‘The Institutional ETF Toolbox’

March 15, 2016

Eric Balchunas is a senior ETF analyst at Bloomberg, where he has more than a decade of experience working with ETF data, designing new functions and writing ETF research for the Bloomberg terminal. He also writes articles, feature stories and blog posts on ETFs for Bloomberg.com and appears each week on Bloomberg TV and Radio to discuss ETFs. ETF.com caught up with him to discuss his just-released new book, ‘The Institutional ETF Toolbox.’

ETF.com: There are other ETF books out there. What were you trying to do with this book?

Eric Balchunas: Most of the [ETF] books out there address retail and advisors. I wanted to find out how institutions were using them. They might be increasing their usage, but really only about 1% of institutional assets are in ETFs. It's not really that much in terms of their total assets.

What I found was they also don't use them just to go long, like to buy and hold. For a lot of advisors in retail, the ETF is a better, more tax-efficient, cheaper version of the mutual fund, game over. ETFs can beat a mutual fund five different ways. But on the institutional side, they have more choices. They can get cheap separately managed accounts. They love active managers. They love alternatives. The Yale model is a whole big thing with institutions.

Institutions use ETFs as adjustment mechanisms to do manager transitions and cash equitization, and to be liquid. Most of the institutions have investments in active managers, separately managed accounts and private investments.

Those things are not liquid. So they love ETFs for the liquidity. They can't get that kind of instant liquidity anywhere else. And for them, the liquidity is really about freedom. They don't have to call anybody. They can just get in and out. Part of what the book is saying is, here's how the big guys use them.

What I also found was they're not that good at using them. They tend to just use ETFs that have the most volume. The reason the top 15 ETFs make up 50% of the volume is because the size of the investors are so big, so the dollar volume becomes massive in those funds. But what they aren't doing is using the toolbox.

My case to the institutions is, “You don't have to use just the one that has the most assets. You can go into the toolbox if you learn how to use implied liquidity. That is the key to opening up the toolbox.”

The basket liquidity is really what the smartest ETF strategists look for. They don't even look at volume; they're looking at the basket liquidity. I make the point that institutions spend all this time and money on consultants and due diligence on active managers, but they don't spend any time on the due diligence of ETFs.

ETF.com: When you say “basket liquidity,” you're talking about what?

Balchunas: About how liquid the stocks or bonds are that are in the holdings. And that's crucial, because an institution, frankly, could just do a creation. They can skip the whole exchange to just have their market maker gather up all of the stocks, hand it in to the ETF issuer and get the shares.

Therefore, the liquidity of the stocks is more important. Most people generally think of ETFs as stocks. They think the volume equals liquidity. The fact is, that is true for stocks. But with ETFs, liquidity can be manufactured.

ETF.com: There seems to be a real sense of resistance to using ETFs on the institutional front. Are the vested interests of the consultants outweighing the responsibility they have for their client? Is that too cynical?
I wrestled with this during the book. You can go down that road and start getting negative about it. Or you can say, well, these are people who have jobs. They want to provide value. They're maybe a little nervous about the ETF being a sort of disintermediating technology. And that's scaring a lot of people. Look at robo advisors; same thing’s happening with the advisors. ETFs are really having a huge effect.

No matter where you turn, ETFs are a technology that everybody's having to deal with. And usually if the technology's that good, it will find a way. The intermediation will start to collapse because it's just that good.

Retail investors—and I think advisors to a degree—have thrown their hands up and said, “You know what? We can't pick a best manager. The costs are too much. It's hard to beat the market.” The retail crowd is a little ahead of the institutions.

Long-term allocation was the 11th-top usage in the chapter on institutional usage. It wasn't anywhere near the top. Institutions see ETFs more as a replacement for a futures contract or potentially cash. Or they might do long-and-lend. Or they use ETFs just to have a little liquidity rebuffer for a portfolio rebalance.

So the question is, will long-term allocation slowly move up the list for institutions like it is for advisors and retail? It's yet to be seen.

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