ETFs open doors to other institutional accounts

On the eve of the 20th anniversary of the first U.S. listed exchange-traded fund — the SPDR S&P 500 ETF — both institutional investors and money managers are still hashing out their views on exchange-traded products.

As assets continue to flow into ETPs — $1.4 trillion in the U.S. at the end 2012 and $188 billion in net new flows, the structure has become too difficult to ignore, but the investment decision is still a challenge for large investors comparing ETFs to institutional funds, commingled trusts and separately managed accounts.

“Many ETF providers just haven't done a good job of reaching out to the institutional market,” said Lawrence Petrone, Boston-based head of research at distribution consultant kasina LLC. Of course, the leading ETF providers — BlackRock (BLK) Inc. (BLK), State Street Global Advisors and Vanguard Group — already are there as the largest institutional index managers, each with its own strategy, approach and suite of licensed indexes.

Those off-the-shelf indexes, however, are where a lot of institutional investors get hung up and where ETFs fall short. Even with more than 1,400 ETFs in the market, and many of the largest and most liquid funds benchmarked to broad-based indexes, some argue most ETFs don't fit the more complex needs of a pension fund or endowment.

“We constantly get requests for custom hedges, different currencies, removing countries or sin stocks, for example,” said Ken O'Keeffe, managing director at Russell Investments in New York. From its arsenal of nearly 100,000 indexes, Russell customizes and licenses strategies to pension funds to run internally or externally.

But, running indexed ETF assets can open doors for money managers looking to expand institutional relationships, regardless of structure.

At a recent investment conference, Benjamin Fulton, managing director for Invesco (IVZ) PowerShares, Wheaton, Ill., said the company viewed separate mandates for modified index strategies as complementary to its current work managing equity and debt ETFs. In fact, its ETF management actually opened the door to institutional indexing. At the end of September, Invesco, Atlanta, managed $23.2 billion in passive institutional assets, compared to $94.7 billion for retail passive.

Flexibility, both around investment strategy and product structure, is critical for managers looking to widen their client base.

Adam Patti, chief executive officer at IndexIQ, a Rye Brook, N.Y., realized early on that his firm's hedge fund replication strategies, which use ETFs as their core holdings, might not always be appealing in ETF wrappers.

Mr. Patti said his firm began offering a separately managed account structure for clients such as the $165 million New Haven, Conn., City Employees Retirement Fund and family offices that were looking for slight modifications from an ETF or even a strategy using futures over funds.

“It was clear that in order to scale, we would need to be able to serve different clients with different needs in different structures,” said Mr. Patti. The firm's largest ETF, holding more than 60% of its total ETF-managed assets, is the $314 million IQ Hedge Multi-Strategy Tracker, which attempts to replicate a hedge-fund composite index primarily using ETFs.

That same sentiment is echoed by Pacific Investment Management Co., Newport Beach, Calif., which manages $9.2 billion in ETF assets as compared with $1.9 trillion firmwide.

PIMCO's move in launching an ETF version of its PIMCO Total Return strategy last March was a very open signal to other managers that ETFs can and should complement institutional offerings.

Northern Trust Global Investments, the fourth largest institutional index manager, re-entered the ETF market in 2011 with a similar plan. After liquidating 17 international equity ETFs in January 2009, Northern Trust made an effort in its FlexShares business to consider products most appropriate for its private client and institutional customer base, as opposed to simply filling holes in the market based on available or widely used indexes.

While this latest attempt is still rolling out, two FlexShares ETFs — Global Upstream Natural Resources Fund and iBoxx 3-Year Target Duration TIPS Index Fund — have each topped $800 million in assets since their September 2011 launch. The company now manages $2 billion in ETF assets.

The swagger of such recent entrants and the ongoing market dominance of the big three are setting up a challenging dynamic for the traditional fund firms and managers, such as Fidelity Investments or T. Rowe Price Group Inc., readying their own run at the ETF market.

Fidelity and T. Rowe will need to approach new and existing institutional clients with unique ETF-centric solutions - not just ETFs alone.

This article originally appeared in the January 21, 2013 print issue as, "ETFs open doors to other institutional accounts".