Since the dawn of the exchange-traded funds (ETF) industry in the United States, the institutional investor community has used this highly liquid product to fulfill its investment and portfolio management purposes. Today, the use of ETFs has expanded, and the sector now includes many asset and product types that are being welcomed by various investors for all kinds of investment goals.
ETFs are investment funds that are composed of a basket of securities that typically track an index and trade on stock exchanges on a daily basis. Their price fluctuates throughout the day as they are bought and sold but typically remains close to their net asset value. Sales of shares of ETFs are usually done in large blocks of tens of thousands for authorized participants, but many investors can buy just one share of an ETF at a time.
State Street Global Advisors created the first ETF, called SPDR S&P 500 (SPY), in January, 1993. The fund corresponds to the price and yield performance of the Standard & Poor's (S&P) 500 Index. The industry assumption at the nascence of the market was that ETFs would have a fairly narrow usage, primarily as a way for investors to buy or sell the S&P 500, or as a cash equitization vehicle for institutional investors.
Throughout the last decade, the ETF market has provided a significant value to institutional investors' portfolios, and many investors are now looking to increase their exposure to the sector. While the total percentage of institutional investors' assets allocated to ETFs remains small, the amount invested is growing.
About 14% of U.S. institutions currently use ETFs in their portfolios, according to the results of a Greenwich Associates 2011 U.S. Investment Management Study that was sponsored by iShares. Among those current ETF users, 40% of institutional funds and one-third of investment managers expect to increase allocations to ETFs in the next 12 months, while just 22% of institutional funds and 14% of asset managers plan to trim ETF allocations. "While the share of institutions using ETFs was stable from 2011–2012, the results of the more recent ETF study suggest that institutional allocations to ETFs will increase to at least some extent in the coming year as investors find new ways of employing them in their portfolios," said Greenwich Associates' consultant Andrew McCollum in the report. Greenwich Associates provides consulting and research-based strategy management in institutional financial services.
The study reports that a large number of institutional investors use ETFs for cash equitization and manager transitions and the study notes new uses.
The financial crisis of 2008 rattled financial markets around the world, and the exchange traded fund (ETF) market was no exception. But while many assets traded downward during this time, inflows into the ETF market rose as investors ran to safer bets. In fact, during the last five years, ETFs have experienced more than $100 billion in positive inflows, with the highest increase of inflows being in 2008. That year, the U.S. ETF market saw $161 billion in net inflows, according to Robert Trumbull, Vice President of State Street Global Advisors and an Institutional ETF Specialist with the ETF Strategy & Consulting Group. "Investors were focused on what was in their control and factors such as liquidity, transparency, and cost efficiency, which led them to ETFs," he said.
WisdomTree, which offers 48 ETFs, actually saw its business increase at that time while the overall financial markets experienced a downturn. In 2008 alone, during the worst part of the financial crisis, WisdomTree still took some $900 million of new money into its ETF funds, $600 million of which was in equities, said Jonathan Steinberg, CEO of WisdomTree. "It's not because ETFs did anything other than what they were expected to do, but it was the shortcomings of the other structures that have driven investors to use ETFs more fully since the financial crisis," he said.
Institutional investors who were once using ETFs solely for transitions or rebalancing are now using them for increasingly strategic purposes with longer holding periods. The results of a study by Greenwich Associates, which came out in May, 2012, show that 57% of institutional ETF users now employ ETFs to achieve strategic allocation ranges. "Many institutions consider strategic applications to include liquidity overlays or longer-term overweights, perhaps to an asset class or a single country, especially if the security is held for more than 12 months," said Jennifer Litwin, a senior director at Greenwich Associates, in the report. Approximately 20% of institutional funds using ETFs in 2012 say they use ETFs for tactical purposes to achieve alpha, as do 38% of asset managers who employ these products, according to the report.
The lower costs associated with investing in ETFs continue to be a big draw for many investors. As investment vehicles, ETFs tend to be a much cheaper alternative to investing in some hedge funds and managed accounts. "It all rests within your brokerage account and on the Exchange, so it is a little cheaper for the ETF sponsor to manage their business because we don't have the shareholder customer-servicing component," said Jonathan Steinberg, CEO of WisdomTree, a publicly traded asset manager exclusively focused on the ETF industry. This has allowed for lower management fees.
One of the latest trends taking place in the ETF industry has been the growth of actively managed ETFs. "Today ETFs are competing in virtually every strategy, so you really do have all of the tools you need to do your most sophisticated active allocations using only ETFs," said Jonathan Steinberg, CEO of WisdomTree, a publicly traded asset manager exclusively focused on the ETF industry. "We've actually hit a critical mass in the industry, which allows us to start to really compete for everything," he noted.
The difficulty with any kind of active style of management is the need for the manager to make up for the higher expense ratios of the sales charges and the taxes involved in the buying and selling of the investment. "But from an execution standpoint, it's now possible to build an active ETF allocation model that can also be competitive in the marketplace," said Steinberg. In fact, "actively managed ETFs tend to be cheaper and more tax efficient than many actively managed mutual funds, when trying to beat the market, which has given ETFs an advantage," he noted.
One issue that has come up with regard to actively managed funds is that as ETF managers are given more latitude in their investment style, regulators are raising some concerns. They want to know how the fund managers are keeping their investors informed about their funds' holdings.
Over the last four or five years, many exchange-traded fund (ETF) providers have been developing and making use of newly developed indexes that focus on dividend-paying stocks. As such, more ETF providers are able to offer clients an even more diverse range of ETFs that invest in dividend-paying stocks. "There's only so many ways you can have an S&P 500 index fund, but if you're having one that's tracking an index specifically targeting dividend-paying stocks, it opens up a couple different ways you can do it, noted John Hyland, Chief Investment Officer of the United States Commodity Funds. "You could have an ETF that just buys the highest dividend-yielding stocks, and that has some sort of minimum threshold of balance sheet strength," Hyland explained. "Or you can go after ETFs where maybe the current absolute level of dividends is lower for a group of companies, but those companies were chosen because they have the longest track record of steadily raising dividends," he said.
The total dividends paid to shareholders by US corporations set a new all-time high recently this year, at over $300 billion. The previous peak, before the financial crisis hit, in November, 2007, was just under that at $288 billion in dividends, noted Jeremy Schwartz, Head of Research, at WisdomTree, a publicly traded asset manager, exclusively focused on the ETF industry.
Regulatory issues remain very much on the minds of investors these days, and the exchange-traded fund (ETF) industry is no exception when it comes to questions being raised about the need for more oversight. Many in the industry have been looking at the Dodd–Frank Wall Street Reform and Consumer Protection Act, which was signed into law on July 21, 2010 and may impact the rules and regulations surrounding the ETFs going forward. ‘For now, however, any real affects of the law on the sector remain to be seen, as much of the Dodd Frank provisions have yet to be spelled out clearly, in terms of how they're going to work," noted John Hyland, Chief Investment Officer of the United States Commodity Funds. Hyland is also the co-founder and Chairman of the recently created National Exchange Traded Funds Association, (NETFA) the first ever ETF industry trade group.
NETFA has recently been spending much time reviewing the Volker Rule, which is a specific section of the Dodd–Frank Act, designed to restrict some United States banks from making certain kinds of speculative investments that do not benefit their customers. "We've been discussing whether or not the Volker rule will impact trading in ETFs, and if so, to what extent, and will it be a negative or a positive," said Hyland. "So far, trading in ETFs does not appear to be one of those sectors where proprietary trading by big banks are an essential part, or a dominant part, of the market making, but the jury on that is still out," Hyland stated.