Research recently published by Greenwich Associates revealed that allocations to ETFs in Europe increased by 50% in 2018 and now total 15% of total assets among 127 institutional ETF investors surveyed by the research firm.
These included 46 institutional funds, 48 asset managers, 14 insurance companies and 19 discretionary wealth managers.
Andrew McCollum, managing director at Greenwich Associates, attributes some of this growth to the market volatility at the end of last year.
“Our data suggests that last year’s robust growth in ETF investments by European institutions occurred not in spite of the turbulent conditions but because of them,” he says.
“As institutions repositioned their portfolios to address heightened volatility and risk, they made wide use of ETFs to implement specific modifications. Institutions are utilizing ETFs as both tactical tools and as a strategic, longer-term staple in the portfolio.”
As bond and equity ETFs become more of a portfolio management tool, banks are racing to integrate them into their broader liquidity strategies.
Jay Mann, Citi
“There has been significant growth in passive investment and it would be imprudent to ignore that ETFs are growing the way that they are,” says Jay Mann, head of global fixed income and currencies beta trading at Citi.
“We weren't positioned to provide a fully integrated offering for this two years ago, but are investing heavily in it now: there are only a few banks that are involved in issuance, market making, lending, servicing and indexing, as we are.”
He adds: “We also have a custody and servicing business, so we can deal with the settlement issues.”
Citi now has 50 people working full time on ETFs across all products and asset classes globally.
“We are radically changing the way in which we move risk around,” says Mann.
The $315.8 billion of global inflows into ETFs in 2018 represented the second-biggest year ever, behind only the $467.1 billion recorded in 2017, and more than 50% of US high-yield trading is now taking place in an ETF wrapper.
Europe has traditionally lagged the US in ETF liquidity because 85% of the market is traded over the counter (OTC), while in the US it is all traded on a single exchange. As a result, the US market is more than 50% retail while Europe retail participation is less than 20%.
The market is now simply too big for the banks to ignore.
“We are using ETFs for liquidity,” says Mann. “We are embedding them as part of the execution strategy.
“In order to do this, you have to be able to model the underlying bond prices. ETFs are becoming price-discovery tools. We need to know where markets should be and embedding an ETF is a very effective way to do this.”
The cost of holding an ETF is known. When you are rolling futures, you are at the mercy of the markets and it is unpredictable- Steve Palmer, HSBC
Many banks are looking to emulate the success of Goldman Sachs, which grew the volume of credit portfolio trades it executes using ETFs from $7 billion in 2017 to around $30 billion by Q4 2018.
ETFs enable authorized participants to price a basket of bonds for portfolio trades.
This is certainly a business that Citi is targeting.
“More and more clients are doing portfolio trading with us and this will be a growing market,” Mann says. “For OTC securities, you can get 85% of the portfolio through MarketAxess and Tradeweb, but you then have 15% tail – and you can’t get these bonds.
“With portfolio trading you pay a bit more, but that 15% becomes the dealer’s problem.”
As ETFs become more liquid, they also become cheaper.
“As we see the ETF product mature, liquidity in the sector is increasing and efficiencies are driving down the cost of holding the instruments and of execution,” explains Steve Palmer, head of ETF sales and trading at HSBC in London.
“Clients are looking at, and considering, ETFs alongside derivative products. Liquidity is there and the cost is coming down. If, for example, we have a client who is a futures trader, they may now be interested in ETFs because they could offer a cheaper solution than trading a future.”
He adds: “The cost of holding an ETF is known. When you are rolling futures, you are at the mercy of the markets and it is unpredictable.
“Furthermore, there is limited liquidity in certain futures – those that are liquid are hyper-liquid, but many aren’t and you can have a tracking error when attempting to replicate a specific benchmark through liquid futures.”
The Greenwich Associates survey published at the end of February found that ETF investors have about 25% of total assets allocated to index strategies, which is well below optimal levels of 37% for equity portfolios and 34% for fixed income – the gap is the result of legacy portfolio positions.
So, this will be another driver of ETF use.
Eighty-four per cent of participants said that ETFs were their preferred index wrapper.
“ETFs tend to be cheap, liquid and track the indices of the markets we’re interested in with low tracking error,” one head of investment risk and portfolio analytics for a UK asset management company told Greenwich Associates.
In the recent volatility, many investors were long corporates hedged with the index, but found that when prices fell the index didn’t move so they ended up losing money on both their long and short positions.
Palmer at HSBC believes that ETFs have now proved themselves.
“An ETF is an instrument that people use to get liquidity and achieve price discovery,” he tells Euromoney. “They do what they were designed to do. You can buy and sell an ETF without having to go to the primary market – you can do it all in secondary.
“A mutual fund becomes a forced seller if it needs to meet redemptions, but the ETF doesn’t have to touch the primary market. Less than 10% of ETF trading ends up in the primary market.”
Citi’s Mann agrees that the liquidity ETFs provide is vital when turbulence hits.
“Pinning concern about outflows and volatility to ETFs is hugely overdone,” he claims. “When people feel that volatility is too high, they aren’t able to price the associated 2,000 bonds [in the vehicle].
“So, in periods of high volatility, investors go for S&P futures, treasuries and ETFs. In periods of volatility, the redemption flow for ETFs actually goes down. The liquidity is better in the ETF than in the underlying bonds.”