ways.
This book also would not exist if not for some folks in Bloomberg’s media operation, namely, Catherine Cowdery of Bloomberg Radio, as well as the folks over at Bloomberg TV – namely, Ted Fine and Jonah Davis who first let me on the air to talk ETFs. Every Friday for five years now I’ve traveled up to New York City to do a weekly segment on ETFs for radio and TV. This consistent deadline was a huge motivating force for me; it sent me into every nook and cranny of the ETF world. All told, I’ve done over 500 segments, and all of the notes from those deep dives provided a solid resource for me in writing this book – especially in the “toolbox” half of the book.
Like any writer, I have influences. My biggest influences come from my favorite ETF trade publications, starting with Dave Nadig and Matt Hougan of ETF.com. When I was first developing myself as an analyst, their articles and podcasts were a major source of knowledge and inspiration. If ETF analysis has a cutting edge, it’s those guys. I’ve also found enlightenment from fellow ETF analysts such as Todd Shriber, Victor Reklaitis, Chris Dieterich, Brendan Conway, Michael Rawson, Tom Lydon and Deborah Fuhr.
In most of the books I’ve read, the author inevitably apologizes to his family for being so pre-occupied with writing their book. Now I know what they mean. It really does demand a lot of precious time. So to my wife and kids, thank you so much for all your support and patience during this book writing process. Daddy is as happy to be done writing it as you are!
Introduction: Institutions and ETFs
It is widely known that exchange-traded funds (ETFs) have democratized investing by giving the little guy (retail) the same access as the big guy (institutions). While that is very true, the less told story is that many institutions have also turned to ETFs for a wide variety of purposes. While retail investors and the advisors serving them largely see ETFs as a cheaper, more tax-efficient version of a mutual fund, many institutions see them as a versatile, liquid tool to help them deliver exposures within their portfolios.
This book explores how those institutions use ETFs as well as how they – or any investor – can use them better.
Institutions such as pension plans, foundations, endowments, hedge funds, insurance companies, asset managers, and foreign institutions are slowly increasing their usage of ETFs. “Slowly” is the key word here, though, because getting an institution to change its habits is a bit like turning around a battleship, as one endowment manager told me.
“My history with institutions is they are naturally skeptical and they are going to be slow to move. And they will probably leg in. Not too much different than what financial advisors did ten years ago.”
While ETFs tend to easily win in terms of benefits when stacked up against the mutual funds used by retail investors and advisors, it is a different story for folks running pensions or endowments. ETFs are in competition with some of the cheapest and most efficient investment vehicles Wall Street has to offer, such as separately managed accounts, total return swaps, and futures contracts.
When an institution puts money to work, it isn’t $200,000 or even $2 million; it can be $200 million or $2 billion. When you are putting that kind of money to work, the world opens up to you and gives you many more options at insanely cheap prices. In short, institutions get the royal treatment from asset managers and Wall Street banks via a broader array of investment vehicles.
“The goal of any investment vehicle or product is to get you to some type of investment strategy or purpose. Whether or not you have access to a conventional index fund, an institutional separate account, a futures contract or you have a swap desk you can trade with. At the end of the day, you care about what’s my trade-off between the best possible tracking instrument at a cost that you find reasonable. The ETF is a new item in that discussion, but all of those things are on the table.”
So while ETFs have earned a seat at the institutional product table, they are still the new kid on the block and are mostly used in small portions, for very specific needs. At this level, they are typically though not explicitly used more as tools to adjust the portfolio exposures or manage cash or stay liquid. We will explore all of these usages in full.
Many surveys have touted these usages and hyped up how institutions are adopting ETFs right and left. While usage is increasing, the actual percentage of institutions’ assets that hold ETFs is still pretty minuscule, as seen in Table 1.1. Using a collection of sources; I estimate generally that institutions are using ETFs for 1 percent of their assets on average. Of course, when you are talking about a combined $75 trillion or so in assets, that’s nearly a trillion dollars and close to half of total ETF assets (advisors and retail make up the rest). And if that number inches up to even just 4 or 5 percent – which is not that that hard to imagine – that’s trillions of new assets into ETFs.
Table 1.1 Institutional Ownership (Estimated and Generalized) of ETFs
Sources: Pensions & Investments, NAIC, Bloomberg, Towers Watson, HFR, Sovereign Wealth Funds, Blackrock, Deutsche Bank
Historically speaking, institutions have used ETFs only in a limited fashion. Perhaps they bought some of the SPDR S&P 500 Trust (SPY) with some new cash to keep market exposure until they give it to an active manager. Many of them look at ETFs more as a retail product, in the same boat as an index mutual fund. How could some generic emerging markets ETF be better than the hot active manager they just hired who was picked after months of scrutiny by a consultant?
What’s interesting about that is ETFs were originally designed specifically for big institutions in the early 1990s. And until around 2000, those were the only investors that used them. In fact, the first two major issuers – State Street and Barclays – were big institutional managers, and the ETF in some ways was a natural extension of what they were already doing. All that changed when Barclays launched iShares and saw the value of ETFs for retail investors and advisors.
“I think there has been a transition. Initially, it was institutional, and then the advisor market grabbed it. Then about five to six years ago the institutions really began to awaken to ETFs. We’ve come full circle.”
Institutions have a lot at stake and a lot of pressure to deliver performance. This is why, as an outsider like myself, it was baffling to see how dedicated they still are to spending so much money on consultants, active managers, hedge funds, and so on.
It begs the question: why do institutions think they can outperform given the shaky track record and high costs of active management and hedge funds and private equity? Why not just make it easy and keep costs low and stay liquid by using an all-ETF portfolio like some asset managers and advisors now do? Have they ever used ETFs? Which ones and for what purpose? How do they choose them? When does an ETF not make sense? Do ETFs pose a threat to their very existence? These are some of the questions I asked many institutions directly as well as people in the ETF industry. I will share what I learned in the book.
Besides cost and a love of active management, another big reason institutions don’t use ETFs is lack of understanding. In fact, in almost every institutional study and survey I reviewed, initial concerns around ETFs melted away as they learned more about the structure and got some hands-on experience with them.
But what is interesting is most institutions and their consultants apply such rigorous due diligence when picking an active manager, yet barely any when picking an ETF. That’s a big mistake as the difference in returns between similar sounding ETFs can be just as wide as or wider than that of active managers
This
