Based on quarter-end and annual filings, many of the largest (and smallest) pension funds in the U.S. would appear to have largely ignored the $1.6 trillion exchange-traded product market. Only a handful of ETPs consistently show up as long-term holdings, from quarter to quarter.
Yet, according to analysis by London-based ETFGI LLP, institutions held at least 51% of the total value of U.S. listed exchange-traded products at the end of 2012. The firm estimates that use of exchange-traded funds, specifically, is closer to 60%.
Identifying the specific products and scenarios by which pension funds, endowments and foundations participate in this market, however, is based much more on word-of-mouth than public holdings data. How much room is there for these institutions to use exchange-traded products for their core exposures? Perhaps more than the filings let on.
“Institutions of all sizes can benefit from using ETPs, both as core exposures and as a way to round out edges and rebalance,” said Jeffrey Blazek, Dallas-based managing director for Cambridge Associates and a former portfolio manager for the Teacher Retirement System of Texas, Austin. Mr. Blazek has observed some midsize institutions (from $300 million to $1 billion in assets)“ willing to have more static allocations,” adding that smaller institutions may use ETPs for ease of implementation.
“The primary determinants are the holding period and the size of the position,” said Daniel Gamba, head of Americas institutional iShares business at BlackRock Inc., in New York. And, while the size of the pension fund itself ultimately may be inconsequential, Cambridge Associates' Mr. Blazek has observed larger institutions gravitating toward international developed and emerging market ETPs specifically for exposures during manager transitions.
“Very often, the questions for a pension fund around ETPs are more about their own operations,” said Mr. Gamba. “Do they trade securities and are they looking to beat an index?”
Mr. Blazek also said the noise of daily tracking differences could be a minor nuisance at the board-reporting level with investment managers being asked to explain issues around market price, fair value and the index level, particularly for international products. “In months where there may be a lot of intraday volatility, there can be artificially high tracking error on monthly reporting,” he said. “A NAV-based approach to reporting would smooth this.”
“Over longer periods of time, this "noise' goes away as a meaningful issue,” said Mr. Blazek, “but it could be a significant contributor or detractor to relative performance in a shorter time period, depending on the size of the exposure.”
In such cases, he said, the discrepancy should be explained to the investment committee.
For the largest investors, with holding periods in the decades, separate accounts and institutional mutual funds are often the most cost effective investment vehicles, while ETPs are used primarily for transitions, cash equitization and tactical moves.
Larry Petrone, Boston-based director of research for kasina LLC, a New York-based asset management consulting firm, said he is seeing institutions use leveraged and short ETPs to “ramp up or ramp down” when trading the underlying holdings might take several days.
While total cost of ownership — expense ratio, trading cost, market impact — come in to play when comparing ETPs against other investments, the value of on-exchange, intraday liquidity afforded by ETPs is often the hardest to quantify.
ETP investors can attempt to measure the value of liquidity by looking at trading spreads for the underlying assets relative to the collective vehicle. The most widely traded and efficient ETPs tend to trade within what is known as the “arbitrage band” or the spread around the ETP's net asset value in which an investor is still better off buying the product relative to buying all of the underlying securities.
“In certain areas of the market, particularly fixed income, some institutions believe that the ETPs are not large enough for them,” said Reginald M. Browne, ETF group senior managing director at Cantor Fitzgerald in New York. “They want to deploy $25 million to $100 million in a single trade.”
With fixed income accounting for 15% of the U.S. ETP market, brokers and market makers can work with clients for almost any size trade. Transition trades also are becoming common as bond market liquidity concerns increase. Here, an institution exchanges individual bonds en masse for shares of the ETF.
Outside of transitions, several other factors should be considered in any institutional ETP trade, said Mr. Browne. Intraday market volatility, liquidity of the ETP and the underlying securities currency exposure for international securities and market impact should be considered before a trade is placed.
