ETFs Increasingly Used for Tactical Management

Institutional investors are using exchange-traded funds (ETFs) both tactically and strategically, according to a study from Greenwich Associates.

Across all institutions participating in the study, 58% describe their use of ETFs as generally strategic or long-term in nature, a slight increase from 57% in 2012. In general, Greenwich Associates defines a strategic investment as any asset held for a year or more.

ETFs have proven to be especially effective tools for tactical portfolio management (for example, adding liquidity through an ETF overlay), and ETFs continue to be used widely in this manner. Seventy percent of institutional ETF users employ the funds for tactical portfolio adjustments, up sharply from 48% in 2012.

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“These results clearly demonstrate that the role of ETFs within institutional portfolios is changing,” says Andrew McCollum, Greenwich Associates consultant.

In addition to using ETFs both tactically and strategically, two other trends emerged: the use of these funds at the core of portfolios and an increase in fixed-income ETFs. “More and more investors are using ETFs as the core of their portfolios, and for a longer time,” Daniel Gamba, head of iShares Americas Institutional Business at BlackRock, said during a press event about the survey results.

Using ETFs at the core of portfolios  

Institutional investors’ need for passive exposures as part of core/satellite portfolio models has become a key driver of ETF demand; the most common application for ETFs by institutions is within the core of their portfolios.

Greenwich Associates found that 72% of insurance company users and 67% of pensions, foundations and endowments that use ETFs employ these products to obtain passive exposures in the “core” component of their portfolios. Approximately 80% of registered investment advisers (RIAs) that buy ETFs use  them  for  passive  “core”  exposures,  and  90%  of  investment  consultants  who  advise  their clients to make use of ETFs recommend using these products for passive exposure to complete core/satellite portfolio structures.

“Institutional investors are attracted to the wide variety of exposures combined with the exchange-traded  liquidity  and  transparency  that  ETFs  provide,”  said Sue  Thompson,  BlackRock’s head of RIA and  institutional  asset management  channels.  “As a result, investors recognize ETFs can play an important role in the core of their portfolios.”

Greater use of fixed income  

While nearly 90% of institutions use exchange-traded funds for domestic equities  exposure  and  74%  use  them for  international  equity  portfolios,  the funds are  also  gaining traction in fixed income. Fifty-five percent of institutions invest in domestic fixed-income ETFs. Usage of domestic fixed income is most common among insurance companies at 78%, and 74% of RIAs also employ ETFs in domestic fixed income.

Fixed-income ETFs are increasingly being used by investors to access  liquidity  and  implement  investment  strategies, said  Matthew  Tucker,  head  of  iShares fixed income investment strategy at BlackRock.

According to the study, institutions view liquidity/trading volume as their top priority when selecting or recommending a specific ETF—76% include liquidity/trading volume among the three most important criteria used in picking an ETF.

The Greenwich Associates study, sponsored by BlackRock, interviewed 179 institutional investors that currently use ETFs.

S&P 1500 Pension Funding Levels Slip

S&P 1500 pension plan funding levels slipped 2% in April as a decline in interest rates offset the effect of a stronger equity market, according to Mercer.

After significant improvements during the first quarter of 2013, the pension plans sponsored by S&P 1500 companies suffered a setback during April, with the aggregate deficit increasing by $47 billion during the month, resulting in a $419 billion deficit as of the end of April 2013, according to Mercer. The funded ratio (assets divided by liabilities) fell from 82% to 80%, which is still an improvement over the estimated 74% at December 31, 2012.

Despite continued strengthening in equity markets during the month of April (1.93%), high quality corporate bond rates fell approximately 21 basis points to 3.65%, driving the estimated liabilities up almost 4%.

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“After six straight months of improvements in funded status, April saw a bit of a step back for U.S. pension plans,” said Jonathan Barry, a partner in Mercer’s retirement business. “It’s an important reminder to plan sponsors that these plans can go down just as quickly as they went up.”

Mercer sees a continued interest in plan sponsors moving towards risk management strategies to help reduce the funded status volatility. Plan sponsors also continue to explore various risk management strategies in 2013, ranging from glide path strategies to cash outs and/or annuity purchases for former employees.

In response to the rising interest in risk transfer strategies, Mercer recently launched the Mercer Buyout Index, which allows plan sponsors to evaluate the cost of an annuity buyout against the liability held on the balance sheet, as well as the administrative costs and other expenses involved in holding plan liabilities.

“At the end of March, the index showed that the cost of purchasing annuities for a retiree group was only 10% higher than the accounting liability,” said Leah Evans, a principal in Mercer’s Financial Strategy Group. “However, we estimate the cost to hold these liabilities for a typical plan is about 9% of the balance sheet liability, so a buyout which removes pension volatility risk can be a very attractive option for many sponsors once these cost savings are considered.”

Mercer’s monthly estimates of the aggregate funded status of S&P 1500 plans are based on each company’s year-end statement and on projections to April 30 in line with financial indices. This includes U.S. domestic qualified and non-qualified plans and all non-domestic plans. The estimated aggregate value of pension plan assets of the S&P 1500 companies as of December 31, 2012, was $1.59 trillion, compared with estimated aggregate liabilities of $2.14 trillion. Allowing for changes in financial markets through April 30, changes to the S&P 1500 constituents and newly released financial disclosures, the estimated aggregate assets were $1.71 trillion, compared with the estimated aggregate liabilities of $2.13 trillion.

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