In recent years, the demand for exchange-traded funds (ETFs) by institutional investors has increased significantly. Today, there is a vast array of exchange-traded products (ETPs) available - ranging from plain vanilla passive ETF index-trackers to sophisticated active risk factor ETFs. A special guest blog from Savvy Investor analyses the relationship between ETFs and institutional investors.
The impressive rise in total ETF assets is due, in part, to their adoption by institutions who are increasingly using ETPs to gain cost-effective exposure to geographies, sectors, themes, styles, philosophies or factors.
In this blog post, Andrew Perrins, CEO of Savvy Investor addresses the ETF world as it stands today from a cost, industry participation and regulatory perspective.
Widespread Industry Adoption
Although collective investment vehicles trace their origins as far back as the 1800s, one could argue that the beginnings of institutional adoption of collective investments began in earnest in the 1980s.
UK managers attending the Inside ETFs Europe Conference in London will no doubt recall the widespread employment of the industry staple unit trust and OEIC in the lead up to the millennium.
As the bull market of 1982 to 2000 facilitated increased demand for investment products that could track “the market” at low cost, the ETF was born with State Street Global Investors’ S&P 500 index tracking ETF - the “spider” (SPDR) launching in 1993.
In recent years, and as market structures have evolved, investor demand has become more specialist and sophisticated. Today, there are not only ETFs tracking indices and sectors, but also theme based products such as ESG ETFs or investment style products like factor ETFs.
The ETF has been well placed to benefit from this increase in market segmentation in the asset management industry. However, given this rapid evolution, managers need to be mindful of the evolving ETF landscape.
Fees
For institutional managers, minimising cost is crucial in order to support long-term net investment performance and to help prevent asset flight. Through industry growth and economies of scale, the competition for ETF assets across the fund management world has helped to lower costs significantly.
Historically, asset managers would have looked to the total expense ratio (TER) to measure how the management costs of a fund compare with other providers. However, as Kempen Capital Management point out in a recent Savvy Investor ETFs blog post, it is now TCO or Total Cost of Ownership which is regarded as a more inclusive metric of total fund cost.
"Total cost of ownership (TCO) captures extra costs that are missed by the TER such as bid/offer spread and gains from security lending."
Whereas TER represents a fund’s costs expressed as a percentage of its assets, the TCO represents the cost to transact as well as the cost to hold assets within the ETF. Transaction costs will consist of several variables: the width of bid/offer spread, cumulative effect of broker commissions, choice of execution venue and time taken to execute considering average daily volumes.
The holding cost, on the other hand, will constitute fund fees, performance fees and taxes. In the case of ETFs where securities lending takes place, this would also be viewed as a holding cost within a TCO framework.
Insurers Using ETFs?
Although widespread adoption of ETFs by the fund management industry has been commonplace for some time, ETFs are increasingly being utilised by the insurance industry.
"Approximately 70% of insurance companies now invest in ETFs in their general accounts."
A 2019 study from Invesco and Greenwich Associates found that approximately 70% of insurance companies now invest in ETFs in their general accounts. Life insurers, who are typically active in the fixed income markets having to manage risk in a basket of securities by themselves, are now turning to ETFs for liquidity and short-term cash management purposes.
In addition to life insurers, property and casualty insurers are also adopting the product in order to gain simple equity market exposure in a timely and cost-effective manner. For more detail on how insurance companies are using ETFs today, the S&P Dow Jones surveyof 1900 insurance firms provides a solid background.
Regulation
In a post MiFID II world where transparency and clarity are paramount, institutional investors need to remain cognisant of the fact that not all ETFs are created equal and differing rules regarding local taxes and the ETF’s domicile are complicating matters for managers.
"UK managers attending the Inside ETFs Europe Conference in London will no doubt recall the widespread employment of the industry staple unit trust and OEIC in the lead up to the millennium."
To illustrate the tax reporting issues in different geographies, earlier this year, Germany introduced new tax rules on collective investment funds to ensure that collectives were not treated more favourably than direct investments with reference to withholding tax.
Taxation in general will no doubt continue to be at the forefront of ETF providers’ minds as they develop their offerings in new markets such as China and other emerging markets.
As well as taxation, regulators are scrutinising ETF liquidity to ensure fair and orderly market pricing in times of market stress. As PWCpoint out in their Report of ETF Regulations and Taxes, the SEC’s “Reporting Modernization Rule” for the US and Europe’s MiFID II are particularly relevant.
For Europe, which has multiple trading venues and settlements, providers must demonstrate to regulators and investors adequate pre and post trade reporting where the majority of ETF trade occurs off exchange.
“Currently, the majority of ETF trading in Europe occurs over the counter ….. and liquidity is less visible.”
For the institutional investor, ETFs are now commonplace; but with fees, regulations and the number of institutions active in the product subject to change, it is imperative that managers stay up to date.
In summary, it may be stated that when buying an ETF, just like when buying a car, it is important to look under the bonnet to see that what you expected is present before you drive away.
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