ETF Adoption Driven by Goals Investing

Interest in specific investment outcomes is likely to drive continued institutional exchange-traded fund (ETF) adoption, according to Cerulli Associates.

Investment managers that take the approach of acting as a tactical manager and show institutions various ways that they can incorporate ETFs into their asset-allocation models are seeing the most demand from institutional plan sponsors, the research suggests. One ETF strategist with whom Cerulli spoke stated smaller-sized corporate defined benefit (DB) plans appear to be especially interested in strategic ETF investing—usually because these plans may not be large enough for an efficient separate account structure.

The Cerulli analysis, presented within the July issue of “The Cerulli Edge – U.S. Monthly Product Trends,” suggests that ETFs may be poised for a “second act,” in which the vehicles are used to build complete investing solutions. Today the products are more often used as individual building blocks to complement mutual fund-dominated portfolios, the analysis shows.

“This view makes sense because the dominant ETF sponsors—BlackRock, SSgA and Vanguard—have covered just about every imaginable index and market sector in an arms race of fee competition,” Cerulli researchers say. “Future innovation, and future growth, will not come from these core building blocks.”

Another ETF provider told Cerulli that institutional use of so-called “smart beta” or “strategic beta” strategies will be a key driver of institutional asset management mandates over the next three years and that exposure will likely come increasingly via ETFs (see “Institutions Like Smart Beta”). As Cerulli explains, strategic beta strategies are a hybrid between passive and active management whereby the investor is targeting new market exposures via different risk factors such as size, momentum, volatility and many others.

Although still a relatively small portion of overall ETF assets, at $360 billion as of June 2014, strategic beta ETFs garnered about $20 billion in net inflows year-to-date in 2014, according to the most recent data available from Morningstar. There are 342 strategic beta ETFs in the market today, Cerulli says, up from none 10 years ago. Much of the assets in existing solutions-based ETFs are found in non-market-cap-weighted ETFs—i.e. those taking a strategic beta approach.

The analysis also reveals that institutional investors employ ETFs far less than retail investors in general. However, institutions such as endowments and foundations are reported to be significant users of ETFs.

Looking to the wider investment marketplace, both mutual fund and ETF assets continue to grow steadily, at respective rates of 3.1% and 0.9% from May to June 2014, Cerulli says. Taxable bond mutual funds have the highest flows year-to-date and achieved $10.5 billion in June alone. European stock, foreign large blend, and real estate ETF categories gathered the most year-to-date flows as of June, Cerulli says.

Cerulli’s analysis cites BlackRock research predicting the global ETF industry will grow to $3.6 trillion by 2017, partially driven by institutional solutions, as institutional investors look for more efficient fixed-income trading or a cheaper alternative to derivatives such as futures and swaps. As Cerulli observes, the growth in institutional ETF use has occurred over the past few years in concert with the growth in specialized fixed-income ETFs.

More than 70 new fixed-income ETFs launched in the past two years, the analysis shows. After years of low interest rates and the potential for rising rates in the near future, institutions are pursuing risk factor exposures such as shorter duration or credit in fixed-income portfolios. They are also using ETFs to move from long duration to short duration, and from longer term high-yield to floating-rate securities, as well as low-duration ETFs, Cerulli says.

One ETF strategist told Cerulli that they are targeting smaller institutions with tactical ETF portfolios designed to be representative of the institution’s unique business needs. One example is an ETF solution aimed for a smaller corporate pension plan that does not have the resources to do a thorough asset-liability analysis on its own. In another example, in BlackRock’s last investor day presentation, the company cited a case study of a large endowment client seeking to diversify interest rate risk in their fixed-income portfolio while not raising correlation to equities, which would be inconsistent with the client’s objectives.

More information on how to obtain a full copy of “The Cerulli Edge - U.S. Monthly Product Trends” is available here.