ETFs being used to get foot into institutional doors

Like the exchange-traded fund, a tool at the core of their strategies, a contingent of money managers is looking to needle into institutional advisory and investment consulting.

Bundled by Morningstar Inc. and others into the catch-all grouping of “ETF managed portfolios,” such firms collectively manage at least $63 billion, mostly for retail and advisory clients, although the true figure for those using ETFs at the core in the U.S. could be twice that.

“The value propositions of these managers can range from alpha generation to a total portfolio solution,” said Morningstar ETF managed portfolio strategist Andrew Gogerty in Chicago.

Morningstar defines an ETF managed portfolio as a separate account strategy in which at least 50% of the assets held are U.S.-listed exchange-traded products. Strategies vary by geography, asset type and implementation. What's missing, however, is the traditional asset class style box associated with many large pension fund and endowment manager searches.

“Some view what we offer and say "this is a retail product,' but I'd say they're a bit behind the curve,” said Robert G. Smith, co-founder of Sage Advisory Services in Austin, Texas.

Sage Advisory, which has more than $10 billion in assets under management, offers fixed-income, tactical ETF and liability-driven strategies, to a mostly institutional client base. At the end of 2012, according to Morningstar, $2 billion was held in ETF portfolios.

The $28.4 billion Arizona State Retirement System, Phoenix, recently made a splash in the ETF world when it revealed that is was the anchor investor in three recently launched iShares products. But the pension fund previously had shown its willingness to explore larger ETF-based options when it allocated nearly 20% or $500 million of its tactical portfolio to Boston-based Windham Capital Management LLC in September 2011. Bridgewater Associates LP, Westport, Conn., makes up the rest.

“The relationship is still early, but it's not so much about the ETF,” said Dave Underwood, assistant chief investment officer for the Arizona State Retirement System. “It's about the manager. The vehicle is incidental.”

Windham also recently announced a $250 million win from the $10.8 billion, Portland-based Maine Public Employees Retirement System.

“We see Windham as a strategic partner in how we approach risk across the portfolio,” said Andrew Sawyer, chief investment officer of MainePERS. “ETFs are their approach and they've spent a lot of time understanding the tradability,” Mr. Sawyer added.

“The ETF is not always the best solution, but they are very good vehicles, cost efficient and tradable,” said Windham Chief Investment Officer Lucas Turton.

Michel Del Buono, chief strategist for Makena Capital Management in Menlo Park, Calif., cautions that for institutional investors with long time horizons, ETFs do not provide access to attractive assets with liquidity constraints, such as private equity. Makena manages more than $15 billion for endowments, foundations and family offices, among other large institutional clients, and will use swaps and futures for specific strategies where ETFs might be more expensive.

“For institutional investors seeking global diversification, many desired investment exposures, such as small- and midcap opportunities in targeted emerging markets, cannot be achieved via ETFs today,” said Mr. Del Buono.

“Managers have found an efficient vehicle for implementing a strategy, but having a product is not enough. There has to be a demonstrated advantage in a sustainable way,” said Kelly Cliff, head of public market manager evaluation for Callan Associates in San Francisco. For ETFs broadly, however, Mr. Cliff said that some in the institutional market are concerned about the ready availability and liquidity that is being translated through ETFs to traditionally less liquid asset classes, such as precious metals and commodities.

While most ETF-managed portfolios also feature individual stocks, bonds and other securities, the increasing size and liquidity, and decreasing price, of large pure-beta ETFs has availed them to larger and larger investors as part of a core holding. According to New York-based ETF research and advisory firm XTF Inc., 207 of 1,462 U.S.-listed exchange-traded products had greater than $1 billion in assets and 109 averaged more than 1 million shares traded per day as of May 15.

The increase in the use and liquidity of ETFs is also raising the viability of once-small money management firms to increase their appetite for larger clients. “We're seeing these firms grow into larger asset managers,” said Kevin Quigg, global head of ETF strategy and consulting for State Street Global Advisors in New York. “And discussions about how to scale are part of the growing pains.”

Erik Knutzen, chief investment officer at NEPC LLC, in Cambridge, Mass., said his firm applies the same standards to any institutional investment strategy, including assessing the infrastructure at the manager and their ability to work with institutional clients.

It's no surprise, then, that the largest of these firms have begun sharing ideas and tactics for business expansion and client development in internal forums. Elsewhere, fund sponsors State Street Global Advisors and PowerShares, a unit of Invesco, have coordinated sessions specifically for ETF strategists. BlackRock Inc.'s iShares recently held a two-day event in New York just for third-party managers. There, BlackRock and research firm kasina, New York, presented data revealing that average pricing was just less than 50 basis points for direct business at the largest managers.

Of the firms submitting strategies to Morningstar's database, Boston's Windhaven Investment Management Inc., is the largest with $13.6 billion in assets under management at the end of 2012. F-Squared Investments of Newton, Mass., with $9.2 billion, and Chicago's Good Harbor Financial, at $3.8 billion, follow.

Alec Papazian, senior analyst at Cerulli Associates, Boston, believes that these managers and strategists have fertile ground to expand through retail and wirehouse platforms and, thus, have concentrated less on institutional clients. But Michael Jones, chairman and chief investment officer of RiverFront Investment Group in Richmond, Va., said his firm has been successful in sourcing corporate and non-profit relationships through units of large financial institutions. RiverFront manages $3.7 billion in assets.

Keith Goddard, CEO of Capital Advisors Inc., Tulsa, Okla., said that he prefers to work directly with the investment committee of local endowments and foundations, often responding to an RFP when referred by a high-net-worth client. While Capital Advisors is working under the radar of traditional consultants to larger pension funds or retirement plans, Mr. Goddard estimates that such institutional clients represent 10% of his firm's clients but 40% of the $1.2 billion in assets under management across seven different strategies.

“We design portfolios with a core allocation to equities and fixed income, but then we add tactical strategies using ETFs to complement the core with uncorrelated return streams,” he said. In his opinion, tactical ETF strategies can deliver similar diversification benefits to those offered by hedge funds at a much lower cost to the client.

“These managers definitely have the ability to occupy some portion of a large institutional portfolio,” said Morningstar's Mr. Gogerty. “An outsourced CIO model for asset allocation could even apply.”