Institutional investors, including defined benefit (DB) plans, can derive many benefits from owning exchange-traded funds (ETFs), sources say.
Institutions that worry about taxes can benefit from the tax efficiencies that ETFs offer, far more than mutual funds, says Justin Sibears, managing director at Newfound Research in Boston.
But even for institutions that do not worry about taxes, ETFs offer several benefits, Sibears says. “The majority of ETFs track indices, which forces the manager to think about their investment process, apply a systematic set of rules to it—and stick to it,” he says. “Active managers are subject to constant pressures from investors and there is a tendency for them to not be systematic. Even if they give transparency into their process, it takes resources and time for investors to ensure they are sticking to their process. With an ETF, it alleviates that due diligence process.”
Sibears cites their proliferation into so many specific areas of the market as a benefit of ETFs. “There are so many building blocks that have been launched,” he says. “If I want an ETF in fixed income, I can get any duration of Treasuries or corporates. This allows institutions to make asset allocation decisions in a very precise way without worrying about having to trade thousands of fixed income positions.”
A third benefit is their liquidity, Sibears says. “One of the ways we have seen institutions using ETFs is, they may have run their own bond portfolio, but that carries an operational burden. Instead, they can build an ETF portfolio that tries to do what they want to do in the rest of the portfolio and easily get in and out of those positions, thereby using the ETFs as a liquidity buffer.”
Leveraged ETFs are also a good way for pension plans and other institutions to manage risk. “Say the investor wants to take an amount of risk in line with the equity market,” Sibears says. “The easy thing to do is to make the portfolio 100% equities, but that means forgoing the benefits of bonds. Our view is that using leverage responsibly can allow people to not have to make that tradeoff. If I take a 60/40 [60% equities and 40% bonds] portfolio and lever it up to 100% equity and 80% bonds, I am able to get the upside of the equity market while still keeping bonds in the portfolio for diversification purposes. Over longer periods of time, that diversification lowers your risk.”
Additionally, pension plans, foundations and endowments that manage their own assets are starting to lend out ETFs, says George Trapp, global head of securities lending, client relations at Northern Trust in Chicago. “The revenue they generate can vary from 20 basis points up to 100 basis points on an annualized basis,” Trapp says. “It can be pretty lucrative depending on what you hold.”
Investors looking to borrow ETFs look for instruments that are impacted by volatility and demand in the market, Trapp says. “For example, some of the ETFs invested in oil, retail or high yield bonds are the ETFs most in demand in the securities lending marketplace,” he says. “The reason they want to borrow it is because they want to hedge a position they have, like the S&P 500 or a specific sector like oil. This gives them hedge insurance against a downturn in the market.”
ETF securities lending is in its infancy but is poised to grow, Trapp says. “Within the securities lending market, ETFs represent less than 5% of the securities on loan. We have our eye on that space as it grows. It is an important space to watch because of the demand for ETFs,” he says.