Fund Providers Foresee Growth in Bond ETFs

Financial analytics firm Cerulli Associates finds that nearly four in 10 (37.5%) exchange-traded fund (ETF) providers anticipate strong growth for taxable bond asset class ETFs.

Jennifer Muzerall, a senior analyst at Cerulli, explains that many ETF sponsors predict heightened interest from institutional investors—including defined benefit retirement plans—in using fixed-income ETFs over investing in individual bond securities. Their interest is primarily due to the challenges of navigating the fixed-income markets in an unfamiliar and challenging interest rate environment, according to Cerulli.

“While individual investors predominantly favor equity ETFs year-to-date, institutions are interested in taxable bond ETFs,” Muzerall adds.

A recent report from Cerulli, “Exchange-Traded Fund Markets 2014: A Maturing Market with Evolving Opportunities,” analyzes asset managers that manufacture and distribute ETFs in the United States, as well as firms that offer packaged strategies of ETFs. The report finds liquidity in bond markets has started to seize up, making it harder to trade securities at reasonable bid/ask spreads. This is driving many institutional investors towards more liquid fixed-income ETFs, Muzerall explains, adding that institutional investors are using fixed-income ETFs for both strategic and tactical purposes.

“To obtain passive exposures while constructing their core-satellite portfolio, investors may use fixed-income ETFs as changes in recent bond market conditions make it easier for firms to employ one ETF holding versus several hundred individual bond securities,” Muzerall continues.

Cerulli says that ETF providers will be looking for additional opportunities in asset classes of interest for institutional investors. Again, taxable fixed income seems to be a particular area of interest for institutional investors, where the spread on individual securities is high so investors can take advantage of lower spreads on ETFs.

Cerulli’s research suggests the success of an ETF provider can depend on a variety of factors, but investment performance and positive brand recognition were rated as having the highest impact on a provider's success. The vast majority of ETF providers (88%) feel that investment performance is a factor that has a high impact on the firm’s success. Three-quarters (75%) of providers feel that positive brand recognition is also a factor.

One smaller ETF sponsor cited anonymously by Cerulli said that building their brand name was their biggest challenge in winning access to institution investors currently seeking more ETFs. The provider felt they had a fantastic product lineup, Cerulli says, “but it is hard to grow assets because they have no name recognition in the industry.”

As a result, institutional investors can expect greater marketing and prospecting efforts not only on new ETF products, but also on new providers themselves and how their firms can deliver value to investors.

ETF providers are also thinking tactically about how they employ their sales force and ensure that they have appropriate coverage to manage all possible channels of ETF interest. While ETFs are still primarily used by investors in the retail channel, Cerulli says firms are increasingly thinking about staffing coverage to access institutional clients.

According to Cerulli, financial adviser adoption is rated as another main driver of ETF growth. About 82% of ETF providers rate this as a significant driver of growth in the future, Cerulli says. Providers are also very optimistic that there will be an increase of use from institutions, with 71% of providers believing institutional investor adoption will expand. Cerulli says this is a major change from last year, as only 38% of ETF providers surveyed in 2013 thought institutional adoption would be a major driver of future growth.

In addition, 65% of the providers surveyed believe the increased use of “ETF strategist firms” among advisers and institutions will be a major driver of ETF growth. As Cerulli explains, ETF strategists are firms that are managing strategies using mostly or all ETFs for clients. Cerulli’s analysis suggests ETF strategists usually provide models to managed account programs, though some firms actually manage separate accounts. These strategies can be offered in open-end mutual funds as well.

Almost half of ETF providers felt another major driver will be an overall increase in the popularity of passive investing among institutional investors, including retirement plans striving to reduce fees, which will also benefit ETFs. The trend of passive ETFs outpacing index mutual funds is apparent when comparing the net flows of products, Cerulli says, with annual 2013 net flows for index mutual funds amounting to $112 million and passive ETF net flows around $173 million.

Year to date through June, passive ETF net flows are slightly lagging index mutual fund flows, Cerulli says, at $66 million versus $71 million, respectively. The analysis argues this should be viewed as a sign that, rather than drawing assets away from passive mutual funds, ETFs instead seem to be expanding the distribution and adoption of passive investing, especially among institutional investors.

However, Cerulli says ETF providers are not overly optimistic that defined contribution (DC) and 401(k) plans will be part of the institutional growth of ETF assets—at least not yet. Many defined contribution sponsors are still concerned that recordkeeping and other challenges around intraday trading are holding back the potential for ETFs to really take off in the DC space.

Information on how to obtain a full copy of Cerulli’s latest ETF research is here.