Institutions snap up increasing share of ETF pie

In the fast-moving world of exchange-traded funds, defined benefit plans, endowments, foundations, hedge funds, mutual fund managers and other institutional investors are becoming a larger — and increasingly sought-after — segment of the investor base.

In fact, in just the last five months of 2010, U.S. institutional investors increased their investments in ETFs by 46% to $512 billion as of Dec. 31, according to Invesco PowerShares' analysis of 13F filing data from FactSet Research Systems Inc., New York.

In an industry that has primarily been the domain of retail investors for the past dozen or so years, the increased use of ETFs (used here to also refer to exchange-traded notes, both of which are known collectively as exchange-traded products) by institutional investors represents a “back-to-the-future” scenario, said Paul Justice, director of ETF research for Morningstar Inc., Chicago.

“Way back in 1993 when the first ETF debuted in the U.S., they were the province of institutional investors. Pension funds used ETFs as a transition management tool to equitize cash they were holding until they could invest the assets with a new money manager or in a new asset class. Back then, hedge fund managers gradually started to use ETFs to short markets,” Mr. Justice said.

“It wasn't until about 2000, when iShares came on the scene and began to educate financial advisers about ETFs that their popularity with retail investors began to rise. Today, the ETF market has a very broad base of users, a useful blend of institutional and retail investors, but it didn't start out that way,” Mr. Justice added.

In fact, the blend Mr. Justice points to is a pretty even mix. Industry sources use a rule of thumb that splits the ETF base by dollars invested 50-50 between institutional and retail investors.

That rough breakdown means institutional investment in ETFs was a hefty $700 billion at year-end 2010, based on the $1.4 trillion invested in 3,503 ETF offerings worldwide, according to research from BlackRock Inc.'s global ETF research and implementation strategy team. BlackRock owns iShares, the largest ETF provider in the world, according to its own ranking.

Sources say it's impossible to get an exact breakdown of the U.S. investor base in the exchange-traded market since shares are traded anonymously on stock exchanges around the world. But experts said analysis of quarterly 13F Securities and Exchange Commission filings from investors holding at least $100 million in U.S. common stocks is one way to look at more precise ownership statistics.

According to an analysis by Wheaton, Ill.-based Invesco PowerShares of fourth-quarter 13F filing data from FactSet, $512 billion invested in ETFs by U.S. institutions as of Dec. 31 represented 51% of the $995 billion of total U.S. ETF assets, and was up 46% from the $352 billion reported as of July 31. The July figure represented 42% of total U.S. ETF industry assets, according to the PowerShares analysis.

Invesco PowerShares and FactSet, BlackRock and other ETF researchers use a liberal interpretation in defining their “institutional investor” universes, including brokers, banks, insurance companies and private banking portfolios in addition to defined benefit plans, endowments and foundations, and money managers.

Brokers remain far and away the largest U.S. ETF investors, with a collective $184 billion invested as of Dec. 31, followed by investment advisers with $127 billion, according to Invesco PowerShares' fourth-quarter analysis of 13F filing data from FactSet.

But Invesco PowerShares' research showed strong growth of 21% to $75 billion in assets in the last five months of 2010 by what some call core institutions — defined benefit plans, endowments, foundations, mutual funds and hedge funds. The largest of these at the end of the year was hedge funds, with $30.3 billion; followed by mutual funds, $29.2 billion; pension funds, $12.1 billion; and foundations/endowments, $2.2 billion.

These institutions are using the exchange-traded market for a variety of reasons, sources said.

Institutional investors, on the other hand, still are using ETFs primarily on the margins to “true up their portfolios in rebalancing and for transition management. The timeframe for ETF use for most pension fund investors generally is very short-term. When they need broad exposure over the long-term, traditional indexed mutual funds and commingled funds are much cheaper and more efficient vehicles,” said Jay Kloepfer, director-capital market research at investment consultant Callan Associates Inc., San Francisco.

“We continue to see very strong interest from pension funds, endowments and foundations in ETFs primarily because they provide the liquidity that many are seeking. Liquidity really has become a governance issue for many pension funds and endowments,“ said Liz Tennican, managing director and head of the institutional sales team for iShares in San Francisco.

In addition to using exchange-traded instruments as transition management tools, Ms. Tennican said pension fund, endowment and foundation clients are beginning to look at ways to use ETFs to add a “liquidity” sleeve to their portfolios.

By placing a portion of their portfolio in ETFs, Ms. Tennican said investors can achieve ample liquidity to make benefit payments, or operating payments in the case of endowments, while still maintaining their target asset allocations.

Ms. Tennican declined to identify iShares institutional clients adopting the liquidity overlay approach or to say how much institutions have invested in iShares' products. iShares had $597 billion globally in assets as of Dec. 31, according to BlackRock's year-end ETF research report.

By contrast, mutual fund, active strategy and hedge fund managers are focused on using exchange-traded products for tactical exposure to certain asset classes, sectors or geographic regions, said Edward McRedmond, senior vice president and head of institutional and portfolio strategies at Invesco PowerShares.

Hedge fund managers in particular are using specialty agriculture and metals ETFs as well as those based on small-capitalization stock indexes. Many are using ETFs based on commodities indexes to capture the “broad commodities beta,” Mr. McRedmond said.

Invesco PowerShares franchise assets were $55 billion as of Dec. 31, making it the fourth largest global ETF provider, according to BlackRock's year-end ETF research report. Mr. McRedmond would not say how much of PowerShares ETF assets came from institutions.

The Vanguard Group of Investment Cos., Malvern, Pa., was the third-largest global provider with $150 billion under management in its family of ETF products, according to BlackRock's year-end ETF research report.

Vanguard's ETF growth has been strong, said Richard “Rick” Genoni, Vanguard principal and head of ETF product management, noting that trading volume in the company's ETFs was up 55% in 2010, compared with -1% for the rest of the industry.

Vanguard's institutional investor client base is growing steadily, Mr. Genoni said. Based on Vanguard's own analysis of 13F filings, 31% of its assets as of Sept. 30 came from institutional investors, vs. 27% as of June 30.

In addition to using them for tactical exposures, hedge fund managers primarily use ETFs as a tool to short market exposure. In fact, 76% of hedge fund managers' gross ETF dollars are in short positions, according to an analysis of third quarter 2010 13F filings in Goldman Sachs Group Inc.'s most recent Hedge Fund Trend Monitor Report.

Part of the reason hedge fund managers use ETFs is sheer necessity, said Stuart Kaiser, a Goldman Sachs analyst. “Hedge funds find it much harder to find short positions than long ones. ETFs are an efficient way to get that exposure.”

“Hedge fund investment in ETFs in dollar terms continues to grow and use is up, especially on the short side,” said James Ross, senior managing director and global head of ETFs at State Street Global Advisors, Boston.

Mr. Ross said SSgA research found that in 2000, just 73 hedge funds were using ETFs, compared with 500 as of year-end 2010.