Institutional investors might have perked up when the Arizona State Retirement System announced this spring that it would be providing hundreds of millions in seed capital to a spate of new exchange-traded funds. While Arizona's announcement was notable, such wholesale funding of exchange-traded products has become increasingly common for large investors and money managers interested in an overlay for their equity portfolio, additional liquidity in bonds and even fixed leverage on a portfolio.
In April, iShares, a unit of New York-based BlackRock Inc., announced the $28.4 billion Arizona State Retirement System, Phoenix, would seed four factor-based ETFs, utilizing MSCI indexes to isolate momentum, size, value and quality stocks factors. Each portfolio launched with more than $100 million, largely funded by an ASRS legacy index portfolio that BlackRock had been managing.
The move offered two signals to the market: that asset owners can work through ETP sponsors and authorized participants for wholesale funding into an ETF; and that a large pension fund was willing to take a flier on seeding a fund with no proven liquidity, showing faith in the creation/redemption process for institutional-size orders.
Of course, the manner in which institutional investors enter a large trade into an ETP depends greatly on how they would prefer to transact. The institutional investor can be long (or short) in an instant by working with a liquidity provider to get a market price. Alternately, they can work directly with an authorized participant, delivering some amount of securities and cash, for a guarantee of net asset value at the close, said David Abner, head of capital markets for WisdomTree Investments, Inc., New York.
When WisdomTree launched its Emerging Markets Local Debt Fund in August 2010, more than $100 million traded on the first day due to a large creation at NAV by an institutional buyer that preferred to participate in the market as opposed to seeding the fund, Mr. Abner said.
“The largest ETF providers now have entire capital markets desks focused on facilitating this process for institutions,” he said.
This has been most telling in the increasing use of bond ETFs by large institutions. For example, the notional creation size for iShares' seven flagship bond ETFs has increased to $60 million to $80 million in the past two years from $40 million to $50 million in the prior four years, according to data analyzed by iShares for Pensions & Investments.
Investors looking to the primary market for ETFs, however, need to consider settlement times and related fees for wholesale creations and redemptions.
“Both the institutional custodian and the ETF sponsor custodian will need to be cognizant that the securities and any cash buffer required for the institution to create shares in an ETF will be exchanged for corresponding value in ETF shares,” said Brian Reilly, vice president for ETF sales at Brown Brothers Harriman & Co. in Boston.
Mr. Reilly added that the institution requesting the creation (or contributing securities in kind) needs to be aware of any cash component and whether the authorized participant creating the shares plans to pass on any related fees and transaction costs related to the ETF share creation.