Trends in institutional ETF investing
We see several main trends in the institutional use of ETFs – including both new and traditional ETF strategies – that are also evident in the results of our Global ETF Study 2020. Below we discuss each of these trends and offer some case studies to illustrate how institutions are integrating ETFs into their thought processes and portfolios.
1. Increased use of fixed income ETFs
In the US, equities still dominate ETF allocations with a 68% market share. But fixed income is poised to catch up: almost 80% of the investors surveyed indicated that an expansion of the fixed income ETF product range would help spur the growth of fixed income ETFs.
Active management is a key driver of fixed income ETF growth. And, investors are immediately benefitting because they can efficiently and quickly adjust portfolio exposures to adapt to changing interest rate or macroeconomic environments, while maintaining the risk management and potential alpha benefits of active management.
What’s important for investors to think through, is in which areas of the portfolio does it pay to be truly active and benefit from the full discretion of a portfolio manager – and in which areas is it helpful to have some oversight on underlying credits, but with minimal tracking error to the benchmark. We have a case study for each scenario below, where fixed income ETFs provided practical solutions in institutional portfolios.
Case study 1A: Gaining access to non-core fixed income sectors
Challenge: Plans or insurers with extra risk budget may not have the capabilities to gain broad, diversified access to inefficient, less liquid non-core or extended fixed income sectors.
Solution: Actively managed ETF for high yield or emerging market debt but with relatively low tracking error to the benchmark. [JPHY]
- Even a modest level of security selection in these sectors can improve risk management and alpha generation potential versus the index
- Same flexibility as a passive ETF to allow fine-tuning of an extended sector weighting, depending on macro conditions, which can be important for extended sector allocations
- Potential for alpha and lower drawdowns
- In some cases, expense ratios of active ETFs are actually notably lower than passive options
Flexibility of a passive ETF with alpha potential
Case study 1B: Managing longer-term cash
Challenge: Cash yields little in the current zero interest-rate environment but the opportunity cost is expensive and resource-intensive.
Solution: Use an actively managed ultra-short duration ETF. [JPST]
- Move out the curve and take on a bit more risk to get 30-40 bps higher yield than a prime money market fund
- Move money down the curve to significantly shorten duration compared to corporates or longer-term Treasuries while maintaining an attractive yield
- Flexibility with intra-day liquidity up to $300 million
- Active management focused on reducing drawdowns
Efficiently manage cash positions to earn extra yield without a big increase in duration risk
2. Importance of low fees and flexibility
Even as the evolution in ETF products creates new uses for institutions, over 60% of US investors in our survey still ranked the low investment cost of ETFs as the most-valued attribute, followed by liquidity and ease of trading (39%). The trends were even clearer among global institutions with over $20 billion in assets: 65% valued the low costs and 43% the ease of trading and liquidity.
In our view, these results mean that institutions will likely continue to find uses for all types of ETFs, from basic passive exposure to more targeted active options, depending on the situation. An increasing array of fixed income and even alternative options means that investors can now create equity, fixed income or multi-asset strategies using ETFs.
No matter which asset class or type of ETF, institutional investors are still looking to ETFs to holistically help lower investment costs; this can be achieved directly through lower fees as well as through other factors that impact overall costs, such as liquidity, flexibility and the ease of trading and managing positions.
Case study 2: Managing liquidity while maintaining exposure and managing costs
Challenge: How can a plan meet its liquidity needs without losing exposure and adding additional expense or complexity?
- Prevent unwanted tracking error
- Maintain exposure to fixed income sectors when cash is yielding virtually nothing
- Efficient implementation with a handful of ETFs and managed by the internal staff
- Minimize unnecessary transaction costs and operational challenges by not having to sell out of active positions
A 5-10% carve out can be invested in ETFs that mirror the portfolio allocation
3. Efficient access to factors
In the US, almost 40% of ETF allocations are already invested in smart beta or active ETFs, up from 20% three years ago. Survey participants expect that within three years, almost half (45%) of ETF assets will be allocated to non-passive strategies.
Factor-based ETFs look likely to remain one of the fastest-growing types of ETFs in the US, with our survey showing that 43% of participants expect strong growth in the next 2-3 years. Like active strategies, factor-based strategies have the potential to “do better” than the index, whether by seeking to reduce risk and/or generate modest alpha by investing in more targeted exposure than a broad index can offer.
Case study 3: Managing factor exposures in a rapidly changing economic environment
Challenge: The current level of macroeconomic uncertainty creates a volatile environment. Many investors want to remain in equity allocations but would prefer to have a higher quality bias.
Solution: A factor-based strategy can screen for metrics indicative of higher quality such as strong earnings and cash flow, low leverage and high interest coverage, and earnings quality. [JQUA]
- Ability to express a view, such as a quality bias, without incurring significant tracking error
- Benefit from stock selection but maintain index sector weightings, limiting tracking error
- Improve risk management
- Little incremental cost over passive ETFs
Similar sector exposure to the Russell 1000 with a meaningful quality bias
4. Growth of ESG ETFs
Institutional investors and asset managers alike are increasingly considering sustainability and environmental, social and governance (ESG) factors in their investment strategies for a variety of reasons including client demand, a desire to invest responsibly and regulation.
Accordingly, our survey shows that ESG is likely to be more prominent in the ETF universe as well. Over 40% of US investors believe that ESG ETFs will see strong growth in the next 2-3 years but the number jumps to 59% globally and rises further to 72% for institutions with over $20 billion in assets. Furthermore, 45% of the US survey participants and 51% globally believe the increase in demand for sustainable and ESG investment strategies is impacting the growth of the ETF market.
As institutions face increasing pressure to align their portfolios with sustainable and ESG principles, ESG ETFs may prove to be practical alternatives. Indeed, the survey results showed that 53% of US investors and 58% of global investors feel that one of the most suitable uses for active ETFs is to gain exposure to specific investment criteria, such as ESG; this trend is even more pronounced (66%) among institutions with over $20 billion in assets.
Case study 4: Improve your carbon footprint by investing in a large-cap, carbon-aware ETF
Challenge: Plans are increasingly acknowledging that climate change presents both risks and opportunities for companies and investors. How do they make an impact without sacrificing returns or taking on too much tracking error?
Solution: A carbon-aware strategy that screens companies on emissions, resource management and risk management, while also managing tracking error to roughly 1%. [JCTR]
- Lower carbon intensity – at least a 30% reduction vs. the Russell 1000 Index
- At least 7% year-over-year self-de-carbonization
- Accessed in a liquid, cost-effective vehicle that aims to manage the opportunity cost (tracking error)
Choosing the right ETF and provider
With so many choices of products, strategies and providers, it is important for institutional investors to consider several factors, especially as ETFs become more sophisticated and more akin to traditional active strategies.
- Total costs: Carefully consider the full cost of ETF investing, which includes the total expense ratio, transaction costs and taxes. Costs can vary so significantly across products and providers that some active ETFs cost the same – or less – than their passive equivalents.
- Liquidity: The number one rule for ETF liquidity is that ETFs are as liquid as their underlying securities – regardless of the average daily trading volume of the ETF itself. Know what you own: a good active ETF will maintain exposure to liquid and tradeable underlying stocks or bonds that enable the issuer to handle large inflows or outflows without major disruptions to the share price.
- Track record and investment philosophy: Choose to invest with a manager you value, that has a history of delivering investment expertise and insights, and that is committed to the ETF market. Identify your ETF investment goals and understand the portfolio manager’s process for selecting securities, constructing portfolios and managing risk.
About the J.P. Morgan Global ETF Study 2020
The study was commissioned by J.P. Morgan Asset Management and carried out by CoreData research in late March to early April 2020. We surveyed 320 professional investors around the world, with average assets under management of $31.8 billion. The respondents represent a broad range of investors, from independent wealth managers and discretionary fund managers to private banks, fund of funds and insurance companies.