3Use Cases for ETFs

excerpt from Managing Market Volatility in 2021 What institutional investors did in 2020 – and what they learned

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MethodologyIn Q3 2020, Institutional Investor’s Custom Research Lab surveyed 766 institutional investment decision makers in North America, Europe, the Middle East, Africa, Asia-Pacific, and Latin America, on how they navigated market volatility in 2020. The research process also included interviews of more than a dozen well-qualified sources at insurers, endowments, family offices, foundations, pensions, and asset management firms. Throughout this report, the phrase “asset manager” is used to refer to survey respondents and interview sources who work for asset management firms, serving their clientele of asset-owning institutions.

The demographic highlights of the research cohort are below.

Institution Type (n=766) Titles (n=766)

Asset management firm 34% Chief investment officer 18%

Insurance company 20% VP or director of investment 15%

RIA firm/financial advisory firm 10% Equity or fixed income

investment analyst13%

Public pension 9% Risk officer 13%

Endowment 6% Portfolio manager 11%

Family office 6% Product specialist 11%

Private pension 5% Director of research 10%

Hedge fund 4% Equity or fixed income trader 9%

Foundation 4%

Multiemployer / Taft-Hartley plan

2%

Location (n=766) Assets Under Management (n=766) North America 36% More than US$50 billion 26%

Europe, Middle East, and Africa 29% US$10 billion to US$50 billion 27%

Asia-Pacific 21% US$5 billion to US$10 billion 9%

Latin America 14% US$1 billion to US$5 billion 22%

US$500 million to US$1 billion 8%

Less than US$500 million 8%

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LIQUIDITY MANAGEMENT, TRANSITION MANAGEMENT, AND TACTICAL ADJUSTMENTS ARE TOP REASONS FOR ETF USEThree core attributes of ETFs are their utility when an asset owner is moving investments out of one manager and placing them with another manager, the speed with which they can be used to tactically achieve market exposures, and the liquidity they have provided even when it was in overall short supply in the markets. These attributes were accentuated during pandemic-related volatility as institutional investors deployed them in essential roles. The growth story of ETFs over the years has been fueled in large part by the consistent emergence of new ways to use them.

Liquidity Management

A majority of respondents (52%) use ETFs of one type or another to manage liquidity (n=762). In a separate question, more than 80% of the 394 eligible respondents say fixed income ETFs are especially well suited for liquidity management applications.

“When there is a need to quickly deploy or raise capital, the first option we consider closely is ETFs because of their liquidity.”

– Portfolio Manager, Asset Manager

“Maybe we have a manager that’s doing significantly better than we think is a reasonable expectation based on how they invest. We could trim from that manager and put some of that into an ETF temporarily while we wait for some performance reversion from the manager. We do that quite often.”

– Senior Analyst, Asset Manager

Transition Management

70% of respondents use ETFs when moving from one manager to another (n=762). A majority of those using ETFs during manager transition see fixed income (74%) and equity (51%) ETFs as especially suitable during manager transitions (n=534).

“We use ETFs to increase our exposure during the time it takes for us to identify, vet, select, and implement a manager. An ETF provides us with the opportunity to buy something and get our beta1 exposure today.”

– Deputy CIO, University Endowment

Tactical Adjustments

More than 60% of respondents use ETFs to make tactical portfolio adjustments (n=762). Such respondents are most likely to report using fixed income (66%) and equity (57%) ETFs for tactical adjustments (n=468).

“If we’re going into a market where they may have a home bias, ETFs are helpful. There’s a lot of regulation outside the U.S., particularly in Asia, around the amount you can invest in underlying funds. When we see we’re reaching those caps, we’ll put an ETF alongside one of our active strategies so we’re not violating regulations and maximum allocations.”

–Portfolio Manager, Asset Manager

“Often, if you sell out of a manager and go to cash or some other transitional vehicle, there’s a lot of risk. When you park it in an ETF, it minimizes performance drag and it’s a very smooth transition from an asset class perspective.”

– Portfolio Manager, Asset Manager

ETF USE CASES

1 Beta is the return generated from a portfolio that can be attributed to overall market returns.

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During critical and sometimes lengthy periods of transition management, 70% of institutional investors relied on ETFs – with 74% of those institutional investors saying fixed income ETFs are particularly effective for transition management (see Fig. 1).

» Tactical adjustments to their portfolios (61%) and liquidity management (52%) round out the top three reasons institutional investors use ETFs.

» In both cases at least two-thirds of institutional investors find fixed income ETFs very useful – 66% for tactical adjustments, 83% for liquidity management.

Institutional investors also prefer fixed income ETFs to individual bonds during the portfolio rebalancing process – 41% to 28%, according to 759 survey respondents. Given how fixed income ETFs were used when the market was most stressed, at the start of the pandemic, it’s possible their use during market volatility may increase over time as institutional investors become more comfortable with the funds in challenging scenarios.

Pensions and insurance companies, two institution types with long-term requirements that occasionally collide with short-term necessities, find ETFs have a place in their liability-driven investing (LDI) strategies. Driven by both regulation and rational preference, pensions and insurers rely on fixed income assets. Nearly three-quarters (73%) of the 264 insurers and pension funds participating in the study use ETFs in their LDI strategies, and another 26% say they don’t currently do so, but are likely to in the future.

Fig. 1: Investors Continually Find New Uses for ETFsWhich of the following types of ETF are especially suitable for . . .

Transition management (n=534)

Derivative complement/replacement (n=342)

Liquidity management (n=394)

Tactical adjustments (n=468)

Rebalancing (n=298)

51%

59%

27%

57%

54%

74% 39%

40%

83% 22%

66% 34%

62% 51%

66%

Equity ETFs Fixed income ETFs Factor ETFs

KEY TAKEAWAYS » Institutional investors continue to find new ways to use ETFs. » Fixed income ETFs are frequently used for liquidity management and tactical

portfolio solutions. » Using ETFs during manager transitions is seen as a way to potentially “reduce portfolio

performance drag,” in the words of one investment decision maker. » Nearly 75% of insurance companies and pensions in the survey use ETFs in their LDI

strategies.

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All text and content of this research report are the exclusive property of Institutional Investor. The research and commentary in this document are intended to highlight results, trends, and patterns among respondents in this study. In no event should the content of this report be construed to constitute an investment recommendation or managerial advice.

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Reprinted with permission of Institutional Investor, January, 2021. The opinions expressed in this reprint are intended to provide insight or education and are not intended as individual investment advice. We do not represent that this information is accurate and complete, and it should not be relied upon as such.

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Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

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Transactions in shares of ETFs will result in brokerage commissions and will generate tax consequences. All regulated investment companies are obliged to distribute portfolio gains to shareholders. Diversification and asset allocation may not protect against market risk or loss of principal.

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