ETFs Make Inroads Among Big Institutions

by on September 22, 2009 | ETFs Mentioned:

ETFs muscled their way into investor portfolios on the strength of their popularity among smaller retail investors, but their next growth spurt might be driven by increasingly widespread acceptance among big investors who recognize the benefits of the exchange-traded structure relative to traditional separate accounts. Thao Hua at Pensions & Investments has an interesting take on the issue, noting that more and more large institutions “prefer the quick access of ETFs compared to a separate account and the added transparency compared to a derivatives approach using, for example, futures.”

According to a recent report from Barclays Global, the number of institutions using ETFs increased 41% around the globe for the period ending September 30, 2008. Major institutional investors with significant holdings in ETFs now include the Teacher Retirement System of Texas, Ohio State Retirement Teachers System, Commonwealth of Pennsylvania Public School Employees’ Retirement System, and the Ontario Municipal Employees Retirement System. Major endowments, including those at Harvard and MIT, have also begun using ETFs with increasing regularity.

While their reduced cost structure makes ETFs ideal for those with a long-term investment focus, ETFs have become popular as efficient means of placing short-term tactical bets among more active traders. Although market volatility has declined significantly in recent months, the turmoil endured over the last two years created numerous short-term inefficiencies that speculators and other short-term investors have sought to exploit. Country-specific emerging market funds offer an efficient way to capitalize on these pricing discrepancies, as do exchange-traded commodity products.

There are some complaints about ETFs: executives note that they typically have higher tracking error than futures, particularly in relatively illiquid markets. But the shrinking expense ratios – the average ETF now charges 0.32%, a drop of 20 basis points from two years ago – are hard to ignore, and in the minds of many outweigh any minor drawbacks.

The increased presence of institutional investors is likely to change the way new ETFs are developed and launched. In previous years, issuers have brought hundreds of funds to market, sometimes without a clear idea of the demand for the product. Now, issuers are responding to demand from institutional investors who are able to make suggestions for exposure not currently available through ETFs. The result will likely be a significant slowdown in new fund launches, but greater investors acceptance and success of funds that do make it to market. The two recent product launches from ETF Securities are an excellent example of this trend: in less than two months, SIVR and SGOL have accumulated over $200 million in assets (in aggregate)

Disclosure: No positions at time of writing.