions for long, so management fee, while important, isn't that important," he said. Still, "liquidity and the right benchmark often coincide with low fees—it's the icing on the cake."
ETFs Aren't Replacing Just Mutual Funds
Lots of ink has been spilled over how ETFs have vacuumed up flows from active mutual funds, but actually they're not the only instruments being displaced by ETFs. Investors are also increasingly substituting in ETFs for individual stocks, bonds and even futures positions.
Nearly half of study participants who reported using futures for their beta exposure say they'd subbed out derivatives for ETFs over the past year. Sixty (60%) reported they were at least thinking about doing so in the future.
"This is probably the single biggest conversation we're having with clients right now," said Goutam.
The majority (58%) of institutions who said they planned to sub in ETFs for futures reported they wanted to do so to lower costs. With higher round-trip costs (including bigger commissions and margin requirements, as well as regulatory pressures inflating costs), futures can be significantly more expensive than ETFs with similar exposure.
"Often, futures contracts aren't just 5-10% more expensive [than ETFs], they end up being 5-10 times more expensive," noted Goutam. "It's a magnitude higher."
Futures also exhibit higher volatility in their roll costs (meaning, the cost to roll from one expiring contract to a new one—essentially, the cost of maintaining constant exposure). For example, over the past five years, the S&P 500 Index futures contract has seen both its most and least expensive roll costs in that contract's history. By using ETFs instead, institutions can mitigate some of that volatility.
ETFs aren't always the cheaper option, added Goutam, but "there are pensions doing the math and moving billions of dollars from futures contracts and into ETFs. They're not just sticking with the way they've done things previously."
There's Alpha, There's Beta & Now Factors
Factor investing isn't quite mainstream yet, but it's getting there. Forty-four (44%) of survey respondents reported using nonmarket-cap-weighted or smart-beta strategies in 2017, up 7% from the year prior.
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Much of that demand growth has come from wariness over the possible return of market volatility. Sixty-two (62%) of institutions already investing in smart beta use minimum-volatility ETFs, making them also the most popular smart-beta category.
The trend toward factors belies a shift in the way investors are thinking about alpha and beta, says Goutam. His clients are increasingly evaluating their portfolios in terms of which factors are overweight and which are underweight, and whether one exposure unintentionally boosts or neutralizes the other.
"They want to make sure their net factor exposure is consistent with their investment view," said Goutam.
Interestingly, investors seem to slightly prefer multifactor funds over single-factor funds (53% to 50%). This difference is likely to grow: Of those investors who planned to increase their use of smart-beta products, 48% say they planned to add multifactor ETFs, while 41% planned to use single-factor ETFs.
Investors Falling For Bond ETFs
With apologies to John Green, investors have fallen in love with bond ETFs the way you fall asleep: Slowly, and then all at once. Last year, investors boosted their allocations to fixed-income ETFs in every category except one: international investment grade (which remained flat year-over-year):
"Growth in use of fixed-income ETFs was underway for several years. However, 2017 likely marked an inflection point in institutional use, both due to the market situation and investor comfort levels," said McCollum.
Rising interest rates, which have posed a risk for years but which finally seem to be coming to fruition, have driven much of this demand growth.
But so too has a continued liquidity crunch in the individual bond market. Dealers hold less inventory than they once did, making liquidity of individual bond issues an ever-greater concern. Liquidity of bond ETFs, meanwhile, has been accelerating, increasingly making them the default choice of fixed-income investors.
Like with futures, bond index ETFs are often substantially cheaper than buying the underlying bonds; sometimes even a factor of 10 or greater. Furthermore, trading in the over-the-counter bond market takes longer and requires more resources. "If you want to get it done quickly and cheaply, and done in one shot, ETFs are the optimal vehicle," said Goutam.
But it's not an either/or, he added: "It's incredibly common for institutions to use ETFs to provide quick beta exposure to the fixed-income asset class, then to choose specific bonds to give them alpha."
Intriguingly, use of smart-beta bond ETFs grew by 18% year-over-year; these funds are now used by a quarter of institutions that use ETFs. With only 61 smart-beta bond ETFs holding just $16 billion in assets, the segment remains a niche of a niche. Yet interest is apparently growing. The question now is whether investors will be satisfied with the smart-beta bond ETFs available, or whether the paucity of choices will inhibit the segment's further growth.
US Investors Still Don't Buy That ESG Boosts Returns
European institutions long ago boarded the environmental, social and governance (ESG) investing train, and ESG-backed investments are commonplace in portfolios overseas. That isn't quite the case in the U.S., where institutions have proven much more skeptical of ESG's benefits.
Whereas 43% of European institutions "believe" that ESG investing leads to strong returns long term, in the U.S., only 8% do. (That "believe" isn't us editorializing; it's the wording used in the report.)
This perception isn't exactly justified: As we've covered in the past, ESG ETFs have actually seen significant outperformance recently, particularly in 2017 (the time period of the Greenwich survey).
Yet only 15% of U.S. investors have sold out of certain strategies or invested in new ones as a result of ESG considerations, compared with about half of European investors. In fact, more than half (54%) of U.S. institutions surveyed say they didn't see any need to incorporate ESG factors into their investment decisions.
On this, the U.S. is an outlier, says McCollum, and over time, the U.S. will likely catch up to its foreign peers.
"The European institutional market has been focused on ESG for over a decade, while the U.S. market is in the early stages of adoption," explained McCollum. "As U.S. institutions further integrate ESG into their investment portfolios, the markets are likely to look more similar in the future."
Contact Lara Crigger at [email protected]