Through November, investors put $86 billion of new money into fixed-income ETFs in 2016, even as many industry observers, including CFRA, expect the Federal Reserve to resume raising interest rates in December.
One reason is that large institutional investors are increasingly using ETFs instead of individual bonds, and a recent survey gives us comfort that further adoption will persist. As this occurs, investors large and small benefit from the enhanced liquidity.
Greenwich Associates recently completed a survey of 104 U.S. institutional investors, including insurance companies, pension funds, endowments and registered investment advisors, about their use and perceptions of fixed-income ETFs. The average size of the firms surveyed was $60 billion in assets under management.
Why Institutional ETF Usage Is Growing
According to Greenwich, post-financial-crisis rules have increased capital costs for banks, causing many fixed-income dealers to respond by slashing inventories and pulling back from their traditional role as providers of secondary market liquidity.
Indeed, 97% of institutions in the study said increased difficulties in bond liquidity have forced them to consider other vehicles, such as ETFs or derivatives, instead of individual bonds to gain exposure. Overall, 30% said they would consider replacing individual bond positions with bond ETFs in the next year.
Based on a separate recently published global institutional investor study, Scott Couto, president of Fidelity Institutional Asset Management, said that "institutions are increasingly managing their portfolios in a more dynamic manner, which means they are making more investment decisions today than they have in the past."
Adjusting Credit Quality With ETFs
In the Greenwich study, approximately 40% of institutions plan to adjust their credit quality in the next year, and nearly 60% would consider using an ETF for implementation.
For example, investors might use the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) to gain access to greater credit risk through an ETF focused on bonds rated BB and B, and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) to gain access to less credit risk through an ETF focused on bonds rated A and BBB.
LQD has been one of the more popular fixed-income ETFs, regardless of style, in the first 11 months of 2016.
|Ticker||Fund||Issuer||YTD 2016 |
|SPY||SPDR S&P 500 ETF Trust||SSGA||11,556.00|
|AGG||iShares Core U.S. Aggregate Bond ETF||BlackRock||10,856.14|
|IVV||iShares Core S&P 500 ETF||BlackRock||10,516.54|
|VOO||Vanguard S&P 500 Index Fund||Vanguard||10,338.40|
|GLD||SPDR Gold Trust||SSGA||9,614.23|
|VEA||Vanguard FTSE Developed Markets ETF||Vanguard||8,942.43|
|TIP||iShares TIPS Bond ETF||BlackRock||6,743.37|
|IEMG||iShares Core MSCI Emerging Markets ETF||BlackRock||6,498.14|
|VWO||Vanguard FTSE Emerging Markets ETF||Vanguard||6,320.37|
|LQD||iShares iBoxx $ Investment Grade Corporate Bond ETF||BlackRock||5,076.67|
Source: FactSet Research Systems
Insurance Companies Embracing ETFs
Among the institutional customer segments highlighted by Greenwich, we are most encouraged by the trends at the insurance companies. Almost half the insurance companies in the survey started investing in ETFs in the past two years, and nearly a quarter have been investing in ETFs for 12 months or less. Across both new and existing insurance company ETF investors, approximately 80% increased their use of ETFs over the past three years.
Two-thirds of insurers in the study use ETFs in manager transitions, and about 60% use the funds to make tactical adjustments to their portfolios.
Josh Penzner, head of iShares Fixed Income & Insurance distribution at BlackRock, provided CFRA with a good example of how a property and casualty insurer has used iShares ETFs as part of manager transition.
The insurer takes a small portfolio of bonds it acquired that it wants to send to its third-party manager. Historically, the insurer would give those bonds directly to the manager to potentially sell directly, which could result in high trading costs. Instead, the insurer works with BlackRock to identify index eligible bonds in its portfolio.
The insurer, through the authorized participant, then delivers those bonds to BlackRock in exchange for shares of LQD, HYG or another iShares ETF that is aligned with the portfolio's risk characteristics. Penzner explained that the third-party manager now has greater liquidity and more precise exposure.
Lower Costs To Obtain Income
Penzner also noted that while manager transitions are often the beginning use case for insurers, these institutional investors are increasingly using ETFs to obtain income in a lower-cost manner. He cited the iShares Short Maturity Bond ETF (NEAR) as one beneficiary of this trend.
When asked for the main reasons for investing in fixed-income ETFs by Greenwich, 84% of all institutional investors cited liquidity and low trading costs. A similar percentage cited ease of use, which bodes well for their continued usage.
According to CFRA Research, 62 fixed-income ETFs, across a range of investment styles, trade with a bid/ask spread of $0.03 or less. Besides LQD and HYG, investors can cheaply trade the PowerShares Senior Loan Portfolio (BKLN), the Vanguard Mortgage-Backed Securities Index Fund (VMBS), the SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (BIL) and the VanEck Vectors J.P.
Morgan EM Local Currency Bond ETF (EMLC), among many others. Meanwhile, 40 fixed-income ETFs trade more than 500,000 shares on average daily.
Liquidity & Costs High Concerns
CFRA has ranked fixed-income ETFs since May 2013, conducting holdings-level analysis and ETF-level analysis. In assessing risk, an ETF's credit quality and duration are combined with a liquidity input. In addition, we use cost factors such as the expense ratio and bid/ask spread.
It is no surprise to us that liquidity and cost matter to these institutional investors, given that their trade sizes can be quite large. Nearly one-third (31%) of respondents in the 2016 survey said they made a trade in excess of $50 million, up from only 19% in the 2015 Greenwich survey.
Looking to 2017, we think the future is bright for the fixed-income ETF universe's ability to gather assets, even as rates are likely to climb higher. Two years ago, more than two-thirds of the institutions participating in the Greenwich survey said their internal guidelines limit ETF investments, but this year, that share dropped to just 26%.
As institutional investors increasingly use ETFs to meet their short- and long-term needs, advisors and retail investors will be among the beneficiaries.
At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at firstname.lastname@example.org. Follow him at @ToddCFRA
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