ETF providers offer more to gain manager business

Exchange-traded fund providers are broadening their institutional offerings to more niche strategies in hopes their products will be used by money managers in institutional separate accounts and commingled funds.

Among the strategies recently introduced or expected by sources to be introduced in the next few years are those focusing on environmental, social and governance investing, along with expanded offerings in emerging markets, high-yield and alternative fixed-income strategies.

Along with those strategies, sources said there are other ways managers are looking to build the use of their ETFs among institutional investors:

• as a tactical strategy in separate accounts that have high inflows and outflows;
• as a way for liability-driven investment managers to transition assets when pension plan assets reach certain glidepath triggers; and
• as a replacement for futures.

The aim, said Lesley Keefe, executive director, Americas asset management advisory leader, EY, Boston, is not to mimic the offerings of giant ETF providers BlackRock Inc., Vanguard Group Inc. and State Street Global Advisors.

"Anyone not part of the big three, it's all about differentiation." said Martin Kremenstein, senior managing director, head of retirement products and ETFs at Nuveen, New York. Nuveen, which began its ETF business in September 2016, has $450 million in ETF assets.

Ms. Keefe added: "When you think of product proliferation, that's where the growth has been. The big three have dominated, but others are trying to figure out how to get some of that business. That's where product innovation comes in. For ETFs, it's all about an innovative product — currency, geographic, proprietary benchmark, country specific. But whatever kind there is, they have to amass assets quickly. ​ That's what makes or breaks new ETFs. The big three have speed to market, product channels, distribution. The next tier can be successful in building those; but smaller, new firms targeting ETFs, it's much tougher."

ESG, emerging markets and fixed-income ETFs have seen increases both in assets and in the number of products in the past year. According to data from ETFGI LLP, London, ETF and exchange-traded products in ESG strategies totaled 136 as of Jan. 31, a 35% increase from the end of 2016, with total assets of $17.6 billion, up 77%. However, those assets were less than 0.5% of the $5.148 trillion in overall ETF and ETP assets, according to ETFGI.

In emerging markets, ETFGI data as of Jan. 31 show a total of 1,300 products, up 12% from Dec. 31, 2016, but with a combined $502 billion, up 63% from the end of 2016. And in fixed income, there were 1,260 products with a total of $834 billion in assets as of Jan. 31, up 12% and 63%, respectively, from year-end 2016.

And the market for institutional ETF use should flourish in the next few years, according to Darek Wojnar, executive vice president and head of funds and managed accounts at Northern Trust Asset Management, Chicago. According to a January 2017 report by Greenwich Associates, Stamford, Conn., and sponsored by BlackRock, institutional investment in ETFs is expected to grow by $300 billion annually by 2020.

Drivers of that growth, Greenwich said, are more ETF use across a broader set of strategies, investors' liquidity needs and ETFs being used as a substitute for derivative positions. Robert P. Browne, chief investment officer at Northern Trust Corp., Chicago, concurred with Greenwich's assessment.

"Increasingly the norm among managers is to allow ETFs to be used in long-only portfolios," said Mr. Browne. "They're used as another form of liquidity managing and as another form of equitization. There's indirect exposure of pension funds to ETFs." Northern Trust had $16.1 billion in assets in its FlexShares ETFs as of Dec. 31.

The move to more specific investments is an evolution from the early days of institutional ETF use 25 years ago. "Originally, asset managers would only gravitate to the largest and most liquid ETFs," said David Mazza, senior vice president, head of ETF investment strategy, at Oppenheimer Funds, New York. "Now, as the ETF structure has become more standard, we're seeing managers use them for specific exposure to a market or asset class in advance of another investment idea. There's also a lot more focus on the composition of the holdings — sector, industry, market cap and increasingly factor exposure — as opposed to just performance. They're not just tactically trading this; they're getting more cost-effective exposure. They choose ETFs that complement their expertise in specific market or product segments that they might not be as good at."

Oppenheimer had $2.6 billion in assets managed in ETFs as of Feb. 27.

ETFs in niche strategies, particularly derivative ETFs in commodities and currencies, also are being used to fill in the blanks some managers might have in commingled funds or separate accounts, said Mark Brubaker, managing director, head of outsourced CIO solutions, Wilshire Associates Inc., Pittsburgh.

"In niche sectors of the market, they can be used for a small allocation of a fund in certain sectors of the equity market, derivatives, short- and long-term exposures," Mr. Brubaker said. "I have seen some clients averse to using futures. That's where ETFs often are used."

At Wilshire OCIO, "ETFs are used for transitional and tactical reasons, and niche market exposure," Mr. Brubaker said. "Wilshire selects the ETFs to be managed by its OCIO subadvisers, generally for cash-flow purposes."

The expected proliferation of institutional ETF use has spurred new providers to enter the business, including Nuveen. Its NuShares ETF business "is a startup," Mr. Kremenstein said. "You want to have a look at the long-term arc in the institutional business. It focuses your business on long-range strategies as opposed to immediate, hot issues. But you can't get into the institutional business without first having a retail business. You might get lucky with some forward-looking institution, but that's kind of a Hail Mary strategy. No matter how good a manager you are, (institutions) will look at your retail numbers. Scale really does matter when getting into the ETF business."

Mr. Kremenstein said popular institutional strategies "on the whole," have focused on straight beta because of investors' cost concerns. "But there's certainly a lot of interest in ESG strategies, especially from smaller institutional investors, pension funds, endowments. Executing ESG through an ETF is a more efficient way to get exposure," Mr. Kremenstein said.

Firms like Nuveen are tapping their broader expertise and scale in institutional investing to build their ETF business, but others, like Cadence Capital Management LLC, Boston, look to get into the ETF business through partnerships. Cadence, with $4.3 billion in assets under management, all in multifactor equity, announced last month it and Horizons ETFs Management (US) LLC, a subsidiary of Korean money manager Mirae Asset Global Investments Co. Ltd., would co-manage the Horizons Cadence Hedged US Dividend Yield ETF.

Michael Skillman, Cadence CEO, said the agreement with Horizons "helps us get into the ETF business. For Cadence, it's the first step on that path. As we get a track record, we will grow out to institutional investors. We have to walk before we run."

Oppenheimer's Mr. Mazza said marketing ETFs to other institutional managers goes hand in hand with marketing to retail investors. "On the retail side, certainly it's a competitive landscape," Mr. Mazza said. "But as we have developed new strategies, we've purposely offered products that will appeal to both the institutional and retail market. We want to offer solutions to both asset bases. The best ETFs are owned both by institutional and retail investors, with tight spreads and robust trading."

In terms of the competition in the institutional ETF market, Mr. Mazza said "Winners and losers will emerge, and that's slowly beginning to happen. The industry used to be solely dominated by market cap-weighted products. The only differentiation was price. But with fixed income or smart beta, for example, there's a much greater need for precision. Institutional investors won't just say, 'Give us the cheapest one.' We'll see new firms enter the space."