How Institutions Choose & Use ETFs

Financial services provider Keefe, Bruyette & Woods (KBW) just concluded its first-ever survey of institutional use of ETFs. What they found was somewhat surprising: ETF adoption remains low and slow among institutions, because they still have concerns about ETFs. KBW analyst Melissa Roberts shares here some of the survey’s key insights.

ETF.com: This is KBW's first survey of institutional adoption of ETFs. You talked to 32 different institutions with a wide range of assets under management. Why the interest on this space now?

Melissa Roberts: Over the past year, we've seen tremendous growth in U.S.-listed equity ETFs. Just last year, about $182 billion of net assets flowed into them. At KBW, we focus on financial stocks, and if we look at U.S. financial-focused ETFs, they've also seen a tremendous amount of inflows since the presidential election in 2016.

In our business, we’ve seen a lot of institutional interest in how ETF flows affect underlying financial stocks, so we decided to take a closer look at ETF adoption among institutions, but we asked about ETFs in general—not just equity ETFs—to get a better sense of how institutions are using them.

ETF.com: The first thing that stands out in your findings is that institutional adoption of ETFs remains generally low and slow to get traction. Was that surprising to you?

Roberts: Yes, I was surprised by how low usage is. One of the questions we asked was, ‘What percentage of your AUM is invested in exchange-traded products?’ and 53% of respondents had 0% in ETFs. The remaining 47% had less than 10% of their AUM invested. I would’ve thought those numbers would have been higher based on the growth of ETFs over the last couple of years.

ETF.com: Does the pace of adoption have anything to do with why and how institutions are using ETFs? Your survey found that when they do use ETFs, it’s more as short-term tools rather than long-term investments.

Roberts: That's exactly what the survey showed us; institutions are primarily using them for risk management purposes, so you won't see them show up in the AUM, because they're being used in the secondary market as a trading tool.

To me, that was interesting. And that's why we think, going forward, there could be room for growth as institutions start using them for asset allocation purposes.

ETF.com: Is that your outlook—that institutions will, over time, convert to ETFs as long-term investments?

Roberts: It probably depends on what the institution is. Funds where their mandate is to make stock selections, or an active stock picker, might not be willing to use an ETF. But for some other institutions, we may see growing acceptance.

There are three main ways ETFs are being used right now; the first being for liquidity, the second for shorting and hedging, and the third for long positions and to lend out the securities. In terms of asset allocation, that's kind of unchartered territory, and the survey showed just how untapped that space is.

ETF.com: Another interesting finding here is on ETF selection. Institutions prefer precision of exposure over liquidity. They’ll also stick with an ETF they already own, even if a more precise ETF comes along. What's your take on this?

Roberts: About 66% of our institutional respondents said they'd rather own an ETF with the most precise exposure rather than the most liquid ETF.

That’s getting to the fact that the secondary market trading doesn't necessarily indicate the overall liquidity of an ETF; it comes down to the construction of the ETF and what the liquidity of the underlying securities is. Institutional investors are savvy enough to realize that.

But most interesting was their claim that precise exposure was the most important thing, and that it seems ETF selection is somewhat sticky. If someone's using an ETF and they're comfortable with it, even if something better comes to market, they may not switch. Only 47% of our respondents said they’d consider switching. This acknowledges there could in fact be first-to-market advantages for ETFs over more precise or correctly sized baskets that might come to market later.

ETF.com: You asked institutions to put into a single word what comes to mind when they hear the word ETF.

Roberts: This was really interesting. The majority of the responses had to be classified as “concerns.” We got words like “crowding,” “overdone,” “threat,” “volatility,” just to give you a sense. That could be what's driving the somewhat-cautious acceptance of ETFs on the institutional side. While they're recognizing the benefits ETFs can offer, maybe they lack education, or there’s some confusion about what the risks of ETFs are.

ETF.com: What specifically are their biggest concerns about ETFs?

Roberts: One of the things they worry about is concentration and the effect on the underlying securities. They talked about ETFs potentially causing volatility. One institution said ETFs make them think of “mindless momentum buying.”

There’s this idea that ETFs have a multiplicative effect of some sort; as people move more to ETFs, it creates more buying from the ETF. Some institutions aren’t as familiar or comfortable with how that impacts the underlying securities.

ETF.com: What's your main takeaway from this survey?

Roberts: Two things. First, it’s that there's a great outlook for institutional ETF usage. When we asked our survey respondents how they would use ETFs in 2018, just 3% of them said they would use them fewer. That means they're at least going to be using them at the same amount, if not more, in 2018.

Second, it goes back to the about ETF selection—it can be sticky. If institutions are comfortable with their products, they may not switch from using that product. We've seen a proliferation of new funds, and it makes you wonder if, in the future, we’re going to see consolidation of funds, as the ones that are most accepted wind up being the more successful products.

The other thing we didn't mention was that institutions also talked about how cheap ETFs are. Adoption is not only for trading purposes, but also because of their low-cost structure. As firms become increasingly cognizant of cost, ETFs can offer an attractive area of growth because of their low-cost structure.

Contact Cinthia Murphy at [email protected]