ETPs attractive as overlay for equity portfolios, liquidity

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.

Some large investors, particularly those looking to quickly allocate a specific strategy across multiple accounts at once, have chosen to work with a bank to launch an exchange-traded note. Unlike a traditional structured note or even a total-return swap, ETNs can be created by a bank in conjunction with an asset manager or institutional investor to deliver precise returns in a liquid vehicle. Of course, the counterparty risk of the note issuer remains.

Fisher Investments, which manages $46.5 billion, has worked with UBS AG and Barclays Bank PLC in the last two years on three ETNs with embedded leverage in the note, including the $1.2 billion Barclays ETN+ FI Enhanced Global High Yield ETN and the $900 million Fisher Enhanced Big Cap Growth ETN from UBS Global Asset Management.

“The exchange-traded nature of ETNs allows us to efficiently accommodate inflows and outflows, and they are overall more flexible in this regard than a standard note or swap,” said David Eckerly, group vice president for Fisher in Woodside, Calif. “Unlike most existing "off-the-shelf' ETFs, the leverage factor is not reset daily,” he added.

Ian Merrill, head of Americas ETNs at Barclays in New York, said the firm has seen more reverse inquiries for such ETN+ products recently because of changes in the over-the-counter derivatives market. (Barclays primarily markets ETNs through the iPath brand.)

To allay some of the concern that large institutions have over ETN liquidity, the notes used by Fisher are redeemable in their entirety every valuation day (any trading day) and cash is delivered on the third business day following valuation.